Rental Property Investing - Increasing Returns by Financing

Expanding the discussion further on leverage, let’s examine what happens to the rate of return based on the annual financial performance of the property, after we factor in mortgage financing. In order for leverage to effectively work, the property must generate a good net operating income (NOI). This figure should be further analyzed to ensure its reliability (aka – accurate) and is consistent into the future (aka – stable leases). Refer back to our blog on “Confirming the Data”, if you need a refresher.

Back to our previous illustration:

I   -   WITH NO FINANCING

          Property Purchase                  -$200,000

          N.O.I.                                     -$20,000

          Rate of Return                         -10%

II  -   WITH 70% FINANCING

          Cash Downpayment                -$60,000

           N.O.I.                                    -$20,000

        *Annual Financing Cost              -$11,964

           Rate of Return                        -13.3% ($11,964/60,000)

        

*Annual Financing Cost - $140,000 1^st M @ 6% with Payments of $997/m (5 year fixed term/20 year amortization)

In low interest rate environments (as is the case across North America currently), leverage works best in cases where NOI’s are higher than the annual financing cost. Leverage can also be further enhanced if NOI’s are able to improve during a set time period (say 5 years), since the financing cost will remain fixed for the same period.  There are further tax benefits involved with financing a property because interest costs are tax deductible (more to come on that subject in a later post).

Conversely warning flags should be going up in the case of NOI’s which are below the annual financing costs or where NOI’s are expected to decline in the next 5 years.  But in the case of both scenarios, it gives us a good ‘base-line’ to evaluate properties, in examining their financial performance.  Lenders will usually only lend on a property based on NOI having a cushion over the annual financing cost - usually referred to as a "coverage ratio", something we will cover in a later post.

Again, it’s all local with real estate – and best practices, is to determine what sort of financing is available for properties you are considering. As always seek out experienced commercial realtors within your area, to assist you with your Leverage strategy.

Rental Property Investing - Leverage

A few posts back, we touched on the concept of “Leverage” and now let’s expand the conversation. By definition, it’s simply using borrowed money to increase your return (aka profits) in an investment property. It is a legitimate investment strategy, but is best applied to ‘good cash flow’ properties, which would appear to have a probable likelihood of future appreciation.

Consider the following investment, as a simple illustration:

I - WITH NO FINANCING

Property Purchase --  $200,000 (all cash investment)

            Recent/Projected  Market Growth – 5% per year

            After Year 2 -- $220,000

            ROI – 10% (on cash invested)

II - WITH 70% FINANCING

            Purchase Price   --  $200,000

            Cash Investment --  $60,000

            Recent/Projected Market Growth – 5% per year

            After Year 2   --  $220,000

            ROI – 33% (on cash invested)

This is a simplistic illustration and assumes the property is in a growth market,

which expects price appreciation – in this case 5% per year. It would not

be a realized gain, unless the property was infact sold after year 2.  But you can see based on the market assumptions which are made, the potential to increase your return goes up significantly in the second scenario.

In the case of a flat market (no growth), the return would be the same (0) - but you would have $140,000 to put towards other properties. For the record in a declining market, the negative return would be less in the first scenario - but you would also have more cash at risk ($200,000 vs. $60,000).

This gets the conversation started on Leverage, with more to follow when we consider the annual financial performance of the property.  Again, seek out experienced commercial realtors within your market to assist you in implementing a successful Leverage Strategy.

Rental Property Investing - Establishing Objectives

Assuming you are considering rental property investing as a way to make

money, then the next step is to establish a set of objectives. If you know what

you want in terms of investment properties – you should try to focus your efforts on the best options within the market that fit.

Typical investment objectives should include:

Type of Property – residential, commercial/office/retail, vacant land

Types of Tenancies  – single/freestanding building, multi-tenanted

ROI and CAP rate expectations

Growth/Appreciation expectations

Capital Available to be invested  (aka – down payment)

Risk Issues – personal liability/financial guarantees/level of acceptable risk

Locational Preferences – core district, new/growth area, transitional area

Quality of the Buildings – older, newer, potential rehab and improvement costs

Management – self manage vs. professional management

Hold Strategy – buy & hold, buy/renovate/sell, buy&flip

This list should help you paint a pretty good picture of what sort of rental property best ‘fits the bill’. As with everything in the business world, compromises must and will be made. But this will allow you to search the rental property market from the outset, with a defined set of objectives.

Just a final note as you investigate your market of choice - all markets are local and operate based on their own local set of dynamics. Your investment objectives should be based in reality, to the market you are looking to invest in. It never hurts to review recent rental property sales, to see how likely you are to succeed - based on the set of objectives which you’ve established.     

Again, seek out experienced commercial realtors to match your investment objectives to the rental property market in your area.

Rental Property Investing - Confirming the Data

When we consider investment property options, doing the math is generally straightforward as we determine  ROI’s, cashflow projections, and the like. It’s how those numbers are arrived at and the ‘legitimacy’ of them, that is the next important exercise.

On the income side, we need to review the current lease agreements in place and confirm the rental amounts, in order to reconcile the gross revenue numbers which are represented.  The lease will contain the balance of the term(s) remaining with the lease - including future increases, balance of time  remaining, renewal details, and deposits which may apply. As a matter of best practice, time should be taken to review all leases in their entirety, to ensure there are not provisions which you may not be aware of (ie. early termination clause, additional rent caps, expiration of personal guarantees - just to name a few).

On the expense data, year end reports are typically provided and are ok for the initial review.  But best practice is to verify the amounts against the owner’s income tax return(s), depending on the corresponding years being considered.  Three years history is probably a reasonable period and again, we are looking for the figures to balance against what has been represented.

Just a further note on the tax return request – this would generally be something that would be incorporated in to the Offer to Purchase and form part of the Due Diligence process. The Seller needs to know that a deal is at hand and that the providing of such confidential details, is ultimately leading towards a sale of the property.  Strict confidentiality provisions may also be required by the Seller.

In any type of rental property investing, as they say -- ‘the devil is in the details’.  Make sure you verify those details, before proceeding to finalize any purchase.

Next up…discussing strategies and objectives with rental properties. Again, seek out experienced commercial realtors within your market to assist in finding the best rental properties available.

Rental Property Investing - Return on Investment (ROI)

Return on investment on rental properties, is a calculation which measures the profit a real estate investment will generate. It is then compared to the amount of capital initially invested, to give a percentage yield on an annual basis. As a simple example consider the following -- a fully occupied commercial plaza sells for $500,000 with a net operating income (NOI) of $50,000.  Based on an all cash purchase, the (ROI) is 10%. Not bad in today’s low interest rate environment.

But consider the effect of arranging a 1^st mortgage on the purchase of $350,000.  Again for illustration purposes - let’s assume a mortgage rate of 5.5% and an amortization of 20 years. Going back to our plaza purchase above, annual mortgage costs amount to $28,740/year, leaving a net income (after debt service) of $21,260. The yield now on the cash invested, is + 14.2% ($28740/$150,000).  Welcome to the world of LEVERAGE!

In the case of part 2 of our example (after arranging a mortgage for the purchase), we can actually increase the rate of return on our cash invested by 4.2%.  In essence, we are increasing our yield through the use of borrowed money.  With this analysis, we are only looking at the existing cashflow (rental stream), which the property provides. We’ll take a further look at ‘leverage’ in future blogs, as we factor in price appreciation/growth and other strategies. 

Just a further comment on the initial cash investment (beyond the actual downpayment) -  be sure to include closing costs, land transfer tax, immediate capital improvement expenses etc.  Essentially calculate the total estimate of your upfront cash requirement to take on the property.

Next up…sifting through the financial data and ensuring its accurancy & reliability.  Again, seek out experienced commercial realtors within your market to assist in searching out quality rental properties to invest in.

Rental Property Investing - Due Diligence on Yourself

Investing in rental properties can be a lucrative way to create wealth, by not only providing an income stream, but also by creating an opportunity for capital growth – AKA -- an increase in the property’s value during your period of ownership. Types of properties can include – residential (single unit & multi-family), retail/commercial buildings (single unit & strip centers), office buildings (single unit & multi-complex), mixed use (ground floor commercial & above ground residential), industrial buildings (single unit & multi tenant complexes), and even raw land that generates some level of income.

After assessing the various property categories, determine the type that best fits with your objectives and will best meet your criteria. It isn’t one size fits all in considering rental property investments and you need to do some necessary due diligence on yourself before moving forward – due diligence on the properties/market will follow later. Markets throughout Canada are littered with investment property ventures ‘gone bad’ and the best advice here is to ‘walk before you run’.

Some key questions to ask yourself:

Am I more interested in residential or commercial/industrial properties?

What locations/neighbourhoods are of interest?

Am I hands on, or will I require a property manager?

What are my cash flow/return on investment objectives?

What type of financing is required and what % downpayment can I put up?

What sort of financial implications can I expect due to vacancies?

What sort of maintenance & capital improvement costs am I willing to accept?

Will I incorporate?  How can I best limit any liability?

What sort of market am I comfortable buying in?

Is liquidity an issue if I need to sell (quickly)?

Any investment comes with its share of risk and rental (investment) properties are no different. Good preliminary planning, starts wth a honest self assessment of YOU, your objectives, capabilities, comfort zone and so on.  Once you’ve figured that out, it’s time to move on to the market in whatever direction best suits you.

Next up – will examine return on investment strategies and look at the mathematics of it all.  As always, seek out experienced commercial realtors within your market to assist with acquiring the best rental properties for you.

Commercial Building Sales/Acquistions - It's a Wrap!

Over the past 7-8 months, we’ve tried to overview in a ‘soup-to-nuts’ fashion the area of buying/selling commercial properties. Targeted more at the owner-occupant market, we’ve tried to provide some valuable input as you consider your purchase/sale objectives. If you are currently active on a specific deal, there may be a topic that applies directly to your situation and perhaps offers some valuable perspective on it.

                      

Within our blog archive, topics are posted weekly and titled according to the subject – which should make for quick reference. If upon reviewing the assorted topics you cannot find the subject you require, feel free to contact us and we will be more than happy to respond. Again, keeping in mind that we operate out of the Windsor-Essex, Ontario area, and our perspective is somewhat based on our market. But if we cannot help, we will try to put you in touch with someone in your market who can.

Some final thoughts on commercial property sales, whether you are looking to Sell or

Buy, “Know your market” or better yet, make sure your broker does. Real estate has always been viewed as ‘local’ and the commercial property market is no different. It’s most important to have a clear picture of  the current state of your market – and specifically - price/ft. trends, market turnover, listing/sale ratios, availability of financing, and general inventory levels of like-properties. Again, market data may be harder to find and less readily available than with the residential market – but it’s out there and you need to be up on it.

 

Again, seek out experienced brokers with strong commercial property sales backgrounds to assist in your area – do not go it alone. To see our sales history, click here.

We are moving on – next week we begin a new series on RENTAL PROPERTY INVESTING with a full slate of weekly topics to keep things interesting.