Before you decide on buying rental property, it’s important to calculate the likely return on investment (ROI) so that you can work out if it’s worth your time, money and (considerable) effort. We’ll take a look at two investment property scenarios in two very different markets in Canada and calculate likely ROIs for each. We’ll also look at ways other than buying a rental property that can provide a consistent income.
How do you calculate the return of investment on a rental property?
ROI measures how much money you made from an investment over a given year, as a percentage of the initial amount of money invested.
There’s a simple calculation that lets you work out this percentage: you take the growth in the investment over the year, subtract the cost of the investment and then divide that figure by the cost of the investment.
So, for example, let’s say you invested $100 a year ago and now it’s worth $115. The calculation is:
ROI = (115 – 100) / 100
ROI = 15%
When you’re considering buying rental property, it gets a little more complicated to calculate the ROI, because you could invest in a property that you bought for cash or one that you bought using a mortgage. Also, some investors calculate ROI either including or ignoring the increase (or decrease) in the investment’s equity (the value of your property minus what you owe on it).
Let’s take a look at rental property ROIs for two markets: Toronto and Winnipeg.
The ROI on buying a rental property in Toronto
You might want to buy a rental property in Toronto because you’ve heard that rents are extremely high throughout the Greater Toronto Area (for example, rents in Brampton, just west of Toronto, rose three times faster than the national average in 2023). But will you get a good return on investment when you factor in the high price of real estate in this city?
For this example, we took the rental price of a condo ($2,400) and the selling price of an identically sized unit in the same building ($549,900). This way, we’ll be using realistic figures when it comes to anticipated rental income.*
First let’s look at the ROI when buying the condo with cash.
The apartment cost $549,900
Closing costs (including land transfer tax) were $18,000
The total cost of the investment = $567,900
Over the first year:
Rent earned = $28,800 (12 x $2,400)
Expenses over the year (property taxes and condo fees) = $10,440 ($870 per month)
Annual return = $28,800 - $10,440 = $18,360
Return on investment = $18,360 / $567,900 = 3.2%
Now, let’s take a look at what the ROI would be for the same property, but using a mortgage to buy it rather than cash. To calculate the mortgage payments, we used a fixed interest rate of 5%, an amortization period of 30 years (this is how long it would take to pay off the mortgage in full) and a down payment of 20%.
Down payment $109,980 (20% of $549,900 — the minimum amount for a rental property)
Closing costs $18,500 (extra $500 for the appraisal fee, as required by the lender)
Total initial outlay to buy the rental property = $128,480
The mortgage is for $439,920 ($549,900 minus the down payment of $109,980).
Monthly mortgage payment is $2,348
Monthly expenses = $870
Total monthly costs (mortgage payment plus expenses) = $3,218
Monthly cash flow ($2,400 - $3,218) = -$818
After 12 months, the annual return would be -$818 x 12 = -$9,816
ROI = -$9,816 / $128,480 = -7.6%
With this calculation, where the home was bought with a mortgage, you would get a negative return of 7.6% — your investment would be losing you money. However, this does not take into account the increase in the condo’s equity, so let’s look at that calculation.
With the above mortgage, after the first year, you would have paid off $6,551 in principal payments, adding $6,551 to your home’s equity (and the annual return).
Your total annual return would now be:
-$9,816 (from the previous calculation) + $6,551 = -$3,265.
The new ROI would therefore be -$3,265 / $128,480 = -2.5%
Even when including the increased equity in the home, in this situation, buying a rental property would still deliver negative returns in the current high-interest-rate environment. You might want to consider some other source of investment income or wait until mortgage interest rates come down considerably before going ahead with this plan.
Would Winnipeg, a considerably cheaper real estate market, offer investors looking to buy a rental property a better ROI? Let’s take a look.
The ROI on buying rental property in Winnipeg
For this example, we took the rental price of a condo ($1,460) and the selling price of an identically sized unit in the same building ($197,500). Let’s test out the theory that investing in a property in a cheaper market would bring a better ROI.
Once again, first we’ll look at the ROI when buying the condo with cash.
The apartment cost $197,500
Closing costs (including land transfer tax) were $2,500
The total cost of the investment = $200,000
Over the first year:
Rent earned = $17,520 (12 x $1,460)
Expenses over the year (property taxes and condo fees) = $8,052 ($671 per month)
Annual return = $17,520 - $8,052 = $9,468
Return on investment = $9,468 / $200,000 = 4.7%
So, perhaps surprisingly, the return on the much cheaper Winnipeg property was only 1.5 percentage points more than the Toronto condo. Now, let’s take a look at what the ROI would be using a mortgage to buy an identical rental property, rather than cash (using the same mortgage calculations as in the Toronto example).
Down payment $39,500 (20% of $197,500)
Closing costs $3,000 (extra $500 for the appraisal fee, as required by the lender)
Total initial outlay to buy the rental property = $42,500
The mortgage is for $158,000 ($197,500 – down payment of $39,500).
Monthly mortgage payment is $843
Monthly expenses = $671
Total monthly costs (mortgage payment plus expenses) = $1,514
Monthly cash flow ($1,460 - $1,514) = -$54
After 12 months, the annual return would be -$54 x 12 = -$648
ROI = -$648 / $42,500 = -1.5%
Surprisingly, when buying this rental property in Winnipeg using a mortgage, you would also get a negative return. Let’s see what happens if we take into account the increase in the condo’s equity.
With the above mortgage, after the first year, you would have paid off $2,353 in principal payments, adding $2,353 to your home’s equity (and the annual return).
Your total annual return would now be:
-$648 (from the previous calculation) + $2,353 = $1,705.
The new ROI would therefore be $1,705 / $42,500 = 4%
The other costs involved in calculating the real ROI of buying rental property
Apart from utilities, insurance, property taxes and condo fees (all included in the calculations above), there can be other, variable costs involved when owning property, which could reduce your ROI even further.
- Maintenance costs can put a serious dent in your ROI in any given year, if it’s something major, like a new roof or furnace.
- You may need to redecorate your property fairly regularly to keep it rentable.
- If you buy a rental property that’s a condo, you have to abide by the condo board’s decisions when it comes to repairs and renos on the whole building, and will have to pay your share. If it’s an older building, this can be substantial.
- Vacant units: if your property is empty for any period of time, this will reduce your income and therefore reduce your ROI.
Also, if you want to avoid the headaches of being a landlord (advertising for new tenants, showing them the unit, vetting them, dealing with complaints, receiving rent payments every month, etc.) you might choose to use a management company to do all of that for you. This, however, could reduce your income by as much as 20%.
Taking into account changes in real estate values
In these calculations, we haven’t included the impact of changing property values. While these have gone up considerably over the long term (especially in recent decades), they aren’t a guarantee.
If you’re buying rental property for the long term, you may want to include projected home equity growth into your ROI calculations but be aware that these would just be projections. High property value growth in the past isn’t a guarantee that it will happen in the future.
Taxes when buying rental property
Rental income (minus applicable expenses) is taxed at the full marginal tax rate. Depending on your other income, this could be as much as 53% of your rental income, if you live in a province such as Ontario.
Compare this level of tax with what you might pay on other types of investments. While you would pay the same rate of tax on interest from bonds or GICs, you would pay considerably less tax on dividends earned from Canadian companies. Also, taxes on capital gains (the amount your investments grow by) are only taxed at half of the full marginal tax rate.
Therefore, there could be a situation in which your gross return on investment would be higher after buying a rental property, but your net (after-tax) ROI would be higher after investing in equities.
The problem of liquidity when buying rental property
Of all the available investment options, buying rental property is potentially the most illiquid (the most difficult to turn into cash). If you ever need to urgently turn your property into cash, several factors could slow this process down:
- Finding a suitable realtor to list it.
- Finding a buyer.
- Holding on for the “right price”, especially if it’s a buyers’ market.
- Going through the closing process.
On top of this, when you sell, you’ll have to pay realtor fees, which can be as much as 5% of the selling price, depending on the agents involved and where you live. This can have a considerable impact on your final overall return on investment.
Alternative ways to earn investment income
If you’re considering buying rental property to provide a regular income, there are other investment options that are specifically designed to do just that. They could also bring you a better return on investment while letting you dodge the headaches that can come with being a landlord.
You can find out more about how to turn your investments into retirement income here. Bond portfolios and dividend-paying equities are two options, but income-generating mutual funds could be the most appropriate strategy for you. These can provide a regular annual income of up to 5-6% of your investment’s value. However, they also have the potential for growth, as they contain a substantial amount of equities, while also being designed to provide greater stability and tax efficiency than general mutual funds.
Talk to your IG Advisor about how the iProfile Enhanced Monthly Income Portfolios — Canadian Fixed Income Balanced and Canadian Neutral Balanced — could be good alternatives to buying rental property. Your advisor will also be able to recommend the best one for your circumstances and also ensure that it fits in with your overall financial plan. If you don’t have an IG Advisor, you can find one here.
* All examples given in this article are hypothetical. Each investment property opportunity should be scrutinized separately.
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