Yesterday I spent my Saturday at a seminar on building garden suites (Oh yes, I’m WILD on weekends). We’ve been toying with the idea of building a garden suite in the backyard, and renting it out to offset the monthly mortgage. It was a fun event (plus they supplied lunch & donuts so finance + good food= my kind of day) and it answered all of our questions. So, ARE garden suites a good rental investment?
To answer that let’s review the basic rules of “good” rental investments, then compare them specifically to garden suites.
Why do I even care?
Let’s go over some background story first, such as why the rental idea even occurred to us. My boyfriend lives in a beautiful neighborhood that he’d prefer to stay in. It’s close to river trails, work, good schools, and is right in the centre of the city. He bought the property about a year ago knowing the house would require major renovations (it’s very old, and has a bizarre layout with a shoe-box-sized kitchen).
Since I’ll be moving in in spring we’ve started to discuss what we should do with it. Ideas have ranged from tearing the house down and building new (however with land in the area being costly adding a new house makes it well above our financial limits), tearing it down and building a duplex (then selling the other half), or simply doing a massive reno of the existing house. We both like living in relatively small places as long as they have beautiful kitchens, so the reno idea kept surfacing as a favourite (plus it’s the most affordable).
The current house does not have a garage, so we began toying with the idea of building a garage with a rental suite above it. This would give us a place to live during the year of house renovations (we want to do the work ourselves as a project) and then it could add to our monthly cash flow when we rent it afterwards. Plus, there’s always been a part of me that found the idea of being a landlord very exciting.
We wouldn’t be doing it for fun though obviously; we want it to be an investment. How can you tell if a rental property is worth it?
First, determine if it meets the 1% rule.
The first number that potential investors typically calculate when they’re deciding whether they should buy a property is whether it meets the 1% rule.
So what is the 1% rule, and why does it matter?
The 1% rule states that the amount you rent a place for monthly should be at least 1% of the price of the property plus urgent repairs.
So if you buy a place for $200,000 and can rent it for $2000, it meets the rule (2000/ 200,000 = 1%).
Determining the percentage is important because it tells you how many months it would take for the property to pay itself off (if everything goes perfectly)!
If it meets the 1% rule, it will pay for itself in 100 months (200,000 / 2000 = 100) or 8.3 years.
While some investors will accept slightly under 1%, it’s an important starting place. Why though?
Imagine another property costs the same $200,000, but would only rent for $1000. In this case it only makes 0.5% (1000/ 200,000) and would take 200 months or 16.7 years to pay itself off!!
The 1% rule assumes a dream scenario where:
- The full rent goes towards the principal (ie you don’t take/spend any of it)
- It’s always rented and never needs repairs
However, if you’ve ever considered rental properties (or own a home) you know that issues always arise. There will be general repairs, appliances that break, months where you cannot find a renter, and many other headaches.
All of these annoyances also cost money, and chip into your profits. How do you estimate for these costs?
The 50% rule
Most long term real estate investors use the 50% rule to account for the headaches listed above.
The 50% rule assumes that appropriately 50% of your revenue will get spent on overhead costs such as repairs, upgrades, and vacancy. Obviously this number will wildly fluctuate from year to year, but it typically works as a long term (>10 year) average.
What happens when you combine the 1% and 50% rules?
Let’s use the $200,000 property with $2000 rent mentioned previously.
Combining both rules, this property would take ~16.7 years to pay itself off [($200,000/ ($2000 monthly rent x 0.5 kept)= 200 months]
What about the property earning $1000 monthly that you bought for $200,000?
It would take 33.4 years to pay itself off!!!
That’s why most investors won’t even consider properties that don’t come close to meeting the 1% rule. The timeline becomes way too long to be worth it.
What does all of this mean for the garden suite we were considering? Or more importantly:
Are garden suites a good rental investment?
During the seminar, they had all professions associated with garden suites available. Realtors, accountant, builders, engineers, previous investors… everyone was represented.
We learned that if we wanted a simple 1bed/1 bath above garage suite with low to mid range (think linoleum floors & laminate countertops) features, it would cost us about $175,000.
To be honest, we were surprised. We originally assumed it would cost ~100k, but had not considered associated costs like moving utilities. We would also be mortgaging most of the cost, so is the garden suite a good rental investment?
There was an accountant there that owns 4 garage suites as rentals personally, and she claimed yes. She gave us a sample budgeting template, and I’ll admit I was excited to play with her numbers (like I said earlier- I’m wiiiiild).
Her template looked like this:
Note: The loan reduction is your principle repayment x 12 months, ie the amount of your mortgage you’ve paid off yearly.
At first glance, they numbers look AMAZING. A 17% return on my money?? That’s very hard to get!
But what about when you look a little deeper, and when you use typical real estate investing rules?
Does the suite meet the 1% rule? Nope. If it could fetch $1400 a month in rent but cost $175,000 to build it fetches 0.8%.
Not terrible enough to be an instant no, but how come the accountants numbers look so amazing?
First, she’s only factoring in 5% for vacancies and repairs. Perhaps in the first year when it’s brand new there will be no repairs, but that will change over time. Considering the mortgage is based on a 25 year term, there will DEFINITELY be repairs that you need to pay for. Your ROI (return on investment) in year one may be 17%, but that will not hold true for long.
Secondly, a one bedroom suite in our neighborhood would likely not rent for more than $1200. Assuming that’s the only number that changes, we’d actually have a negative $104 monthly cash flow (meaning even with a tenant we’d need to pay that much of the mortgage ourselves monthly).
But wait I thought… after 25 years we would outright own the garage suite! That must make it worth it, right??? I only had to invest $39,700 and now I own something worth $175,000 (assuming no appreciation or depreciation). Is that good?
Ready for it? $215,469!!! (Calculated on calculator.net)
That’s well over $40,000 MORE than the garage suite, and it required zero work beyond the initial investment.
So are garden suites a good rental investment?
Not necessarily! They can be:
- Cash flow negative (unless you can fetch high rent)
- The return on my money (after dealing with the headache of being a landlord for 25 years) doesn’t compare to what I could get passively investing the down payment in index funds instead.
I still find garden suites incredibly cool. I think there’s tons of reasons they make sense such as aging in place, building a unit close by for family, or neighborhood densification.
However as an investment (unless you can build one significantly cheaper or depend on much higher rent), the numbers just aren’t there unfortunately.