- By Tamils in Finance
- April 11, 2022
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Recall, in our last piece, we made the notion that even in pricey market conditions, real estate can prove to be lucrative, if you know where to look. Certain markets, mostly secondary markets (smaller cities outside the GTA), might be an inexpensive way for investors to secure residential real estate. While market conditions have materially changed since COVID-19, opportunities still exist. Indeed, my partners and I did just that last year.
In March 2021, we closed the acquisition of a seven-unit apartment building in Atlantic Canada for $395,000 – on a per unit basis, this equated to $56,000. Acquiring a similar property in the GTA would have cost an arm and a leg. After the implementation of our strategy (comprised of strategic renovations as well as realizing operational efficiencies through better expense management and higher revenues) along with the help of market momentum, we were able to increase the value of our property significantly over the span of the year. The property today is worth ~$750,000, nearly double what we paid a year ago.
You might say, well that is just due to an extremely hot housing market (we will get to this later). While that is partially true, there are other forces at play. With commercial properties (loosely defined as buildings with more than six units), value is derived using an income-based approach – as in, the value of the property is dependent on the operating income (revenue less expenses excluding cost of financing) potential of the asset. That is, the higher the income, the higher the value. The other side of the value equation is what is known as a capitalization rate. The capitalization rate is the rate of return on a real estate investment property based on the income that the property is expected to generate. While higher cap rates usually signify higher risk, they also have potential for cash flow – that is why markets in Atlantic Canada have a far better chance of generating meaningful cash flows vs markets like in Toronto where cap rates remain compressed (trading near the cost of financing and thus less attractive from a cash-flow perspective).
Before we get into the nuances of the deal in itself, let us first talk about what makes a good deal. For us, we looked at several factors:
- The condition of the property – there were no structural issues that needed to be addressed and higher rents could be achieved through modernizing the units (these typically include cosmetic renovations such as painting, flooring, updating the kitchens/baths or the addition of a new room/bathroom) as they were dated;
- The location – the property was located in an up and coming area, which supports a higher rent potential as well as lower default rates;
- Transferability of expenses to the tenants – given that each unit operated on separate utility meters and the majority of tenants were not paying for their own heat and lights, there was a possibility to pass-along the expenses to the tenants, thereby effectively increasing our bottom-line and thus our value; and,
- The price paid to acquire the property vs the value we expect to achieve after the implementation of our strategy – the going capitalization rate at the time of acquisition was ~5.5-6-0% and the asset was under-performing. We knew, the value of the asset could be higher. So, the deal checked all our boxes. The next step was to figure out how to fund the acquisition.
Financing the deal with the correct terms can make or break deal since the cost to carry financing throughout the turnover period can sometimes lead to a cash burn. Since this was a commercial deal, we required a 25% down-payment, which we funded using private funds (at a rate of 13% for a one-year term, and the remaining 75% was funded by a credit union at a sub-5% rate).
At the time of acquisition, the property was generating ~$55,000 in rental income and ~$18,000 in operating income. Once we closed the acquisition, we turned our focus to instituting our strategic renovation plan and operational improvement efforts to generate a positive return on our invested capital. We instituted a staggered renovation plan as units turned-over and re-rented them to high quality tenants at market rates, as well transferred the utilities over to the tenants. With these changes, the property now generates $67,000 in rental income and $39,000 in operating income and thereby increasing the implied value of the asset. Upon a recent appraisal, the property fetched a value of $750,000, which we then used as a basis for our refinancing efforts. Typically, for our projects, upon completion, we refinance our asset with a traditional lender. This is critical because it allows us to redeem our initially invested capital and roll-it over into a new project as well as pay-off private financings.
Before we log-off, we do want to make readers aware of current market conditions. Market sentiment is growing bearish, with the consensus expecting a market correction and a slow-down in activity. While activity did slow in February (down 8.2% year-over-year), supply remains tight with just 1.6 months of inventory vs a long-term average of 5+ months. We believe, with rising rates, cooling down of demand, rising recessionary fears, and regulatory changes, turbulent times lie ahead for the housing market. That said, with capital back in-our pocket and investors happy, we ask – what’s next?
Vaikunthan Ambalavanar is a Research Associate at Desjardins Capital Markets.
This article is re-published from the Spring 2022 issue of “Street Talk”, TiF’s flagship publication. Interested in writing for us? Click here for our submission guidelines.