For the Small Investor
I get a lot of calls from former students – from the b. school, from engineering, from architecture – and from consulting clients to tell me that they are now ready to invest in real estate. The calls are all pretty much the same: “Hey, Bruce, I have a few dollars kicking around and I want to buy a multi res property. Can your team help me with that?”
I have yet to hear from anyone that they might look at a different class of property, say, for example, industrial property or commercial retail. That is because they don’t believe that a small investor can play in the commercial space and because the multi res market is all they have ever heard about.
Investors are all the same everywhere – they only tell you about their winners. So you will hear someone talk about the multi res property that they bought a few years ago in Deadmonton that went up by 30% in two years and they sold for a humongous profit.
People like to tell stories where they are the hero and there is always a happy ending. But before you run off and buy your first multi res property think about this:
1. Are you ready to be a residential Landlord?
2. Do you know anything about the RTA (Residential Tenancy Act) that governs relationships in Ontario between Landlords and Tenants?
3. Can you stand to get a midnight call: “My plumbing is plugged and I need you to come over right away and fix it?”
4. Are you any good at collecting rents, doing credit checks, looking at the background and references of prospective tenants, fixing stuff that gets broken, property maintenance, etc.?
5. Have you got the time and expertise to go down to the Rental Tribunal and start and complete the process of evicting a tenant that does not pay their rent or causes trouble for you or other Tenants?
6. Can you market your multi res property effectively?
Now you might be thinking that you can delegate some of this or out source some of this to, say, a property management company. You can but it will cost you. Have you taken those costs into account?
I am not trying to discourage you but residential rental is not a game for the faint hearted or the time-pressed executive. It is in an industry in itself and you need expertise in a lot of different areas to become a proficient, profitable Landlord.
When I was younger, I looked at other opportunities and I try to get some of my clients to, at least, think about alternatives. One area I am keen on is the industrial condo market.
You can buy industrial condos in the Ottawa area for between $125,000 and $300,000 for anywhere between 1,000 and 1,500 sq. ft. I like this market because:
1. Industrial tenants tend to be more reliable than residential tenants.
2. They tend to pay their rents on time.
3. If something goes wrong, they fix it themselves most of the time and don’t even bother to phone you. These folks are independent people to begin with.
4. They tend to stay a lot longer – five year leases are common.
5. Cap rates in the industrial sector are higher than in multi res so returns can be higher to the investor…
6. There is less competition for the product. Your main competitor is, in fact, the sitting owner (owner-occupied space). The big guys: REITS, Banks, Insurance Cos., Pen Funds, publicly traded r.e. firms – don’t buy little spaces like these. Plus other small investors are all running after multi res product.
7. Vacancy rates are generally low in this class of product.
8. The property management function is low intensity so you should be able to manage it yourself.
9. If a tenant does not pay their rent, you can distrain – lock them out and seize their property as liquidated damages for unpaid rent. You do not have to wait months for the Rental Tribunal to allow you to change the locks and kick a tenant out.
10. Leasing is relatively straightforward. You can hire any number of commercial brokerages to assist you with marketing and drafting up the Offer to Lease or Agreement to Lease or you can do it yourself.
11. Most commercial leases these days are triple net. That means that the tenant must pay (in addition to their basic rent or minimum rent which goes to you, the Landlord): operating costs (like snow and garbage removal, common area charges, insurance, property management fees), property taxes and utilities. The Lease is ‘carefree’ to the Landlord. This gives you some inflation protection too. Think about what has happened to utility bills or property taxes, for example, over the last few years.
There is a long-standing tradition in commercial real estate to prepare two documents for a new tenant – an Offer to Lease (OTL) followed by a Lease. To me, this is anachronistic.
The reason it is done is to get the Offer drafted and signed by all parties relatively quickly. The Lease (which can often run 30 to 60 pages long versus the OTL at maybe 5 to 10 pages with Schedules) takes much longer and usually requires lawyer involvement for both the Landlord and the Tenant.
When I was a developer, we signed an OTL (which all parties agreed would be the Lease) for 80,000 sq. ft. with Nortel which was four pages long. As many of my readers already know, when you have a 60 page document, it is presumed by a Judge in any future dispute between the parties that you were trying to anticipate any or all eventualities. When you have a four-page document, the reverse is true. So in the former case, the Judge will usually look to the document for answers, in the latter, he or she will look to the merits.
Speaking personally, I would rather take my chances on the merits of a case. Nortel felt the same way.
This was a huge competitive advantage too – we could draft up a short from Agreement to Lease, written in English as opposed to legalese, and have it executed by all parties in a few hours or days while our competitors were fussing about with two documents and their lawyers, sometimes for months. It is also a heck of lot less expensive.
I certainly would not recommend an OTL followed by a Lease for a 1,000 sq. ft. transaction. But some people won’t make a move without their lawyer and that is OK with me as long as they understand that there are alternatives.
When you sell an industrial condo, you are basically selling into either the owner-occupied market or the investor market so your exit strategy has two options. Often, the place to find your Buyer is your existing tenant.
Real estate is a ‘get rich, slow’ field. You should not buy a property to flip it – the transaction costs are just too high – real estate agency fees, LTT (Land Transfer Tax), legal fees, commissions paid to REALTORS for their assistance in finding a tenant (even if you represent yourself, the tenant may have a Brokerage representing them and they will want you to pay a Brokerage fee), maintenance and repair costs, etc.
The stuff you see on TV – Flip This, Flip That – is just entertainment. Don’t be misled – there is no easy way to get rich that you can plan for. Hard work, effort, focus and expertise are needed. Some luck doesn’t hurt either.
There may also be some added value that you can bring to your industrial condo. My Dad loved basements – he always put a basement in the buildings he built. I like mezzanines – we used to add legal mezzanines to roughly double the space we had for rent.
We had numerous 1,000 and 1,500 sq. ft. industrial condos with 18 to 24 foot ceilings. As the nature of industrial companies has changed over the last 25 years, they use relatively more office space and less warehouse space. (A higher proportion of the value of products and services these days are produced by what Richard Florida calls the creative class. These people need high end PCs not warehouse space and loading docks. See: The Rise of the Creative Class and How It’s Transforming Work, Leisure and Everyday Life, 2002. Basic Books.) So we might decide to put in a mezzanine that could add anywhere from 40% more space to 87.5% more.
Other cool things that we used to do included putting in a double door and fire separating the upper and lower levels so you could rent out the upper level separately from the main level. In real estate, it seems that every time you draw a line on a piece of paper (create a severance, create a separate floor, have a second entry, create a second tenancy), you increase the value of the property.
One of the negatives about this type of investing is that you need to put up relatively more equity – maybe as much as 35%. Banks and other lenders view commercial property as more risky. Plus any type of commercial financing can be hard to come by today.
Real estate provides some tax advantages – you can deduct your CCA (Capital Cost Allowance, i.e., depreciation) from your income. When you sell your investment, it will in all likelihood be treated as a capital gain and not income and tax rates will be lower. Remember though that when you sell, even if the gain is treated as a capital gain, you will have CCA recovery; that is, you will pay taxes on the depreciation reserves you took earlier against income. Like so much in the taxation field, taxes are deferred not avoided. Also, how you set up your investments can be important.
Many of my clients already have a personal holding company (PHC). If not, I tell them to get one. The PHC is a fundamental building block to successfully owning and controlling different classes of investments. Your primary residence is not usually owed by the PHC because (at least in Canada), increases in value on your primary residence are tax free. The ownership of the principal residence is usually in the name of the spouse with a lower risk profile. But shares in, say, your tech company or your r.e. company would be held by the PHC. Note that your tech co. and your r.e. co. are separate corporations. If anything bad happens to your operating company where liability and the chances of something going wrong are much higher, hopefully, you will still have your r.e. co.
In Canada, you can move funds from your subsidiaries (for eligible Canadian Owned and Controlled Companies) to the PHC without paying any taxes using tax free inter-corporate dividends. Once you have money in your PHC, you may also be able to dividend out funds to your shareholders (i.e., you) tax-free if you have a capital dividend account. You can also do some income splitting – pay your spouse some money or your kids (after they turn 14 or 15). Like my Dad used to say: “Proudly pay your taxes in a great country like Canada, just don’t pay any more than you have to.” Never invest to intentionally lose money. That is a sucker’s strategy.
The types of returns you will see from owning real estate include:
• Cash on cash returns;
• Real estate inflation;
• Wealth effect from paydown of mortgage principal;
• Tax advantages (mortgage interest deductibility, capital cost allowance deductions, capital dividend account for tax free dividends, capital gains taxes are lower).
You can deduct not only interest you pay on the mortgages for your commercial property but if you mortgaged your principal residence to put up equity, the interest on that mortgage also becomes deductible from your income.
It is also a heck of a lot easier to build up, say, $2 to $3 million in real estate (using leverage, aka mortgages, and principal paydown facilitated by your tenants’ monthly rent payments) than it is to save that amount in cash from after tax, personal income, or to develop a stock or mutual fund portfolio of that size. So if you ever plan to retire, buying say 20 industrial condos and paying off those mortgages in the next 25 years might not be a bad strategy. If you got $1,000 per month net from each unit after taking into account all factors including a vacancy allowance, you would have $20k a month to live on – somehow, you might find a way to squeak by on that.
Prof Bruce
Ps. It is also likely that your cash on cash returns from your industrial condo portfolio will be higher than on your T-bills or a conservatively managed stock portfolio or mutual funds. And it could be a lot more predictable too. The downside is that r.e. investments may be a lot less liquid.