Investing in residential or commercial properties can be an excellent alternative to an often-volatile stock market, but there can be costly pitfalls if the investment is structured poorly.
Rule one: Plan ahead and know exactly what you’re getting into before you seal the deal.
Structuring a real estate deal that dovetails with the buyer’s intended use of the property is key, says Josh Engel, managing partner at Ottawa accounting firm GGFL.
“If clients tell me they are interested in buying real estate,” he says, “my first question is ‘what do you intend to do with the property?’ Are you looking for a short-term investment? Do you intend to buy, fix it up and flip it? Or are you interested in holding onto the property as a long-term investment to rent out?
“The tax implications from the investment income in these two situations are very different,” says Engel. “The government regards profit from flipping as regular business income and that can potentially mean double the tax rate relative to the longer-term investment option of owning and renting real estate.”
Buying to flip isn’t necessarily a bad option, he adds, but it depends on the price of the property, its location and an individual investor’s ability to afford the immediate renovations necessary to drive up the price and, ultimately, sell at a profit.
To avoid at least some of the pitfalls, GGFL’s Engel offers these general tips for the prospective investor in residential or commercial real estate:
1. Do proper due diligence on the property to ensure there are no environmental issues or other undisclosed liabilities related to the property.
2. If you plan to finance the property and it’s for investment purposes, see if it can be structured in a manner such that any interest would be tax deductible.
3. For commercial properties, inquire as to the state of the leases with current tenants. How close are they to expiry? It’s all well and good to buy a building, but if the leases with tenants are about to expire, you have to cope with renewals and filling vacancies. Conversely, are they locked into leases with terms that are so generous that you’re not able to turn a profit?
4. Have significant repairs been done in the past few years? If not, you need to assess the potential cost of future repairs when determining how much to pay for the property and in budgeting for future years.
5. Research sale prices of comparable properties that have recently sold in the same immediate area.
6. Prepare cash flow projections to ensure the property will be generating sufficient funds to cover the mortgage payments and allow for the creation of an emergency fund to cover unexpected repairs.
7. Are you in a financial position to have your real estate investment cash locked in for the long term? The stock market can be risky, but you can sell some shares if you suddenly need access to cash. With real estate, investors often only have two options: sell or refinance.
8. Consider diversifying and investing in several properties.
9. Consider investing with one or more partners to mitigate risk.
If the choice is between commercial or residential real estate, Engel cautions that investing in a commercial unit can be a more complex proposition and, generally, a riskier venture.
“Finding tenants for a commercial building is generally more challenging than finding residential tenants,” he says. “Typically, a 10-unit residential property with one vacancy is easier to cope with than a five-unit commercial property with one vacancy.”
Whether residential or commercial, there may also be potential sales tax issues to be addressed as well as federal and provincial rebates to consider.
Other important considerations for real estate investors include whether to own the property through a corporation or as an individual. There are also varying risks and rewards between buying new and older properties.
Regardless of an investor’s level of expertise, a discussion with a legal and/or a real estate accounting and tax specialist is time and money well spent.
The bottom line is that there is a lot to know when investing in the residential and commercial markets and some not-so-obvious financial pitfalls to be avoided.
Which brings us back to rule one: Plan well and seek the best advice.
