Let’s take a look at specific advantages of placing some of your hard-earned capital into income-producing commercial property. The examples I am using will be applicable to investors who wish to place their money long term.
Keeps pace with inflation: All commercial real estate derives income from tenants who pay to rent the premises. Obviously supply and demand for rental property can vary.
We have seen periods in the history of Saskatchewan commercial real estate where rents have flat-lined for a period of time or maybe even dropped slightly. Over the long term, rental income will keep pace with inflation, which is reassuring for retirees concerned about future purchasing power.
Income, however, is only one of the sources of return on your investment.
Leverage: Very few will borrow money to invest in equities. It is quite simply too risky. Even if you did, the interest charged is unlikely to be favourable. Conversely, most commercial real estate is purchased with (an average of) only a 25 per cent initial investment.
Assuming the property appraises and the asset is sound, financial institutions will compete aggressively to finance your purchase. That means your tenants are paying you a return on your investment and at the same time paying off your mortgage (most commercial mortgages are amortized between 15 and 20 years).
Starting to sound interesting? Wait, there’s more.
Cash on cash return: Today you can obtain commercial mortgage funds at anywhere between 2.75 and 4.5 per cent. It is likely the property you purchased is showing a cap rate of between 6 and 7.5 per cent.
That means in addition to your return of 6 to 7 per cent on your initial investment and your tenant paying your mortgage off, you are also receiving a return on the money you borrowed.
That spread in today’s market is likely to be 2.5 to 4 per cent. This is found money.
Asset appreciation: The examples used above regarding the factors that affect rent levels are also true for the value of real estate. I can provide you with countless examples of increased value in commercial real estate my clients have experienced since I have been the business.
Appreciation, more than any other factor, provides tremendous growth opportunity for your capital. Let’s say two partners each invest $187,500 (plus closing costs) into a $1.5-million property.
It’s not inconceivable for someone to offer them $2 million after 5 years. If their mortgage was amortized over 15 years, they have paid down the mortgage by roughly $300,000.
Add that to the $500,000 capital gain and they have each turned their initial $187,500 investment into $587,500 (less recaptured depreciation tax). Many investors, rather than selling, will remortgage their property, pull out some equity and do it again.
In most cases, rental income should have increased to cover the additional mortgage amount.
I like real estate because it is a tangible asset. I can take an older, tired property, add value through renovations and increase both rent income and market value. It’s yet one more example of how your investment can grow.