AMA - BRRR in Toronto?

Evan from Toronto asks,

My wife and I, along with our Real Estate Partner, are looking to buy our first rental property in the GTA by the end of the year! We really like the BRRRR strategy but have some questions since we've never used it before!

1. What have you found is the best way to structure private lending?

2. What are the top three things that can go wrong?

3. How do we find comps in smaller/more rural neighbourhoods?

Evan, this is a great question. But before I answer your specific questions, I want to set the context so that you look at the opportunity the right way.

You see the prices in Toronto are so high that it’s almost impossible to charge enough rent to recoup your investment in a reasonable timeframe. You end up tying up too much cash in the equity of a home in order for the numbers to make sense.

The driver for housing in Toronto has been population growth. The city has added about 125,000 population a year and has only added about 35,000 units of new construction a year. The supply isn’t keeping pace with the demand which is why prices keep increasing, commute times keep getting longer, and the boundaries of the city keep expanding.

When you’re paying $700,000-$800,000 for a townhouse, it’s hard to charge enough in rent to cover the cost of financing this project. The ratios are too far out of whack.

What is working in the Toronto market is to renovate with a sale to an end-buyer as the exit strategy.

You can go to lower density more rural areas, but they’re a long commuting distance from the core of the city. Low density also means low demand. There is so little developable land within commuting distance that the land is worth a lot of money. Construction is cheap by comparison.

I personally don’t think the BRRRR strategy works in Toronto.

Of course the market is in a strange state right now with the Covid-19 pandemic still affecting the market. We have less immigration which has been a traditional demand driver in Toronto. We also have a lot less foreign investment in the market.

The key to buying a suitable property in the Toronto area is to buy at a sufficient discount and to add enough value. You see in Toronto the municipal development charges, what are called impact fees in many cities are incredibly high. For a single family home you’re looking at a fee of $84,000 depending on the area in which you’re building a new home. So two identical houses side by side could differ in cost by $84,000. One is new construction and the other is replacing an existing house. You can do a lot of renovation for $84,000.

You could take a single story house, cut off the roof, add a second level and more than double the value of the house, without doubling the cost of the house.

You want to see what is working in an area and copy it. Don’t try to be a hero and blaze a new trail on your own. That’s a recipe for disaster.

The other main challenge in Toronto is finding high quality subcontractors and trades people that are reasonably priced. The guys that are good are already busy for the next two years with existing projects. Trades people are in high demand. Contractors are often looking for smaller projects as gap fillers in order to keep their people busy. They have to keep their people busy or they will lose them. But the flip side to that is that getting people to come to actually work on your project can sometimes be a problem.

Finally, you have to consider the sales tax. There is sales tax on new home sales, but not on the resale of existing homes. That adds another 13% to the cost of a new home in addition to the already exorbitant development charges. So you want to make sure you don’t renovate the house too much so that it is considered a new house. You want to be treated as if you are re-selling an existing house that has already paid the sales tax.