Here’s my perspective on real estate investment properties. I use the same type of criteria that a company like Skyline Properties uses when they are buying large apartment buildings and malls, but the same market dynamics apply in both cases.
Real estate has proven itself to be one of the most secure forms of investment over the past 50 years, and I believe it remains so today. There has been talk about a “bubble”, but as long as the government supports the current levels of immigration to Canada (300,000/yr.) there’s a market for new housing and in many cases, people with money ready to make a purchase. Those who arrive with less in the way of financial resources still need housing and they will form the backbone of the rental housing market.
I have advised several clients on the purchase and sale of investment properties.
Investing in a real estate property needs to be a very “unemotional” process. Everything depends on the numbers, but there can be considerations for such things as “future value”. For the analysis of the value of the property, I use the following formula:
- What is the expected gross annual income? (Determine this amount based on the established market for the property as you envision it. I’m going to use $400/bedroom)
- What is the annual cost of taxes associated with the property?
- What is the annual cost of insuring the property?
- What is the annual cost of the utilities for which the landlord will be responsible?
- If the property is a condo, what is the annual cost of the monthly maintenance fee?
- What is the amount of money that will be required to upgrade the property to a level satisfactory to the Buyer (i.e. improvements)? This may depend on the type of tenant you are trying to attract.
- Determine what you are prepared to accept as a minimum return on total capital employed or “capitalization rate” (cap rate). This is a function of your assessment of the risk premium resulting from the investment in property versus something like a GIC. The better GIC programs are currently producing about 2.55%/year, with minimal effort.
- Determine the market vacancy rate (expressed as a percent). (In April of 2013, the vacancy rate in Guelph was hovering at about 1.0%, and that’s deemed to be an “underserved” market. I also have friend in the apartment rental business in Guelph, and when the units become vacant, they are picked up in “days”.)
- I always employ a 5% of gross income maintenance charge and a 4% of gross income management charge. After all, you do spend some time overseeing the property, and you deserve to be paid, outside of any profits the property may generate. When the time comes to re-shingle the roof, you need to have some money put aside, and there’s always some painting and minor repairs to consider.
- There will also be some closing costs that will include legal fees, Land Transfer Tax, and adjustments for taxes and in some cases utilities.
When you have the above information the calculation is as follows:
Value = (((gross annual income)*(1-((maintenance charge) + (management charge) + (vacancy rate)))-taxes-insurance-utilities-condo fee)/(acceptable cap rate))-(improvements)-(closing costs)
Assume the gross income to be $400/month/bedroom (4) = $19,200 plus basic utilities; assume 2013 taxes to be about $2800.00; insurance will cost about $700/yr., and the tenants should pay for all utilities, except for any rental items, like water heaters (If the tenants choose to not pay the rental bill, the provider can come back to you to collect, so you might as well factor it in as a cost and reflect that in the rent. A water heater rental will cost about $300/yr.) Most properties will require some initial investment in order to bring them to a physical state where you are comfortable they can be maintained with the 5% annual maintenance budget. For this example, lets’ assume that amount will be $5,000.
Most knowledgeable investors would say the risk premium for a well-managed income property needs to be at least 3% and preferably 3.5%. (Large commercial ventures will often seek risk premiums in excess of 5%.) That then translates into a cap rate of somewhere between 5.55% and 6.05%. I would not recommend any property that cannot support a cap rate of at least 5.50%, since that’s only 0.50% more than the major banks’ posted 5-year mortgage rate.
In this instance, we can assume the legal fees will be about $1200 and the closing costs will be about $2500.
Plugging these numbers into the formula gives: Value = (((19200)*(1-((.05)+(.04)+(.01)))-2800-700-300-0)/(.0525)-5000-3500) = $248,262.
This tells you the maximum price you should pay for such an income property. However there may be other factors involved that you choose to take into consideration. As an example, the land may have a significant redevelopment potential, so you really just want the property to support itself until such an opportunity comes along.
Please note: this calculation does not include the cost of borrowed money (financing charges). That’s because they are temporary in nature and you want to be protected when you need to renew the mortgage on the property, probably at a rate higher than today’s rate.
Many people think it’s great to keep rents level for several years, but doing so will only dig a hole from which you may not be able to get out. If you buy a property today that meets the financial criteria, but don’t change the rents, as interest rates start to climb, those GIC’s are going to look better and better, so the value of the property versus alternative investments starts to decline. I strongly urge investors to push up the rental rates on their properties as much as the government will allow each year.
As an example, let’s say the government is allowing rents to increase by 2.5%. That may not seem like a lot, but it would mean an increase from a starting point of $1600/month to $1640/month. So how does that translate into value? Just run the calculation, and you’ll get $(((19680*0.9)-2800-700-300-0)/(0.0525)-5000-3500) = $256,490. So just a $40/month increase in rent will produce a value of the property that is greater by $8228. Looking at this a bit differently, if you could improve the quality of the unit so you could attract tenants at $1700/month by spending $10,000 on improvements, you could afford to pay $(((20400*0.9)-2800-700-300-0)/(0.0525)-10,000-3500) = $263,833. In this case you’d be spending an additional $5,000, but even with that expense, the value versus the base case would increase by $15,571.
The City of Guelph Zoning By-law has a couple of aspects that owners of investment properties need to recognize. Property owners can occupy a 5 or 6 bedroom home with no issues, but if you want to rent the property, it can have no more than 4 bedrooms in a rental living unit. There are just 2 ways to deal with this situation. You can either create an “accessory apartment” or you can create a “certified lodging house”.
If a property has a second kitchen (it needs to have a wet sink that could be used to wash dishes, not just a stove), a bathroom, and an area suitable for sleeping with a closet and a window sized to be no less than 5% of the floor area being served by that window, that configuration is deemed to be an “accessory apartment”. The City wants to have all such units registered with the City, and in order to get them registered, they need to meet certain criteria. This will include a set of drawings of all floors of the home, showing the portion that is the accessory apartment. This cannot exceed 45% of the total living area of the home, or 80 sq. metres (about 900 sq. ft.), whichever is the smaller, and not more than 2 bedrooms. That said, I understand the sq. footage requirement is about to be dropped, but the apartment must be deemed to be “secondary” to the principal residence. The property must also have legal parking for at least 3 vehicles, and you can only “stack” one of the parking spots. Of course, the whole house needs to be inspected by the Electrical Safety Authority (ESA) inspectors, and it will have to meet the current fire code, and the City of Guelph Building Code.
A “certified lodging house” currently can have up to 12 bedrooms, but that is also under review and will likely be reduced to as low as 8 bedrooms. To get a lodging house certified, it will have to have building permits for any modifications, along with an ESA inspection and a Fire Department inspection. It also cannot be any closer to another lodging house or group home than 100 metres from any part of the respective properties.
One of the reasons I have such a familiarity with these requirements is that I was a member (Chairman for 2 years) of the Committee of Adjustment for the City, and we heard many applications for variances from these requirements, with varying degrees of success.
I can send you a list of properties that may meet any criteria you deem to be acceptable by e-mail as soon as they are listed.
I trust this is informative and look forward to working with you on the purchase of a great investment property.