Property Investment Overview
A lot of uncertainty lies around how investors can participate in property investing. Consumers are unclear and wary as to how they can get involved in allocating a percentage of their portfolio to real estate without having to get directly involved in operating this tangible asset. With a few options available including REITs, MICs, second mortgages, subprime funds, investors typically get confused which route they should pursue.
Clarifying the Options
Provide and overview of some of the common ways an investor can participate within real estate and clarify the steps involved. This is meant as an overall guide and we will delve further into the specifications and detials of some of the options listed within this overall guide through individual articles.
Weighing the Pros and Cons
There is no one best option to getting involved as an investor. Each route comes with it’s own hurdles and benefits and serves each investor in a different way. A more hands on investor may look to purchase their own property and have direct control over the asset whereas a more passive approach on the opposite end of the spectrum would involve placing money in a diversified public fund composed of hundreds or thousands of properties.
Clarity Through Insight
Provide clarity through the understanding of the higher level investment options assessment. The goal is to drive awareness across the different paths an investor can take and not single out any one option with any bias. We are not an investment company and hence do not hold any bias or receive any benefit from promoting one investment over another. We hope we can bring clarity to the real estate investment landscape.
Why Invest in Real Estate
Real estate investment can be a compelling vehicle for you to reach your financial goals; but to confidently build your wealth with real estate, you need to have the right information. One of the most imperative things you need to understand as an investor is, “why real estate.”
A Safer Option
Real estate is comparatively a safer option than stock market-based investments, especially in today’s market. History shows that if you can buy and hold, your property is almost guaranteed to appreciate better than stocks, bonds or mutual funds. Of course, risk level varies based on factors such as the population growth and employment rates of the surrounding area among numerous other factors.
Leveraging is a great way to stretch your investment dollars. When you invest in real estate, you can borrow against your property. This means that you only have to pay the down payment (20-25%) for your investment, and you can mortgage the rest. Lenders will use the property itself as security and allow for a 9:1 or 8:1 borrowings to capital ratio.
On top of this, you will be receiving rental payment from your tenants, which can be used to pay off your mortgage. The lower your mortgage amount is, the more equity is in your property.
Real estate loses little value in periods of rising prices. It holds its value and purchasing power during inflation, which is paramount in today’s volatile economy. Real assets hedge better than paper assets; this makes real estate a better inflation hedge than stocks because the former has intrinsic value whereas the latter does not. In the past, the rate of appreciation has been 2%-4% higher than the rate of inflation.
There are many different tax laws in Canada you can take advantage of to increase the profitability of owning property.
- Property Taxes
When buying a property in Canada, you are subject to a transfer tax, which varies from 1% on the first $200, 000 and 2% on the balance of the cost; however, there are exceptions to this if you are purchasing your first property.
- Taxes on Rental Properties
If your rental property incurs net losses, you can claim the taxes you previously paid on the property. Also, certain incurred expenses can be deducted such as current operating expenses and capital expenses. Ongoing operating costs are day-to-day expenses (i.e., utilities); capital expenses are long-term expenses for your rental property (i.e., furniture) that last for more than a year. For capital expenses, there is a capital cost allowance. This allows capital cost to be deducted over time as items, like furniture, depreciate. Lastly, interest on mortgages, property taxes, bank loans or lines of credit is tax deductible on investment properties in Canada.
- Sale of a Property
If the property is listed as your principal place of residence, you do not have to pay taxes on your capital gain when you sell your property. If the property is not your principal place of residence, you only have to pay a percentage of the capital gain.
Theory of Supply and Demand
It is common knowledge these days that the world’s population number is growing with time and the growth rate is increasing each year. On the other hand, land supply is limited. With this in mind, following economics and the theory of supply and demand, housing prices have nowhere to go but up as demand drives it.
When investing in rental real estate, you will receive ongoing positive cash flow (that is providing that you make sound investment choices). Who doesn’t want money flowing in every month?
No Entry Barrier to Investing
Anyone can be a real estate investor. More importantly, the skills required to invest are quickly learned and relatively simple. Information sessions and educational events are frequently offered for people eager to learn more about real estate investing.
Small Capital Required to Invest
As mentioned above, when investing, you only need to pay 20%-25% for the down payment. You can then borrow against your property and finance the balance.
Different Ways to Invest in Real Estate
Now that you know why to invest in real estate, here is how to get started. There are many different options available to you if you want to get involved with real estate investing.
Mortgage Investment Corporations
A MIC is a lending company that investors can buy shares in as a way to invest in a diversified and secured pool of mortgages. The capital is then lent out, and investors receive monthly cash flow via interest rates and borrowing fees; they are also paid 100% of the net profits.
A MIC also includes small second mortgages on residential property and is organized for investing in pools of mortgages that are secured by real property.
Why Invest in a MIC
There are many benefits to a MIC. If you do not have any previous experience directly investing in individual mortgages, investing in a MIC allows you to gain access to mortgage investment with a hands-off approach. It relieves investors of all management responsibilities and provides for them to pool resources in a collective effort to accomplish what they couldn’t have on their own. Every MIC has a management team that sources investment opportunities, negotiate mortgage terms, manages the mortgages themselves and distributes money to investors. This is beneficial to those without the expertise, experience, means or time to invest in mortgages themselves.
MICs are also a more secure and safer option than directly investing in real estate. When you invest in a MIC, you are investing in mortgage loans, which are less vulnerable to fluctuating property values. MICs also offer protection in the form of a fixed interest rate during the investment period.
On top of that, there are specific tax exemptions that can be applied to MICs. If shares in a MIC are held within a RSP/RESP/RRIF, any dividends paid to the investor are tax-free.
On the flip side, however, due to the nature of MICs, there is no capital growth. Furthermore, MICs usually deal with second mortgages and as a result, are subordinate. If a loan goes into default, the primary first mortgage is paid out first, leaving the second mortgage next in line to collect. Therefore, MICs are somewhat risky for investors also, come with a higher interest rate compared to first mortgages.
Borrowing from the MIC
We discussed investing in a MIC as a means to get into real estate, but borrowing from the MIC can also help you as a real estate investor as well. Generally, you can utilize a MIC to attain a second mortgage and receive up to 90% LTV. With the way it is organized and structured, a MIC is especially useful in helping you attain a second or third investment property. Here is how:
Say you have invested in a previous property (PROPERTY A) that has the appraised value of $150, 000 and are looking to invest in another property (PROPERTY B) with the appraised value of $150, 000 as well. If you take out a $120, 000 first mortgage on PROPERTY B, you only need to pay $30, 000 for your down-payment. Using the MIC, you can take out $15,000 second mortgages on both PROPERTY A and PROPERTY B to give you the $30,000 needed for PROPERTY B’s down-payment. In the end, you will have another property to your name while having spent zero dollars.
- Purchaser bought PROPERTY A
First Mortgage: $120,000.
- Purchaser wants to buy PROPERTY B
First Mortgage: $120,000.
Down Payment Needed: $30,000
- 10% down-payment : $15,000 second mortgage on PROPERTY A
- 10% down-payment: $15,000 second mortgage on PROPERTY B
- *No out-of-pocket cash investment required*
Real Estate Investment Trust (REIT)
A REIT is an investment trust that owns a portfolio of real estate assets.
There are two kinds of REITs.
Units in public REITs are like stocks. They are traded on stock exchanges with fluctuating values. When investors buy shares of a public REIT, they pay the current market price based on other investors’ buying and selling of shares, rather than the actual price of the properties.
Private REITs are immune to an active secondary market. Their unit prices are dependant on the appraised values of the REIT’s properties. Private REITs can be considered a safer option than Public REITs as they are safe from the volatility of investors entering and leaving the market.
Why Invest in REITs
REITs allow you to gain access to real estate investment if you are new to investing and are looking for a hands-off approach. Similar to MICs, REITs relieve investors of all management responsibilities and allows for them to pool resources in a collective effort to accomplish what they couldn’t have on their own.
Again, like the MIC, REITs have a steady, monthly cash-flow from property rent; however, REITs also experience capital appreciation while MICs do not. REITs own the properties they invest in; therefore, you benefit from increases in property values.
REITs experience several tax advantages. For example, capital depreciation can be deducted by the REIT. Also, investors do not have to pay taxes on capital growth until his or her units are sold. REITs also allow investors to collectively acquire diverse types of properties such as malls, hotels, residential apartments and more.
Real Estate Limited Partnership (RELP)
A Real Estate Limited Partnership (RELP) is a partnership formed to generate income by acquiring, managing and selling real estate. Essentially, the partners’ resources are pooled to own and operate real-estate assets. This is the chief advantage, as limited partners benefit from the economy of scale associated with larger-scale ventures, but without the risk.
One of the main features of this type of partnership is that the limited partners do not possess any management control and are least exposed to risks that may arise as a result. Structurally speaking, RELPs involve at least one general partner, who absorbs the risk and legal liability. Typically, limited partners in a RELP are only responsible for investment debt up to the amount they invested, meaning they can’t lose more than they initially contributed.
Why Invest via RELPs
Aside from the financial rewards, RELPs offer tax savings and relative investment security. The security arises from the general structure of these partnerships, which operate with a general partner who assumes liability. Limited partners are passive investors. They contribute financially to these projects and do not have to worry about the hassles involved in the administration or management of them.
Limited partnerships receive favorable tax treatment in Canada, due to a limited partnership’s treatment as a non- taxable entity. Income derived from the partnership has the associated income tax-deferred, and accounting losses can be claimed as tax write-offs.
When acting alone, an investor can come across a variety of roadblocks that are diminished in a partnership. For instance, limited capital or lack of available financing is often a private investor’s most significant obstacle. In addition, the risk of debt or legal liability would fall squarely on an investor’s shoulders, whereas in a limited partnership the general partner would be liable for any losses or legal repercussions.
Also, a single investor is exposed to the threat of vacancy more acutely. This is simply because RELPs are more likely to invest in multi-residential and commercial buildings where the risk of loss due to vacancy is mitigated because the investment is spread over several units.
Direct ownership is when you are legally registered as the owner of a unit or property. You have complete flexibility over the investment and assume all responsibilities that come with the property. Traditionally, you, as the landlord and owner, are responsible for paying the mortgage, fees, insurance, taxes & maintenance costs, rental collection, maintenance, tenant placement & qualification, expense disbursal and move-in and move-out inspections.
Why Invest via Direct Ownership
The most important benefit when investing via direct ownership is that you, as the investor, are in complete control. You can control how well your investment performs. For example, you can perform renovations, to justify a higher rent. Furthermore, even though you are responsible for day-to-day management and maintenance of your investment, you can bring on a property management company to render your investment hassle-free.
Because you have complete direct ownership of your property, you benefit the most from the power of leverage. For example, if a property’s value appreciates by 10% and you only paid 20% for your down payment, the return on your 10% becomes inflated to around 50%. This leveraging power is the most beneficial part of direct property ownership as it usually results in a higher return on investment.
It is also important to note that any growth in property value is tax-sheltered until you sell your property. Any profit from a property sale benefits from the capital gains status, whereby you only pay taxes on 50% of the gain at your marginal tax rate while the other 50% is tax-free. There are also value-added tax deductions that allow you to minimize the amount of tax you have to pay such as, the costs of financing and operating your property.
What to Look for In a Property When Investing
When it comes to real estate investments, it all boils down to the property itself. Everything from the region to the nearest amenities impacts the return on investment, and it can be difficult to know where to begin. Below are a few things that deserve the investor’s attention.
Types of Property
The investor will need to determine the property that fits their investment strategy. Single-family, multi-family, condominiums, apartments, residential and commercial are terms that the investor needs to understand.
Also called single-detached dwellings or detached houses, single-family homes refer to a freestanding residential building and are usually occupied by a single household or family. These terms can apply to a cottage or a mansion, and everything in-between. One of the main advantages is that the entire space surrounding the building is private to the owner.
Detached houses have no additional monthly fees, such as maintenance and parking, which can be found in other types of property, like condominiums. Also, if renovations or upgrades are required, this can be done at any time, without the permission of a building board or association.
Otherwise known as a multi-dwelling unit, multi-family residential refers to multiple separate housing units contained within the same complex, whether it is a single building or several. Apartment buildings, townhouses, duplexes, and semi-detached homes are some common examples.
The benefit in investing in a multi-family residential unit is the ability to invest with companies that make it a hassle-free experience. In some instances, companies will take care of all the property management, maintenance, fee-payments, rental collection, tenant placement and more. Some companies will even offer rental security programs to eliminate investment risks and protect investors investing with them.
Condominiums and Apartments
The difference between condominiums and apartments cannot be determined merely on sight, but rather through ownership. A condo refers to a unit in a multi-family residential building that is owned by the tenant. The condo owner also owns a share of the condo corporation, which in turn makes it so that he or she owns the surrounding land and common areas within the building.
Due to the increasing demand for the convenience and luxury that condo living offers, it is relatively easy to find tenants, especially in major cities. There is also minimum upkeep, and management and maintenance problems are taken care of by the condo corporation, making high-maintenance facilities, such as tennis courts and swimming pools, more convenient.
Apartment buildings are owned by a single person or a corporation, and the units are rented out to many. Because many condo owners choose to rent out their unit for investment purposes when speaking of the two colloquially, a condo refers to the unit owned and the apartment refers to the unit rented.
Residential vs. Commercial
Residential buildings are primarily used as residences, while commercial buildings contain a retail unit or business component. A commercial building can also be mixed-use, with apartments and retail housed within the same complex.
New entry investors often prefer residential buildings, primarily because they are more familiar with this type of building and the associated costs. Residential buildings also have a considerable pool of potential renters to draw from, and vacancy is much less of an issue than with commercial buildings. However, once a commercial unit is rented, an investor can look forward to longer leases, often ranging anywhere from five to ten years.
Commercial properties also encounter less competition on the market than residential, giving investors more opportunity to choose a property that makes sense to them, numbers-wise. Another benefit is that most commercial leases stipulate that the tenant is responsible for taxes, maintenance, and insurance, meaning that the investor is insulated against cost increases.