Real estate investors in Toronto (or any other hot market) know that the returns from capital appreciation far exceeds cash-flow – and this becomes an attractive trap to fall into.
And that’s fine if you want to roll the dice and get a little money quick. But if you’re looking to build long-term sustainable wealth – the kind that funds your retirement and gives you the financial freedom you dream of – then cash-flow is crucial.
To fully understand why, we’re going to consider three perspectives: investing vs speculating, assets vs liabilities, and cash-flow vs appreciation.
Investing vs. Speculating
Benjamin Graham, the godfather of value investing and Warren Buffet’s mentor, defined investing as follows:
“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”
By Graham’s definition, buying real estate based primarily for capital appreciation on the assumption that prices will go up is speculating.
The reality is that all markets go through corrections at some point so speculators who don’t time things correctly risk losing everything. So if you’re serious about creating long term wealth, then you’ll want to focus the bulk of your portfolio on investing rather than speculating.
That isn’t to say that you can’t make a lot of money speculating – because you can (and we have!). But keep those speculative bets on the smaller side and always be prepared that they won’t all work out.
Assets vs. Liabilities
The Investorpedia defines “asset” as:
“a resource with economic value that an individual, corporation or country owns or controls with the expectation that it will provide a future benefit.”
But we prefer how Rich Dad Poor Dad’s Robert Kiyoskai sees it:
“Assets put money in your pocket, whether you work or not, and liabilities take money from your pocket.”
Hence a real estate investment that is not cash-flow positive is not an asset, but a liability.
(We do not include the development phase in this category because there are no expenses on the deposit – but a condo that is has negative cash-flow of $500 per month will still certainly feel more like a liability.)
In times of rapidly rising prices, “investors” are prepared to pay premiums for assets but as soon as the expectation of price appreciation goes away, they will quickly sell off the asset – even at a loss – rather than keep an ongoing liability.
Cash-flow vs. Capital Appreciation
Focusing on chasing cash-flow or yields alone is not necessarily the answer.
Yields in growing markets like Toronto, where there is high population and job growth, will always be lower than in weaker markets, where investors require higher returns to offset other risks. So for example, if Toronto has cap rates (meaning yield over one year assuming the property was purchased on cash) around 3%, then weaker markets will have cap rates as high as 10%.
So why not just buy in weaker markets? Because those markets almost always have higher vacancy rates and are far less liquid. Meanwhile, vacancy rates in Toronto have been less than 1% for years and homes are selling in less than a week.
And finally, in those high yield markets, there is often a loss when selling because the appreciation has not been strong enough to cover the transaction costs and fees.
THE BIGGEST MYTH: You can’t be cash-flow positive in Toronto?
We hear this all the time but you 100% can be cash-flow positive in Downtown Toronto – and it’s our favorite type of investment to make.
In general, we believe the best way to do so is by investing in pre-construction condos because you are will be buying future real estate at today’s prices.
The Woodsworth condos in the Fashion District is a perfect example. It’s already in the heart of Downtown, so there’s strong appreciation and no shortage of renters but on top of that: the developer is guaranteeing positive cash-flow at $6/PSF for 2 years.
We are personally investing in this property and you would be insane not to consider it too. This is an incredibly rare Downtown property where positive cash-flow is guaranteed.