Buying an Income Property
Purchasing real estate is a proven effective long-term investment strategy.
There are several types of residential income-producing real estate, each offering different levels of revenue potential and carrying varying degrees of risk. The most basic of these types of real estate include:
- Duplex (two apartments)
- Triplex (three apartments)
- Multiplex (multiple apartments)
- Rooming house (many rooms with shared kitchens and bathrooms)
- Low-rise apartment building
- Mixed-use commercial and residential
- Properties that need to be fixed up for resale
Whether you are an investor who is looking to purchase a property that nets you a profit each month or a home buyer who wants to find a smarter way to bear the cost of home ownership, we have the information you need.
Factors to Consider When Purchasing Real Estate as an Investment
The inflation rate is an arbitrary measure of the progressive increase in prices of goods and services used by the government to set monetary and other policies. This rate has two variations -- the headline inflation rate, which includes volatile food and energy costs, and the core inflation rate, which does not. The increase in rate of inflation over the course of your real estate investment will affect your overall profitability. An investment in real estate has to be considered in terms of how much the money gained from your property will be worth at the time it is realized. Without proper planning, inflation can erode purchasing power and cancel out your investment efforts. If the interest rate you earn on savings is less than or equal to the inflation rate, then inflation has cost you ground. Over a long enough period, if the average price for apartment rentals rises in your neighbourhood at a pace considerably slower than the inflation rate, in relative terms, then the rental market suffers. Many Canadians are in financial trouble when they retire because they didn't consider the long-term effects inflation would have on their investments. You have to be cautious not to save today's dollars for use in tomorrow's economy.
The proceeds from the sale of an income property or the monthly proceeds realized from rental income are taxable under Canada's Income Tax Act. Speak to your accountant or financial advisor to understand the tax consequences of your real estate investment. There are many ways to best arrange your finances to minimize taxes. Remember that in Canada tax avoidance is legal but tax evasion is not. Be prudent to determine the best strategies to pay the least tax possible. By analyzing your real estate investment from a tax viewpoint, you can be better prepared to make wise decisions for the future. Cash flow after taxes gives the investor the best indicator of the true value of an income property. It does not matter how much you make from your property but how much you get to keep after taxes.
Risk is defined as the uncertainty, chance, exposure and vulnerability imposed on an investor with particular regard to financial loss that may accrue from an investment. When buying an income property to speculatively renovate and sell at a later time for profit, an investor assumes a certain degree of risk. As the risk increases, so does the potential reward. There are four broad segments that risk is often divided into:
- Financial: Interest rates, inflation, etc.
- Market: Vacancy rates, market trends, etc.
- Business: Tax issues, investment climate, etc.
- Building: Labour availability, physical calamities, etc.
A prudent real estate investor will ask key questions when assessing risk such as:
What is the maximum amount of money that can be made on the property in question (assuming no erratic turns in the local market)?
How much will it take for this property to reach it's maximum potential and how much money will be needed to get it there?
How much can you potentially lose if the property in question is a fairly risky proposition?
Is the property attainable at a price that makes the ensuing risk worth taking?
Are you in the right cash-flow position to consider this property? Or are you better off waiting until you have more capital (either for a larger deposit or extensive renovations)
You will need to determine you own risk comfort factor.
Gross Income Multiplier
This is a quick and easy way for an investor to determine the value of a potential income property. The gross income of a property is multiplied by a factor to arrive at a price. An investor in a given market may choose to pay ten times gross income, i.e. a factor of 10. A property with a gross annual income of $40,000 using a gross income multiplier of ten would have a value of $400,000. Residential income property listings often give gross rents but do not list all the expenses, making a formal calculation based on net operating income difficult. Listings will give the annual taxes but often not the utility, maintenance and insurance costs. The first step in determining a suitable gross income multiplier is to select a number of comparables from which sufficient information can be extracted. Such comparable properties should be familiar in terms of size, price, location, financing, expense ratios and rents. An income property experiencing excessive operating expenses of 70% may not be worth six or seven times gross unless the expenses can be reduced. Use care when using a gross income multiplier as it is should only be used to suggest a cursory price range.
The Capitalization Rate, commonly referred to as the Cap Rate, is the rate of return anticipated by an investor in an income property. Cap Rate is expressed as the mathematical relationship between income and capital value. A building producing a net operating income of $20,000, capitalized at 10%, has a fair market value of $200,000. The formula is: Income multiplied by the Cap Rate equals Property Value. Using Cap Rates allows lenders to take into account the operating costs of a property in order to assess value. It does not take mortgages into consideration - all results are based on the property being free and clear of all financing. You should become familiar with the cap rates that are being used in your area by other buyers. If income properties have a 10 cap in a certain area, you know the maximum price that a prudent investor would pay when analyzing the net income of a comparable property. It is recommended that you also find out what cap rates your local lenders are using because this will affect their appraisal of a property.