Rental Property Investing - Office Properties

Now let’s look at Office properties. Again, they come in many shapes, sizes, design styles, and for a variety of user types. Specifically on users, they can be categorized as follows: business office, institutional/government, medical or commercial service.

Multi-tenant office developments may be located near residential neighbourhoods, within business parks, or in established commercial districts within a city.  Tenant rosters could include accounting firms, law offices, personnel agencies, mortgage brokers, insurance offices, and chiropractors.  As in the case of retail, a development can be designed for a single user and within a freestanding building.    

In looking at successful office properties – same advice as with retail -- pay particular attention to not only the property’s current vacancy status, but what its historical pattern has been. Are current rentals on a per ft. basis, at or above/below the prevailing office rates within the area. It’s all about supply & demand, and lease rates are mostly dependent based on the realities of your particular marketplace.

As with other commercial properties, the value of an office building is very much tied to the amount of rent collected. Review applicable Cap Rates for recent office building sales, to give you a benchmark as to how your subject building relates. Also in studying the tenant summary, how dependent is the landlord on 1 or 2 units in order to sustain an adequate cashflow?  It’s the ‘What-If’ analysis – so if a tenant occupies 50% of your building (representing 50% of your rental income), what happens when they leave and how easily can the unit be re-tenanted and at what cost?  It is as we’ve said many times before, all about good Due Diligence.

Just a final word, on evaluating a property to see how it performs on a daily basis.  Visit the site during busy times and see how it functions – Is there really enough parking?  Is there a good/compatible tenant mix? Ease in visitors accessing the site?  Does it appear to be an operational success for tenants, their employees and visitors?  On site observations are always well worth the effort and can tell you a lot about the viability of the property.

As always, seek out experienced commercial realtors within your market to assist in reviewing viable Office Properties as investments.

Rental Property Investing - Retail Properties

Another decision you must make when considering rental properties -- what type of property to do you look to invest in?  Based on the market you’re considering, are retail centers preferred or do you see office uses as being more optimal?  Let’s first look at Retail.

Retail properties come in many shapes and sizes.  Think neighbourhood plazas which might include a fast food restaurant, laundromat/dry cleaner, variety store, beauty salon, etc.  These are viewed as convenience centres and for the most part, serve the immediate neighbourhood. The same can be said for freestanding buildings (serving a single tenant), but again, target the neighbourhood demographic as their primary customer.   

In looking at successful retail opportunities, pay particular attention to not only the property’s current vacancy status, but what its historical pattern has been.  In addition, you want to look at the availability of parking, neighbouring tenant mix, and the tenure of current occupants.  Bottom line – is it a quality development which results in successful and stable retail operations?     

In addition, you should examine general vacancy trends in your market.  Stronger lease rates typically go with higher occupancies and vice versa.  It’s again a due diligence exercise – but the data/information is out there and you need to make best efforts to obtain it.  Stay where the action is and look where retail tenants succeed.

As a final note, with respect to financing retail properties, certain lenders may prefer this area of real estate versus other categories (ie. office or industrial).  Keep this in mind as you consider financing options. 

As always, seek out experienced commercial realtors within your market to assist in reviewing viable Retail Property Investments. 

Rental Property Investing - Single Tenant vs. Multi-Tenant

This is a debate that has gone on for years – do you opt for a Single Tenant property or do you consider only Multi-Tenant buildings.  Lots to consider here, and as with everything in real estate investing, ONE SIZE DOES NOT FIT ALL!

Look back at your objectives and confirm what you are trying to achieve.  Is it ROI? Is it minimal management? Best opportunity for price appreciation?  Risk tolerance? Income growth through lease rate expansion? Mid-long term lease commitments? Triple A Covenants Only?  These may be some of the key criteria which you have identified.

Now let’s look at which Property Type, each of the above tends to favour.

ROI                        -  Multi-Tenant more likely

Price Appreciation   -  Multi-Tenant more likely

Management           -  Single Tenant less management (if any)

Risk                       -  Multi-Tenant more likely (spread across multiple leases)

Income Growth        -  Multi-Tenant more likely (given multiple leases)

Long Term Leases   -  Single Tenant more likely

Triple A Covenant     -  Single Tenant more likely

You can see the benefits of each, given the criteria that we’ve set out – but it all comes down to what you are prioritizing. There are clearly advantages to both and again as we’ve said many times, it is a set of property objectives that must be aligned with your particular market. For those of you keeping score, the above comes out 4-3, in favour of Multi-Tenant investments.

As always, seek out experienced commercial realtors within your market to assist in reviewing the available Single Tenant vs. Multi-Tenant opportunities.

Rental Property Investing - Debt Coverage Ratios (DCR)

Since leverage involves debt, let’s discuss how we analyze the debt relative to the property’s cash flow. The standard measurement within the investing world, is referred to as the Debt Coverage Ratio (DCR). The math is pretty straightforward –the ratio measures the property’s net cash flow divided by the annual mortgage costs.

Consider the following examples:

Property 1                                                   Property 2

Net Operating Income - $75,000                Net Operating Income - $45,000

Mortgage Costs (Debt) –$50,000               Mortgage Costs (Debt) - $50,000

DCR – 1.5                                               DCR – 0.9

• All Dollar Amounts are annual

Now in the case of Property 1, the cash flow comfortably covers the mortgage requirement with a residual leftover (AKA –return on cash invested). With Property 2, a deficit is created (of $5000), which in essence becomes an annual loss and generates a negative return on your cash invested.

The significance of this exercise becomes really clear once you look to arrange mortgage financing in either case. The 1.5 DCR will receive good support with the Commercial Mortgage lenders, as the cash flow of the property provides a cushion against the mortgaging costs you will be incurring. However in the case of the 0.9 DCR, the deficit will raise red flags with Commercial Mortgage lenders and certainly fall outside of their normal guidelines.

Standards will vary from area to area and lender to lender, in terms of DCR ratios required. But more importantly, it must fit with your own objectives for investing and in considering viable rental property options.

Again, seek out experienced commercial realtors within your market to assist in searching out rental properties with positive DCR(s).

Rental Property Investing - Cautions in Leveraging

Based on our prior blogs on Leverage, the opportunity to increase returns is clearly a prudent strategy for many. But it should be applied on the right properties and primarily those with the right circumstances. A realistic understanding of the risk involved should be foremost in your decision making.                                                 

Let’s look at the following ‘Cautions’:

1. Mortgage Payments Change When Interest Rates Rise – if the payment is manageable in the intial term (say 3 years), what happens if the rate rises 2-3% in a subsequent term. Does the return disappear? – Can the payment be covered?
2. Maximum Leverage vs. Poor Real Estate – the best leverage deal does not improve a bad investment . You can also lose focus on value, lack opportunity for appreciation, and easily be ‘underwater’ at some later stage. Lucrative financing can often be a trap!
3. Cash Flow is Key – Is the current cash flow sustainable? Are current rents in fact market rents?  Status of expiring leases?  All are key parts to this exercise.  Buy and Hold strategies very much depend on sustainable cash flows and lack of price appreciation is much less of an issue as a result. 
4. Over Estimating Price Appreciation – being too optimistic in this area is a major downfall for many and results in negative returns. Best practice here is to be conservative and have this part of the risk analysis be of least importance – meaning future value appreciation, is not key to your decision in acquiring the property.
5. Risks of Overleveraging with Personal Liability – the consequences can be catastrophic on a personal level if your portfolio of properties underperform and end up selling below the initial investment. Personal guarantees (known as convenants) are pretty common in the market today, so you need to understand the risks they present and factor that into your decision making.

A sound leverage strategy is worth implementing – but keeping the above points ‘top of mind’ as you execute your plan. As always, consult a experienced commercial realtor in your area, to assist in implementing your plan.

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.