CategoriesAdvice

Apartment buildings: Fighting rising interest rates

Interest rates are the lifeline of our real estate world. Without the lenders and financial leverage, all investors would have to buy any investment properties in cash, completely removing the whole concept of leverage, ROI and yields from our business.

Real estate ownership is generally a long-term play, however, and an owner will see rates go up and down during the duration of asset holding. Managing the financial aspect of leverage (debt) can make the difference between winning and losing the game of returns.

Currently, the central banks have made the unfortunate decision of fighting inflation by penalizing the debtors and hence we have seen a massive push of rate hikes since last year.

A five-year insured mortgage would have had an interest rate of 1.80 per cent in June 2020, 2.30 per cent in June 2021 and 4.60 per cent as of June 2022.

Not only will these rate hikes cause problems to the cash flow of the borrower, but they will also significantly impact the financing obtained, as the loan amount obtained will be lowered by 33 per cent, which has to be made up by either lowering the sale price or providing a higher down payment.


The solution

How should multiresidential owners combat this rate hike?

The only property owners who will be able to navigate properly in this kind of environment will be those able to increase their net operating income to make up the difference (net operating income is the income left after all the fixed costs like property taxes, insurance, utilities are removed from the gross revenues), since one of the most important criteria that the lenders use when evaluating a property is its net operating income in place.

These solutions that follow will seem very basic to the experienced landlords, yet in our brokerage business most properties that we sell are hardly optimized.

There are three main ways to increase the net income:

Renovations of units

Beautifully renovating one unit and increasing its monthly rent by $200 per month seems trivial, yet this means an increase in the property valuation by approximately $50,000. Repeating this process four times gives $200,000 of increased asset valuation.

Property insurance

Each dollar saved monthly on the insurance bill will potentially increase the property value by $240. This by itself is a 1,900 per cent return on investment annually, and it does not cost anything more than shopping around for the right insurer or the right insurance broker, because there are major discrepancies between insurers in terms of rates.

Energy costs

Energy is an entire other problem we are seeing these days.

The high prices paid by all of us at the pumps are a real problem, but a bigger problem is natural gas prices year-over-year. The average natural gas bill has gone up approximately 25 per cent in 2022 versus 2021.

If the natural gas bill in 2021 for a given property was $20,000, that same property is now going to pay $25,000.

This $5,000 increase in the gas bill means a $100,000 decrease in asset valuation. This issue cannot be left uncorrected.

The owner must know all the energy programs available to perhaps change the in-place heating furnaces to more efficient ones, or learn about the various CMHC energy programs, which are always updated and changed and may provide high benefits to the landlords based on specific situations.

In conclusion

We have seen a significant change in the capitalization rates between 2021 and 2022. However, the capitalization rate is not the only measuring factor in property valuation. The net income of the property remains the most important element.

By doing the needed renovations to the units when they become vacant, by managing the property expenses including insurance and energy maintenance, the prudent property owner will come out much ahead versus those that are not pro-active in our current higher interest rate environment.

More details in an interview with STOREYS: Interview Link 

Baron Realty specializes in matching buyers and sellers of apartment buildings. Ramona works in partnership with Mikael Kurkdjian and a team of real estate professionals to bring the best boutique-brokerage services to the apartment transactional space in Ontario and Quebec.

Work with Baron Realty. Reach out today!

CategoriesAdvice

Apartment Buildings – Value not immune to interest rate increase

With the governments “printing” money and the inflation creeping into all aspects of our daily lives, it was only a matter of time before the federal government increased the interest rate to curb the spending. But a lot of people were surprised at just how fast this happened.

Let’s take a fictitious example of an apartment building a broker may have evaluated at $8M six months ago.

Note the down payment requirement changed by more than half a million dollars over the last 6 months, i.e., the buyer would need to have half a million dollars more in non-borrowed funds in order to be able to close this transaction.

Why does this matter? The down payment requirement is key in successful sales. The rate of down payment used to be 20-30%, further increased last few years to 40-50%, and now an almost impossible 60%+. Sure, there are all cash buyers in the market; these buyers know “their value” and will act accordingly (buying at a discount, because they know the majority of regular buyers will not be able to produce or justify the down payment required today).

Vendors need to be aware that in a fast-shifting interest rate market, deals can fall apart at financing stage just because the down payment can increase so drastically from one month to the next. Hence, if a buyer showed proof of funds with offer in October, but had to wait for the Vendor to finalize the environmental report until this April, the same buyer may not be able to close the deal.

Ways to navigate the current market (for Vendors):

  • Hold on to the asset until a significant interest rate decrease happens, to maximize the number of buyers available and willing to purchase. Of course, nobody has a crystal ball as to when this will occur; this strategy can be an issue if the building has maximized its value and is now on the decline, or for private owners who are sellers for different reasons (dissolutions of partnerships, changing life directions, no longer being able or manage the building, etc.)
  • Be prepared with all the documents needed in the sale process, most important of which being environmental reports (which can take 6 weeks to 6+ months, depending*) – without a “clean” environmental report, the buyer will not be able to obtain financing.
  • Watch for deal-delays and know that short delays are very valuable – as long as you trust the buyer has not simply committed to short-delays to tie up the deal with the intention to come and renegotiate the timelines later (buyer reputation is key*).
  • Buyers must be willing to commit in writing (offer stage) to put more down payment than required at offer-time.
  • The value of an apartment building should always be taken as the value today; in a fast-changing world, even the “safest” real estate investment asset class is not immune; if you have an evaluation from 6 months ago, it will surely not be accurate today.
  • The marketing of a property should keep in line with the changing market dynamic. Based on the asset and timing, a bid process, an asking price process or a process of no price (just a range with its respective loan potentials) and “offers anytime” may be appropriate – but the best way to market will be best determined at listing time, not based on the broker’s record from last year*.

Baron Realty custom-tailors each marketing process, and brings the right buyers based on the asset and vendor requirements for deal timelines. We have generated 5-12 offers on each of the listings we have taken over the last 18 months. *Ask us why; we are happy to talk to you about how to best navigate the current environment to achieve your end goal.

Baron Realty specializes in matching buyers and sellers of apartment buildings. Ramona works in partnership with Mikael Kurkdjian and a team of real estate professionals to bring the best boutique-brokerage services to the apartment transactional space in Ontario and Quebec.

Work with Baron Realty. Reach out today!

Baron Realty - Apartment Buildings in Montreal, Toronto, Canada
CategoriesAdvice

Exiting An Apartment Building Partnership

Joint ventures have always existed, and they are making a comeback now that the market is uncertain: not taking the risk alone may be worth taking less of the profit in the long term.

The following two are the most common partnerships do we usually see in apartment building transactions and our advice on how to handle the sale process for each:

Inherited partnerships

These are joint-ventures that have been structured by the previous generation (usually family) and inherited by children (usually cousins). Delicate by nature due to family dynamics, they are most of the time ran successfully by only one or two of the second generation, while the rest of the family becomes “passive” in the partnership. These can run smoothly as long as there is trust in the family structure, and as long as all parties are in agreement about keeping the asset. Once a sale discussion takes place, it is rare that all family members would be 100% on board with selling the asset, or in agreement with the ultimate price that should be achieved. The active partner usually seeks control over the sale process as they feel more qualified to do so; the rest of the partners would either grant this control, resist or insist in being involved on some level; the last two options rendering the sale process lengthy and harder to navigate.

 

Sweat / Equity

Type partnerships; apartment buildings rarely run themselves. In this type of partnership, an experienced managing partner invests together with an equity partner. The equity partner’s share of investment is usually much larger, but they are “silent” in the day-to-day operations and management such as selecting tenants, administering rent increases, addressing building code requirements, awarding building contracts, etc. Where we see complications is when the sweat partner is tired of running the building and wants to cash in on the profits; while the silent partner does not want to sell (why would they? They are passively accumulating wealth).

The sale process can be complex even for an ultimate owner (where the owner can pull the trigger on any decisions), let alone for a partnership. Here are some elements to consider for an easier exit:

 

Inherited Partnerships

If you are the active partner, take the time to explain the day-to-day operations of managing the building, building expenses, Gross vs NOI, how assessment is different than value etc.; get more than one quote for work you need to do in order to prepare the building for sale (such as environmental testing) and discuss the best option with your family. Do this way in advance of an actual sale; family can usually “sense” when the others may want out (or may need to cash in their equity). It is generally not a good idea to offer to “buy them out” unless the family dynamics are so strong that there is no doubt of fair pricing; but this is rarely possible irrespective since the active partner almost never feels they should be paying “market price” for a building they have managed for years. It is important to for all to remember that only the then-current market “makes the price” – not the owners, nor the broker, nor the appraiser, and not even the last comparable sale.  We find that every 3-4 months, the market becomes different, the players change (larger buyers may have changed strategy in the product they buy ex: older vs newer assets; smaller players may have already tied up deals and are short on capital for the next year or so, etc). Only by exposing the asset to the then-active buyers can a fair price be achieved. Most families select a bid-date process, because this ensures they get the best offer; the sale process is longer, but we believe worth it the peace of mind of every partner.

Sweat / Equity

Create a clear exit structure up front. Avoid agreeing to the shot-gun clause, which is usually only beneficial for the partner with more cash (this is usually the silent partner). A good exit strategy is to agree in the original partnership agreement the property will be marketed at the end of a 5-year or 10-year loan and sold if a return reaches a certain minimum pre-determined threshold. As well, when structuring such arrangements, ensure that the sweat partner has the latitude to run the building the way they see fit since requiring the input from the silent partner adds stress and delays. For example, making a decision to spend on a major extermination is time-sensitive and may not be able to wait for agreement from the silent partner. A tenant board case may need the involvement of a lawyer and therefore incur legal fees for the partnership, etc. When preparing the building for sale, re-involve the silent partner in agreement on quotations; even though they may not have been involved in the past they may appreciate “knowing what’s going on” towards the end.

Always keep an exit strategy when setting up a partnership; and in the cases of inherited partnerships, a good practice could be to confirm keeping status quo every couple of years; this way, the non-active partners can feel involved in the decision to sell, whenever it may come.

Baron Realty specializes in matching buyers and sellers of apartment buildings. Ramona works in partnership with Mikael Kurkdjian and a team of real estate professionals to bring the best boutique-brokerage services to the apartment transactional space in Ontario and Quebec.

 

Work with Baron Realty. Reach out today!

 

Québec

Baron Realty / Immobilier Baron
400 – 6500 Transcanadienne
Pointe-Claire, Québec H9R 0A5
Telephone: 514 932 9000

info@baronrealty.ca

Fax : 514 221 2221

Ontario

Baron Realty, Brokerage
303-225 Duncan Mill Road
Toronto, Ontario M3B 3K9
Telephone: 416 301 3931

À PROPOS

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