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Make a Sound Investment in a Residential Rental Property

03 June 2019 by National Bank
Rental investment

Plex prices keep rising in markets everywhere, and Montreal is no exception. This, however, does not deter the many investors looking to buy these multi-unit residential buildings. Would you like to be one of them and rent out apartments for a profit? Here are some tips to help you make a profitable purchase. 

Start by establishing whether you have the temperament for this type of investment, because investing in real estate requires a much more intensive commitment than investing in bonds, mutual funds or stocks. “You have to truly enjoy management, be very patient with tenants and be available to respond to their requests. If that doesn't sound like you, you're better off consulting a financial planner and putting your money into some other investment vehicles,” warns Rosanna D’Alessio, Mortgage Development Manager at National Bank.

Calculate the building's profitability

The first step towards figuring out if a building can generate income is to estimate its financial viability. Do not rely solely on the Gross Income Multiplier ratio (GIM), which is essentially the price paid for the building divided by the gross annual rental income. For a more accurate assessment, you need to also take expenses into consideration. This is done by using the Net Income Multiplier (NIM).

Net income is what is left of gross income after deducting the building's operating costs (electricity, heating, real estate taxes, insurance, maintenance and snow removal, management or caretaking fees, etc.). For example, if you pay $450,000 for a four-unit building and the total annual net income is $30,000, your NIM is 15. The target ratio to ensure a good return on your investment lies somewhere between 10 and 16. 

Evaluate rent costs

Rental income allows you to capitalize on your investment, i.e., to gradually pay down your mortgage as you incrementally increase your equity in the property. 

Consequently, the purchase price must not only reflect the condition of the building, but also the rent amounts. A building with apartments rented at sub-market rates does not have the same value as a building with more expensive rents. Establish the appropriate amount to charge for rent based on the building's type, location, condition, etc., and factor this into the purchase price.

“To get added input for your number crunching, feel free to ask the seller how long the current tenants have lived there, what the average tenant turnover is, when the latest rent increase was, and so on,” recommends Rosanna D’Alessio.

Create scenarios incorporating the real NIM and the market NIM, using optimal rent amounts, and use these figures when negotiating and presenting a purchase offer. Also, compare the asking price to that of similar buildings sold over the past year, always taking into account the rent amounts. A real estate broker can do this for you.

To be or not to be an owner-occupant

You need to determine whether you wish to live in one of the units or not. If all the housing units are rented, you are entitled, from a tax perspective, to deduct from gross income all current expenses related to the building. “On the other hand, as an owner-occupant, only expenses for the units being rented are deductible,” explains Rosanna D’Alessio. “However, if and when you later sell the building, proceeds attributable to the owner-occupied portion are exempt from capital gains tax. Were the building completely rented out, the full amount of the capital gain would be taxable.”

Plan for the down payment

Buying any property requires a minimum of liquidity. For a rental property whose units are all rented, the minimum down payment is 20% of the purchase price. If you choose to occupy one of the apartments, a mortgage loan insurance policy, such as the one offered by the CMHC, helps reduce the down payment to 5% for a duplex and 10% for a triplex or quadruplex.

Consider related expenses

Before inking a final deal, consider the real estate transfer tax, notary fees, inspection fees and municipal and school taxes. To cover these expenses, Canadian mortgage loan insurers charge a standard premium equivalent to 1.5% of the building's purchase price.

To protect against unforeseen circumstances, a number of financial institutions, including National Bank, also recommend establishing a contingency fund equivalent to 3.5% of the purchase price and comprised of readily liquid savings held in a savings account or line of credit.

Remortgaging to buy a new property

When they can, some investors opt to remortgage a property to finance the purchase of another one. If you've already reimbursed a good chunk of your mortgage, you can use that initial asset to take out a loan at a more preferential rate than that of a personal loan. This way, the new mortgage loan can represent up to 80% of the first building's value. This is known as the leverage effect. Your financial advisor can help you evaluate the advantages of this approach based on your particular situation. You can also learn more about other specific situations, such as investing in a rental cottage.

When buying a rental property, it's important not to act on impulse, but to instead consider the various human and financial factors. Preparation, calculation and evaluation are the foundation of a real estate investment that can generate a comfortable income stream and a good long-term return on your investment. 

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