Buying an investment property can be an excellent way to diversify your portfolio. Before embarking on this major project, however, you need to weigh the pros and cons so you can make an informed decision. Here’s an overview of the steps to follow, plus plenty of tips to guide you along the way.
Income property: Definition and challenges
What is an income property?
An income property (also known as investment property or rental property) is a real estate asset that generates rent or lease income for the owner. There are several different types of income properties.
Single-family residential buildings, such as single-family homes, townhouses, and condominiums, can be an attractive investment for first-time buyers, since they generally cost less than other properties and often require less maintenance.
Multi-unit residential buildings, or plexes, are usually made up of two to six units, but can also have many more. This type of property is more expensive than single-family residential buildings and may also require more maintenance.
Commercial properties include industrial, office, and retail buildings, as well as mixed-use properties, such as buildings with both residential and office spaces. Buying a commercial property has many advantages, including stable tenants and flexible commercial leases. However, you may be required to make a larger down payment than for a residential property.
What are the challenges of owning an income property?
In addition to boosting your monthly net income, buying a rental property can be a good way to diversify your portfolio and protect against inflation. A rental property can also provide financial leverage for future investments, not to mention that the value of your property is likely to go up over time!
You may also be able to take advantage of a number of tax breaks in the form of deductions and tax credits that you can apply to your rental income. You’ll pay fewer taxes and increase the profitability of your property at the same time.
For more details on tax credits and deductions available to income property owners, consult the information provided by Revenu Québec and the Government of Canada.
Of course, you should also be prepared to deal with certain challenges, such as managing tenants and handling repairs and maintenance.
Step-by-step guide to investing in a rental property
From a long-term perspective, real estate is normally a safe investment, but that doesn’t necessarily guarantee a steady stream of profits. Before investing, you need to assess your tolerance for uncertainty, both psychologically and financially.
Assess your investment capacity
Are you up for the challenge of owning a rental property? If so, the first step in the investment process is assessing your borrowing capacity. Financial institutions will look at factors like your gross annual income, your expected down payment, and your debt load to determine how much you can borrow. Requirements vary from lender to lender and according to the property market.
As with any real estate investment, you’ll also need to put together a down payment. For buildings with four units or fewer, the minimum down payment is 20% of the purchase price, which means you don’t have to take out mortgage loan insurance. If you plan to live in one of the units, the minimum down payment for a duplex is 5% for the first $500,000 plus 10% on the remaining amount. For a triplex or fourplex, the minimum is 10% of the purchase price.
If the building you’re interested in has five or more units, you’ll need to make a down payment of 15% of the property’s economic value, not the purchase price, even if you plan to be an owner-occupier. If you want to avoid having to take out a mortgage loan insurance policy with the Canada Mortgage and Housing Corporation (CMHC), you’ll need to put down 25%. Whether you take out CMHC loan insurance or not, you’ll still need to show that you have 25% of the sale price in cash. This includes your down payment, your investments, and the market value of any other real estate.
Finally, don’t forget to leave yourself enough wiggle room to cover the other costs that come with buying a home, such as notary fees, building inspection fees, taxes, and insurance, which usually amount to around 1.5% of the property’s sale price.
Choosing a property
Location, location, location. The old adage is true, especially when it comes to investing in a rental property. Of course, buying a conveniently located building in a sought-after neighbourhood will cost more both upfront and in property tax. But it could well provide you with several advantages, including a larger pool of tenants and higher income potential.
Keep in mind that larger units will attract more families or people who want to live in your building long-term, which will limit tenant turnover.
Before taking the plunge, make sure your building doesn’t have any unpaid taxes or violations. You can check by making an enquiry with the Tribunal administratif du logement (TAL) and the municipality.
The condition of the property should also be examined with a fine-tooth comb. Ordering a building inspection and carefully reading the seller’s declaration may spare you from unpleasant surprises.
Assess the building’s profitability
The first step is finding out how much your rental income is and making sure it’s at least in line with the market average. At the same time, take care to examine the lease terms and clauses so you know exactly what you’re getting into.
Even if the seller tells you how much the operating expenses are (electricity, taxes, maintenance, insurance), you should still work out an estimate yourself or have one drawn up by an expert.
You can also calculate the property’s profitability as follows:
Let’s say you want to buy a duplex with a sale price of $500,000. The building’s annual rental income totals $35,000, and operating expenses total $10,000. You don’t plan to live in the building yourself. You make a down payment of $125,000 (25%) on a mortgage with a 5% interest rate, amortized over 25 years. Interest for the first year will be roughly $18,000. Lastly, let’s assume that the building appreciates at a rate of 1.5% ($7,500) annually.
This gives you a total of $14,500 after subtracting expenses and interest and taking the appreciation in value into account. Next, we’ll divide this amount by your down payment ($125,000) to get an annual return of 11.6%.
Assuming the building appreciates annually, your return on investment will need to be significantly higher than your mortgage rate for it to be worth it.
Of course, don’t forget that time is money. If the financial returns are good, you need to consider whether they’re worth the investment in time. Other factors such as taxes and the cost of major renovations will also have an impact on profitability. It’s important to consult an expert before making your decision.
Financing your purchase
If you want to buy a building with four units or fewer, you’ll need to put together the required down payment and take out a mortgage just as you would for a house or condo.
The rules change, however, if the building has eight units or more, as you’ll need to get a commercial mortgage instead of a traditional one. Commercial mortgages have different eligibility criteria.
Your financial institution will assess the profitability of the property, its location, the condition of the building, the occupancy rate of the units, your experience in property management, your financial situation, and your available liquidities after financing.
There are a few things you can do to improve your chances of getting more favourable mortgage terms, such as reducing your debts and financial obligations and increasing your down payment, credit rating, or income.
If you already own a home, you may be able to refinance it to fund your purchase.Whatever your plans, you can count on a Multi-Prêts mortgage broker to offer valuable advice.
Tips for managing your income property
What happens if one of your tenants doesn’t pay their rent every month? What do you do if you have to make an emergency roof repair? As a landlord, you’ll need to be prepared to deal with situations like this and spend time and money to address them. That’s why it’s important to plan for repairs and expenses with a budget. Managing your finances wisely is critical to making this type of investment worth your while.
There’s more to being a landlord than owning a building; it’s a role that requires certain skills. Being able to do repair and maintenance work yourself can make a big difference for your bottom line, since contractor fees pile up fast. However, note that in order to comply with CCQ regulations, you may need to have certain jobs done by a contractor who holds an RBQ licence.
Of course, the interpersonal aspects of the job are also crucial, especially for owner-occupiers. Your tenants will expect to be able to enjoy the use of their units in the agreed condition, and you should be prepared to respond at any hour of the day if there’s a problem.
In addition, you will have to negotiate things like rent increases, lease terms, and other tenant requests. Make sure you’re fully aware of the rights and responsibilities of landlords and tenants.
Keys takeaways
- Owning a rental property offers many benefits, such as revenue diversification, tax breaks, forced savings and protection against inflation.
- You must quantify and analyze the financial aspects and intangible factors before getting started.