Financing an investment property is as easy as 4, 5, 6…

That is to say that four is easier than six, but still not easy.

Sounds difficult?  It’s easy to follow…

If you think financing is easy to obtain in our red-hot Toronto real estate market, you’re right.  But maybe you’re not thinking outside the box, or rather, your bubble…

When most people think “real estate,” they think condos and houses.  When most people think about mortgage financing, they think about standard 5-year, fixed rate mortgages for their 2-bedroom, 2-bathroom loft on Brant Street or their 4-bedroom, red-brick house on Mildenhall…

But something I don’t talk about nearly as much as residential properties is investment properties.  More specifically, multi-unit dwellings.

In yesterday’s post, I examined what I consider to be an actual “investment property.”  There are hundreds and hundreds of single-family dwellings disguised as “multiplexes” throughout our city, but I don’t even give those a serious thought.

When it comes to true, actual investment properties, it can be the financing that is the be-all and end-all in your endeavors.

Back in July of this year, I received a phone call from a young man named “Spencer” who lives in Silicon Valley, California.  Spencer wanted to purchase an investment property in Toronto, as he had already accumulated a few similar buildings in California and was looked to expand his portfolio.

Spencer is an extremely intelligent, experienced, and knowledgeable investor, and we saw eye-to-eye right from the get-go.  His three criteria to examine were always capitalization rate, location, and condition of property – but the order of importance  varied depending on the property.

You might be willing to accept a slightly lower cap rate if the property was in pristine condition, since it will require less upkeep, and likewise you might be willing to accept a property in worse condition if it were in a fantastic location, since you’d expect a better capital appreciation down the road.

But it’s all a moot point if you can’t finance the property, and this is where Spencer and I encountered some difficulty.

The rule of “four, five, six” came into play right from the onset, as we sat in my car on Crawford Street in August and had a conference call with my mortgage broker, Joe.

Joe told us, “We can finance four units no problem, five units – there is one lender who will do it, but six units is where you run into a problem.”

What is Joe talking about?

Residential versus Commercial.

There is a monumental difference between residential properties and commercial properties when it comes to financing!

For your house or condo, you can make a downpayment with as little as 5%.

With a property zoned commercial, or deemed commercial by a lending institution, you have to put down a minimum of 35%.

Now do you see where the four, five, six comes into play?

If we found a four-unit investment property, Spencer could put down as little as 5%.  I think Spencer was looking at putting down 10-15% initially, but eventually decided to use some of his funds for the purchase of a principal residence in Silicon Valley, and reduced that number to 5%.

If we found a five-unit investment property, there is one lender that Joe told us we could use to finance the property as residential.  Every other lender would view this as commercial, and the 35% rule would apply.

And if we found an investment property with six units or more, every single lender in Canada, even the private lenders, would deem this as a commercial property.

It’s a shame, because the first property that we really got serious about was a six-plex on Crawford Street.  This was a semi-detached, 3-storey building; and I say “building” because there was nothing house-like or residential about it, with five above-grade units and one bachelor unit in the basement.

At the same time, we were looking at a five-plex on Halton Street, owned by the same people.  This was also a semi-detached property but it was much more “house-like” in that the units weren’t nearly as defined as the property at Crawford Street.

Halton was priced at $959,000 and brought in $71,000 per year in gross income – a 7.4% cap rate, which is unbelievable in the Toronto market.

Crawford was priced at $1,289,000 and brought in $102,000 per year in gross income – an even better 7.9% cap rate!

Spencer and I had been looking at properties all over Toronto with cap rates as low as 4.8%.  It’s amazing to think of the mindset an owner of an Avenue Road four-plex has when he brings in about $48,000 per year and decides to list the property at $1,000,000.  What planet does he live on?

There was no comparison between the two properties – Crawford was in pristine condition and it felt like an apartment building.  There was a common hallway and staircase that led to each unit, and the floors were all made of poured concrete so there was no sound transfer.  Every single unit had an updated kitchen and bathroom, and some of the rents were even under market!

The property on Halton Street was really a house that was converted into five units.  Two units were accessed from the front, one from the side, one from the back, and one from the staircase that led into the basement.  This wasn’t what you’d call a “small apartment building” like Crawford, but the cap rate was still unreal.

When we spoke with Joe, he gave us the bad news: Spencer would have to put down 35% on the Crawford property since it had six units and is considered commercial.  Maybe we could “piece together” a couple of mortgages and he could get away with 25%, but he definitely couldn’t finance this as a regular CMHC residential mortgage!

Spencer then said, “That thing is never gonna sell.”

He made a very good point.

Sure, it had a more attractive 7.9% cap rate, but if you had to put down 25-35% to achieve that rate, why would you bother when you could put down 10-15% and get the 7.2% cap rate on Halton?

Would you spend an extra $150,000 to chase 0.7%?

This experience at Halton and Crawford made us realize that we couldn’t look at anything with six units or more.

A couple of months later, we got very serious about a property on Jones Avenue which had an ungodly 8.4% cap rate.  This is when the three pillars of investment properties come into play: cap rate, location, condition of property.

The cap rate was unbelievable – so unbelievable in fact that I asked for copies of the leases, and the property was renovated from head-to-toe just like the one on Crawford.

But the area was a question-mark.

Jones Avenue runs north-south from Danforth to Queen Street, and while Danforth and Queen are hot spots, there isn’t much in between.

Regardless, the condition of the property and the obscene cap rate were enough for us to move forward.

But once again, financing proved difficult.

Here is the best rate we could work out – and when I say “best rate” I mean that Joe Sammut is the best mortgage broker in the city and if he can’t do better, nobody can!

Purchase Price: $1,100,000
Downpayment (15%): $165,000
1st Mortgage (75%): $825,000 – 4.35% interest rate
2nd Mortgage (10%): $110,000 – 12.0% interest rate

We would essentially be piecing together two mortgages so that Spencer could get away with a 15% downpayment, but the 12% interest on the second mortgage from a private lender proved to be too much.

The blended-rate was 5.25%, but it was a far cry from the 4.35% rate we were hoping for if we could finance this property as a regular CMHC residential mortgage.  The 15% downpayment was also more than Spencer was looking to invest, so while he might have ponied up with 15% for a 4.35% rate, it didn’t make sense to him at a blended rate of 5.25%.

So what does that mean for Spencer and I?

Well, it means that we’re looking exclusively at four-unit properties from now on!

It’s not that you can’t get financing for five-unit and six-unit properties – it’s that they’re in categories of their own and the numbers have to make sense for YOU.

Every investor is different, and had Spencer not been looking to purchase his primary residence in Silicon Valley, he might have been able to put down 15% on the Jones Avenue property and accept a 5.25% blended rate.

Then, there are investors out there that might be willing to put down 35% on a six-unit, or twenty-unit property!

But what kind of return are they looking for?

The last property I looked at with twenty units was on St. Clair Avenue West and it had a cap rate of 12.5%.  I suppose if you’re gonna invest the bigger money, you want the bigger return!

So was that easy enough?

Four, Five, Six?

I guess one is always the easiest to work with…