Residential real estate has been called one of the safest of assets and is considered part of a balanced portfolio. That’s because, when markets are down, clients can hold with little risk as long as their carrying costs are manageable. When markets rise, they can make solid returns.
Still, there are considerations, especially if clients intend to rent out the property. To get approved for a mortgage, a client must put 20% down. The maximum loan to value ratio can’t surpass 80%, says Jason John, a CIBC mobile mortgage advisor.
And while a broker will also consider a client’s credit score and income sources, the key factors are the cash flow from the rental property and market value of the underlying collateral. “We also look at actual rents versus market rents, and whether the client has other rentals,” explains John. “We want to ensure the rental income will service the mortgage.”
But the biggest challenge? Tenants. Ensure clients consider not just the quantitative side of the investment (e.g., financing and the rate of return) but also the qualitative side, says Amy Dietz, investment advisor, BMO Nesbitt Burns in Toronto.
After going through a client’s plan and ensuring he can afford to invest, she’ll ask if he’s ready to dedicate the time necessary to deal with tenants. “Our clients have had situations where the furnace breaks down in the middle of February and the tenant has a new baby,” says Dietz. “You have to have someone fix it immediately, and have the emergency expenses to cover sudden repairs.”
And while hiring a property manager can offload daily oversight of tenants, it’ll also eat into an owner’s monthly rental income—between 5% and 25%, depending on the location and property. This option is typically used by more seasoned investors who own dozens of rental properties.
But a newbie investor should be able to manage a single property on his own, as long as he picks the right tenant (someone who pays rent on time and doesn’t abuse the property), says Abrar Beg, sales representative at RE/MAX Rouge River Realty Ltd. in Pickering, Ont.
“Unfortunately, the laws don’t protect the landlord as much as the tenant,” he says. “If the tenant doesn’t pay, she’s entitled to stay for at least three months before having to vacate.”
And, during that eviction process, the landlord is still responsible for making mortgage and property tax payments. “So have a cash-flow buffer to account for non-payment by the tenant,” says Beg.
John agrees. “Clients should have at least three months’ mortgage payments in savings to cover their property expenses, including taxes and heating.”
When interviewing potential tenants, Beg suggests checking credit and job status by asking for a pay stub, an Equifax or Transunion report and references. And it’s important to call previous landlords to see if the candidate has a history of not paying rent or doing damage.
New development or resale?
Finding the right property is also important. First, determine if the client is interested in short-term capital gains, or long-term cash flow.
“If short-term, I’d guide him towards new development areas, possibly even through the builder,” says Beg. “This way, he can get appreciation on the property value as the neighbourhood develops.”
If it’s a residential, freehold property (detached, semi- or townhouse) through the builder, the typical possession date is usually 1.5 years after purchase. If it’s a condo, he says, the possession date could be three or four years later. During this time, the property usually appreciates. However, if the investor is looking for long-term tenants, Beg suggests a resale property that allows for multi-income revenue (e.g., renting out the top floors and basement to different tenants).
For instance, Beg bought his first investment property in Pickering, Ont. in July 2012 for $352,000. It has three bedrooms upstairs, and a one-bedroom basement apartment. His gross monthly income is $2,600, for a positive cash flow of more than $600 after paying the mortgage, property taxes, insurance and other expenses. And, today it’s worth $500,000.
Meanwhile, one of Dietz’s clients is a handy couple who wanted a fixer-upper close to their home in Orangeville, Ont. “Initially, they were looking at student housing, but realized they wanted longer-term tenants with less turnover,” she says.
They purchased a detached home in July 2010 for $214,000 and spent $65,000 on renovations, including fixing the leaky roof, updating the kitchen and bathrooms and adding a basement apartment, so they could maximize their rental income.
The house rents for $1,450 upstairs and $800 downstairs. It’s currently worth $325,000.
To help the couple realize their investment dreams, Dietz connected them with a team of experts, including mortgage and insurance specialists, who worked with the couple’s accountant, lawyer and real estate agent.
The couple “went through the planning eyes wide open, so they better understood the risks and rewards.”
Clients can deduct mortgage interest on investments, but the loan must be traceable to the related property, notes Paul Rhodes, partner, Audit & Advisory Group at Crowe Soberman. “A term-loan mortgage passes that test, compared to a line of credit where there may also be personal use. The deduction of interest can be challenged when there is personal use.”
A client may consider incorporating if he owns several residential properties, but he must ensure the operation meets the definition of an active business, warns Rhodes. CRA defines an active business as one in which the “principal purpose is to derive income from property.” If he incorporates, active business income is taxed at a lower rate than the top personal rate. “If the income is active and can be left in the business to be reinvested, there are more after-tax dollars available to reinvest,” says Rhodes.
Another consideration: tax on property gains. “When a property is sold for a profit, [the proceeds] may be taxed as a capital gain at 50%,” says Rhodes.
The taxman may consider the proceeds to be income (fully taxable) instead of a capital gain (taxed at 50%) if the taxpayer did not earn rental income from the property while it was held, owned the property for a relatively short period or has a history of buying and selling properties (see Advisor’s Edge March 2015, “Condo investment shouldn’t be a tax nightmare”).
Suzanne Yar Khan is a Toronto-based financial writer.