A Rental Condo as an Example of the Only Way to Think About an Asset

I live in Vancouver. A perfectly true stereotype of people in Vancouver is that they are obsessed with real estate as an investment. People in Vancouver love to talk about how real estate is the best investment since sliced bread. Real estate can be a good investment, but it depends entirely on the price you pay. As a famous investor once mused: “at what price and on what terms?” What determines the returns you receive on an asset? The returns you receive on any asset depends entirely on the price you pay. Let me show you by using a rental condo as an example.


 

Let’s imagine that you can generate a net profit of $10,000 per year from a rental condo. That is, after you’ve paid taxes, insurance, strata fees, and maintenance costs, you can pocket $10,000 per year in pure profit.

The return you will receive from your rental condo will depend entirely on the price you pay for the asset. Take a look:

  1. $100,000 = 10% Return
  2. $200,000 = 5% Return
  3. $300,000 = 3.33% Return
  4. $400,000 = 2.5% Return
  5. $500,000 = 2% Return
  6. $600,000 = 1.67% Return
  7. $700,000 = 1.4% Return
  8. $800,000 = 1.25% Return
  9. $900,000 = 1.11% Return
  10. $1 Million = 1% Return

Now, it doesn’t take much to realize that this rental condo is a steal at $100,000 and a disaster at $1 million. The return you will receive on your investment will depend entirely on the price you pay for the stream of profits your asset will generate.

You can extrapolate this to any asset.


A stock, for example, is a piece of ownership in a business. The price you pay for that ownership of a business through the purchase of a stock will determine the returns you receive. It’s true.

A stock isn’t some piece of paper that fluctuates in value every second of the day. Well, it is. But it legally represents a fractional ownership of a business, and that fractional ownership entitles you to a share of the profits that business generates.

Hypothetically, if McDonalds only had 1 stock and you owned it, you would be the sole owner of McDonalds and would be entitled to all the profits McDonalds generates.

In 2013, McDonalds had net profit of $5.58 billion. I’m over-simplfying here, but as the sole owner of McDonalds, you could have pocketed that $5.58 billion and gone off and spent it in any which way you so desired. Perhaps you would have spent it buying $5.58 billion worth of rental condos?

Of course, this is not the case in reality. Rather than 1 stock, as of 2013, McDonalds had 990,400,000 outstanding shares of stock. That means the net profit was divided by the total number of outstanding shares. If you owned only 1 share, you were entitled to 1/990,400,000th of the profits – this worked out to $5.55. The more shares you owned, a bigger slice of the business you owned, and a bigger slice of the profits you got.


Your job as the investor, is to determine whether the cash stream that an asset is going to generate for you is worth the current entry price of ownership. The price you pay will entirely determine the returns you receive. If you overpay, you will get dismal returns. If you can get a great deal, you will get fantastic returns. Always ask yourself “at what price and on what terms?”

13 thoughts on “A Rental Condo as an Example of the Only Way to Think About an Asset

  1. Steve,

    Belgium is very much like Vancouver in that everyone believes real estate is the be all and end all of investments. So much so that housing prices have never ever gone down on a yearly basis.

    Now, I understand that from the perspective that you buy a house to live in yourself, but not always as an investor who is looking to realise passive income. When I ask about the numbers behind their rental properties, many people generate at most a 3% return. To me that is ridiculously low even with the appreciation of the assets over time. Such a low return is not worth the hassle and amount of time managing rental properties demand.

    Good old business ownership ftw!

    Cheers,
    NMW

    1. I would imagine that the majority of people in Vancouver with rental units do not earn returns above ~3-5%.

      For example, our condo, was last listed publicly in 2013 for $350K. Let’s say our current landlord bought the unit for $350K after all expenses, etc. Based on what we pay in rent per year, before taxes and other expenses, it’s a 4.1% return on investment. I would imagine it’s somewhere between 3.5% ~ 4% after taxes and expenses.

      Now, in an opportunity cost analysis, this is terrible, imo. For the risk you assume, you are compensated between 1% – 1.5% above the risk free rate: the risk free investment being a 30 Year US Treasury Bond yielding 2.4% (as of 1/16/2015).

      Don’t get me wrong, it all depends on what your goals are for your investments. If our landlord is content and happy with the risk assumed and the returns his investment generate at current prices and rents, who am I to argue.

      But if one is looking for superior returns on invested capital, you should pass on owning this condo as a rental unit at current prices. There are so many other, more attractive opportunities.

  2. Agreed. People here in the UK are also obsessed with buying their own property. Prices on nearby Cambridge never went down, crap poor the economic crash a few years ago, and in fact, they’ve been high for several decades.

    1. Diageo plc – makers of Guinness, Johnnie Walker, Captain Morgan, Smirnoff, Crown Royal, Bailey’s, etc – has an earnings yield of 4.9% and a dividend yield of 3.9% based on ttm.

      Based on the calculations I did for NMW below on the yield our landlord receives for the condo we rent, it’s a no brainer to me that Diageo plc is a much better investment (even at current prices of ownership) than our condo as a rental unit based on price to pay for entry of ownership and the earnings generated by the investments.

  3. It’s always important to step back and evaluate the investment before you put down the money. A lot of people are just too emotional when it comes to investment, this is especially true for a real estate property. Some people see a place, fall in love with it, and would get the property at whatever cost. That’s not too smart especially when you’re using the property for rental.

      1. I think the local real estate market is a bit high but so is most of the Canadian market. Having said that, Canada reminds to be quite high on most desirable places to live. People will continue wanting to own a place in Vancouver. There’s not going to be more land, so the land value will continue growing I think.

  4. I think people in Vancouver love real estate because it seems to defy logic – just when you think it can’t go any higher it does. No job increases, positive net migration or any core economic fundamentals that would normally mean an increase in prices. Another obvious reason people like real estate is that it tends to magnify gains when the market goes up. Since most people only pay for a portion of the house using a down payment the rest is borrowed which means the gains from an increasing market are amplified. Thats fine when the market is going up, but it also works the other way when the market goes down. Who knows where the Vancouver market is headed this year though

    1. Who knows how long an irrational market can go on for. The tech bubble built up for over a decade. The most prudent approach is to continue using rationality and logic as others let emotions sway. We are planning on buying a townhouse in the next few years and the purchase will be approached not as an investment, but a lifestyle choice – a suboptimal use of capital that is being “invested” because we choose to live the lifestyle of home owners.

      1. Steve, so having never been to Vancouver I don’t know the market (except that it is very expensive). However, my question is how far out to people go for the suburbs? Is it common for a 45 minute drive into work each day? And are those suburbs more or less expensive than condo’s / townhomes in the city? Living in the Midwest US real estate is cheap.. and honestly I would think that it should be that way in Canada. Baisclly my thought is regulation / zoning keeps the real estate supply low? Is this true? The cost to build is directionally similar in any city .. it is the land and number of units per said area of land that are expensive / scarce. Thanks for any feedback!

Leave a Reply