Do the math, and you can see this property runs cash-flow negative by $6,716 per year or about $560 per month. Sounds brutal, right?
If we assume the investor does not claim depreciation on the property, there is also tax payable on the net rental income. Depreciation—called capital cost allowance—can be used to bring your net rental income down to zero, but not to create a loss. However, upon sale of the property, your previously claimed CCA is brought into income and typically taxed at a high tax rate.
Despite running at a loss in this example, the mortgage principal payments of $10,939 are not tax deductible, so the property has a positive net rental income for tax purposes. Tax payable based on a 35% tax bracket (about average at $75,000 of income across the country) would be $1,478. That means the owner has a net cash-flow outlay of $8,194 in the first year to carry the rental property after tax.
For this property to be cash-flow neutral, an investor would need a down payment of about $220,000 or 44%; or, after considering taxes and assuming no CCA, they would need about $275,000, or 55%.
Other financial considerations besides cash flow
But cash flow is not necessarily the best way to assess the numbers. Here is how I would evaluate the property as an investment.
With a purchase price of $500,000, the property actually costs $508,170 including land transfer tax and legal fees. If the property grows, at 3%, to $515,000 after the first year, and the $400,000 mortgage is paid down to $388,135, that means $126,865 of net equity. The buyer invested $108,170 ($100,000 plus the land transfer tax and legal fees) upfront, plus the $8,194 net cash flow loss after taxes. That is a cumulative investment of $116,364 that is now worth $126,865—representing a 9% return. Of course, that return is all just on paper because to sell there would be transaction costs of 4% to 5% of the property value, turning the gain into a loss in no time.
What do the numbers look like after 10 years? By this point, the buyer’s cumulative investment is $188,555 including future annual cash-flow shortfalls, which would yield $398,700 of net equity and a continued 9% tax-deferred annualized return.
Over 25 years, the annual return would fall to about 7% due to the decreasing leverage and reduced mortgage interest deductions.