001

Table of Contents
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

001

Preface
Investing in commercial real estate is a very specialized form of investing. Most people are familiar with residential real estate investing, where an investor manages a portfolio of single-family and multi-family units to create cash flow and use increased values to buy more properties. The commercial real estate sector takes the form of investment in apartment buildings, office buildings, industrial buildings, warehouses, plazas or malls, and property development. The inherent risks and rewards are much different; the due diligence requirements are much different; the financial strategies are much different between these forms of real estate investment.
Through our years of experience in commercial real estate, it became apparent to us that we had gathered a body of knowledge that would be of interest to investors and professionals, such as real estate agents and brokers, financiers, lawyers, property managers, various professionals, and their tenants. We would often be called on to render an opinion or conduct research on various aspects of commercial real estate. Hence, we thought it timely to write a book that is both a primer on commercial real estate investment and a useful tool and reference guide for those seasoned professionals with a keen interest in real estate literature.
While subjective as it might be, in our opinion here are some “80-per cent facts” about commercial real estate that clearly indicate that a book such as ours could prove helpful:
• 80 per cent of commercial buildings are not properly managed, even by large landlords
• 80 per cent of landlords do not maintain a proper, rewarding relationship with their tenants
• 80 per cent of commercial properties do not generate the income they are capable of generating
• 80 per cent of landlords who are in financial trouble should not be in financial trouble, and
• 80 per cent of buildings need to be environmentally upgraded to reduce their environmental footprint, which will deliver cost savings to the owner.
Here, in broad strokes, are the main topics our book addresses:
• why you should consider investing in commercial real estate
• what to look for in each of the main types of real estate
• purchasing strategies
• a primer in real estate taxation
• how to build your team of professionals
• how Offers to Buy and Leases are structured and what you should look out for
• how commercial property financing works
• an understanding of property management, repairs, and renovations
• the requirements and responsibilities of being a good landlord
• how to conduct due diligence for prospective tenants
• ways to increase income from the property
• the pitfalls you need to avoid
• an introduction to real estate terminology, and
• sources of further information.
Please note the following:
 
Pronoun Usage: The pronoun “he” also encompasses “she”. We respect the modern trend to use “he” and “she” but this construction can become awkward at times. For ease of reading we decided to let the pronoun “he” speak for both genders.
 
Measurements: We show both metric and imperial measurements as both are employed in every day real estate life.
 
We’d also like to invite you to visit our Web site at <> and contact us with questions or comments. These will be most helpful in ensuring future editions provide the most current and useful information.
 
Pierre Boiron
Claude Boiron
Thornhill, Ontario

PART 1
Introduction to Commercial Real Estate Investing
Chapter 1: INTRODUCTION
1.1 Types of Real Estate Investors
1.2 Purpose of this Book
1.3 Is this Book for You?
1.4 Scope of this Book
1.5 Overcoming the Barriers to Success
 
Chapter 2: THE BUSINESS OF COMMERCIAL REAL ESTATE
2.1 Sorting Out the Terms
2.2 Commercial Real Estate Defined
2.3 Benefits of Investing in Commercial Real Estate
2.4 Evaluating the Market Outlook
2.5 Building Wealth through Real Estate Investing
 
Chapter 3: THE SUCCESSFUL INVESTOR
3.1 Understanding Risk
3.2 Developing Your Investment Plan
3.3 Excessive Caution Leads to Paralysis

CHAPTER 1
Introduction
By the end of this chapter you will be able to:
• Differentiate between the three roles of real estate investors.
• Identify how this book will assist you.
• Determine if real estate investing is for you.
• Recognize that there are jurisdictional considerations.
• Know how to rise above the common obstacles to success.

1.1 TYPES OF REAL ESTATE INVESTORS

Differentiate between the three roles of real estate investors.

There are many kinds of real estate investor, ranging from the uneducated to the Ph.D., from the charming to the obnoxious, from the sophisticated to the vulgar. There are those who start out with money and those who don’t (but be reassured, you don’t need that much money to get started). So, do you have what it takes to be successful?
Based on many years of experience, we are convinced that you need only two things to succeed as a real estate investor: an indomitable determination to succeed and plenty of courage.
There are, however, three distinct hats that you must wear at different times to be a successful real estate investor:
1. The entrepreneur
2. The property manager
3. The technician.

1.1.1 THE ENTREPRENEUR

This is the dreamer, the person with the vision, the creativity, the desire, and the ability to make things happen. He finds, analyzes, and negotiates the deals. He will arrange financing or set up partnerships. He is the lifeblood of the business and without him nothing would be started.

1.1.2 THE PROPERTY MANAGER

This is the person who deals with the tenants, the suppliers, and employees. Without him, things might get done, but the “right” things would not get done properly and cost-effectively.

1.1.3 THE TECHNICIAN

This is the “maintenance” person who watches over the building. He decides which repairs need to be done, when, and which brands of equipment to use. The technician decides what to replace, what to repair, and which energy saving measures to implement. He also decides if major changes should be made, such as dividing a large two-bedroom apartment into two small one-bedroom units, or building an addition. The technician who starts as a small investor may do the work himself or hire and supervise others to do it.
The real estate investor must take on all three roles, whether personally or with the help of others. If your budget is generous you can hire some of this expertise, but if your budget is limited, you may have to perform all three jobs yourself, especially when starting out. The important point to remember is that you need to create these “company” positions both on paper and in your mind as part of your business plan. Each one is important to keep your real estate investments growing. You will be building on your strengths and finding outside help, where required, to compensate for your limitations.
Each position — entrepreneur, property manager, and technician — is important to keep your real estate investments growing.

1.1.4 KEY CHARACTERISTICS

Although you do need some knowledge starting out, most of this can be acquired by reading and by heeding the advice of trained professionals in the real estate industry. You don’t need an MBA; street smarts are much more precious. In the end, your temperament, your personality, and, above all, your desire to succeed will be your ticket to success.
If we had only one piece of advice, it would be this: at all costs avoid associating with people who are negative and condition yourself to reject negative thoughts. How do you do that? By following the advice of the sage French pharmacist, Emile Coué, who, centuries ago, invented self-hypnosis: keep repeating to yourself what you want to accomplish. For example, repeat to yourself, “I will buy a property before the end of the month (or year).” It sounds funny, but it works.
Desire is the key. Let it burn inside of you. Become obsessed. The most important thing is to get started. Buy a property — rented or to be rented (it doesn’t matter which) — but start and start small (e.g., a $100,000 property at 5% down = $5,000).
This is not to say that your journey as an investor will always be smooth; not at all. In fact, it would be a miracle if you never encountered difficult times. In all likelihood, you will have to make sacrifices and exercise self-discipline (particularly in your spending habits). As in anything new, you will make mistakes. But don’t worry about any of these hurdles.
Real estate can be very forgiving of mistakes and it is through them that you will learn. Even if you make mistakes, with the help of this book, there is a 99% chance that you will break even. Remember, a property does not disappear. If you can commit yourself and survive the ups and downs, you will have demystified the process of buying and managing real estate. You will have taken the first step and started building the foundations of your real estate investment program. If by an extraordinary stroke of bad luck, you lose money on your first foray into the world of real estate investing, it will be very little because you started small. Remember, there are a number of experienced advisors to help you: lawyers, real estate agents, accountants, and appraisers.
Remember, there are a number of experienced advisors to help you: lawyers, real estate agents, accountants, and appraisers.
Virtually everyone is a little apprehensive when doing something for the first time and it becomes easy to justify not doing anything, because you can’t find the “perfect property” — that is, the ideal property type, in perfect condition, at the right location, for a price you can afford, etc. The fact is the “perfect property” doesn’t exist. The best you can hope for is to acquire enough knowledge to make informed decisions and act on them. All the time you spend learning about real estate investment will be wasted if you do not act on it.
You will increase your likelihood of getting started if you can find a good partner for your first venture. Sometimes, a spouse does the trick! And, if you are starting out with limited means, please, go out there and buy a rental property. When in doubt, remember the words of Wayne Gretzky: “You miss 100% of the shots you do not take”.

1.2 PURPOSE OF THIS BOOK

Identify how this book will assist you.

The purpose of this book is threefold:
1. to encourage commercial real estate investing by showing that to be successful takes more courage, organization, and discipline than luck or brains;
2. to give the reader a solid understanding of how to select, acquire, lease, and manage income-producing properties (IPP), so that he can avoid trouble or deal with it at any point throughout the process; and
3. to provide investors or investors-to-be with a comprehensive reference guide that answers the “What should I do if …?” questions when they arise.
This book is written to support a wide range of readers — from those considering or just getting started in commercial real estate investment to experienced investors and the professionals who advise them. If you are just starting out, this book will motivate you to begin by showing you that knowledge and a little bit of money go a long way. You will gain an understanding of how to do things yourself to save money.
If you have been investing in commercial real estate for years, this book can help you to become a superior investor by pointing out many things that the professionals are doing. You will discover many ideas that you had forgotten or, perhaps, never knew.

1.3 IS THIS BOOK FOR YOU?

Determine if real estate investing is for you.

This book will benefit a wide range of individuals in or near the commercial real estate industry, but especially the following:
• residential agents who want to move into commercial real estate
• students planning to acquire their real estate agent’s license and intending to specialize in commercial real estate
• real estate investors and property managers, who want an easy-to-use, comprehensive reference book at hand
• residential investors, home builders, and land developers who are considering a move into IPPs, and
• financial consultants, accountants, lawyers, and lenders who work in the real estate industry.

1.4 SCOPE OF THIS BOOK

Recognize that there are jurisdictional considerations.

Real estate in Canada falls under provincial jurisdiction, which means that taxation, assessment, and legal systems are regulated or influenced by provincial law, as are many of the professionals who service the industry. Land use regulation is imposed by municipal authorities in combination with provincial and federal governments. Despite this maze of controls, there is, in fact, little variation in how business is conducted among the various provinces and territories. Although the examples in this book are Ontario-specific, readers will find that the information and advice presented apply across the country.
Indeed, there are some differences between various jurisdictions, such as condominiums (in Ontario) being called stratas in British Columbia. But this is superficial and applies mainly to the income tax and legal systems. The basic tenets of this book apply equally well to Toronto as they do to Calgary, Los Angeles, or Sydney.

1.5 OVERCOMING THE BARRIERS TO SUCCESS

Know how to rise above the common obstacles to success.

Many people view real estate investing as a great avenue to acquire wealth. While this is true, surprisingly it is not always the better-educated people who end up owning investment property. In fact, if a survey were conducted, we believe it would show that just as many, or perhaps more, truck drivers and trades workers as university professors and doctors are real estate investors.
In our experience the three most common barriers to investment success in commercial real estate are:
1. analyzing everything to death and focusing too much on the risk
2. not being aggressive or gutsy enough to make decisions, and
3. perceiving the business as being more complicated than it is.
This book will give you the information you need to approach commercial real estate investment with confidence. It will explain the risks and opportunities involved and give you the tools you need to analyze and compare investment opportunities.
Many books on real estate investing are theoretical, written by those who have little personal commercial investing experience, while many others are written by get-rich-quick artists who count more on their books to make money than on their real estate investments. This book focuses on practical advice, based on our combined 50 years of experience in the industry. It is intended to help you get started, but also to act as a one-stop resource that you can turn to again and again, either to refresh your memory about some less-often encountered detail or to help you negotiate your way through a complicated deal. We hope that it rekindles your enthusiasm and recharges your batteries for real estate investing.

CHAPTER 2
The Business of Commercial Real Estate
By the end of this chapter you will be able to:
• Distinguish between real estate, real property, and other industry terminology.
• Analyze the pros and cons of various categories of commercial properties.
• Compare real estate and other types of investments.
• Consider all the factors when deciding upon the type of real estate investment.
• Evaluate the current marketplace and its near future.

2.1 SORTING OUT THE TERMS

Distinguish between real estate, real property, and other industry terminology.

“Real estate” is land in its natural state, including anything of a permanent nature on or under the land, such as trees, minerals (if allowed by law), and all the rights that go with that land. When one talks of real estate in populated areas, one is generally referring to the improvements to the land, such as the buildings, parking lots, etc. The land and its improvements are tangible property since it is quite easy to touch them.
Intangible components can include such things as zoning, the quality of a particular address, and the exposure or orientation of the buildings on the land. The term “real property” is used in this book because it includes both the tangible and the intangible components. When one buys a property, it is land only which is conveyed, from the viewpoint of the land registration system. The improvements are not shown in the deed.

2.2 COMMERCIAL REAL ESTATE DEFINED

Analyze the pros and cons of various categories of commercial properties.

Most of us are familiar with residential real estate. It includes the houses or condominiums that are our homes. “Commercial real estate” is defined in the context of this book as income producing property (IPP). However, there are many types of IPPs, ranging from farms or gravel pits to hockey arenas and shopping centres. The purpose of this book is to focus on the most common IPPs that make up the bulk of commercial real estate investing opportunities for the small- and mid-size investors. These IPPs are buildings that are leased to tenants (lessees) by landlords (lessors) and not occupied by their owners.

2.2.1 FOUR CATEGORIES OF COMMERCIAL PROPERTY

We cover four main categories of commercial real estate in this book: industrial, office, retail and multi-family residential.

(a) Industrial

Industrial buildings tend to have medium- to long-term leases (five or more years). They are the least management-intensive type of IPP, unless they comprise many small units of, say, 93-465 m2 (1,000-5,000 sq ft). These are called multiple-occupancy industrial buildings.
These buildings are more frequently damaged and even abused by tenants, due to their uses, such as painting (air-borne paint deposits), steel fabricating (dust and damage to floors), woodworking (dust everywhere), and truck usage. Environmental problems or risk, due to tenants’ use, is greater than in the other categories. Convenient access to freeways is important for the transportation of supplies and finished products as is availability of public transportation for the labour force.
Depending on the user, it can be very costly to move to another building at the end of a lease term. This motivates tenants to renew their leases. It is difficult to find industrial buildings for purchase for less than $1 million. It is more difficult to sell leased industrial buildings than retail or multi-family residential properties.

(b) Office

Office buildings come in all sizes (from a converted bungalow to a traditional multi-storey tower). Likewise, the size of tenancies varies enormously, starting with a one-person office to an entire building of 9,300 m2 (100,000 sq ft) or more, housing hundreds of employees.
It is an advantage if the address is a well-known artery has sufficient parking, which is a large plus. Exposure is a factor too, but not crucial, and traffic count is usually of little interest. This type of tenant, particularly the larger ones, expect a higher level of involvement on the part of the property manager/owner.
Office buildings are more susceptible to downturns in the economy. Therefore it is the riskiest of the four types of commercial real estate and tenant turnover tends to be greater than with industrial or retail properties.
We cover four main categories of commercial real estate in this book: industrial, office, retail and multi-family residential.

(c) Retail

Any potential buyer of retail property must remember that appropriate location is very important and there are three key aspects: address, exposure, and traffic count. The astute buyer would do well to hire a professional to study the demographics of the property.
Analyze the tenant mix, which is poor in many plazas. Make sure that there is plenty of parking and easy access to the highway and public transportation. Ideally, if the centre is big enough, it should be anchored by a supermarket or other major retailer that will generate huge amounts of traffic for the other tenants.
In retail, leases are the most complex, as is property management (both in terms of technical complexity and multiple details). However, some landlords prefer retail over other types of commercial property because of the stability of tenants. From their viewpoint, a retail tenant who makes money is extremely reluctant to move. It is not overly expensive to enter this category as one can start with a single building containing one main floor store and one or more apartments above.

(d) Multi-family Residential

This category offers the two extremes — the least risky and the most management intensive. Also multi-family buildings are easy to sell, but good ones are hard to find.
This category is often chosen by new investors because one does not need a great deal of sophistication. However, it requires that the landlord, or the property manager, roll up his sleeves and have a great deal of patience and tolerance. It has the drawback of being subjected to rent controls and tenant turnover is quite high. This category allows for the highest loan-to-value ratio financing. Apparent returns are the lowest, but rentals can usually be increased almost every year, which is not usually the case with the other categories, since most leases are for five or more years.
Public transportation and nearby shopping (particularly a supermarket) are big pluses, as is proximity to employment. Buildings where the tenants are seniors is advantageous for landlords, as they tend to be “gentler” on the property.

2.2.2 VALUE OF COMMERCIAL PROPERTIES

Some investors want only shopping malls, others only apartment buildings, and others only office buildings. For others, the amount of money required is the key factor in determining how they are categorized as investors. Real Estate Investment Trusts (REITs), huge pension funds, such as Ontario Municipal Employees Retirement System (OMERS), and large institutions, such as Sun Life, have become significant players in the commercial real estate investment market, gobbling up expensive properties in prime locations (referred to in the industry as “class Triple A” or “A-type” locations). This trend started around 2000 and has reached such a crescendo that mid-size investors have little opportunity to compete for these properties.
Basically, we now have three categories of property values:
• over $10 million, dominated by the huge buyers mentioned above;
• between $3 million and $10 million, the hunting ground of the medium-size investor, where there is less competition than in the first category; and
• under $3 million, the stomping ground of the small, to very small, investor.

2.2.3 CAUTION: DO NOT BUY LAND

In this book we cover only properties that generate income, such as shopping centres, retail stores, industrial, office, and multi-family buildings. Many readers may wonder why we do not recommend land as an investment. There are three main reasons.
1. Land Is an Alligator; It Keeps Eating All the Time. This old saying means that if there is a loan on the land purchase, which is generally the case, interest has to be paid and eventually the principal of the loan. In addition, there are property taxes that, although generally quite low on vacant unzoned land, can jump significantly when or if the land is zoned. There may also be local improvement taxes for new services, development studies, etc. In other words, the cost of holding land will at a minimum remain constant, but can also increase, while there usually is no income to offset these costs.
2. The Activist Challenge. There are many activists, particularly environmentalists, who fight against any land development. Some would say this is an exaggeration, but it is easy to name a number of commercial real estate projects, particularly in land development, that have been hampered, delayed, or even stopped by activist intervention. One can argue about the benefits and detriments of these activists, but the fact is that for anyone who wants to develop land, they raise a spectre of incalculable costs that increase the risk of investing in land.
3. Government Controls Are Complicated and Cumbersome. The system controlling land development has become incredibly complex, rigid, and costly in its demands. In Ontario, the main cause is the Ontario Planning Act. In many places one can find the wording, “If the Municipality thinks that … it may request ...” Ninety-nine per cent of the time, municipal planners replace “may” with “must.”
Here is an anecdote to illustrate our point. In 1970, or thereabouts, in a small community located one hour north of Toronto, a farmer applied to subdivide approximately 20 acres of his land into residential lots. He went to see the local planner one day at 2 p.m. and at 4 p.m. had the subdivision approved, subject to having a plan of survey prepared that would show the lots. In 1985, the same farmer applied to the municipality to subdivide a 30-acre site abutting the first site. This time it took him eight years and cost him $100,000 in consultant’s fees and studies to have his draft plan of subdivision approved!
To give you an idea of the complexity of taking a site through the planning process, and in case you happen to own a piece of land and want to understand what is involved, charts the typical process.
Land development is a very risky, lengthy, and costly process and often incredibly frustrating. As a result it is also often less financially rewarding. Although we concede that some very knowledgeable people make a lot of money in land development, our advice to the average investor is to avoid getting involved with land.

2.2.4 A NOTE ABOUT SPECULATION

Speculation is very different from investing. The latter is the rational analysis of risk. It generally consists of buying land or a building that has the potential to provide you with steady returns on your investment over the long term, through the income generated by the property and, upon selling, the profits realized through appreciation. Speculation is more of a “devil-may-care” approach to real estate investment — more of a gamble, less of a science. It is buying with the objective of selling quickly and “making a killing”. It is buying land or a building with the hope that the market will change significantly, perhaps because of new zoning, new roads, new servicing, growth, etc., resulting in windfall profits.
Rewards in speculative ventures can be staggering, but losses can be equally severe. Generally, one has to be very patient, since the factors that cause a market to change are beyond the control of the investor and influenced by any number of unpredictable circumstances. Speculating is not for the weak of heart and ought only be attempted by those who have “play money” or money they can afford to lose.

2.3 BENEFITS OF INVESTING IN COMMERCIAL REAL ESTATE

Compare real estate and other types of investments.

There are many benefits to investing in real estate, not the least of which is that it can be an excellent way to build wealth. If you buy property that is good value for the price paid and manage your properties wisely, your investment should pay off substantially.
In truth, the commercial real estate investor has only one real enemy — an empty building.
While this seems trite, it is worth thinking about it. One of the more successful real estate investors we know, Don, always operates with this in mind. As real estate brokers, we would present him with an offer to lease, say at $32 per m2 ($3 per sq ft) and he would sign it back at $40. The tenant would counter offer at $35. He would say, “OK, I’ll take it.” We would tell him that if he could give us a couple of hours and sign it back at $38, we thought we could get it, and 80% of the time we would be successful. The point is that Don was very conservative, always willing to accept less because he didn’t want to take a chance on having empty buildings. In fact, he hated empty buildings. He was very conservative in other areas too. He financed his new buildings (he built himself) and when the mortgage was paid off, he did not refinance them.
Land Development Process
Source: Sernas Associates
002
003

2.3.1 INVESTMENT CONSIDERATIONS

There are five main factors that you should consider when making any investment:
1. Preservation of Capital. How secure is the investment? What could happen if things go wrong?
2. Liquidity. How liquid is the investment? In other words, how easily and quickly can it be turned into cash? Real estate is not considered liquid because it can take a long time to sell it and some properties that have serious drawbacks are particularly difficult to sell.
3. Recovery of Capital. How will I get my money back? Will this happen only when the property sells, is refinanced, or from rentals?
4. Stability of Income. How predictable is the investment? Will it fluctuate considerably or be steady?
5. Return on Investment. Commercial real estate returns are usually excellent when one takes appreciation into account.
Some other considerations to review before making an investment are the growth of capital (through appreciation), the cost of managing the capital and the asset, amount of involvement (by you), and protection against inflation. These factors usually play less significance, but you may want to review them. See for a comparison of investment characteristics for various types of investment vehicles.
Investment Characteristics
004

2.3.2 KEY CHARACTERISTICS OF REAL ESTATE INVESTMENTS

Although real estate has much in common with other investment options, there are a number of characteristics that make it unique:
• Real estate is fixed in location and highly dependent upon its surroundings for its value.
• Developed real estate (improved with buildings) is not easily altered; once land is committed to a specific use, it is difficult, costly, and time consuming to change.
• Real estate development and ownership are subject to an ever-increasing amount of government control. Taxes on land sales and transfers, along with rent controls and land use controls, are expected to become an even more significant part of the Canadian real estate market.
• Most real estate investments require a great deal of money. Therefore, many investors prefer a large degree of leverage (see “leverage” at section 2.5.2).
• Real estate provides a wide variety of investment possibilities, ranging from converting a basement to a one-bedroom apartment for lease to purchasing a shopping centre.
• Real estate can often be used in whole, or in part, by the investor for his own use.
• There is a fixed, limited supply of real estate. The demand is growing as the population continues to increase (very rapidly, in some places!). This means demand will remain strong, particularly in choice locations, defying pressures from other factors such as inflation, deflation, recession, or interest rates.
• Although certainly not recession proof, real estate tends to
Although real estate has much in common with other investment options there are a number of characteristics that make it unique.
weather downturns much better than stocks and bonds. Since 1934, real estate has seen negative returns 5% of the time during periods of downturn while stocks and bonds were negative 25% of the time.

2.3.3 REAL ESTATE OR STOCK MARKET?

Practically speaking, the modern investor who is interested in passive or semi-passive income has two choices: real estate or the stock market. By “passive income” we mean income that is generated with no need for intervention; you make your investment and earn a return with no action required.
An investment in real estate can be fully passive if the investor buys shares of a Real Estate Investment Trust (described in Chapter 6 at section 6.7.5) or semi-passive if he buys an income property and uses a property management firm. However, if the investor manages the property directly the investment is definitely not passive. In fact, it could require a lot of involvement in the case of multi-family buildings.
Although huge fortunes have been made in the stock market, such as that enjoyed by the legendary investor, the late John Paul Getty, most large and small fortunes were realized in real estate. Even Paul Getty was active in real estate. “The first Marshall Field ... once remarked: ‘Buying real estate is not only the best way, the quickest way and the safest way but the only way to become wealthy.’”
People who favour stock market investments over real estate investments overlook two paramount points. There is far less risk in real estate and an investor has much more control over its condition, future, management, and results.
With real estate one has real value, not some esoteric or anticipated value, as is the case with many stocks. Most stocks trade at 15 to 30 times earnings, and sometimes much more. In fact, stocks have traded at over 150 times earnings in the high-tech field. Commercial real estate generally trades at 8 to 12 times earnings, and there is real, intrinsic value to it. Real estate historically also offers a higher cash flow. In support of this view, consider the case of one of our clients, a senior financial advisor and vice-president of a very large capital management firm. This company specializes in advising high-net-worth clients and investing on their behalf in the stock market, REITs, bonds, and similar items. This executive is a sophisticated professional, intimately familiar with the stock market, yet he told us that he counted on real estate to provide for his retirement. compares an investment in real estate to an investment in the stock market.
Investment Characteristics — Real Estate vs. Stock Market
Question Real Estate Stock Market
Is the supply limited?YesNo
What percentage of control do I have on running the investment?100%0%
If things turn sour, do I have the option of correcting them?YesNo
Can part of the income be sheltered through building depreciation?YesNo
Which percentage of high-grade investment can I finance?85% (up to)70%
Which percentage of low-grade investment can I finance?60%0%
Can I see and touch my property?YesNo
Which percentage of the investment do I understand personally?100%0-50%
Can I set the direction of the investment?YesNo
Can I improve the building/investment?YesNo
What is the percentage of volatility of my investment?5%70%
Can I do some of the work myself, if needed to improve the investment?YesNo
Can I keep a close eye on my investment?YesNo
Can I examine, and influence, income and expenses and decide how
to increase the former and lower the latter?YesNo
Is my investment liquid?NoYes
Probably, quite a few readers will think we are biased towards real estate, and they are right. However, it is not without justification. A comparison of rates of return among a variety of investments as shown in demonstrates part of the reason we are so committed to real estate as a strong investment choice.
Comparison of Returns
005
People invest in real estate for economic and non-economic reasons. One non-economic reason is that most investors like the feeling of being closely involved with their investments and the pride and satisfaction in being owners of a property. The ultimate goal of investing in real estate is economic, the maximization of after-tax returns. Real estate offers an investor an average yield of one and one-half to two times that of most common stocks. However, the investor must accept the corresponding increase in risk and also give up substantial liquidity.

2.3.4 ADVANTAGES OF INVESTING IN REAL ESTATE

There are a number of reasons to invest in income-producing properties (IPPs) rather than in other conventional types of investments, but the main reasons are set out below.
To “Park” Your Capital. Do not squander it. For some investors, it is a benefit that real estate is not a liquid investment, that is, it is not easily converted back into cash. It forces the investor to be disciplined about the investment. Once you buy a property and sign a loan agreement (mortgage), you will do your utmost to make the scheduled payments, even if you have to keep your old car for a few more years or do without a European vacation.
To Be Protected Against Inflation. Based on the Canadian Price Index (CPI), in Canada the average rate of inflation between 1914 and 2006 was 3.19% per year. Every time the cost of a square metre of land or of laying a new brick increases, every square metre of similar land or brick already laid increases in value too, although not necessarily in the same proportion. This concept disregards other factors, such as neighbourhood transitions and the economic obsolescence of buildings, but the simplistic implication is still that you generally benefit from price appreciation when you invest in real estate.
To Build Equity. Assuming that you have made a wise investment, each time you collect a rental payment you will be building equity in your property by using your tenants’ rent to pay a portion of your mortgage.
The Ease of Refinancing. Every time your Net Operating Income (NOI) increases markedly, through increased rentals or lowered expenses, you can arrange for a higher mortgage, freeing some of your initial equity. In other words, you will recover 100% of your equity in 5 to 8 years; sometimes even sooner, with a little luck.
To Secure Positive Cash Flow. This is the amount of money left after you subtract all operating and repair expenses, plus allowances for vacancies and bad debts, and mortgage payments, from the gross income. These regular monthly cheques are pretty nice.
To Increase your RSP Contributions. Because rental income is considered by Canada Revenue Agency (CRA) as “earned income” for individuals, it can be used to increase the allowable amount of your Retirement Savings Plan (RSP) contributions and, thereby, defer the payment of taxes.
To Benefit from Income Tax Sheltering. This is done through building depreciation (Capital Cost Allowance). In Canada, you may depreciate the building itself, not the land, at the rate of 4% (for most buildings) per year, on a declining balance.
To Benefit from Favourable Capital Gains Treatment. If you sell the property, often you pay taxes on only 50% of your profits.
Insurance Premiums on Income Property Mortgages Are Tax Deductible. If you have an insured mortgage, in case circumstances are such that you cannot make the mortgage payments, the insurer will do so for you, but you will lose the equity you have in the property. You may deduct the premiums from the property income, so you are protected but pay with “before-tax dollars”.
To Weather Economic Recessions.
- Leases are relatively long term, the most common being five years.
- Staggered lease expirations are of benefit in smoothing out the impact of recessions.
- Real estate investments enjoy relatively longer market cycles compared to other kinds of investments
- This is due to the fact that it takes years to erect new buildings, from concept to occupancy, passing through feasibility studies, architectural plans, financing, bids, construction, and leasing.
Significant Future Demand. There is the same amount of land but more and more people.
Greater Protection of Capital. A prudent person would need to be consistently negligent to lose the capital he has invested in real estate.
Secure Higher Rates of Return. Profits from ongoing operations, plus capital appreciation, plus leverage result in higher rates of return than most other investments.
Low Degree of Volatility. Multiple tenants, staggering lease expiration dates, and long-term financing result in lower degrees of volatility.

2.3.5 DISADVANTAGES OF INVESTING IN REAL ESTATE

Since there are always two sides to any coin, you should consider the drawbacks of investing in real estate too.
• It is not a liquid investment, as it usually takes months and, in some cases, years to sell a property.
• It requires relatively large amounts of money for the initial investment.
• There may be unexpected surprises (from a cash flow viewpoint), such as a substantial tenant going bankrupt or a roof needing replacement at an inopportune time.
• It is “fixed”; that is, it cannot be moved.
• It requires management:
- of the asset (business and property management)
- of the money (bookkeeping, etc.), and
- of the tenants. In addition, dealing with tenants can be unpleasant, as landlords are not liked, as a rule.
• One is at the mercy of governmental decisions: expropriation, new roads, new neighbours, new zoning, new taxes, rent controls, etc.
• The risk of financial loss, fortunately, is rare, but it can happen due to several reasons:
- because the investor did not pay enough attention to the economy, in general, and to the real estate cycle, in particular, when making the decision to purchase the property,
- the investor was too greedy; he took too much risk, or
- it may be due to rotten luck. Some situations are difficult to anticipate: war, a good tenant going bankrupt, a down-turned market meaning that your building stays empty a long time before a new tenant can be found, etc.
• Insufficient knowledge or a lack of trustworthy professionals to advise the investor.

2.3.6 FACTORS INFLUENCING INVESTMENT SUCCESS

As with all investment, real estate investment comes with some risk both from controllable and uncontrollable factors. Controllable factors are those that an investor can influence, either before a property is purchased or during the ownership of the property. Uncontrollable, or external, factors are those that cannot normally be influenced by the investor. The wise investor is aware of these, but concentrates his attention on the factors that are within the investor’s control.

(a) Controllable Factors

Below is a list of significant, controllable factors affecting the level of returns from a property.
As with all investment, real estate
investment comes with some risk both from
controllable and uncontrollable factors.
Location. Find a good location for the specific use. This includes considerations regarding lot shape, neighbours, noise, odours, and natural risks such as flooding.
Type of Real Property. Is the property to be used for industrial, office, or other purposes?
Design of the Building. This would include the following factors:
- attractiveness for tenants and their clients (this will keep the vacancy rate low and command higher rentals); and
- quality of the construction (this has a direct bearing on the cost of heating, air conditioning, lighting, and maintenance).
Property Management. Too often, it is not as good as it should be.

(b) Uncontrollable Factors

These are factors that cannot be influenced by an investor, either before or after a property is purchased. These are generally external factors.
Inflation. Inflation is one of the most significant external factors that affect the level of real estate returns. This factor is most easily apparent in two situations - rentals of existing buildings increase if new properties cost more and the appreciation of a property’s value is greater during a period of high inflation.
Interest Rates. Assuming that the investor borrowed money to invest, rising interest rates will decrease the level of cash flow generated by IPPs financed at a later rate, but have a beneficial effect on the potential for long-term capital appreciation. In contrast, declining interest rates will have a positive effect on the current operating income of a newly financed property and encourage builders to expand the supply of IPPs.
Supply and Demand. The supply and demand for real estate is cyclical. An over-supply will decrease rental rates and returns, while under-supply will have the opposite effect. Supply and demand must be considered on a local basis. For example, there may be a shortage of apartments in Peterborough, but an abundance of them in Goderich.
Governments. We are at the mercy of new laws. In addition, governments have the right to expropriate property for a number of reasons, such as new roads or freeways, community buildings, transportation corridors, etc.
Income Controls. In the case of residential properties, the government can step in and regulate possible increases via rent controls.
Taxation. Again, government controls such income factors as capital gains tax, capital cost allowance, and property taxes.
Land Use. Zoning regulations will impact the income producing capacity of a property. For instance a property may be located in an area that is being down-zoned so that the zoning becomes more restrictive and therefore less attractive.
Economy. Like all business people, real estate investors are affected by the condition of the economy. Little, or rather nothing, can be done to control it, but many an investor with a financial cushion is able to weather a bad economic period. The one who is already stretched at the start of a downturn ends up stretched beyond his limits, financially speaking.
Natural Disasters. Since these events cannot usually be anticipated, it is wise to not buy in areas that can be affected by natural disasters, such as flooding or earthquakes. In 2005, even buildings that had never been affected by heavy rainfall found their basements in four feet of water in north Toronto and Markham, due to unprecedented rainfall.
Buying real estate can be complex. To lower your investment risk, you need to acquire enough knowledge to feel quite comfortable when you purchase a property and you should consult knowledgeable professionals.
Success requires four things: time, talent, money, and good marketing. If you are weak in one area, the other three must compensate for it. Talent (people) is, by far, the most important. To invest successfully in commercial real estate you will need a pool of knowledgeable trusted advisors — including real estate professionals, appraisers, lawyers, tax advisors, investors, property managers, and various tradespeople, to name just a few. But as captain of this ship you must become knowledgeable enough to lead this crew. It is much better to have a poor ship with a good captain than a good ship with a poor captain. Obviously, if you read this book from start to finish, you will be on your way to real estate knowledge.

2.4 EVALUATING THE MARKET OUTLOOK

Consider all the factors when deciding upon the type of real estate investment.

To understand the factors that can influence real estate markets, let’s look at the current market situation. The years 1996 to 2007 have been a vendor’s market for real estate in much of Canada because of increased demand, due mainly to the very successful investing channel that REITs represent. During this decade, there was increased demand, but the supply remained the same because building developers erect buildings only if they can find tenants.

2.4.1 UNCERTAINTY IN THE STOCK MARKET

The stock market’s quasi-meteoric rise in the second half of the 1990s appealed powerfully to the greed that is present in most people. However, the horrific crash of the market in 2001 and a few highly publicized scandals (Enron, WorldCom, Nortel) made many people leery of continuing to invest in equities. Instead, they turned to real estate, one of the few investment avenues that was maintaining its value and was substantial enough to “park” large amounts of money.

2.4.2 INTEREST RATES

During the same period, record low interest rates made borrowing to purchase more affordable, while lenders were eager to make these loans because of the tangible nature of real estate and its permanency.

2.4.3 INTRODUCTION OF REITS

REITs are public corporations that are listed on stock exchanges and sell shares to investors. They derive their income primarily from real estate as owners, property managers, lenders, or a mixture of these. Created in the United States in 1960, they grew dramatically in the early 1990s. REITs must pay 90% of their profits to shareholders.
A major appeal of REITs is that they do not pay income tax, thus eliminating the drawback of double taxation. They facilitate access to real estate investing for the small investors as well as the large ones who do not want to own real property directly or prefer to leave selection and property management to the specialists. Their diversification in terms of property types and geographic markets results in low risk.

2.4.4 STRONG ECONOMY

A boom in the resource sector, a strong export market, low unemployment, etc., means that people are employed, are well paid, and are spending on many things, including real properties.

2.4.5 SUPPLY AND DEMAND