4 Types Of Toronto Real Estate Investors: Which Type Are You?
Your first step, before you start looking for specific properties to invest in, is to take a step back and figure out your investment goals. Of course, it’s good to get higher returns but these investments also come with higher risk. So, this means maximizing returns might not be the right investment goal for everyone.
In this video, we’ll talk about the 4 main types of real estate investors in Toronto and how their risks, cash flows, and returns might vary.
Jumping right into things, these are the four types of real estate investors that I’m going to talk about. Like the name implies, conservative investors are those who take on the lowest amount of risk for the most stable but likely lowest returns.
Typically, investors in this group might be those close to retirement or have retired, and so the main objective of their investment is to provide regular cash flow to support their ongoing lifestyle. They don’t need to grow their wealth but rather want to preserve it at least hedge their net worth against inflation. Usually, there’s also preference for better liquidity, so that they can cash out of their investments more easily at any given point in time without big negative implications.
One step up this list is the group that I call balanced investors. These investors take on a bit more risk for better returns. Instead of being focused on maximizing cash flows and liquidity, they are fine with a more balanced approach with returns coming from a more even distribution of appreciation, rental income, and leverage.
Leverage lets you use borrowed money to grow your returns faster. But if there’s a loss, it grows your loss and increases your investment risk. The other thing is that because you’re using some of your rental income to service your monthly mortgage payments, monthly cash flows will be lower than the conservative investors, so you’d likely need income coming from other sources as well.
Going further up the risk ladder are our growth investors. These investors make good income, but like to keep it safe and make sure their investments service themselves. In other words, rent you get should be enough to pay for all of your expenses and your mortgage, so nothing needs to come out of your pocket.
One trend in real estate investments is that properties with higher appreciation typically have lower rent yields. As a whole, the average returns for higher growth properties are better, but because there’s a bigger weight on appreciation which fluctuates more than rental income, it’s inherently higher risk. This means that if the market swings the other way and you need to cash out quickly, there’s a chance that you might be selling for loss especially in the short term. If you hold it long enough, you should be better off than those who take on lower risk. Growth investors also take on higher leverage, which further magnifies your returns and your risk level.
Finally, the last type of investors are even more aggressive, which is my I name them unoriginally, “aggressive investors”. These investors also have good income and likely no dependants or much lower monthly personal expenses than the growth investors. So, aggressive investors tend to be able to stomach the biggest real estate risks out there. Essentially, these investors are looking for properties with the highest growth potential maxing out their leverage, for the best possible returns possible and possibly negative cash flows.
If you’ve watched my video before, of course you know I’ll probably dive into an example with some numbers to help you visualize how actual risks, cash flows are returns might differ. To keep things simple, let’s assume that we have the same $500,000 to invest in for all investor types. To narrow the scope down even more, let’s zero in on investing in houses.
Our conservative investors have the lowest risk tolerance, need the highest liquidity and cash flows, and so the search usually lands with properties that see the lowest price fluctuations out there. In this case, we’re going to go with buying a house not in Toronto, for $500,000 with cash to remove the higher risk of leverage. The cap rate, in other words, the net rent yield, on this house is very good sitting at 5%, which is higher than what we typically see in Toronto houses at around 3.5 to 4%. On the other hand, average appreciation is much lower than Toronto, sitting at just close to inflation at 3%. So in the most average case, our conservative investor’s annual return is 8%.
But remember, these investors’ main goal is cash flows, wealth preservation, and liquidity, and the main benefit of this house is that prices are very stable. So if there’s a downturn, we might see appreciation dip down to 1%, which means the principal is still protected and the total return isn’t far off at 6%. On the other hand, if there’s a market rally, appreciation might go up to 5%, which takes total returns up to a better 10%. You’ll soon see that the range in returns on this sample property is lowest, only fluctuating between 6 to 10% in any given year. Based on a $500K investment, we have a monthly cash flow of around $2,000 and an annual return of between $35,000 to $45,000.
Let’s take a look at our balanced investor. Remember, this the one with a better balance of appreciation, rental income and leverage. In this case, the cap rate is a bit lower at 4.5% but appreciation makes up for it at a higher 4%. So if you look at the total returns before leverage at 8.5%, it’s better than the conservative investment at 8%. These balanced investors are also okay with taking on some leverage. So in this sample property, our balanced investor will use 50% of borrowed money at an interest rate of 2.5% to buy a $1M property. Because they have to pay for the mortgage payments, cash flows drop to 1.3% of the purchase price each month.
The benefit with choosing a more balanced investment is that you have better returns before leverage, and it gets better with leverage. After two times leverage, you’re looking at an annual ROI of 14.5%. Just note that appreciation does fluctuate more in any given year. This means that if you need to cash out in the short term, you might end up making less on the sale compared to the conservative investor.
For example, if you end up having to cash out in the first year and it turns out it’s a downturn, then you might be faced to no appreciation for the balanced investors, whereas the conservative investors might still see a 1% appreciation. The good thing is that if you are able to hang onto it for a longer period of time, your average returns are likely much better at 14.5% per year instead of 8% per year. Based on the same $500,000 investment, you’d see monthly cash flows on this sample property of around $1,000 and the annual return might vary between $32,500, which is lower than the conservative investor, to $112,500, which is much higher than the conservative investor.
Next, let’s look at a sample property for our growth investors. These investors take on better growth opportunities. So, in our sample property, you might see cap rates closer to 4% and appreciation better at 5%, which offers better average returns before leverage compared to the balanced investor. Growth investors typically also take on more leverage for even better returns. Based on a 35% downpayment, we’d see cash flows closer to break even, and total average returns after leverage of 21%, which is better than the conservative and balanced investors.
This property has bigger price fluctuations, so in the short terms it’s possible to sell for less than what you paid for. Once you factor in higher leverage, you see bigger swings in your annual ROI. This property is sitting higher on the risk ladder. With $500,000 of investment capital, you can expect your returns to swing drastically from $16,000 to $195,000 in any given year.
Finally, let’s look at a sample investment property for our aggressive investors, who choose the best growth potential and highest leverage. These properties might see the lower cap rates of 3.5% but better average appreciation of 6%. In other words, this sample property has the best returns before leverage. This investor maximizes leverage with a 20% downpayment, so after paying for operating expenses and the mortgage, the aggressive investor sees around -$1,000 of cash flows each month in this example.
Now, we said this property has the best appreciation but also the biggest swings in price. On a downturn, perhaps we might see a 3% drop in price so these types of higher risk investments make sense if you can hang onto them for the long haul. In the long run, average returns are the best at 37.5% or 187,500 per year, but can also range drastically going from negative returns to high double digit returns in any given year.
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To summarize it all, the cash flows are usually best for the conservative investors, and the average returns are usually best for the aggressive investors. What’s important to see is that the risk level will increase as your potential returns grows. In other words, you’ll want to make sure you’re still comfortable financially when things turn south, with negative cash flows and negative short term returns, in exchange for better long term performance.
As you can see, what you choose to invest in will depend on your financial situation and risk tolerance profile. Even if we look at the same amount of investment capital and zero in on strictly houses, there are still very many options out there. This makes choosing the right investment property especially confusing for new investors, and it can still confuse experienced investors who are facing changing life stages.
So if you want an expert to help you hash things out, we’d be happy to help! We can look at your specific situation and then match you up with the best investment property that fits your needs. After we help you buy it, our team also provides renovations guidance, leasing and property management if you need it. Just connect with us if you want to learn more about our services
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