Given we’re based in Toronto and work with clients largely in the GTA, our approach to income properties is a bit different than smaller real estate markets where prices haven’t seen the same price appreciation over time.
The primary challenge with buying an income property in the greater Toronto area is that while the rental rates are high and vacancy rates are low, the cost to buy is high enough that it often doesn’t make financial sense.
Way back in 2016 we wrote about what makes a great income property and in that article we explained the concept of a capitalization rate, or cap rate.
While the cap rate is a great way to compare income property options, it’s worth noting two important things about cap rates. They’re both fairly self-evident but it can be easy to forget them if you are just doing simple math and moving on if it doesn’t work.
First, if you buy for less, the same income generates a higher cap rate.
The first thing impacting the cap rate on a property is the price you pay to buy it. Any property can be an amazing income property if the purchase price is low enough.
Secondly, if you increase the rental income, you increase the cap rate.
The second part of the cap rate equation is the rental income. When you buy a property the income (or potential income) is what allows you to calculate your cap rate. If you can do something after purchase to increase the rental income, you also increase the cap rate.
Yes, both of the above are obvious if you stop and think about how cap rate calculations work. The implications are less apparent and there are ways in which you can structure your search for an income property that allows you to realize an improved cap rate.
Here are our three rules on how to buy an investment property so you get the best deal – and therefore the highest cap rate.
Rule #1 – No properties holding back on offers.
These types of listings are inherently competitive, which means that sellers and listing agents often do not provide all the information we should know about the property. It is a function of our current market that buyers are taking huge risks on homes that may have serious defects.
As an investor in real estate for income purposes, you need to go into a purchase with as complete an understanding of the property as possible. This includes information such as surveys, home inspections, permit and notices of deficiency review and much more.
Listings that are holding back on offers until an offer date are often priced below-market value to attract multiple offers and most sellers are expecting a clean offer with no conditions.
If you are constantly in competition with buyers who don’t have the same perspective and who are willing to overlook concerns (or missing information) that they shouldn’t, you will regularly be outbid by buyers with more money than sense. The alternative is to overpay for a property which may have costly work to be done, resulting in a lower cap rate.
Rule # 2 – No properties that are fully renovated and in near perfect shape.
The principal behind this rule is an extension of the thinking behind Rule #1.
Properties that have been significantly renovated (or appear to be significantly renovated) attract greater interest from buyers who have no ability or willingness to do renovations. As a result, they sell for a higher price and any current or estimated rental rates have already built in the impact of these renovations. This is particularly troubling as we have no idea if the work that was done was to a high quality or whether the cosmetic updates conceal troubling issues with the home such as water leakage, structural issues or more.
The cap rate for such renovated properties could be higher based on the higher rental rate (on the assumption that a premium rental unit commands a premium rental rate) but the higher purchase price means that the cap rate is often the same or worse than a property that needs work.
In essence, the sale price that incorporates the renovations is often higher than a similar home without those renovations. The end result is that the home costs more than the renovations actually are worth and it means that you have no opportunity to add value through doing some renovations.
Contrast this against a home that needs updates and work in order to show better and to command a higher rental rate. Fewer buyers are willing to consider the property as many investors are looking for turn-key solutions and are not interested in a renovation project. As such, the sale price is likely to be lower due to less competition.
At the same time, the rental rates (either currently being charged or estimated) are lower due to the lower level of finishes in the home. By arranging vacant possession, you can do the necessary renovations to increase the appeal of the property and then rent out at higher rental rates to a better class of tenants.
A lower purchase price and a higher rental rate after our renovations equals a better cap rate.
Rule # 3 – No properties that also appeal to an end-user directly.
The attributes of a good income property can be quite different from the attributes of a good family home.
- As an investor, you want to be close or on transit routes to appeal to tenants who have no vehicle of their own.
- As a home owner, you want to be on a quiet side street where you aren’t bothered by the noise of buses or streetcars.
- As an investor you want as many units as possible within a property to maximize rental income while minimalizing potential replacement costs.
- As a home owner, you want a property that works for your family and gives you privacy and space.
Whether it is location or housing type, when you’re looking for an income property, you need to focus on properties that aren’t appealing to end-users themselves. By doing so, you realize significant benefits, including a much higher likelihood of:
- Appropriate zoning (such as for a legal triplex)
- Renovations done with permits (properties with a history of being used an income properties have often come under increased scrutiny over time and required permitting for work)
- Legal secondary suites and registration with the local municipality
Individual or families buying a home have far different metrics for their purchase considerations and income properties typically sell at a discount compared to end-user properties. If you focus on properties that are inherently less appealing to an individual or family who would live in it themselves, you reduce the level of competition, which should mean a lower sale price.
All real estate is bought and sold within the prevailing market conditions for the area, but not all properties have the same opportunity to be bought for a lower price and to increase the rental income from the property.
If we follow the above three rules, we have:
- Sellers who are motivated to deal with our offer and who provide the information we need rather than simply sell to another (non-existent) buyer who doesn’t ask questions.
- Properties that we can buy for less, where we can oversee some renovations after purchase that add value in terms of increased rental rates and valuation over time.
- Properties we can buy at better prices as we don’t compete against emotional end-user buyers who drive up the price.
If you’re keen on buying an income property, make sure you work with agents who know and appreciate what it takes to find a good investment. We look forward to hearing from you!