The below is presented as general advice on real estate investing. Finalyze makes no claims that the below advice will be applicable in every investor’s situation. Please seek professional advice for your specific facts and circumstances before acting on any strategies in the below article.
So you want to get involved in real estate investing and aren’t sure where to start? You may have some cash saved up and are starting to see what you believe is a great buying opportunity.
Real estate investment can include active or passive investment opportunities. Active real estate investment opportunities are where you own and manage the real estate asset while taking on all credit risk of the associated mortgage. Many investors choose to invest in passive real estate opportunities due to how time consuming it is to actively manage real estate, lower capital requirements (down payment), and the risks involved. In many cases investors do not have the expertise in a particular real estate product or the asset may be far from their existing home.
Before diving into key criteria to consider for investment its important to understand what the target allocation is you are looking for. It is generally recommended to have some allocation in your total portfolio to real estate and that number varies based on many factors such as your risk tolerance, need for cash flow, income situation, and how far you are from retirement. As part of a well-balanced portfolio you will want to have exposure to a variety of asset classes so that your investment can withstand market fluctuations and meet your investment milestone objectives such as saving for a home purchase, children’s tuition, or retirement.
For the purposes of this article, we will focus on passive opportunities where your investment has an equity claim on the underlying real estate through an investment structure. Passive opportunities can be as simple as investing in a real estate investment trust (REIT) in the public or private markets, pooling capital with other investors to make a direct investment known as syndication, participating in a larger pooled real estate fund with many assets, or purchasing units in a Mortgage Investment Corporation (MIC). The latter product known as a MIC provides you exposure to the credit side of real estate, essentially investing in mortgages which creates a different kind of investment exposure.
What is an Accredited Investor?
Investments can be made in the public markets which include the stock exchange or mutual funds for example. There is a growing market for private investments that are not publicly available. Due to Canadian and US securities regulations not all investors have access to private investment opportunities. In order to protect the public, private investments are generally accessible to accredited investors. The main reasoning behind this restriction is that private investments have higher risk involved, are generally more complex, and have less liquidity then publicly available products. We will discuss some of these attributes later on in the article.
To summarize for individuals the criteria for an accredited investor is at least one of the following:
1. An individual who beneficially owns, or who together with a spouse beneficially own, financial assets having an aggregate realizable value that, before taxes but net of any related liabilities, exceeds $1,000,000;
2. An individual whose net income before taxes exceeded $200,000 in each of the two most recent years or whose net income before taxes combined with that of a spouse exceeded $300,000 in each of those years and who, in either case, has a reasonable expectation of exceeding the same net income level in the current year;
3. An individual who has been granted registration under the Act or securities legislation as a registered investment dealer or financial advisor.
As you can see from the above, the criteria targets folks with high net worth, high income, or are registered in the financial services industry. If you do invest in private investments, the dealing representative will be working with you to ensure you meet at least one of the above criteria.
Passive Real Estate Investment Criteria to Consider
Numerous criteria need to be considered when making a passive real estate investment. We’ve grouped common considerations and devised the “6 C’s” of passive real estate investment criteria as a general guideline to help you evaluate the type of passive real estate opportunities you’d like to invest in. For purposes of this discussion we have focused in on income producing real estate versus real estate development which generally has a longer lead time to generating cash flow. Finalyze would be pleased to discuss your real estate investment objectives and help you devise an investment strategy.
1. Capacity – In terms of capacity it comes down to whether you are an accredited investor or not and what your track record or comfort level is with real estate investing. For folks just starting out the easiest way to get into real estate investing is to purchase units in a public REIT where you get ongoing cash flow payments and the capital gain on the underlying investment. The benefit of a REIT is that in most cases the income is generated tax free and then is taxed based on your tax scenario. For example, if you purchase a public REIT and place it in a TFSA you can shelter the distribution income (dividend) from tax indefinitely. Finalyze has published a podcast with LumiQ on this topic which is available here.
2. Cash Flow – As they say revenue is vanity, net income is sanity, and cash is king! When evaluating a real estate investment, you will want to understand the expected cash flow performance over the investment lifecycle. How will the investment manager or sponsor grow the cash flow over time is this through filling tenant vacancies with higher rents? Will they make capital improvements that will generate more cash such as an electrical vehicle charger? Are the units rent controlled or open-market? When looking at cash it is important to look at how much is leftover after the mortgage payment inclusive of principal and interest because if you are taking an equity position your cash flow is what is leftover. A simple calculation known as “yield” is to take the annual cash flow available to unitholders and dividing this by the initial investment.
3. Capital – Many passive investment opportunities include future capital contributions that may be required by equity holders for capital expenditures such as a roof replacement or parking lot repairs. Investment might have a capital reserve where every year a portion of the excess cash flow is set aside for this purpose similar to a condo corporation. Future funding s an important consideration as you may be required to contribute additional funds beyond your initial investment. The other side of capital is to consider the debt leverage in-place and will the investment be able to meet its lender restrictions such as having a sufficient multiple of income versus their debt payments. The last few years should be a great indication that having sufficient credit capacity to handle interest rate increases is crucial.
4. Capability – Who will be managing the asset? Is there expertise and property management on the ground level working with tenants? It is critical that the asset is managed so that rent is collected, expenses are paid, and tenants are serviced appropriately. From an investment perspective what is the investment thesis? Is the strategy to just own and hold long-term, value add, or future additional development (intensification? What is the manager’s fee structure? Remember you get what you pay for and so sometimes a higher fee is justified for higher expertise and higher returns.
5. Credibility – Will the financials be provided by a qualified real estate accountant and the associated tax slips? How will we know the tax composition of distributions? How often will you get performance reporting and valuation updates? Will the investor reporting include commentary on asset performance, KPI’s, and other information to evaluate how the investment is doing? Will there be a 3rd party providing audited, reviewed, or compilation financial statements?
6. Close – What’s the exit target date for this investment? Long term hold, target to sell in 5 years? What happens if the deal underperforms, and we must liquidate? What is your risk? Where do you sit in the pecking order of cash flows between lenders, preferred equity, and various classes of common equity? What happens if you need to redeem your units early are there penalties or is your investment locked in for X years?
We hope the above gives you a sense on criteria to consider when selecting a passive real estate investment opportunity. At Finalyze we apply our unique Plan ,Raise, and Manage approach to help our clients achieve their real estate investment objectives. We encourage you to book a free 30 minute consultation at info@FinalyzeCFO.com where we’d be pleased to discuss your real estate investment objectives.
