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How to invest in a hot rental market

  • First National Financial LP

An emerging trend in housing, "the rise of permanent renters," has ignited a hot market for apartment buildings.

However, investor demand far exceeds supply and there are several things borrowers need to know in order to qualify for financing and prosper in this complex, competitive real estate sector.

"We are seeing prices going up drastically, multiple bids, the whole bit," says Vancouver-based Russell Syme, an Assistant Vice  President, Commercial Financing, at First National Financial LP, Canada's largest non-bank mortgage lender.

“Today, we are seeing the rise of permanent renters − a new demographic in many Canadian markets, especially as a growing proportion of the population cannot assemble the down payment for a new home."

"So to qualify for apartment financing, I see three main things being needed: property management experience, equity and liquidity."

If the prospective borrower does not have sufficient experience managing multi-unit income properties, the lender might make it a condition of financing that the borrower hire a property management company, say apartment financing specialists with First National. This can be an unanticipated expense for many first-time investors.

 "Over the last 10 or 20 years, people were able to buy rental apartment buildings with relatively little focus on operational efficiency and potentially still do very well financially over time because of the drastic increase in values that we have seen in the marketplace. I don't think that will be the situation going forward," Syme says.

 "I don't want to discourage people, but having that experience, or partnering with somebody who does, is a good way to go if you are buying an apartment building. The values are high, so you need to find other ways − through managing the property − to add value. Buy something that is not operating at its best and improve management of it . . . that's how you do well on these kinds of investments."

The lender wants to hear what the borrower intends to do to increase rents over time − if the building is currently generating below-market rents − and what the borrower might do to reduce vacancy rates. "The primary source of repayment for a loan on an apartment building is the cash flow from that apartment building, so that's what we are looking at," Syme says.

For investors with the management savvy and net worth to qualify for financing, "these properties offer investors steady income and stable cash flow. In the current environment, that's an attractive proposition," according to a recent report by PwC and the Urban Land Institute on emerging real estate trends in Canada and the United States. Furthermore, there is growing demand for well-managed and maintained rental units.

 Attitudes about accommodation have changed, the report says. "Renting is no longer seen as a temporary step on the road to home ownership, but as an alternative. Today, we are seeing the rise of permanent renters − a new demographic in many Canadian markets, especially as a growing proportion of the population cannot assemble the down payment for a new home."

The research resonates with Syme. He says even those who can afford to buy are choosing to rent, in some cases, because of the flexibility and convenience. In Vancouver, for instance, there are older homeowners opting to cash out and move to higher-end rentals instead of downsizing to a condominium or smaller house.

There is no shortage of investors wanting to take advantage of the shifting demand for rental apartments in multi-unit buildings, but they do not always know how to qualify for a mortgage, First National says in a paper co-authored by apartment financing specialists Peter Cook and Robert Fleet.

How to qualify
The lender will want to see net-worth statements from all beneficial owners, satisfactory credit reports, resumes outlining the borrower's real estate experience and details of additional real estate holdings or assets, including current debt.

Information on the property that’s required includes a current rent roll, an account of annual expenses such as insurance, utilities, property taxes and details of recent improvements.

The lender will require a minimum down payment of 15 per cent of the lending value for an insured mortgage, although the amount may vary depending on location, quality and condition of the building and the potential for rent increases. Typically, the down payment would be substantially higher in a small community highly dependent on one or two industries. "In those communities, you see wide swings in vacancy levels. It might be zero vacancy today, but if one of the industries in those communities has a downturn, the vacancy rate in that market might be 25 or 35 per cent and you can't rent out those empty units no matter what you do," Syme says.

In addition to the down payment, the lender may expect the borrower to have a minimum net worth of 25 per cent of the loan amount. Syme also looks at liquidity – i.e., a borrower's access to cash to cover unexpected expenses such as repairs to a roof or replacement of a boiler.

First National's preference is that the borrower not be an absentee landlord. "It's tougher to make sure the property is being well operated if you can't visit it regularly," Syme says. "There is nobody who is going to care as much about your building as you, so if you know how to operate a building and what to look for, it helps a lot.

"When I talk to some of my borrowers, they say 'if I didn't know what I was doing here, I would have somebody come in and charge three times more than they should to replace these toilets or do this plumbing work and whatnot.' That's just the nature of the business."