Investing in Real Estate: How to Get a Good Return
Thinking of investing in real estate to generate rental income? Whether you’re considering a residential or commercial property, we’ve got some expert advice to help you make the right choice.
Through good years and bad, investors still see real estate as a safe bet. The leverage effect is one aspect you can always count on, but there are more. Rental income from a property can provide revenue that is significant, and more importantly, regular. Before you reach that point, you need to carefully analyze the potential returns for any properties you are considering. What are the primary considerations to keep in mind for a successful investment?
Location, tenants, and commercial leases
Investors who buy commercial property—offices or a retail building—will receive income from the rent paid by tenants. To properly assess the revenue from such properties, Michael Williams, Associate Vice President, Real Estate Financing at National Bank, recommends looking at a number of criteria. “The property’s location is the first thing to consider,” he explains. Is it in a good location, on a site with good potential for development, or, on the other hand, is it in an area that is losing steam?
Another aspect to consider—the tenants. “Do they have a solid reputation, is their brand or franchise well known on the market? Or is the long-term survival of their business in doubt?” These are important questions, according to Williams. Which sectors or industries do they operate in? Do financial institutions consider their field risky, as is the case for bars and restaurants? “You need to think about your tenants’ line of business. For example, on-demand streaming led to the demise of DVD rental stores and many commercial proprieties were left vacant practically overnight.”
The tenants’ lease term is also very important. Let’s say you find a commercial property that is fully occupied. “This is a no brainer!” you might think. But that might not be the case if most of the leases are near the end of their term. You could soon find yourself with a lot of unoccupied units if tenants do not renew their lease because they’re no longer in business or have moved. You need to find out about the leases in force and check their end dates. Looking ahead will help protect your investment in the long term.
You also need to consider the tenant distribution. If a single tenant occupies more than 80% of your rented space and their lease is about to end, you need to come up with a plan to find a new tenant, even before you buy the property. Remember—a number of small but sound tenants can be better than one big one that is not on solid ground!
Commercial property: Calculating return vs. risk
The return you get on a commercial building depends on many different things. However, you need to remember that in this sector, the lender will typically require the borrower to make a down payment equal to at least 25% of the purchase price. “But that does not necessarily mean the lender will loan 75% of the price. It also depends on the economic value of the property,” Williams points out. The down payment could be much higher than that required for a residential building.
Moreover, before signing off on the loan, the bank will have certain requirements for covering the debt. Typically, the lender will ask for the debt service ratio to be 1.25 times, or 125% of, the annual mortgage payments (capital plus interest). For example, if your annual mortgage payments (capital plus interest) are $10,000, the financial institution will require the building to generate total annual net income, after expenses, of $12,500.
“So before making a final decision, it’s important to take a stress test,” Williams suggests. Consider in particular how high the vacancy rate can go before you have trouble servicing the debt. If just one vacancy will cause you to go bankrupt, keep looking.
Before you take the leap, you also need to have the property inspected by a professional real estate inspector. The inspector’s report will identify any structural issues and could even help you negotiate a lower price. This will help you avoid unpleasant and costly surprises down the road.
Residential property: You do the math!
When it comes to residential property, the location and vacancy rate are among the most important criteria. You need to look for easily accessible buildings located near amenities. But that’s not all. You also need to consider how well the building has been maintained, a key factor in attracting and retaining good tenants.
The down payment lenders typically require is 25% of the purchase price, but buyers can also usually take out mortgage insurance if they want a lower down payment.
Once these criteria have been met, what are your chances of making the building more profitable? “You need to think about how much extra income the building can generate, says Caroline Tourigny, Associate Vice President with National Bank’s Real Estate Development team. For example, if it’s in a location that’s highly sought-after but is already well managed with high rents, it will be difficult to increase your return. Residential rents in line with market prices have a lower potential for long-term growth.”
You need to look at other options, such as “making the building more energy efficient, which could increase net income,” suggests Tourigny.
But you have to look carefully at the math and be realistic. “It’s a mistake to think that a residential building will instantly generate a large amount of cash. You need to remember that income will mainly be used to repay the loan, pay property taxes, and cover maintenance costs,” she adds. What’s more, unless you’re very handy, you’ll need to hire professionals to do most of the repairs, resulting in even higher expenses. The more units you have, the more time and energy you will spend on property management. That’s something to keep in mind before signing on the dotted line.
Ready to dive in? One last piece of advice: “Don’t put all your eggs in one basket, and set money aside for the unexpected,” says Tourigny.
Edited on 13 September 2017