Buying First Investment Property.
Thursday May 07th, 2020
Real estate around GTA has been a great investment for many decades, the prices have appreciated over time, if anyone was unlucky and purchased at the peak prior to a correction, given enough time they were able to recover and show significant gains, most people who invested in rental properties have accumulated significant wealth, in reality owning real estate in GTA equals wealth.
Why invest in GTA? The answer is actually very simple: the populations is growing, it attracts migration both from other parts of the country, and immigration from around the globe. Growing population ensures the demand for the housing, growing demand means increasing prices. There will be arguments that due to covid-19 crisis and the unemployment the immigration will stop. Yes, it will stop but only temporarily, when things go back to normal, and they will, the immigration will resume because Canada needs growing population to sustain its economic growth, this will not happen without immigration. Majority of the immigrants will want to come to major metropolis, and GTA will be the most likely destination for large portion of it, and it will continue to be well diversified, vibrant city without reliance on one single industry or employer.
Real estate only goes up, or some say, that is not true. First off, it’s definitely not always, even in the most desirable places there are periods of downturns and corrections despite the long-term uptrend. Secondly the population of the area needs to be growing to support the demand, areas without population growing will have a stagnant, declining, lagging growth in real estate.
Do I want to be a landlord?
Being a landlord is definitely not for everyone, there are other ways to invest in real estate such as buying REITS, in this article we will concentrate on all aspects of purchasing a first rental property. In any case being a landlord will require some amount of risk, dealing with tenants, equity available to invest, work and effort, and dealing with local regulations.
What kind of property should I invest in?
As a first-time real estate investor, you are most likely looking at condo or a freehold, this article is not meant to explain the process of investing in apartment buildings or a shopping plaza, it is geared towards investors thinking about buying their first rental, and starting small.
Condo v Freehold.
Condos – the benefit of buying a condo is that for the most part it can be hands off in comparison to a freehold, condos are smaller places, do not require maintenance comparable to freeholds, some of the maintenance is taken care of by the condo management (as part of your fees). It is suitable for people who do not want to spend much time or effort. The downside of the condo is that the condo fees can be significant, and will have an impact on the cashflow, please read our blog explaining why condo fees are so high. Please also read our blogs regarding buying resale condos as well as preconstruction condos, with few exceptions the same principles apply for buying owner occupied units and rentals, but there are exceptions.
Freehold – unlike with condos you can decide your maintenance schedule and expenses, if you think roof can last another year it will be up to you to make this decision, owning a freehold comes with more autonomy but at the same time it requires more work. It would be more suitable for individuals who have time and desire to put in the effort, I also suggest this option for people who have the skills and tools to do repairs as calling a plumber or handy man for every little repair will get expensive very quickly.
If investing in freehold look for houses which have two rental units, it will produce better return on investment, but at the same time you will be dealing with two tenants which means twice the headaches. The properties with basement rentals will likely be older, it is fairly uncommon for the new builds to have basements with separate entry. Older properties in itself will require more hands-on approach and would be more suitable for people who have time and are somewhat handy to take care off little repairs.
You can also look at purchasing a property which doesn’t have a rental basement unit at the moment but can be fairly easily and inexpensively converted to one, you can ask for an opinion of a trusted contractor before attempting to do this.
The properties with two units should have a separate laundry for each rental apartment, as well as driveways wide enough to park the cars beside each other without shuffling the cars, proper soundproofing between the units. This type of properties are appreciated by the tenants and easier to rent out, not to mention have better resale value.
How to build wealth with real estate?
We have already talked about selecting the city with growing population, location is of utmost importance for any real estate purchase, and there is also the scary leverage. In simple terms you put in the down payment, you borrow the money and have the tenant pay for the property. In majority of cases the investors will put as little of their own money as possible, and use others money to built the wealth. It can be a very good long term strategy, every 4 or 5 years you can have enough equity in the unit build up to purchase another one, rinse and repeat, in 20 years you could have a very nice real estate portfolio, retirement funded, or enough to gift a property to each of your children. The two other main aspects of the successful wealth accumulation is buying properties which have a very good chance of long term price appreciation, as well as good rental income.
When using the leverage in your arsenal of tools make sure you don’t overleverage, and have enough cushion to survive any crisis, be it tenant not paying or global catastrophes, so you are not forced to sell when you don’t have to.
Long term v short term.
The popular HGTV shows made the house flipping look so easy, you just buy, come and make money, easy peasy. In reality some people are making money this way, they have experience in construction, access to financing, have access to well priced labour, for most long-term investing (10 years plus) will result in better outcome. Buying and selling real estate is not like trading stocks, when you add up all the costs including selling and buying costs, land transfer taxes, income taxes, every transaction gets very expensive, buying for long term will be better approach in most cases.
Bottom line is be prepared for the worst. The idea is that after you have done all your research everything will go relatively smoothly, but that is not always the case. Be prepared for tenant not paying, damage, unexpected repairs, vacancies, recession, just to name a few, have enough funds available so you can survive any type of disaster.
Before you start shopping for properties make sure you have the finances in order, this is true for every real estate purchase including buying a principal residence, when purchasing investment property the lending is even more strict, you will need at least 20% down payment, some lending institutions will have even stricter criteria. Get in touch with a good mortgage broker to ensure you qualify for the investment property, and you will be able to obtain the financing.
Property management company.
Management companies exist to provide services to individuals who want more hands-off approach. The costs will vary depending on the services, company etc., and will obviously eat into your profits. On average you can expect approximately 10% of the gross rents to be charged in management fees. The best use of the property management company will be for people who can’t manage it themselves, have larger real estate portfolios, own a property that is in another city. For example, you have owned a condo for couple of years but an employment opportunity came up in another city or country, when you are away and can’t manage the condo yourself hiring a property management company will be a perfect solution. The management company can typically find tenants, collect rents, arrange repairs etc.
When selecting a potential investment property consider the commute, this will be especially important for freehold properties you want to manage, and do repairs yourself. It will be easier to accomplish the tasks if the property within a short driving distance than an hour and half away. I imagine you have a full-time job or business, family and other responsibilities, invest in a property that will be manageable for you.
Legal v illegal basement apartment.
Distinction between legal and illegal basement apartment has nothing to do with reporting rental income to CRA, it is related to having the basement approved by the city as a legal dwelling. The rules affecting legalizing basement apartments differ from one municipality to another, in some areas legal basements are not permitted, in others they are easy to obtain, yet other areas allow for it but have very strict criteria. Legal basements are the once which passed safety inspection (for example large enough windows to exit, fire preventative measures installed such as fire resistant door, drywall etc) as well as other requirements such as number of parking spots available.
Legal basement apartment increases the value of the property.
What are the consequences of renting out an illegal basement apartment? Let’s face it, many basement apartments are not legal and have been rented for many years without issues, why would this potentially present a problem? All it takes is one neighbour to complain to the city about too many cars parked on the property, or too many people living in the house, and the city can shut down your rental operation. It can also create issues with the insurance company if something goes wrong, god forbid there is a fire in the illegal basement suit, the insurance company may cancel the coverage and not cover the damages.
Let’s talk numbers.
The goal of investing in real estate is to make money, that means understanding numbers. An advice from a tax professional is suggested for your specific situation, the below is a guideline to help you understand the basics.
Your goal is to purchase the property which will appreciate in value in the future triggering a gain. In all likelihood the profit will be taxed as capital gain if you hold the property for long term, have rented it while you owned it, and in general CRA has determined that it is an investment and not a business. The rental property is not a principal residence so there will be a tax on disposition, if deemed a capital gain the tax will be based on the 50% of the gain. If the adjusted cost base of the property is $500,000, net proceeds after expenses are $800,000, your gain is $300,000. If you are in the 45% marginal tax rate, the tax liability will be calculated as follows: 45% tax rate x ($300,000 x 50%) = $67,500 tax owing to CRA due to the sale of the property.
Adjusted cost base.
Adjusted cost base of the property is the sum of purchase price of the property and any expenses related to the purchase such as land transfer tax, legal fees etc.
Net proceeds are calculated as a selling price of the property less any expenses related to the sale of the property such as real estate fees, legal fees, etc. In the above example $800,000 was used as net proceeds, that means that the actual selling price of the property may have been $830,000 but after all the expenses were accounted for the net proceeds were $800,000 which was the number used for calculation of the capital gains.
What is a cashflow, in simplest terms cashflow is money coming in versus money going out. Cashflow calculations are very common among real estate investors because it will show if every month there is excess or shortage of cash. Positive cashflow (good) in a month (or any other given period) means you have received more in money rents collected than you have paid out in disbursements, cashflow negative (not good) means you are paying out more than you bring in, and cashflow neutral means the exactly the same amount is received as it is spend.
In the last couple of years vast majority of investment properties purchased in the GTA with a minimum 20% down payment were cashflow negative due to the recent price appreciation in real estate, that makes real estate investing less profitable and less attractive.
Cashflow is often confused with profit, yet there are two different things.
Rental profit and loss.
Profit and loss is simply a calculation determining if you have made or lost money on the rental property in a given period of time, and you would need to report it annually on your tax return. This calculation includes all revenues and expenses, but unlike cashflow calculation it excludes payments such as repayment of the principal portion of the mortgage.
Let’s do a simple example to illustrate profit and loss calculation and to compare it to the cash flow calculation, for simplicity purposes we won’t be including every possible expense and we will ignore CCA.
Rent collected: $2,000
Property tax: $300
Interest exp: $700
Total exp: $1,500
Based on the above example we have a profit for a month of $500, notice we have only included interest portion of the mortgage payment and not the whole payment which includes principal repayment. The principal portion of the mortgage repayment is always excluded from the profit and loss calculation, but the total mortgage payment is included in cashflow calculation, if we assume the monthly mortgage payment is $1,300 (principal and interest), the principal repayment is $600, and you are cashflow negative by -$100.
It is important to understand what profit and cashflow mean, and that you can be making a profit and be cashflow negative at the same time.
The profit on rental property is taxable and, if the properties are owned personally and not in the corporation, it is added to the overall income, rental loss is deducted from total income on the tax return, hence affecting the tax liability for the year.
CCA And Recapture.
CCA – Capital Cost Allowance. When acquiring a depreciable property such as a building used for rental property you can’t deduct the total amount in the year, but because the property may become obsolete over time, you can deduct the cost of the property over time.
When purchasing a property for the purpose of renting you are likely purchasing land and a building sitting on this land, land is NOT a depreciable property and can’t be amortized over time, CCA doesn’t apply. CCA can apply to the building, there is no set rule which will state what percentage of the property purchase price is for the land and the building, a property in a good neighbourhood that has an old house requiring a lot of work may have 90% of the cost allocated to the land, a condo may have 5% allocated to the land.
Only the portion of the purchase price allocated to the building can be expenses each year on the tax return, there are many classes related to rental properties which are listed here on the CRA website, the most commonly used is class 1, assets in this class can be depreciated at the rate of 4% per year and you can further read CRA folio regarding limiting rules, half year rule, available for use rule to further educate yourself.
As explained above you can use CCA on a depreciable class of your rental property, the key word is “can”, the option is available but it doesn’t mean it should be used in every scenario. For example if you had a change of use, in order to claim election 45(2) or (3), you can’t claim CCA, if you are renting portion of your principal residence you may jeopardize the principal residence exemption.
Recapture occurs when the asset is sold at the price higher than the undepreciated amount and it is added to the income (not capital gain) in the year of the sale. Let’s look at a typical example which could have occurred around GTA.
The property was originally purchased for $700K (including all cots to purchase) in 2010 and sold in 2019 $1.2M (after all costs to sell have been deducted).
If the owner didn’t claim CCA on his or her tax returns over the years in 2019 he or she will report a capital gain of $500K, since this is a capital gain only $250K will be subject to tax at a marginal tax rate of the seller.
In a second scenario the owner decided to deduct CCA, the total CCA deducted over the years was $100K, and the owner benefited each year from deducing the amount and reducing the annual tax liability. In 2019 when the property is sold the recapture will occur, meaning the $100K deducted over the years will be added to the income in the year of sale, the seller has now additional income of $350K to report ($250K taxable gain and $100K recapture).
CCA is basically tax deferral, there are situation where it may make sense to use it (if you are in the highest tax bracket regardless of the sale of the property), and it may not make sense when the seller is in the lower tax brackets, but in the year of sale it would put him or her in the highest tax brackets.
Consult tax specialist before making the decision about claiming CCA on your rental property.
Repairs v Improvements.
Your rental property will require maintenance, sometimes it will be a small plumbing repair, other times it will be very expensive upgrade, quite often questions arise if the specific item is a repair and can be expensed in the year, or is an improvement and will need to be amortized (CCA) over the estimated lifespan of the improvement, it will be pretty obvious in some cases and more confusing in other circumstances.
Once again CRA provides information regarding current v capital expenditures and what to look for when trying to determine what’s what.
Here are few of examples:
- The property needed new roof at a significant cost, the old roof was asphalt shingles, the new roof is also asphalt shingles, while this have a lasting effect it is not an improvement and can be expensed in the year.
- The property needed new roof at a significant cost, the old roof was asphalt shingles, the new roof is metal which is a significant improvement over the old roof, despite performing the same function the new roof will be classified as improvement of capital nature.
- Your deck is older, made of pressure treated wood, and needs paint and few boards replaced, this is repair to be expensed in one year.
- You decided to extend the deck and use more durable and expensive composite decking material, this will be capital expenditure which can’t be expensed in one year.
Return on Investment.
The bottom line in real estate investing is that you want to make money over time, it’s a combination of rental income and property appreciation. There are many metrics of calculating the returns, the most common are Return on Equity (ROE), Cash On Cash (COC), Internal Rate of Return (IRR), I will have a blog dedicated to this topic.
Incorporating v buying personally.
This is a question which is often posed by the investors. Please consult your accountant to get the advice for your specific situation.
Purchasing the real estate inside a corporation for a small investor typically may make sense if the funds to purchase are already held in the corporation (person owns operating business and has excess cash to invest), if you don’t already own a corporation typically there will be no advantage to incorporate just for this purpose.
Buying investment before buying first principal residence.
The common scenario is for people to own a principal residence first, have equity built up in the principal residence and venture into investment properties later on.
Is it possible to buy an investment property first before buying a principal residence? Yes, there are however couple of items to discuss.
If you purchase an investment property first you will never be entitled to a land transfer tax rebate for the first-time home buyers when you purchase your first principal residence later on. The amount could be significant depending on the price of the property especially in areas such as Toronto where municipal land transfer tax is charged on top of the provincial land transfer tax.
It also may be easier to get into the market with a principal residence because only 5% down may be required, as oppose to 20% down for the investment property.
Buying investment property first is not that uncommon, young people who want to get into the market early will buy a condo or a small freehold property to rent out while staying with their family and saving on rent themselves if the situation allows.
Other very common way to get into the market is to buy a principal residence with a second rental unit, this way the perks of being a first time home buyer are not lost, and makes most sense if you have to pay rent elsewhere regardless. A blog dedicated to this very subject will be coming soon.
Residential Tenancies Act.
If you would like to became a landlord, I strongly suggest you get familiar with the rules and regulation regarding dealing with tenants, what you can and can’t do, the regulations deal with evictions, rent increases, deposits, first and last months rents just to name a few.
Please see some of the helpful websites related to this topic:
Selecting the right tenant.
Every landlord knows that having nightmare tenants is, well a nightmare and can ruin you financially, that is why selecting the tenant is of the most importance. Once you get familiar with the landlord and tenant rules you will know that evicting a bad tenant is not so easy. Keep in mind that when selecting a tenant the process has to be done in a legal way without a discrimination, you will be able to ask for references, obtain approval for credit check, or possibly use services such as naborly (if potential tenants approve) to help with the screening process.
The following landlords self help website has a very useful information on the subject.
When buying your first rental property keep in mind what type of tenants it will likely attract, a condo DT with the view of the lake is likely to attract different type of tenant than a basement apartment in a small-town Ontario.
Short term rentals.
If you are looking for a controversial topic it will probably hard to find one that is more controversial than short term rentals, anyway let’s try to stick to the facts.
Please familiarize yourself with the short term rental rules in your area, here is a link to Toronto’s By-laws, for example if you wanted to buy a condo with a purpose of short term rentals, most Toronto’s condominiums (except for approx. 15 buildings) have by-laws prohibiting short term rentals, and the city only permits short term rentals if they are portion of your principal residence. The bottom line is most short-term rentals in Toronto right now are operating illegally, the issue is with the enforcement. Even if you don’t plan on doing short term rentals check if the building has many apartments available for rent on sites such as Airbnb, or the condo by-laws allow for it, this may effect the rentability (tenants or owners may not want to live in a building which is knows for short term rentals) and resale.
If you are in any other areas of Ontario please check local by-laws.
If you have any questions or comments regarding this article please don’t hesitate to contact us.