What Real Estate Investment Strategy Provides The Highest Returns?
Video Transcript
If your goal is to make the highest and best use of your capital in real estate, what should you do? Here are three strategies:
- Buying and holding (and do nothing else)
- Taking profit of your property and buying a bigger property every 5 years
- Refinancing every 5 years to add an extra property to your portfolio
Out of the three strategies, which one provides the best total returns? I’ll be comparing them one by one and along with a financial comparison to show you which strategy will put your capital to highest and best use!
Strategy 1: Buying & Holding
Buying & holding for 10 years has the least amount of work and also the lowest transaction costs of the three options. Each time you buy and sell a property, you have to pay land transfer taxes, legal fees, and each time you sell a property you have to pay agent fees and HST, and these can add up to almost 10 percent of your property’s price. But there’s two issues that limits your returns:
- As time goes on, your mortgage amount decreases and rental income increases, so you’ll have more cash flows which is great. The problem here is cash flows alone might not be enough for you to buy another property so you can’t get the same returns on this accumulated cash flow.
- You build up equity and appreciation over time – the problem is it’s stuck in the property so it’s not invested efficiently.
Another way to look at this is that as your equity increases over time relative to your mortgage – lower leverage means lower rates of return over time. For example, when you start with a 20 percent downpayment, you’re 5 times leveraged. If annual returns are 7 percent on the property, you’re essentially getting 7 times 5, or 35 percentage returns on your capital in year 1.
But closer to year 10, your loan is now only a third of the property’s market price, and you own the remaining two-thirds, so you’re only one and a half times leveraged. With 7 percent annual returns times 1.5 leverage, your returns are closer to 10.5 percent on your capital. Your risk has dropped significantly compared to what you started with, and so have your returns.
Summary: If I were to summarize the buy & hold strategy, I would say there’s a higher retention of equity combined with declining rates of return over time.
Strategy 2: Taking Profit Every 5 Years
Taking profit and buying a new property every 5 years allows you to put your money to better use. When you buy a new property, you’re essentially restructuring your equity so you can improve your leverage and returns. Now there’s also two issues with this strategy:
- Every time you sell a property, there’s high costs related to land transfer taxes, legal fees, selling fees and HST.
- When you sell a property, it triggers capital gains tax with the government. This also reduces the amount of equity you can put into your next property.
I would say strategy 1 and 2 are opposites of each other. It’s hard to tell which one is better if you don’t crunch some numbers which I’ll do at the end.
Summary: If I were to summarize the strategy of taking profit every 5 years, I would say you have lower retention of equity combined with more stable rates of return.
Strategy 3: Refinancing Every 5 Years
Refinancing and restructure every 5 years is kind of a hybrid of the other two strategies . When you refinance, you can access & reinvest the equity in your existing property without triggering selling fees and capital gains tax.
Somewhere down the road when you decide to sell your investments, you’re still responsible it but it’s deferred. The negative here is that refinancing means you’re borrowing money the money even though you technically have the equity, so your interest expense is higher than the other strategies.
Summary: For the refinancing strategy, I would say there’s higher retention of equity combined with stable rates of return (but you also have the highest costs).
Financials For Strategy 1: Buying & Holding
The gross return is the total of all cash flows, equity gained, and market appreciation throughout the 10-year investment period.
We have to pay selling costs (assume 4.5 percent of purchase price + HST) and closing costs (land transfer tax + legal fees) and they are deducted from the gross returns. We also deduct capitals gains tax (assume 25 percent of gains).
So, we’re left with a 10-year total net return of $586,000.
Financials For Strategy 2: Taking Profit Every 5 Years
You buy the same property as strategy 1, but you only hold it for 5 years before you sell the property. Because you’re selling, you have to pay selling costs and capital gains tax at the end of year 5, which leaves you with a total 5-year net return of $237,000.
You take the $237,000 proceeds that plus the original property’s downpayment of $160,000 to buy a bigger property with 20 percent downpayment. You hold this property for years 6 to 10, then you sell it. Following the same calculations, the new property’s total net return after deducting all costs and taxes is $471,000.
When we add up the returns of both properties, we have a total 10-year net return of $708,000 – and this is better than strategy 1!
Financials For Strategy 3: Refinancing Every 5 Years
For the refinancing strategy, we’re also buying the same first property. The difference between strategy 2 and 3 is that we’re not selling the first property like what happened in strategy 2, but keeping it for entire 10 years. This means the total 10-year net return for this property is the same as strategy 1 which is $586,000.
This also means anything extra you make from the second property is bonus, so even without looking at numbers, it’s already better than strategy 1.
At the end of year 5, you refinance the first property to take out $178,000. Assuming the same interest rate at 2 percent per year for 5 years, the total borrowing cost for this is $17,000.
Now, you use the refinanced money of $178,000 to buy an extra property and the total net return for this property from year 6 to 10 is $242,000.
So when you add up the net return for both properties minus the extra cost of refinancing, the total 10 year return for strategy 3 is $811,000 – so this is our clear winner!
If your goal is to put your money to highest and best use, then you’re want to preserve your equity as best as possible. You should also restructure your portfolio if there’s significant changes so you can maintain your leverage and rates of return.
The benefit of refinancing is that you defer the bulk of your costs to the very end since you aren’t actually selling anything, so your returns will snowball much quicker with a bigger base.
Refinancing rates are low compared to what you can get with real estate returns, so it’s definitely something to consider if you want to maximize real estate returns.
When you’re considering refinancing, you need to make sure you’re not stretching yourself too thin and over leveraging. Positive cash flows are key to have a sustainable long term real estate portfolio that can withstand fluctuations in the market.
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