For the average investor, building up your real estate portfolio takes time and patience. Every journey starts with a single step, and the single most important step in building your real estate investment portfolio is buying your first property.
Unless you have access to large sums of cash, saving up for a down payment on your first home can be hard, especially if you’re currently renting and paying as much or more than you would on a mortgage already. Despite how hard this process can be, saving up your first down payment and buying your first property is crucial to your long term success, and gaining the eventual advantage of purchasing power most seasoned investors possess after many years in the business.
Fortunately, once you’ve purchased your initial property and have let it mature for an appropriate amount of time, purchasing additional properties can get easier the further down the real estate road you travel. Where you once had to scrimp and save every spare penny from your own personal income to come up with a down payment, you can now start to access additional equity that has built up in your home to buy further properties, without having to dip into your household income.
Here’s how it works:
Let’s say today you buy a house for $325,000. You’ve socked away every spare dollar you could to come up a 20% down payment of $65,000 and the remaining balance on your mortgage is $260,000.
Assuming you sign your mortgage for a 5-year term at a fixed rate of 2.74%, your mortgage principal would be reduced by about $7000 each year. After the 5-year term, the balance left owing would be $225,000.
Now let’s assume your house will also appreciate at a conservative rate of 3% each year. The trick here is to purchase into a market where this kind of appreciation or higher is likely to happen. With so many positive things happening in Guelph right now, such as the lowest vacancy rate in the entire province for 5 years in a row, and with Guelph just being named #1 for jobs in Canada by the Globe and Mail, I’m not sure why you would search anywhere else! But wherever you decide it is best to purchase, just be sure to buy into what you foresee being an inflating real estate market.
So at the end of the 5-year term, the house you bought for $325,000 would now be worth $375,000.
When you go to renew your mortgage at the end of the 5-year term, instead of just signing for another 5 years at the same mortgage amount ($225,000) you tell the bank that you wish to have your home reappraised and borrow against it’s newly appreciated value. This is called refinancing.
Most banks will only lend up to 80% of the newly appraised value on a “refi”, so in this case they would be willing to lend you a maximum amount of $300,000 against your home that has been evaluated at $375,000. Because you already owe the bank the original mortgage balance of $225,000, the bank would cut you a cheque for the difference, which in this case would be $75,000.
That’s right, the bank would cut you a cheque for $75,000!
I want to take a moment to point out the fact that this $75,000 did not come off your monthly income and in no way came out of your household operating budget. What happened was, because you owned a piece of real estate that was consistently going up by 3% each year, and which had a reducing debt against it, you “rode the market” and were able to capitalize on it’s overall equity increase without having to sell your home.
This is how many investors, especially ones that don’t have access to large sums of cash from a high paying job, an inheritance, wealthy family members, etc. are able to purchase properties much easier than someone who has never owned or is just starting out in real estate. Their properties make the money for them, and the more properties they have, the more money they make.
So now that you’ve got your cheque for $75,000 from the bank, let’s take this one step further:
Assuming your dreams are to own multiple income properties and expand your real estate portfolio, the only logical solution would be to use that $75,000 for a down payment on your second home.
Let’s say you take the entire $75,000 and use it as 20% down on a home worth $375,000. Now you own two properties, both going up in value and both having the debt against them reduced.
At the beginning of the two new terms, collectively, you would own $750,000 worth of real estate and you would owe the bank $600,000 for both mortgages.
Because your goal is to pull additional equity out of these two properties as fast as you possibly can to reinvest it into more homes, you sign both mortgages for only 3-year terms instead of 5-year terms.
Again, we’ll assume both properties go up by a conservative figure of 3% per year and each mortgage gets paid down by $7000 each year. At the end of both 3-year terms, your $750,000 in combined real estate would have grown to $820,000 and your combined mortgage amounts owing would have been reduced to $558,000.
So, 80% of $820,000 equals $656,000, minus your $558,000 amount still owing on both mortgages, gives you $98,000 in surplus equity that you can pull out and continue your cycle of investing.
As you can see, once you start owning multiple properties it can create a snowball like effect of appreciating assets and reducing debt loads. The more homes you own that are increasing in value and debts loads that are being reduced against each property, the more purchasing power you will ultimately have in a shorter period of time. In the scenario above, you were able to acquire 30% more equity with two properties in 3 years than you were with one property in 5 years. The math just simply makes sense. Imagine what owning 5 or 10 properties could do for you.
Now, to be perfectly fair here, just because you have the additional equity required to buy more and more real estate does not necessarily mean you will be granted mortgage after mortgage with no holds barred. At some point along the way almost every investor will run into challenges with their TDS or Total Debt Service ratio. Without getting too technical, this basically means that most A lenders will assess the income you generate and compare it to the debt that you are responsible for and may refuse to lend you any more money based on normal lending circumstances. This isn’t the end of the world, nor does it mean you have to stop investing, it simply means continuing on the path you’ve set out for yourself may begin to pose new challenges you did not face in the beginning.
Regardless of the challenges you will almost inevitably face, think about how this cycle of borrowing on properties to purchase further properties could benefit you 10, 15, 20, or even 30 years down the road.
Think about if the markets went up by 5% or even 8% some years instead of the conservative 3% figure we used in our example. I know for a fact certain niche markets in Guelph have jumped higher than that in one year. Take, for instance, what happened between 2013 and 2014 at 1055 Gordon St in Guelph. In just one year the average sales price of those particular townhouse units rose from $285,000 to $327,750! That’s over $40,000 in average sales price increase in just one year, representing 13.04% increase in equity. All I’m saying is 3% is a nice conservative figure to use, but having your property appreciate more than that is possible – especially in a prosperous real estate market such as Guelph’s. Even if you had one or two years where prices went down, chances are if you stick to your plan you will come out much farther ahead in the long run.
As your portfolio continues to mature, a world of opportunities begins to open up, and it was all made possible because you worked as hard as you could to save up for your first home and decided to put a plan into action that would take care of you for many years to come.
For the patient investor that is willing to put in the time and effort to see this plan to the very end, the rewards can be well worth their wait!
Until next time, Happy Investing!