Buying Income Property
Discuss the pros and cons of owning an income property and how they work in your situation with your accountant, lawyer, banker, or financial advisor. In my opinion, real estate values will continue to climb. The ideal way to profit from purchasing an income property is to buy, manage, and hold it long term.
The advantages of buying a residential income property
— Growing Investment
The big money in real estate comes from long term investment. History proves that real estate increases in value over time. How quickly the value increases and by how much depends upon where the real estate is located and what the market is like. On average over the last 30 years in Canada, housing prices have increased 5.4% per year. Housing prices in Toronto increased 6.1% per year over that same period. Returns fluctuate, but over the long term, real estate is a solid, growing investment.
Income properties are investments that are in high demand. Approximately 33% of all housing in Ontario is rental housing, but with limited housing in Toronto and only a handful of rental complexes built since the 1970's, rental properties are even more limited in the city. The need for rental property is expected to grow. A city of Toronto report estimates population growth at 100,000 new people every year for the next 19 years (to 2034). This does not include normal growth of young adults moving out of their parents' homes or movement within Canada. Landlords with income properties will reap the benefits of this growing pool of tenants for the next few generations.
— Monthly Income
In addition to increasing in value over time, income properties generate a regular monthly income. You must pay taxes on the income, but only on the net profit. Expenses you pay to maintain your property, including mortgage interest, are deducted from the income before calculating taxes. At times, your expenses may exceed your rental income. If this happens, you may be able to deduct that loss from any other source of income you have. This could reduce your total tax bill.
How much will I earn with an income property?
— Purchase Investment
If you will not be living in the property, you will need at least a 20% downpayment for the purchase. If you will also be living in your rental property, you need at least a 5% downpayment. An ideal downpayment is 30% or more. Most banks now structure financing based on the value of the property: mortgages of up to 80% on the first $million and up to 50% on the remaining value. You will also pay provincial and municipal Land Transfer Taxes on purchase.
The rate of return varies from building to building. An average rate of return for income property (known as “cap rate” or cash flow) is about 3–4%. This means that your net operating income (rent less expenses but NOT including financing/mortgage payments) will be about 3–4% of the value of the property. Savvy long term investors pay less attention to the rate of return and more to the location, condition, rentability of the property. While rates of returns have been dropping in Toronto they are still well in line or below major major international cities like New York or London.
— Retirement Investment
The secret to using property for a retirement investment is to hold the property over the long term. With good management, the rent from your property will pay off your mortgage over the course of 20 to 25 years. When you retire, the rent becomes your income while you continue to retain the full value of the property. Think of the property as a Retirement Savings Plan that will pay you an income when you retire without disposing or depreciating the asset.
— Return on Sale
Your profit on sale will depend upon how long you kept the property, what the market has been like, and how well you managed the property. On average, the value of houses increases between 5 to 6% per year. You will pay income tax on the profit you make at sale (as you with any capital gain), but you will have written off maintenance costs and mortgage interest, and enjoyed tax breaks while owning the property.
What are the risks of buying an income property?
— Initial expenses may be high.
There are always expenses with owning an income property, and planned well, the rent you receive from your tenants will cover the expenses. But costs may be a little higher when you first purchase if repairs or renovations are needed on the property.
— You take on the responsibilities and challenges of a landlord.
Dealing with tenants can be challenging, especially if they don’t pay their rent on time and cash flow is tight. There are rules and guidelines you must follow when renting property. Rental units also need repairs, sometimes on an emergency basis. You can hire a property manager to take care of these things for you but include their fees when calculating your expenses.
— Market conditions at the time.
Real estate is not a liquid investment. Unlike bonds or GICs, it can take time to sell property, depending on market conditions. However, even in downturns, the best maintained and best presented properties sell faster and for more money than poorly maintained properties. Properties also sell well when the rent has been maximized: make sure you increase your rent to the maximum amount each year for each tenant. An extra $5,000 in rental incomes translates into tens of thousands on the purchase price.
What to look for when buying an income property
It's not the rate of return you should look for in an income property. While this should play a role in the decision, the truly savvy investors think long term; they look at location, size of units, rentability, access to transit, schools, shopping and parks. Over the years, a well located property with spacious updated units, will fare better in terms of the income it generates, and the increase in it's value over time.
Rate of Return
Also known as Cap Rate, Return etc. It's the Net Income (Gross rent minus expenses, but not including financing) divided by the purchase price.
The profit you make on an income property depends upon a number of factors, but the most important considerations are the location and the type of the property you purchase. To start off with the right property, it pays to do your homework.
The neighbourhood where the income property is located will affect the types of tenants you’ll attract, how often you will be dealing with vacancies, and how much the value of the property will increase over time.
- Consider how close the income property is to transit, schools and universities, parks, gyms, shopping, and entertainment areas.
- Research the average price and time it takes to rent in that neighbourhood.
- Look at the market trend for the neighbourhood over the last few years.
Regulations - Condos/Townhouses
If you're purchasing a condo or a townhouse, review the corporation’s regulations specifically their rules on rentals. If you’re purchasing a freehold property, ensure the correct zoning and any licenses are in place, or can be obtained.
Make a careful assessment of the property, its age and need for repairs. Get an estimate of what it will cost to make the necessary repairs and how long the repairs will take.
Also consider whether renovations are needed. Speak to a contractor to find out what’s possible, how much it will cost, how long the renovations will take, and whether the units can be occupied during renovation.
Asking about the rental history of the property will give you some idea of what you can expect. Consider:
- Current rents and whether they are in line with the neighbourhood.
- Vacancy rates over the last few years. Also determine how many rentals and property sales are listed generally for the neighbourhood.
- Rental History - Is there a lot of turnover for each unit ?
Consider whether you will manage tenants and handle maintenance and upkeep yourself or hire a property manager.
Know Your Numbers
A qualified financial analyst can help you determine what kind of profit you might make and whether the costs are within your means. But a basic assessment of the obvious expenses can get you started. Consider:
- Mortgage and projected interest rates
- Property taxes
- Current rental income
- Current maintenance costs
- Contingencies and Utilities