 Alternative Investing in Real Estate - Globe & Mail Feb 26, 2006 REPORT ON ALTERNATIVE INVESTING: REAL ESTATE
Forget everything you knew about mortgages
If you approach the financing of rental property as if you were buying your own home you could make costly mistakes
THERESA EBDEN Globe and Mail February 26, 2006
Sometimes finding an investment that's "as safe as houses" means exactly that.
With property prices increasing in most Canadian cities, and interest rates near historical lows, a growing number of people are becoming landlords in order to generate extra income, says Michael Polzler, executive vice-president and regional director at RE/MAX Ontario-Atlantic Canada Inc.
"Many Canadians see real estate as a safe and predictable investment, especially for the longer stretch," Mr. Polzler said. "Canada gets between 200,000 to 300,000 new Canadians annually, and it's between four and six years before they're ready to buy . . . so they rent."
Canada's population has risen by about 1 per cent for at least the past five years, helping drive demand for rental housing.
Potential investors, however, should understand that arranging financing isn't like getting a mortgage for their own home.
Ratio of financing
To start with, potential landlords should make lower down payments than they would on the home in which they live, according to Don Campbell, president of the Real Estate Investment Network.
An investor who buys a $100,000 property outright that appreciates 5 per cent in value in a given time period will have a return on investment of 5 per cent, Mr. Campbell explains in his book, Real Estate Investing in Canada.
But if that same investor puts down only $25,000 to buy the same property, the return becomes 20 per cent.
Banks will generally demand a 25-per-cent down payment. Mortgage insurance from an organization like Canada Mortgage and Housing Corp. or General Motors Acceptance Corp. can reduce this minimum to 15 per cent for an investment property and 5 per cent for a primary residence or a rental property in which the buyer also will live. Some alternate lenders will arrange financing that allows you to pay as little as 10 per cent down, but in Mr. Campbell's eyes this is often a mistake.
"It can be very attractive if you're in the right market, at the right time, and the rents cover all your expenses. But I don't recommend the super-high financing," he said. "If you're over-financing and you're down to the last nickel, that's when the water heater explodes, inevitably."
High-ratio mortgages -- those with a down payment of less than 25 per cent -- aren't common because many investors don't want to pay the insurance premium, said Peter Majthenyi, a consultant at mortgage broker firm Mortgage Intelligence Inc. For investors who opt for a high-ratio mortgage, Mr. Majthenyi generally finds more relaxed requirements for fire and hydro retrofits with GMAC than with CMHC.
Shopping for a mortgage
Don't just go to your existing banker and accept the mortgage rate offered, said Doug Gray, a former practising real estate and business lawyer and author of Making Money in Real Estate.
In general, lenders won't give as good a mortgage rate on an investment property as they would on a person's own home. Getting as many lenders competing for your business as possible requires shopping around for mortgage brokers, Mr. Gray said.
"They have all the lenders in their database," Mr. Gray said. "The individual normally doesn't have the street smarts, skill, time and inclination to knock on doors."
When it comes to getting approvals, lenders will consider the state of your personal finances, your potential rental income and whether tenants exist, Mr. Gray said.
Sometimes, a bank will offer a blanket mortgage for both your home and your investment property. Avoid this, Mr. Gray advises. "The basic rule of thumb with investing is you try not to have your principal residence involved at all," he said.
Not all mortgage brokers are created equal when it comes to handling investment real estate deals, and you should seek out the more experienced ones for a smoother transaction, Mr. Campbell said.
Also, giving bankers an organized binder of information holding everything from your net worth to proof of income to a pre-filled application will make it easier to seal the deal, he added.
Structure of the purchase
Sophisticated investors will consider purchasing through a trust if they want to take advantage of income splitting, said George Vandebeek, a tax partner at BDO Dunwoody LLP in Markham, Ont.
Specifically, discretionary trusts are set up with you, the investor, as the trustee of this separate legal entity that holds a property for the beneficiaries -- who can be anyone, but are usually a spouse or children. As a trustee, you have the discretion to say which beneficiaries the trust will pay income or capital to.
You can take advantage of the lower marginal tax rate of a spouse or child, who then uses the money from the trust, such as for tuition or hockey lessons.
Beneficiaries must pay a rate of interest annually to the trustee by Jan. 30 of the following year, or the income goes back to trustees at the fully taxable rate.
Setting up a trust costs about $2,000, and tax benefits are generally $300 to $400 each year, Mr. Vandebeek said. The trust ownership structure is more popular among small real estate investors than corporate structures, he said.
"There's no real tax advantage to corporate ownership over personal ownership, unless you have an active business," he said.
If you're purchasing many properties, or a large building with many tenants, a corporation will provide an extra layer of protection against your personal assets in case you are sued, he said.
Don't cut corners
If you're considering an investment property in another city, be aware of the costs of monitoring it, said Christine Mitchell, sales manager and broker for Royal LePage Real Estate Services in Mississauga, Ont.
Otherwise, investors risk finding their hard-earned investment has been misused, she said.
Marijuana grow-houses are on the rise, and targeted houses are primarily in good areas, with unfinished basements and with wood or ceramic floors that make it easy to manoeuvre pots and soil, she said.
These tenants usually want to pay rent all up front, and the mould and bills for electricity as well as legal costs can be ruinous, she said.
"You have to keep aware of your properties," Ms. Mitchell said.
Another cost that potential landlords shouldn't skimp on is an accountant's assessment of how the new investment will affect taxes, she said.
Sometimes investors are attracted to what Mr. Campbell calls "grey waters." For example, an unscrupulous broker may suggest you'll get a better mortgage interest rate if you sign a letter of intent to move into the property, even if you have no such plan.
This can result in fines, fraud charges and loss of support from future lenders, he said.
Paying a lawyer to look over your mortgage agreement before you sign is a good way to ensure your agreement is entirely above board, he said.
Posted February 26, 2006 by Theresa Ebden |
