Post-Registration Phase Course 4 - Understanding Commercial Real Estate as an Investment - Fundamentals [V7, 7 ed.]

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Module 1: Understanding Commercial Real Estate as an Investment Disclaimer: This is a reference document which contains pages from the Accessible eLearning module. You should complete the eLearning module to proceed to the next step. Please note that the accessible module on the LMS only contains the interactive pages and you need to go through the content of this document thoroughly to attempt the interactive activities in the module. Please use Adobe Acrobat Reader (Recommended version 9 or above) to navigate through this PDF. Real Estate Salesperson Program ©2021 Real Estate Council of Ontario. All Rights Reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or in any means – by electronic, mechanical, photocopying, recording or otherwise without prior written permission, except for the personal use of the Real Estate Salesperson Program learner.

© 2021 Real Estate Council of Ontario

Module 1: Understanding Commercial Real Estate as an Investment This module will guide you through topics related to commercial properties as an investment. You will learn about identifying users and investors and how to determine their needs. You will also learn about real estate investment concepts including leverage, rate of return, the distinction between return of and return on an investment, and investment yields. The module discusses considerations involved in analyzing risk and return for sellers and buyers, such as risk tolerance, financial exposure, and factors that can influence operating costs for users. It also gives an overview of the risks associated with acquiring commercial real estate, as well as a salesperson’s duties, obligations, and disclosures during the transaction. Finally, you will learn about factors related to sellers and buyers when a corporation or partnership is involved, including verification, binding signatures, requirements under the Financial Transactions and Reports Analysis Centre of Canada (FINTRAC), and third-party involvement. To check your understanding of this module, you must complete all the activities in the online module. While navigating through the online module, click the Legislation button to view laws and regulations related to this module. The contents of the thumbnails Accessible PDF.

and References from the module are added to support your learning throughout this

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Menu: Understanding Commercial Real Estate as an Investment

Number of Lessons

Lesson Number

9 Lessons

Lesson Name

Lesson 1

Client Requirements and Characteristics of Users and Investors

Lesson 2

Types of Leverage

Lesson 3

Returns and Risk

Lesson 4

Advantages and Disadvantages of Investing in Commercial Real Estate

Lesson 5

Risks Associated with Acquiring Commercial Real Estate

Lesson 6

Legislation, Due Diligence, Disclosure, and Responsibilities of the Salesperson, Seller, and Buyer

Lesson 7

Recognizing Seller or Buyer when a Corporation or Partnership is Involved

Lesson 8

Summary Practice Activities Module Summary

© 2021 Real Estate Council of Ontario

Lesson 1 | Page 1 of 16

Lesson 1: Client Requirements and Characteristics of Users and Investors

This lesson identifies a client’s requirements for investment properties, such as understanding investment profiles, needs, expectations, and finding appropriate properties based on these factors. This lesson also includes factors and characteristics that may distinguish users and investors, including considerations that may influence the profitability and desirability of an investment property for each.

© 2021 Real Estate Council of Ontario

Lesson 1 | Page 2 of 16

Understanding the characteristics and needs of users and investors allows you to assess the objectives, expectations, and time frames involved in a real estate transaction. When representing sellers, it enables you to list or to market a commercial property accurately and to discuss property values and prices. When representing buyers, this information enables you to align potential buyers with appropriate commercial investment properties that will meet their needs as either a user or an investor. Upon completion of this lesson, you will be able to: • Identify a client’s requirements when addressing investment properties • Define and identify the characteristics of a user when addressing investment properties • Define and identify the characteristics of an investor when addressing investment properties Throughout this lesson, you will participate in decision points to test your knowledge on the topics presented.

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Lesson 1 | Page 3 of 16

You should have a thorough understanding of the needs, risk tolerance, and objectives of your clients to be able to show them properties that align with their needs. When working with sellers, this knowledge is beneficial when listing and marketing properties in a manner that will appeal to potential buyers from an investment perspective.

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Lesson 1 | Page 4 of 16

Return of Investment Versus Return on Investment When determining the performance of an investment, two metrics are commonly used; return of investment and return on investment. Although they sound similar, these are two distinct concepts and should not be used interchangeably. You should recognize the distinction between the terms when speaking with clients to ensure that you are providing correct information. A return of the investment is sometimes referred to as the rate of return. This is the recapture of initial funds at some future date through cash flow and is a way to determine when an investor has had the sum of their original investment returned to them. A return on the investment is a return on funds invested through cash flow (for example, operations cash flow and sales proceeds cash flow). This is the gain experienced on the total value of an investment, or the amount that an investment has increased or decreased. The topic will be discussed in further detail later in this course.

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Lesson 1 | Page 5 of 16

Knowing the Client and their Investment Profile An investor typically secures real estate with the goal of acquiring profit. However, other factors based on the individual investor have to be considered when showing properties. The client’s personal perceptions, preferences, and risk tolerance all must be factored into a commercial property investment. Each investor tolerates a different degree of risk. For example, one buyer may be prepared to offset a current lack of operating income against the opportunity for capital appreciation. Alternatively, a seller in investment real estate may defer the sale of an investment property and continue to lease until they are able to secure a favourable sale price. The common denominator for most investment acquisitions lies in the present value of the future benefits arising out of ownership. It is the role of the salesperson to quantify alternate proposals, forecast relevant financial data, and provide meaningful summaries to arrive at a logical conclusion for clients. While the typical investor may not exist, rational investors do. More importantly, most seek the guidance of informed professionals. Sellers and buyers need and want expertise to help minimize investment risk.

© 2021 Real Estate Council of Ontario

Lesson 1 | Page 6 of 16

A salesperson is working with an investor who is considering the purchase of a retail mall. Several years ago, highway expansion isolated this property from prevailing traffic routes within the area and the value dropped as a result. The investor believes this is an opportunity to reposition the mall as a neighbourhood facility, given increased residential housing construction within the area. The complex consists of 10 small retail stores that pay $1,500 per month in rent and; two larger units (10,000 sq. ft.) at $9.52 and $10.05 per sq. ft. per year, respectively. Operating expenses for this location are $22,500 per month with an anticipated purchase price of $850,000. Taking this into account, the investor explains to their salesperson that after factoring in operating expenses, they anticipate a financial yield of $105,700 annually over an eight-year period before they sell the property for $1,000,000 for an after-tax profit of $150,000. The investor explains that in total this investment should yield $995,600. Based on the information, what can the salesperson determine about this investment? There are four options. There is only one correct answer.

1

The return of funds invested through operations cash flow only.

2

The recapture of initial funds at a future date through both operations and sales proceeds cash flow.

3

The recapture of initial funds at present date through cash flow.

4

The return of funds invested through sales proceeds cash flow only.

© 2021 Real Estate Council of Ontario

Lesson 1 | Page 7 of 16

A factor to consider in commercial real estate is whether the potential buyer is a user or an investor. The distinction matters, as property users consider different aspects than investors when looking at a property. You should have knowledge to provide insight to your client about an investment’s suitability, marketability, and profitability.

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Lesson 1 | Page 8 of 16

Commercial Property Users Versus Investors Commercial real estate is often distinguished by two types of groups: investors and users. An investor may purchase a property in order to lease out the space and generate income from tenants. Users, however, are more likely to use the space within the building for their own business needs. This distinction can often be blurred, as users may have personal objectives relating to the utility of a property, as well as an investment strategy. In some cases, a user may also be an investor. A potential buyer looking for premises for their business may decide to buy the building instead of leasing it. The primary purpose would be to occupy the required space for their business, but also to take advantage of the investment component. The buyer would not have to pay rent to a landlord and would also be able to create equity for themselves through debt reduction (i.e., mortgage payments). A user’s consideration during purchase could be the overall suitability of the property for the business or the ability to modify the property to satisfy their business needs.

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Lesson 1 | Page 9 of 16

Considerations for Property Users A user is likely to prioritize certain aspects about a commercial property investment that an investor may not. Understanding the different considerations for a property user enables you to better assist buyers of properties intending to purchase a property and operate it as a user. It also enables you to better assist sellers when marketing the property. The following four sections contain information on considerations for property users.

Location and visibility Overall, users would like to ensure that the real estate they purchase has a suitable location for their business, clients, and customers. Factors such as visibility may include how easy it is to locate the business or the ability to promote the business through signage and advertising tools, such as billboards. Businesses located within multi-unit buildings, such as a shopping centre, will want to determine if their business will be located in the main corridor with the greatest amount of foot traffic or a more isolated section of the centre.

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Property use and access Users of a commercial investment property would need to consider the accessibility of the location in terms of employees, customers, and suppliers. This may include challenges for entering and parking, availability of parking facilities, and proximity to public transportation. It may also be necessary to consider the proximity to the location in relation to major highways and thoroughfares. Certain businesses, such as trucking companies, will further need to verify adequate roads and loading docks for shipping and receiving. For properties with industrial components, loading zones on the street, loading docks, and traffic congestion may also be factors that can appeal or deter a potential user.

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Building efficiencies Overall efficiencies, including building layout and structure, can positively impact operating costs and maintenance. Building efficiencies could refer to many different factors depending on user preferences, but generally, this refers to whether the building aligns with the needs of the user’s overall business plan or if the space will require significant renovations to improve efficiency. This is also the case for an industrial user. A manufacturer, for example, may require a space that allows for the safe and efficient movement of personnel and material throughout the structure. Retailers may consider building efficiencies through the context of displaying goods that are appealing and draw in potential consumers.

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Decorative features Decorative features of the building can attract tenants and improve future resale value of the property. This varies based on the intended use of the structure. For example, the decorative features of a building will have almost no relevance to an industrial property. For office and retail operations, however, the first impression for potential employees and clients have an impact on the perceived value and overall health of the business. Retail operations often strive for a more appealing and comfortable atmosphere that is inviting to shoppers. Office spaces also benefit from this, as productivity and comfort for employees within the environment are considerations for a successful business. Decorative features may include overall colour schemes, sufficient design spaces, lighting, and even treatment of floor surfaces.

© 2021 Real Estate Council of Ontario

Lesson 1 | Page 10 of 16

A salesperson is working with a potential buyer who is interested in purchasing a building for their trucking operation and wants to ensure that the building can accommodate their needs. This will include sufficient clear height, which will allow for inhouse vehicle repairs, ample parking, and docking space. Which of the following factors will the salesperson need to consider in order to accommodate the needs of the buyer? There are four options. There are multiple correct answers.

1

Location

2

Access

3

Building efficiencies

4

Decorative features

© 2021 Real Estate Council of Ontario

Lesson 1 | Page 11 of 16

Much like users, investors are driven by specific considerations when purchasing commercial real estate. The goal of all commercial property investors is to either earn income from tenants to generate periodic cash flow, benefit from capital appreciation of the investment, or both. Capital appreciation represents the increase in value of the structure over a specific holding period. Investors are willing to take calculated risks to generate wealth and seek predetermined objectives, including the creation of equity and cash flow. While selecting properties to show to an investor, you should consider their personal preference and the property traits that appeal to them.

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Lesson 1 | Page 12 of 16

Objectives for Investors Investors share some general characteristics, which may provide indications of the type of properties that would be suitable to them. Understanding their preferences enables you to show appropriate properties that align with their needs. Analyzing cash flow is a crucial factor for an investor to determine the value of an investment. The following four sections contain information on objectives for investors.

Rate of return As previously discussed, the rate of return on the investment (i.e., overall capitalization rate) and the return of invested capital (i.e., recapture rate) are two metrics in assessing an investment’s value. An investment that generates a high overall capitalization rate is an important objective for an investor, as it will determine the profitability of their investment.

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Return on invested capital Investors typically prioritize the creation of wealth and a sustainable income stream, as opposed to focusing on the design and use of a commercial property. The return on invested capital, or the investor’s actual investment versus the total value of the investment, is a primary motivating factor for investors. For example, if an investor purchases a property for $1,000,000 and uses $250,000 of their personal resources as a down payment, they will primarily be concerned with the return on their portion of the investment (i.e., $250,000), and secondarily, the overall return on the investment. Different metrics to calculate return will be discussed later in the module.

Present value of future cash flow Present value (PV) of future cash flow is a significant consideration for a commercial property investor. It refers to the current value of a future sum or stream of cash flow given a specific rate of return. This is not to be confused with net present value (NPV), which is achieved by deducting the initial investment from the present value of the future income stream. Present value represents the total of all values (benefits) accruing to an investor discounted by an appropriate discount rate. This is the present worth (today’s dollars) of a future income stream (tomorrow’s dollars). Present value of future cash flow ties into both capital appreciation, which is the increase in value of a structure over a specified holding period, and operations cash flow

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realized during the projected holding period. Present value is commonly used in estimates involving yield capitalization techniques, which will be discussed later in this module.

Purchase cash flow Purchase cash flow (or operations cash flow) is the amount of revenue generated from the typical operation of a business. It can also be measured to determine if an operation is generating sufficient revenue to maintain or expand its operations, or if additional finances are required for the expansion of the business.

© 2021 Real Estate Council of Ontario

Lesson 1 | Page 13 of 16

Tenant Selection and Considerations When working with investors for commercial investment properties, one factor to consider is tenant selection. An investor will want to ensure that the tenants who lease their property are suitable and will provide a reliable and consistent revenue stream. There are several ways in which you can assist a potential buyer to determine this. One common way is to look at a potential tenant’s credit and business history. Other factors may include the degree of experience a tenant has in operating their business and the length of time the business has been in existence. The success of an investment in terms of sustainable revenue stream will often depend on the quality of tenants, as the income that is generated from them will be used to pay the operating expenses for a building and what remains is the profit of the investment. A poor tenant selection could result in a lessee who defaults on their rent or creates other negative revenue issues. This topic will be further expanded in the next module in this course.

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Lesson 1 | Page 14 of 16

Future Value of Investment Properties The future value is how much the investor hopes to sell the property for. To arrive at current value, investors predict a future value greater than today and discount that value back to the present. Future value is built out of a combination of projected cash flows into the future, plus what the investor hopes to sell the property for. For example, if an investor has a quality, long-term lease with a corporation with strong financial history, the investor could estimate the future value of the property based on the rent they would be receiving from the tenant. One of the ways to estimate future value is to project the net operating income in the last year of the holding period and divide it by the terminal capitalization rate (also known as cap rate), which will be discussed later. Terminal cap rates are estimated based on comparable sales transactions, or what is believed to be appropriate for a particular property’s location and attributes. Future values of any investment are estimated using financial projections and forecasts, measures to assess risk, and various market assumptions.

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Lesson 1 | Page 15 of 16

A salesperson is working with an investor who is interested in purchasing a motel and is assessing the financial details of the investment. The asking price for the commercial property is $7,200,000. The investor has estimated the operating costs of the operation, including salaries, maintenance and repairs, advertising, supplies, and utilities, among others. The estimated total annual cost of operating this business is $650,000. Furthermore, the investor has determined that based on estimated revenue, the net operating income will be $280,000. Based on the investor’s assessment, which financial concept can the investor determine about the property? There are four options. There is only one correct answer.

1

Purchase cash flow

2

Net present value

3

Present value

4

Rate of return

© 2021 Real Estate Council of Ontario

Lesson 1 | Page 16 of 16

Congratulations, you have completed the lesson! Completion of this lesson has enabled you to: • Identify a client’s requirements when addressing investment properties • Define and identify the characteristics of a user when addressing investment properties • Define and identify the characteristics of an investor when addressing investment properties There are three sections on this page with a summary of the key topics that were discussed in this lesson. You should recognize the needs, risk tolerance, and objectives of your client to be able to Client requirements for introduce them to appropriate properties. If you are working with sellers, this knowledge is beneficial when listing and marketing properties. commercial investments

Characteristics and considerations for users

Users intend to occupy a building for their own business needs. Understanding the characteristics and needs of their business enables you to determine the property characteristics that will appeal to them.

Characteristics and considerations for investors

A typical investor’s needs will be focused around the returns they can get through an investment. However, each investor will have a preference in terms of the property type that may appeal to them. Understanding the needs of your investor clients enables you to provide insight when showing and marketing properties.

© 2021 Real Estate Council of Ontario

Lesson 2 | Page 1 of 7

Lesson 2: Types of Leverage

This lesson describes different types of leverage, including the difference between positive, negative, and neutral leverage in the context of commercial investment properties. This lesson also covers the significance and how to determine a leverage ratio.

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Lesson 2 | Page 2 of 7

In investments, to leverage something is to use borrowed capital with the expectation of making profits greater than the interest owed. It is important for you to understand the concept of leverage, its types, and the way in which it is used for investment properties. Recognizing all of these considerations enables you to provide suitable advice to your clients regarding the way in which an investment property should be purchased and financed, and which options would garner the highest return. Upon completion of this lesson, you will be able to: • Explain the concept of using leverage for an investment property, and define the different types of leverage Throughout this lesson, you will participate in decision points to test your knowledge on the topics presented.

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Lesson 2 | Page 3 of 7

Leverage is a focal point of conversation in most real estate acquisitions and contributes directly to the yield realized on the equity investment in real estate capital projects. The results of leverage calculations may be used to determine the way in which an investor should pay for or otherwise finance their investment. When working with investors, you are expected to understand how to engage in conversations with your clients and provide advice regarding investment measurement techniques, such as leverage calculations, to identify benefits and risks to the return on investment of a commercial property.

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Lesson 2 | Page 4 of 7

Types of Leverages Most commercial real estate transactions involve borrowed funds for leverage, thereby reducing the owner’s initial investment and permitting them to participate in various projects within defined financial capabilities. Leverage has the potential to increase the owner’s return on any given investment, but risk is a consideration. Three types of leverage can occur: positive, negative, and neutral. When speaking about leverage, it is important to understand that the different types of leverage will greatly impact the advice you provide your client about how to finance a purchase. The following three sections contain information on types of leverages. Positive leverage Positive leverage occurs when the yield to an investor exceeds the overall rate of return that would have been realized on a property if no financing had been used. This means that more money can be made through an investment using borrowed capital than without using it. Two calculations are required for a leverage calculation; the overall capitalization rate (for example, net operating income of an income producing property divided by its value) as discussed earlier, and the equity capitalization rate (for example, cash flow before tax divided by the initial investment of the buyer or the equity in the property). When the overall capitalization rate is compared to the equity capitalization rate for a property, the results will determine the type of leverage. If the equity

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capitalization rate is greater than the overall capitalization rate, the leverage is positive. In this case, the investor sees a higher return on invested capital by using borrowed funds rather than using cash. Negative leverage Negative leverage occurs when the use of borrowed funds results in a lower equity yield than the overall rate of return that could have been realized had no financing been put in place. During an equity calculation, negative leverage is indicated when the equity capitalization rate of an investment is less than the overall capitalization rate. In the case of negative leverage, borrowing money to pay for an investment under the existing terms is not the best way to finance the investment. Typically, in this situation the investor should increase their down payment/initial investment or source financing with more favourable terms, which can increase their equity capitalization rate.

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Neutral leverage Neutral leverage occurs when no increase or decrease in yield occurs as a consequence of leverage. As a calculation, neutral leverage means that the equity capitalization rate and the overall capitalization rate are relatively the same (generally within one or two percentage points of each other). For an investor, neutral leverage means that it will not make any difference if money is borrowed to finance an investment or if existing capital is used instead. Typically, most investors today consider neutral leverage to be a satisfactory ratio for an investment. The results of an investment with neutral leverage mean that the building is generating enough net operating income to pay the mortgage and all operating expenses. Although there is no incremental profit from operations cash flow for an investment property with neutral leverage, most investors recognize that profit will be generated on the capital appreciation of the property through sales proceeds cash flow.

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Lesson 2 | Page 5 of 7

Leverage Ratio A leverage ratio can also be referred to as the loan to value ratio or debt/equity ratio. As previously discussed, it is a measurement tool used to determine how much capital will be used in the form of debt (often through loans) and how this will impact an investment’s profit or loss. You must understand the concept of leverage, as it will influence what advice you provide your client regarding how a property should be purchased and which option would yield the highest return on investment (ROI). The calculation for a leverage ratio is: Mortgage Amount ÷ Property Value For example, if an investor wanted to purchase a commercial property that was worth $1,000,000 and, in order to finance it, they put a $750,000 mortgage on it through borrowed capital, then the leverage ratio would be: $750,000 ÷ $1,000,000 = 0.75 (75%)

© 2021 Real Estate Council of Ontario

Lesson 2 | Page 6 of 7

A salesperson is working with an investor who is interested in purchasing a commercial property. The cost of the building is $10,000,000 and the anticipated annual net operating income from this property is $550,000. The buyer intends to provide a down payment of 25 per cent, or $2,500,000, and have the remaining cost leveraged through financing at an interest rate of five per cent. The investor plans to hold onto this property for around 10 years and then sell it after it appreciates at an estimated 20 per cent. Based on the information, what is the leverage ratio of this investment? Leverage Ratio or Loan-To-Value Ratio: ___Loan___ Value

There are four options. There is only one correct answer.

1

0.75

2

0.25

3

0.33

4

1.33

© 2021 Real Estate Council of Ontario

Lesson 2 | Page 7 of 7

Congratulations, you have completed the lesson! Completion of this lesson has enabled you to: • Explain the concept of using leverage for an investment property, and define the different types of leverage The following is a summary of the key topic that was discussed in this lesson: Leverage for Investment Properties Leverage is the act of borrowing with the intent of generating a profit. The amount of capital that will need to be borrowed for an investment is an important conversation to have with your investor. Understanding how to determine a leverage ratio and what this means for the profitability of an investment enables you to determine the quantity of leverage required for an investment.

© 2021 Real Estate Council of Ontario

Lesson 3 | Page 1 of 29

Lesson 3: Returns and Risk

This lesson discusses the rate of return, cash on cash return, taxation, and investment yields. This lesson also identifies how to determine risk tolerance and contributing factors that can influence risk for a commercial investment property.

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Lesson 3 | Page 2 of 29

The way in which risk and return is perceived and addressed may differ between a user and an investor. You should be able to provide required knowledge when speaking with your client and respond to questions regarding the potential profitability or risk of an investment property. Recognizing risk and return considerations for investment properties is an important aspect of meeting the needs of your clients. Upon completion of this lesson, you will be able to: • Identify the importance of analyzing returns in investment properties • Identify the importance of analyzing risks for a user of investment properties • Identify the importance of analyzing risks for an investor in investment properties Throughout this lesson, you will participate in decision points to test your knowledge on the topics presented.

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Lesson 3 | Page 3 of 29

Investors are profit driven and, therefore, will not move forward on a property purchase unless they are assured that the investment will provide a reasonable return. It is important for you to provide information to users and investors regarding the future yield of that investment. Calculations related to risk and return help in estimating the overall profitability and returns on the invested property.

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Lesson 3 | Page 4 of 29

Overall Capitalization Rate An important metric to analyze returns on an investment property is through calculating the capitalization rate. Cap rates provide a comparative tool for an investor to look at potential investment properties. It tells the investor the income that can be generated through a property in relation to its price. Two methods prevail: direct (income) capitalization and yield capitalization, which will be discussed later. This module will describe the concept of capitalization and provide an overview of relevant formulas; however, an indepth discussion of capitalization will occur later in the course. The overall capitalization rate (OCR) may also be referred to as the overall rate of return. For the purpose of this course, we will be using OCR. This concept expresses the relationship between net operating income (NOI) for a single year and the value of the property. The overall cap rate is the most widely applied direct capitalization method and consists of two parts: the rate of return on an investment (i.e., discount rate) and the rate of return of the investment (i.e., recapture rate). © 2021 Real Estate Council of Ontario

The OCR is best described as a blended rate. Typically, the rate is based on market research using the net operating income and sale price of comparable properties. The underlying assumption is that both the discount and recapture rates are implicitly included in that market-generated rate. The formula for calculating the overall capitalization rate is NOI ÷ Value. Example: The annual net operating income for an investment property is $53,000. The purchase price is $885,000. Therefore, $53,000 ÷ $885,000 = 0.0598 or 6% (rounded).

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Lesson 3 | Page 5 of 29

Equity Capitalization Rate Equity capitalization (sometimes called a cash on cash return) reflects the relationship between cash flow before taxes and an initial investment or down payment. The return on equity is a popular measure, given the large number of financing and leveraged purchases. Two comparable properties may have similar overall cap rates and yet realize significantly different equity return rates, due to the buyer’s use of borrowed funds and the amount of the down payment. Equity capitalization measures the annual rate of return made on the down payment after all operating expenses and debt service obligations have been satisfied. The formula for calculating the equity capitalization rate is as follows: Cash Flow Before Tax ÷ Equity or Down payment

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Example: Using the NOI and purchase price from the last screen, the net operating income of $53,000 is reduced by annual debt service (principal and interest) of $20,000. Therefore, the cash flow before tax is $33,000. The investor provided a down payment from their personal resources of $300,000. The equity capitalization rate is calculated by dividing $33,000 by $300,000, which equals 0.11 or 11%.

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Lesson 3 | Page 6 of 29

Yield Capitalization Yield capitalization, as with direct capitalization, analyzes the present value of a future income stream for purposes of investment valuation and comparison. However, yield capitalization should be clearly distinguished from direct capitalization. Direct capitalization involves a single year’s projected income and expenses to arrive at value. Yield capitalization relies on projected income and expenses over a specified holding period, which is the intended duration of the investor’s ownership. These projections include operations and sales proceeds cash flows. When the projections are made, an appropriate capitalization rate or discount rate would be applied to arrive at an estimate of the present value of the projected cash flows. Discount rates are selected based on an analysis of market activities, which would include previous sales and may be established by the investor given their investment return expectations. This topic will be discussed in greater detail later in this and the next course.

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Lesson 3 | Page 7 of 29

Taxation and Returns Taxation is an important factor in any investor’s decision-making process. When operations and sale proceeds cash flows are calculated, one final reality that every investor will encounter is tax liability. Fortunately, real estate has always been viewed favourably, given its tax sheltering capabilities. Often, the most meaningful analysis when discussing rates of return on an investment involve the use of cash flow after tax. When the net operating income is calculated and annual debt service is subtracted, the result indicates the cash flow before tax. When tax liability is subtracted from cash flow before tax, the result is cash flow after tax. Due to taxation complexities and investor’s reluctance to release sensitive income and tax information, it is often difficult to conduct accurate cash flow after tax calculations. Brokers and salespersons are not taxation experts and a thirdparty professional, such as an accountant, should be involved in cash flow after tax analysis.

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Lesson 3 | Page 8 of 29

A salesperson is working with a buyer who is interested in purchasing a commercial property and is assessing its value as an investment. The property is available for purchase for $395,000 with the assumption of a long-term $205,000 mortgage. This property has a net operating income (NOI) of $48,750 per year and an annual cash flow before tax of $31,300. Based on the information, what is the overall capitalization rate of the property that the investor is seeking? Overall Capitalization Rate: _________NOI_________ Value (Sale price)

There are four options. There is only one correct answer.

1

0.0792 (7.92%)

2

0.1234 (12.34%)

3

0.2378 (23.78%)

4

0.1526 (15.26%)

© 2021 Real Estate Council of Ontario

Lesson 3 | Page 9 of 29

Much like investors, each user of a commercial property will have a certain level of comfort and risk tolerance when it comes to purchasing commercial real estate. Determining this level of risk tolerance and using it to show and market properties that align with the needs of your user are an important aspect of performing due diligence and meeting the needs of your client.

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Lesson 3 | Page 10 of 29

Understanding and Determining Risk Tolerance for Users Risk in commercial real estate centres on fluctuations in the income stream and the vulnerability of that stream to external influences, such as market trends, availability and suitability of financing, degree of positive or negative leverage, and overall economic conditions. Understanding a user’s level of risk tolerance is an important component in showing properties to them that align with this tolerance. Some buyers, for example, are conservative and unwilling to take risk in their purchase. This type of buyer may often look for a building that is generating acceptable and consistent cash flow. This building will likely be in excellent condition, fully leased, and located in an optimal location. Other types of buyers may be willing to take a bit of a risk on a lower quality building with the intent of refurbishing it in order to attract a better quality of tenant and achieve a greater return on investment.

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Lesson 3 | Page 11 of 29

Financial Risk for the User Users of investment properties are likely to face financial risks that are different from those encountered by investors. It is important that you understand these risks in order to advise users on the anticipated profitability of their purchase. The following four sections contain information on financial risks for users.

Lease rates Leasing cost analysis involves the examination of costs incurred in a lease agreement, commonly associated with comparison of commercial lease alternatives for clients seeking or marketing rental premises. To properly compare costs, the full cost of occupancy must be established, followed by an effective rent calculation. Typically, the cost of occupancy would be the contracted rent for the period, plus any additional costs incurred (for example, tenant improvements), less any allowances or concessions provided by the landlord. Lease rates can pose a financial risk to a user, as a rate that is higher than previously expected will negatively impact their net operating income.

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Additional rent escalations A rent escalation is typically a provision included in a lease that states that base rent will increase at predetermined times during the term of the lease. This is done as a way to increase the revenue of a building and its overall value. For example, a tenant may sign a five-year lease and agree to the terms of base rent. The lease may also specify that on the anniversary date of the tenancy, the base rent will increase by $3.00 per sq. ft.

Cost of borrowing The cost of borrowing is a financial consideration that will impact both users and investors. When purchasing a commercial property, a portion of the cost of the building will be the investor’s down payment. This will impact a property user, as debt service costs of an investor will be factored into the rent required from the tenant to pay expenses and generate a profit.

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Cost of inventory and salaries The cost of inventory and salaries is an important conversation to have with a user client. These considerations would form part of a conversation between the salesperson and their client through the context of operating expenses and how they may impact a user’s ability to pay rent. A user’s previous experience in this regard can be helpful in providing estimated costs to the salesperson. Based on previous operating costs, the user could estimate the anticipated cash flow.

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Lesson 3 | Page 12 of 29

Condition of Space and Tenant Work Required The condition of a commercial building’s space and amount of tenant work required for a commercial property prior to leasing available units are important aspects that relate to risk. A risk averse user will typically be more inclined to purchase a property that is high quality, in a good location, or even one that is already established as profitable based on previous information. This type of building would likely have less need for repairs or renovations to make it ready for tenants prior to leasing. However, a user client with a higher degree of risk tolerance may purchase a less than desirable property for a lower price, with the intent of renovating the unit.

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Lesson 3 | Page 13 of 29

Future Business Growth When selecting properties to show to a user client, you should understand the buyer’s future plans and anticipated growth of the business. A commercial property may seem ideal for a business at the time of purchase. However, if the business is unable to expand as a result of limited space, this can lead to stagnation, reduce the profit potential, and limit competitive advantage. Understanding the buyer’s long-term business goals will help you select properties suitable to the growth plan of the business and help the buyer avoid the costs of moving and re-establishing a client base in a new location.

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Lesson 3 | Page 14 of 29

Changing Business Climate and the Economy When selling or buying any type of real estate, the financial benefit or risks will be influenced by the current and future business climate, and the state of the economy at the time a property was bought or sold. A changing business climate and the condition of the overall economy, for example, can have a considerable impact on a user’s business. If the business climate and conditions decline, it could mean consumers are less likely to spend money and this can impact the profitability of an investment.

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Lesson 3 | Page 15 of 29

A salesperson has recently been approached by a potential client who is interested in purchasing a commercial property for their current business. The client explains to the salesperson that they are relatively new to commercial property ownership. Which of the following questions would the salesperson ask their client in order to gauge their risk tolerance? There are five options. There are multiple correct answers.

1

Will this be a cash purchase, or will you be obtaining financing?

2

Are you aware of the maintenance and upkeep costs associated with this property?

3

Are you familiar with comparable lease rates of this particular area?

4

Are you aware of the current market conditions related to this commercial property purchase?

5

Will the investment be self-managed, or will you be hiring a property manager?

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Lesson 3 | Page 16 of 29

A salesperson is working with a buyer who is interested in purchasing an electronics store for their business use. The buyer intends to provide a down payment of 25 per cent of the $2,400,000 asking price. A financial lender will be used for the remaining cost and would be repayable at a five per cent interest rate over a 10-year holding period. Based on information from their business advisor, the buyer anticipates additional annual costs to include $375,000 for merchandise and $187,000 to staff a team of six sales representatives. The majority of the property will be used for retail service and merchandise; however, there is an existing kiosk in the centre of the store that the buyer intends to lease to a mobile phone retailer in exchange of $2,500 in rent, per month. Which of the following considerations is not factored into the investor’s annual estimate? There are four options. There is only one correct answer.

1

Cost of borrowing

2

Cost of rent escalations

3

Cost of inventory

4

Cost of salaries

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Lesson 3 | Page 17 of 29

Generally, investors are distinguished from users through the intended use of a property and their overall objectives for a property upon purchase. A key objective of an investor is often to purchase a property with the intent of acquiring tenants who will lease the property and provide operating income. This is a significant component of what will enable the investment to be profitable, in addition to capital appreciation.

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Lesson 3 | Page 18 of 29

Understanding and Determining Risk Tolerance of Investors The financial benefit of each investment decision is weighed heavily against the potential risk of the investment. Real estate investment analysis is often predicated using typical conditions in the marketplace (for example, an average market with no undue risks). However, the unpredictability and range of unknowns is an important consideration, and investors routinely institute measures to control risk in line with investment objectives and anticipated returns. Risk tolerance for investors may impact buyers who seek favourable terms and interest rates and sellers who may compare operating costs or lease rates against alternative investment opportunities. Most investors concentrate on prudent investment decisions based on accurate market and property information and diversification to shift or mitigate risk. In the context of real estate, diversification refers to spreading out the potential risk through multiple properties or acquiring multiple properties in different economic sectors (i.e., apartment buildings, strip malls, or light industrial properties). It is important for you to understand how to assess the risk tolerance of the investor and how to use the results of this assessment when selecting properties to show.

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Lesson 3 | Page 19 of 29

Exposure due to Changing Interest Rates Rising interest rates (or the cost of borrowing) can pose a serious risk to the yield on an investment property. Rising interest rates means an increase in the cost required to service a mortgage, which can in turn reduce the overall financial profitability of the investment. Changes in interest rates are typically linked to economic changes. It is important to note that it is not the responsibility of a salesperson to assess whether interest rates will rise or fall for the duration of a property’s holding period. Analysts, however, do make predictions regarding future interest rates, which can be assessed by a potential buyer and used when considering a property purchase.

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Lesson 3 | Page 20 of 29

Considerations Regarding Building Calamities Calamities that may occur to a commercial property could include anything from fire, vandalism, theft, or any event that could cause damage to a property. These events may be unpredictable but are factors related to risk that can impact the profitability of an investment. Some investors will use certain strategies in order to minimize risks of this nature. A landlord, for example, may employ a professional property management team to control expenses and minimize financial risks. The property manager would be able to focus on the operations of the property and put in place preventative maintenance systems as a defense against costly equipment breakdowns (e.g., HVAC). The savings and peace of mind can effectively balance any increased costs. The owner of a structure may also acquire business loss insurance, in addition to fire and theft coverage. The added expense could reduce risk and business calamity in the event of total destruction. The commercial landlord may place stringent requirements on tenants to ensure that most or all costs are passed to the lessee. While potentially limiting the range of possible tenants, the owner limits exposure to unknown variables.

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Lesson 3 | Page 21 of 29

Vacancies and Defaulting Tenants A significant portion of operating income generated by an investment property will be from the tenants who rent units in the property. Vacancies and defaulting tenants are factors that can sometimes be overlooked when carrying out financial due diligence. These factors, however, should be taken into consideration when determining the profitability of an investment property, as occasional vacancies and defaulting tenants are likely to be encountered. Potential rental income lost due to unit vacancies and bad debts, caused by defaulting tenants, can be assessed through a number of ways, including prevailing marketplace trends based on comparable properties or a survey of sufficiently comparable properties for valid vacancy trends. It is also important to note that vacancy rates and tenant default rates can vary by property type, property management skills, type of tenant, and lease arrangements.

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Lesson 3 | Page 22 of 29

Rising Operating Costs You should make your client aware that an increase in operating costs not recovered from the tenants (such as taxes, utility costs, or insurance fees) will decrease profitability. When discussing future returns with a client, it is important to consider potential increases in operating expenses in order to create a more accurate investment analysis. Advice on the matter should also be sought from other third-party professionals.

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Lesson 3 | Page 23 of 29

Changing Business Climate and Consumer Preferences A changing business climate and consumer preferences can have a considerable impact on a user’s business. You should be able to provide your clients insights regarding these topics, as they may impact the profitability of an investment. The following two sections contain information on the significance of a changing business climate and consumer preferences.

Changing business climate As you learned earlier, the financial benefit of an investment will be influenced by the current and future changes in the business climate. Economic development offices have important resources for those seeking advice regarding changing business climates, as well as suitable commercial sites for business operations. These offices in most Ontario municipalities attract new investment and employment opportunities, as well as supporting the growth of the existing business community. In doing so, they compile significant data about available real estate inventory (vacant land and buildings) and community statistical and related data to assist in the site selection process.

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Consumer preferences Consumer buying habits can influence an investor’s choice of a property. For example, if consumer preference is trending towards online shopping, an investor previously inclined towards purchasing a shopping centre may instead want to buy a warehouse distribution facility, as it may be a more appropriate investment.

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Lesson 3 | Page 24 of 29

Liability Coverage Acquiring liability and other types of insurance for an investment property is an additional cost to consider; however, insurance is an effective way to mitigate risk. Costs associated with building and property calamities can often be offset or eliminated by insurance, thereby preserving cash flow. Liability coverage is designed to protect the owner from risks imposed through lawsuits and similar legal claims. It is important to determine the details and limitations of liability insurance to prevent unexpected costs from events that are not covered. An insurance plan, for example, may not reflect the appropriate liability coverage for a building. Advice should be sought from an insurance broker or a company specializing in commercial insurance packages.

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Lesson 3 | Page 25 of 29

Third-Party Professionals for Investors Third-party professionals, such as lawyers, accountants, business and financial analysts, and other specialists are often required to provide their insight and knowledge on investment properties. When you are unable to provide appropriate advice, you must refer the client to the appropriate third-party professional. Additionally, the costs associated with third-party professionals should be considered when estimating the acquisition costs of the investment property. The following three sections contain information on third-party professionals for investors.

Lawyers Lawyers are an important third-party professional for commercial real estate. A lawyer may be used at any stage of a commercial property transaction, including a buyer’s initial intent to purchase a property, drafting of a commercial contract, and assisting with tenant lease agreements following a purchase. A lawyer may also be used to oversee the preparation of various documents that are relevant to the transaction to ensure they are prepared and executed properly. They can also provide advice regarding certain representations made as part of the negotiation and assist in confirming their accuracy. A lawyer will also be used to ensure that a commercial property complies with local zoning bylaws and that there are no restrictions on the property that may impact the quality of the investment.

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Accountants Accountants can be used to address taxation matters relating to the acquisition, disposition, and ownership of any commercial real estate. This is important to an investor, as it can enable them to gain insight about taxation costs associated with a particular type of investment property. An accountant will also be able to identify potential benefits of investments, which may be otherwise overlooked due to depreciation, recapture calculations, terminal losses, and timing issues surrounding property disposition.

Business analysts and financial advisors Business analysts and financial advisors may be used as third-party professionals to assess the internal rate of return and profitability of an investment, among other things. As there are several different ways in which an investor can direct their capital, analysts and financial advisors can provide insight, not only about the financial yield, but also its yield when compared to other investment options.

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Lesson 3 | Page 26 of 29

Investor Financial Risks The specific risks that an investor may encounter when investing in commercial real estate will be discussed later; however, it is important to generally identify the different considerations that a potential buyer may need to take into account. Some of these factors will present an immediate concern for a buyer, such as rising interest rates. When interest rates go up, the cost of borrowing increases, reducing the investment’s profitability. Vacancies or failure to renew leases are also a consideration. Increased vacancies within a property will impact the overall profitability of the investment, as the revenue normally received from rent would not be obtained. In addition, the condition of the property will pose certain risks to the investor owner, as the cost to correct any deficiencies will significantly impact the returns on the investment. It is important for you to ensure that the investor client is given ample opportunity to carry out their due diligence investigation by including specific conditions and other clauses in any agreement of purchase and sale. Involvement of various third-party professionals may be required in order to satisfy the investor’s due diligence concerns.

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Lesson 3 | Page 27 of 29

Property Absorption Rates An absorption rate is the rate or frequency at which space is being leased or occupied over a specific time period, such as monthly, quarterly, or annually. In terms of commercial properties, this is important information as the absorption rates are crucial in estimating a property’s potential cash flow. Typically, analysts prefer net absorption rates as a more accurate measure. The net figure reflects total office space leased less space vacated during the period under analysis. Absorption rates also tie into vacancy rates. For example, if a commercial property is experiencing an eight per cent vacancy rate, the absorption rate will be determined based on how long it may take to lease the vacant space over the next 30 to 180 days. Absorption rates, like all market data, can be obtained by analyzing the leasing experiences of other landlords, consulting with business analysts, chambers of commerce, and economic development offices. Information about vacancy rates can be obtained through your brokerage, a commercial property’s landlord, or a property manager. A salesperson should have a thorough understanding of how to present and review vacancy rates and absorption rates with a client as they will be components of cash flow and profitability discussions.

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Lesson 3 | Page 28 of 29

A salesperson is working with an investor who is interested in purchasing a commercial property and leasing the units to tenants. It is evident that throughout the period of ownership, this property will require renovations. In order to minimize tenant vacancies and defaults, the investor buyer intends to provide a credit of two month’s base rent ($5,000) per tenant willing to enter a long-term agreement. This credit is intended to be applied against leasehold improvement costs. The investor intends to take out a loan of $75,000 to offset the initial costs of this lessees’ credit, at an interest rate of 3.5 per cent compounded annually over a three-year term. The investment property is comprised of 15 units and the investor buyer anticipates an 80 per cent occupancy rate. If the owner elects to use the maximum loan amount, what will the total cost of the tenant incentives be at the end of the three-year term? There are four options. There is only one correct answer.

1

The total cost will be $62,625

2

The total cost will be $67,875

3

The total cost will be $82,875

4

The total cost will be $122,625

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Lesson 3 | Page 29 of 29

Congratulations, you have completed the lesson! Completion of this lesson has enabled you to: • Identify the importance of analyzing returns in investment properties • Identify the importance of analyzing risks for a user of investment properties • Identify the importance of analyzing risks for an investor in investment properties There are three sections on this page with a summary of the key topics that were discussed in this lesson.

Analyzing returns Investors are profit-oriented and would like to know how a property will perform. It is

important for you to provide information to users and investors regarding the future yield of that investment. Calculations related to risk and return help in estimating the overall profitability and returns on the invested property.

Analyzing risks for users

Analyzing risks associated with commercial property investments from a user perspective is an important component of your due diligence. This includes determining and assessing a user’s risk tolerance, what factors a user may prioritize in a commercial structure, and if the intended use of the structure aligns with the needs of the user.

Analyzing risks for investors

Risks faced by investors will differ from that of users. The fundamental reason being that an investor will not be occupying the property and may have fewer requirements. Investor risk relates to factors that can reduce the profitability of the investment, such as vacancies, defaulting tenants, and costs related to building condition. It is important for you to take these risks into account.

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Lesson 4 | Page 1 of 16

Lesson 4: Advantages and Disadvantages of Investing in Commercial Real Estate This lesson gives an overview of the factors that may influence the profitability and desirability of a commercial investment property and aspects to consider prior to purchase. This lesson also covers considerations related to the costs associated with commercial investment properties, the investment techniques that take these costs into account, and the distinction between investment value and market value.

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Lesson 4 | Page 2 of 16

Typically, commercial properties tend to have a higher financial return compared to residential properties. However, there are also additional risks associated with commercial property investments. You should understand their benefits and drawbacks to provide a more holistic view to your clients. Upon completion of this lesson, you will be able to: • Describe factors to consider when investing in commercial real estate • Describe the advantages of investing in commercial real estate • Describe the disadvantages of investing in commercial real estate Throughout this lesson, you will participate in decision points to test your knowledge on the topics presented.

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Lesson 4 | Page 3 of 16

There are numerous factors to be taken into account when purchasing a commercial investment property. You should have an understanding of the full scope of both the initial costs and expenses that may occur throughout the holding period of the investment. Having knowledge in this regard enables you to provide insight to your client about an investment’s profitability.

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Lesson 4 | Page 4 of 16

Property Management Property management is the administrative operation and maintenance of property, according to the objectives of the owner. Hiring a property manager is usually a good way to minimize the risk of a commercial property investment, but its cost must also be considered. The role of a property manager may include general property upkeep, such as tending to lawns and greenery, plowing snow, or coordinating repairs done by others. In a large commercial complex, their function may be through oversight related to the operations of the electrical, plumbing, heating, air conditioning, elevator, and other systems. A property manager must be able to provide a wide range of services, all of which are designed to maximize the owner’s benefit from the property over time. These services can include maintaining positive tenant or lessee relationships, collecting rents, and paying expenses and securing new tenants as vacancies occur.

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Lesson 4 | Page 5 of 16

Investment Techniques Investment analysis is a highly complex and multi-faceted subject with many factors to consider. Several of these investment technique concepts are introduced in this module. A more in-depth discussion, including sample calculations, is presented later in this course. Typical standard calculations include cash on cash returns, payback periods, break-even ratios, and gross income multipliers. Capitalization calculations may include overall, equity, mortgage, termination, and split rate capitalization and can be used to gauge a critique of a property at one particular instance. Additionally, dynamic presentations of cash flow can be calculated through operations cash flow (before and after tax), sales proceeds cash flow, discounted cash flows, and internal rates of return. All of these are investment techniques that are used to measure the profitability of an investment.

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Lesson 4 | Page 6 of 16

Capital Budgeting Capital budgeting is the process of selecting assets based on the allocation of resources towards the goal of financial return over an extended period of time. This will typically involve identifying specific investments for possible acquisition that align with predetermined investment goals and objectives. Comparative analysis of forecasted returns is often used to evaluate the merits of one investment over another. The theory of capital budgeting rests on a fundamental premise that the value of a project depends on cost in relation to future incomes. Direct and yield capitalization approaches can be used to provide detailed equity analysis, either through income rates (direct) or through yield rates (yield). Leverage is also a focal point of conversation in most real estate acquisitions and contributes directly to the yield realized on the equity investment in real estate investments.

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Lesson 4 | Page 7 of 16

Investment Value Versus Market Value You should be careful not to confuse investment value with market value. Market value is the probable selling price of a property in a competitive market given reasonable time, knowledgeable parties, and a competitive, open market. Market value focuses on value relating to the typical investor. Investment value is more narrowly focused to a particular investor based on individual requirements and circumstances. The market value of a property may not reflect the investment value perceived by a client and does not factor in their particular needs as an individual. However, while always distinct, the transition from one to the other is largely driven by assumptions.

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Lesson 4 | Page 8 of 16

Factors to Consider for Investing in Commercial Real Estate Although market value can be used as an accurate way to gauge the probable selling price of a property, individual circumstances must also be considered. Some of these may include a property’s intended holding period, property use, the purpose of the property, and various tax implications that can arise from the purchase or sale of the property. The following four sections contain information on factors for buyers to consider when investing in commercial real estate.

Liquidity One disadvantage of investing in commercial real estate, in comparison to other investment types, is its lack of liquidity. Liquidity refers to how quickly a person can convert assets to cash by selling them. It can take time for an investor to find someone to purchase their property, and even more time after to go through the selling process.

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Payback period The payback period for an investment is a way to measure the number of years required for cumulative cash flow, before taxes, to equal the initial investment. This is the time needed for the investor to recoup their initial investment. The formula for calculating a payback period is the equity investment divided by the cash flow before tax, expressed annually. There are, however, a few notable considerations when making this calculation. Payback period calculations do not consider capital appreciation.

Property purpose and use An investor has the option of investing in numerous types of properties. Office building and complexes are one type of commercial investment property in which revenue is generated through business owners who will pay rent over the course of multi-year leases. This provides a sustainable and reliable cash flow, with rental rates increasing over periods of time. Multi-unit industrial buildings may have many small businesspeople engaged in repair, servicing, and specialty shops, including tool and die operations, furniture and cabinet manufacturers, commercial kitchens, and banquet halls, among others. Given their kind of use, these properties require larger square footage. Typically, fewer tenants are available for industrial properties compared to commercial

© 2021 Real Estate Council of Ontario

properties. However, long-term agreements can be negotiated to provide a sustainable income stream. Retail properties may include shopping malls or other retail storefronts. Similarly, a large component of the financial return for office properties are tenant leases. Occasionally, property owners may also receive a predetermined percentage of sales generated by the tenant stores in addition to the base rent.

Tax implications Tax implications assist in gauging an investment’s profitability. Capital gains tax, or the tax on the profit achieved through the sale of a property, will impact the overall revenue achieved through the sale of a property following its holding period. Capital gains tax will be discussed in more detail later. The listing salesperson is strongly advised to confirm that the seller and the buyer have consulted accountants regarding tax related matters.

© 2021 Real Estate Council of Ontario

Lesson 4 | Page 9 of 16

Government Policies and Incentives Commercial real estate may benefit from government policies and incentives geared towards encouraging property ownership, economic growth, and business development. These may occur at a municipal, provincial, or federal level and may apply in a number of ways, such as tax credits interest-free loans or other incentives intended to encourage investors to acquire properties. For example, a municipality may provide initial and ongoing property tax relief as a means to encourage new investments, which in turn will reduce the investor’s operating expenses and promote economic development. As specifics regarding government policies and incentives may vary region to region, you should have a thorough understanding of programs that may benefit your investor client.

© 2021 Real Estate Council of Ontario

Lesson 4 | Page 10 of 16

A salesperson is working with a buyer who is conducting an analysis on the profitability of an investment property. The investor plans to purchase a commercial plaza for $3,900,000 and lease out the 14 individual units to tenants, each at $30,000 annually ($420,000 in total per year). All operating expenses, including property management, will be recovered from tenants through additional rent. The annual net operating income is estimated to be $202,000. The investor has determined that the property will then have a market value of $7,410,000 upon sale, after a 15-year holding period. Based on these estimates, the investor has calculated the overall capitalization rate (OCR) for this investment at 5.17 per cent and anticipates a return of $3,930,000 through both the property sale and rental income after deducting all operating costs including property management. What considerations did the investor overlook in their investment’s analysis? There are four options. There are multiple correct answers.

1

The investor did not factor in property appreciation over the holding period

2

The investor did not factor in capital gains tax for the property

3

The investor did not factor in vacancy rates for the property

4

The investor did not factor in revenue from sales generated by tenant stores

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Lesson 4 | Page 11 of 16

A salesperson is working with an investor for a commercial property purchase. The investor is comparing the length of time required for them to achieve a return on their investment. There are two different options for them to consider. Option One requires an initial investment of $50,000, with an annual cash flow before tax of $3,500. Option Two offers a monthly cash flow before tax of $300, after an initial cash outlay of $45,000. What is the shortest payback period and which option would it apply to? There are four options. There is only one correct answer.

1

14.3 years; Option One

2

12.5 years; Option Two

3

12.5 years; Option One

4

14.3 years; Option Two

© 2021 Real Estate Council of Ontario

Lesson 4 | Page 12 of 16

It is important to understand why commercial properties are used as investments in order for you to provide adequate and professional service to a potential client. Simply put, why should buyers invest in commercial real estate? Any well-balanced presentation to either the seller or the buyer will highlight both advantages and disadvantages. After all, the commercial salesperson is competing for investment dollars within the broader local, national, and international marketplace. A well-informed buyer must know the rewards and pitfalls of real estate to make an informed decision.

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Lesson 4 | Page 13 of 16

Advantages of Investing in Commercial Real Estate Investing in commercial real estate offers several advantages that enable an investor to enjoy stable cash flow through rental income followed by additional revenue generated through capital appreciation. Understanding the advantages of investing in commercial real estate enables you to provide insight to an investor about the way owning a property can be beneficial. The following four sections contain information about advantages of investing in commercial real estate.

Personal control Real estate, as an investment, has a higher degree of personal control as opposed to other investment types (for example, stocks, bonds, futures, or investments) with high volatility. The owner of commercial real estate will likely also experience more control than the owner of residential real estate. This is most evident through the regulations regarding tenants for both property types. Under the Residential Tenancies Act in Ontario, the tenant will hold most of the rights and privileges in the relationship. The Commercial Tenancies Act, however, highly favours the landlord who enjoys the largest amount of benefits. It is important to note that although commercial real estate will have a higher degree of control than residential, many small investors prefer residential real estate as an investment due to the complexity of commercial property ownership and the barriers to entry, such as cost, financing, etc.

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Opportunity for capital growth Capital growth (i.e., capital appreciation) is an increase in value of an asset or an investment over a given period of time. During inflationary periods, if a property is well maintained and kept up to date, the owner of a commercial property will experience an increased sales price when they sell in addition to revenue generated from tenants. A well-maintained property will also attract a higher quality tenant resulting in more stabilized cash flow.

Tax sheltering possibilities Tax sheltering is broadly viewed as any financial arrangement that results in the reduction or elimination of taxes due. A salesperson should have general awareness of significant tax provisions. Property use is an important factor regarding taxes, such as if the property is used for business/investment income or as a primary residence. While taxes are payable on the business and investment income, capital appreciation of a principal residence is generally excluded from taxation under the Income Tax Act.

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Physical presence In contrast to other types of investment (for example, stocks, bonds), a commercial property is a tangible asset. Both the land and the building itself can improve their value over time, through renovations, building upgrades, modifying unit spaces, or even redeveloping the land. Improving the overall valuation of a property, in turn, allows the landlord to increase property lease rates, both for new tenants and when renegotiating leases with existing tenants.

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Lesson 4 | Page 14 of 16

Disadvantages of Investing in Commercial Real Estate Along with numerous benefits of commercial properties, there are also challenges. Understanding the disadvantages of investing in commercial real estate enables you to provide a complete picture of commercial properties to your clients. The following four sections contain information on the disadvantages of investing in commercial real estate.

Lack of liquidity Liquidity refers to the ease by which an asset can be converted to cash. Commercial properties and real estate in general are considered to have a lack of liquidity when compared to other investments. This is due to a number of factors, including the time required to locate potential buyers, and the time required to complete the transaction.

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Disposition cost A disposition cost refers to any out-of-pocket expenses that occur through the sale or disposition of the asset. In terms of commercial real estate as an investment, this includes items such as taxes, real estate remuneration, and legal fees, which are factored into the overall financial yield of an investment. This can impact a seller, as it may dissuade them from reinvesting their capital from a property sale back into commercial real estate.

Capital investment cost An investment in commercial real estate can yield a high rate of return, both during a property’s holding period and upon its sale. However, when compared to other financial investment opportunities there is a high initial capital cost involved. This can often restrict the potential pool of investors, but an alternative could be investing in a Real Estate Investment Trust (REIT) or mutual funds that hold real estate in the portfolio.

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Administrative costs Unlike other financial assets that require lower personal oversight and maintenance (for example, stocks, bonds, etc.), real estate investments often require constant care, attention, and management. The administrative costs related to ensuring the upkeep, maintenance, coordination, and operations of a commercial property are all financial considerations that need to be factored into an investment. As the owner of the property is the beneficiary of financial yields for their investment, their return would be the income generated less the costs of maintaining the investment.

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Lesson 4 | Page 15 of 16

A salesperson is speaking with a buyer who is interested in purchasing an investment property. The buyer has previous experience with various investment options, but never commercial real estate. The buyer is not sure if owning a commercial property is an appropriate choice for them. They ask the salesperson to explain the financial benefits of commercial real estate. Which of the following are advantages of commercial investment properties that the salesperson could discuss? There are five options. There are multiple correct answers.

1

Opportunity for capital growth during inflationary periods

2

Easy liquidity at the time of disposal of the property

3

Tax sheltering possibilities

4

Potential to recover capital through refinancing

5

Opportunity for preferential administrative costs

© 2021 Real Estate Council of Ontario

Lesson 4 | Page 16 of 16

Congratulations, you have completed the lesson! Completion of this lesson has enabled you to: • Describe factors to consider when investing in commercial real estate • Describe the advantages of investing in commercial real estate • Describe the disadvantages of investing in commercial real estate There are three sections on this page with a summary of the key topics that were discussed in this lesson.

Factors to consider when investing in commercial real estate

A seasoned investor will likely have a reasonable understanding of what to expect throughout a property’s holding period. However, providing insight and advice regarding potential costs and projected financial returns can be beneficial for investors of all experience levels. You should understand factors related to investing in commercial real estate, as it enables you to provide your clients with an accurate representation of what to expect and minimize the risk of unanticipated costs.

Advantages of investing in commercial real estate

Commercial real estate can be an asset with numerous financial benefits. Some of these may relate to the security of the investment, the ability to increase financial yield through a property’s holding period, or beneficial taxation situations. It is your responsibility to ensure that your buyer is well informed and is referred to a third-party professional when appropriate.

Disadvantages of investing in commercial real estate

Although commercial real estate can be an excellent investment opportunity, you should make the client aware of potential risks and disadvantages related to this type of investment. You must ensure that your buyer is provided with the necessary information to make an informed decision about a real estate investment.

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Lesson 5 | Page 1 of 23

Lesson 5: Risks Associated with Acquiring Commercial Real Estate

This lesson discusses the risks associated with acquiring commercial real estate from different perspectives including financial, market, business, and building.

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Lesson 5 | Page 2 of 23

Risk is typically assessed as either external or internal. Most risk analysts acknowledge this distinction as factors beyond the property and factors within the property. These factors can be further divided into specific types of external risk. External risks, for example, may be financial (i.e., interest rates and purchasing power of future dollars) or market driven (i.e., market trends and occupancy rates). Internal factors may include risks to a business (i.e., taxation, economic activity, and investment climate) or specific risks to a building, such as physical calamities. Understanding the different risks in an investment property enables you to provide insight to your client regarding what to expect throughout the duration of their investment. Upon completion of this lesson, you will be able to: • Identify financial risks associated with commercial real estate • Identify market risks associated with commercial real estate • Identify business risks associated with commercial real estate • Identify building risks associated with commercial real estate Throughout this lesson, you will participate in decision points to test your knowledge on the topics presented.

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Lesson 5 | Page 3 of 23

Financial risks are an important consideration for investment properties and can significantly alter their value and the revenue they generate. You should be able to understand the factors related to financial risk and to refer them to the appropriate third-party professional to discuss financial matters, as appropriate.

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Lesson 5 | Page 4 of 23

Financial Risks for Commercial Real Estate Financial risks may arise throughout the holding period of an investment that may lead to increased operating costs, decreased sales activity, and an overall decrease in the amount of profit achieved through an investment. The following four sections contain information on different types of financial risks to commercial properties.

Interest rates When interest rates increase, so does the cost of borrowing. If the increase in the cost of borrowing is not anticipated, this additional expense will reduce the capital generated by the investment. A third-party professional, such as an accountant, a lawyer, or an investment advisor will be able to provide insight regarding the terms of a desirable mortgage, taking into account the current market conditions.

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Currency purchasing power Commercial investment properties typically involve large sums of money and attract investors from all over the world. To adequately meet the needs of foreign buyers, it is important to recognize the concept of purchasing power, i.e., the value of a currency when compared to that of a different currency. Although the value of Canadian real estate will be calculated in Canadian dollars (CAD), foreign investments often use the United States dollar (USD) as a standard for comparison. When working with a foreign buyer, you will need to ensure that the correct metric is used when providing any information. As the value of currencies can vary, mistakenly using a different one can result in notably different financial costs and outcomes from an investment.

Operating costs Operating costs include property taxes, insurance premiums, and common area maintenance costs. An increase in operating cost can pose a risk to an investor, as returns would be reduced should the investor not be able to recover those costs through additional rent.

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Sales activity A decrease in sales activity can pose a risk to both a user and investor of a commercial property. For users, when sales revenue drops, it reduces cash flow and profits. Depending on the business operation, it may also lead to a surplus of unsold inventory, which would either need to be stored or sold at a discounted price. For investors, a prolonged period of decreased sales activity may result in an increase in vacancy rates. If a portion of capital is gained through tenant leases, and tenants are not achieving their anticipated revenue, they may reduce normal business operations or relocate, rather than renew their lease upon expiration. The cost of increased vacancies would then impact profitability that would otherwise be realized through a commercial property.

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Lesson 5 | Page 5 of 23

Government Policies and Incentives Current or future changes to government policies can both benefit and hinder the profitability of a commercial investment property. Some policies, for example, may be more favourable to particular types of business. For example, changes to international trade can open new trading markets for business owners. Favourable policies may also benefit business profitability through additional tax return benefits, income statement credits, low borrowing rates, or interest-free loans intended to support lessees or buyers. Alternatively, government policies may also negatively influence an investment’s profitability. For example, a specific policy change that may include additional requirements for permits or licenses related to the operation of a particular enterprise, or the withdrawal of a subsidy that a business relied on. Collectively, several changes in policies may decrease market confidence and influence the trading climate. A salesperson is not required to predict future market conditions, but should be able to provide insight to a client regarding policy changes as a potential financial risk for an investment.

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Lesson 5 | Page 6 of 23

A salesperson is working with a client who is selling their commercial warehouse, which was previously used for storage of their menswear company’s inventory. The buyer is an international investor from Germany who intends to retrofit this warehouse to turn it into a state-of-the-art distribution centre (rather than use multiple facilities) for their emerging online retail business. The buyer intends to use their existing financial lender to negotiate a competitive interest rate for this investment. In what ways does the buyer intend to minimize financial risk or otherwise benefit from this investment? There are four options. There are multiple correct answers.

1

Interest rates: The buyer intends to leverage additional capital with their existing lender.

2

Value of the currency: The buyer intends to cut costs related to maintaining multiple buildings by retrofitting the warehouse into a state-of-the-art distribution centre that can handle the overall distribution process.

3

Operating costs: The buyer will make their purchase in Euros, as opposed to the CAD.

4

Sales activity: The buyer intends to reduce their bricks and mortar retail costs by re-branding as an online shopping experience.

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Lesson 5 | Page 7 of 23

Market risks, along with financial risks, are two key elements of external risk for an investment property. Recognizing a shifting or unstable market in a particular trading area can enable you to convey crucial information to your client and provide them with the opportunity to better estimate a commercial property’s value.

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Lesson 5 | Page 8 of 23

Vacancy as a Market Risk As previously discussed, vacancy rates can impact the financial return generated through an investment property. However, the overall conditions of the marketplace can also pose significant risk to an investor. For example, an investor interested in a retail property in an area with a high vacancy rate. The investor would need to determine how their retail property can be differentiated from other poorly performing properties within this trading area in order to attract favourable tenants. A low vacancy rate is often a safer investment; however, this may also mean a more competitive marketplace, which can increase the investment acquisition price. Although a high vacancy rate may present more financial risk, it may also provide attractive buying opportunities, as the price of the properties will likely decrease. It is important to provide your client with sufficient information regarding how vacancy rates can impact the cost of the proposed investment.

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Lesson 5 | Page 9 of 23

Market Conditions The conditions of a market pose different risks to an investor. As a general risk, economic changes that occur at various levels (i.e., federal, provincial, and municipal) can impact factors such as interest rates and government incentives designed to promote business growth. Market conditions may also include specific risks associated with a commercial property, such as the condition of a particular trading area. A neighbourhood with a strong seller’s market, for example, may result in increased cost to the purchase price of a commercial property. It is important to be familiar with both local and national events that may impact the trading area, in order to provide competent service.

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Lesson 5 | Page 10 of 23

Occurrence of Lease Renewals As a lease is a contractual obligation between a property owner and a tenant with a definite expiry date, there is a degree of risk to the owner when the term of a lease nears completion. Until a new lease is agreed upon by the investor and the tenant, the investor will not have assurance that the tenant will remain at the location and continue to pay rent. If a tenant leaves, and the property owner is unable to find a replacement in a reasonable period of time, the overall profitability of the investment would suffer. Depending on market conditions, the rental unit may remain vacant for a significant amount of time and the property owner may have to reduce the rent in order to attract a new tenant. It is important for a salesperson to make their client aware of potential risks that occur when making investment decisions and ensure that the investor client is given an opportunity to review all existing leases as part of their due diligence investigation to identify, among other things, the expiry dates of the leases.

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Lesson 5 | Page 11 of 23

An investor is deciding between two comparable properties located in different trading areas. The first property is located in a highly desirable location, which will attract a great deal of foot traffic and has a vacancy rate of just one per cent. As a result, the asking price is $10,000,000, a significantly higher number than the market value. The second property has a higher vacancy rate of eight per cent, due to a much lower foot traffic. The asking price is $7,500,000. What information should the salesperson provide to the investor about vacancy rates? There are four options. There are multiple correct answers.

1

A low vacancy rate can mean a more competitive market.

2

A low vacancy rate presents more financial risk to an investor.

3

A high vacancy rate can be a good investment opportunity.

4

A low vacancy rate can cause the price of properties to increase.

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Lesson 5 | Page 12 of 23

Risk to businesses can occur through a number of ways and can hinder business growth and returns received from an investment. Tax incentives, the condition of the economy, and specific trade regulations are all factors that can alter the returns on invested capital, and the operation of the business itself. Recognizing the significance and the impact of business risks can enable you to provide your client knowledge regarding a commercial real estate investment.

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Lesson 5 | Page 13 of 23

Taxes as a Cost to Consider Taxes can impact the profitability of an investment property, as they represent a significant cost when calculating an investment’s value. The property owner may be required to pay taxes at the time of acquisition, during the holding period, and when the commercial property is sold. Transfers of real estate ownership, for example, are subject to land transfer tax at the provincial and sometimes municipal levels. Municipal property taxes are payable by a property owner, along with income tax, which is payable on the income generated by the investment property. Furthermore, a portion of the profit generated from the sale of a property is subject to capitals gains tax, which must also be considered when estimating sales proceeds. As taxation matters are often beyond the expertise of the salesperson, you would always encourage your client to seek advice from a third-party professional.

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Lesson 5 | Page 14 of 23

Business Opportunities and Investment Climate Investment climate can impact investment profitability in several ways. From an economic perspective, it can dictate the willingness and degree to which banks and financial lenders provide capital for investments. It can also be affected due to other conditions, such as employment rates, tax rates, and the overall state of the economy. Business opportunities are directly impacted by market conditions, which correspond to the investment climate. If a trading area is undergoing a state of decline, it can present additional challenges to investors. Information regarding business opportunities can be gained from a number of resources, such as business development offices within the local community, local chambers of commerce, various trade organizations, and even professional associations.

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Lesson 5 | Page 15 of 23

Trade Regulations and Commercial Properties Trade regulations are laws that regulate specific industries or commercial undertakings. In terms of commercial real estate, trade regulations may influence both users and investors. Various trade regulations may prevent a prominent corporation from dominating a particular trading area and gaining a monopoly by limiting the amount of facilities allowed within the similar area. Trade regulations can also refer specifically to various types of industries. The Canadian Radio-television and Telecommunications Commission (CRTC), for example, has particular guidelines about businesses operating within the broadcast and telecommunication industry. In some cases, multiple entities may oversee a single industry. Rail and air transportation, for example, is overseen by Transport Canada, but the Ministry of Transportation (MTO) is responsible for regulating highway transportation and vehicle licensing. Additionally, the Transportation Safety

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Board is an investigative body that can assess all types of transportation occurrences that could have provincial, national, and international consequences. As a salesperson, you should determine from the client if there are specific trade regulations that will impact the size, location, and physical characteristics of the required premises. Trade regulators can impose restrictions that must be considered when selecting properties for the client. In addition, zoning bylaws could also dictate where a business could be located within the community.

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Lesson 5 | Page 16 of 23

Removal of Tax Incentives As discussed earlier, government tax incentives may be offered to investors at a municipal, provincial, or federal level. This can often be done as a way to enhance business growth or increase employment opportunities within a particular area. For example, sometimes a local municipality will offer a reduction or elimination of property tax for a specific period of time to boost economic development within that area. It is important to provide your client with knowledge about various incentives they may qualify for, but also to explain potential risks associated with their removal. For example, if a business has become dependent on one or a combination of tax incentives that expire or conclude, it can pose a risk to investment profitability.

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Lesson 5 | Page 17 of 23

A salesperson is working with a buyer who is interested in purchasing an industrial property for their international trucking company, which they plan to expand into Canada, starting with Ontario. The buyer, who is unfamiliar with Ontario regulations, has requested guidance from the salesperson to ensure that the properties are compliant with all required laws and guidelines. The salesperson informs the buyer that they will require a third-party professional to confirm this information but is happy to provide any general information they can. In what ways could trade regulations impact the buyer’s intended proposal? There are four options. There are multiple correct answers.

1

The licensing of vehicles used for business operation

2

The weight of each vehicle load

3

The qualifications of each vehicle’s driver for business operations

4

The number of vehicles used for business operations

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Lesson 5 | Page 18 of 23

Risks associated with buildings can impact both the investment value and the overall safety of a commercial property. There are numerous potential structural and site issues to be considered that may require additional capital investment during the holding period. These issues can negatively impact an otherwise profitable investment. Recognizing the ways in which building risks can impact an investor enables you to direct your client to the appropriate third-party professional to provide an insight on repair requirements and their costs, as required.

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Lesson 5 | Page 19 of 23

Condition of the Structure For a proper estimate about an investment property’s potential and to mitigate financial risk, the investor would need a clear understanding of any deficiencies. Damaged structural components or building systems can vary from minor maintenance items to major structural problems that can seriously impact the profitability of the property. It is recommended that appropriate third-party professionals (for example, property inspector or building assessors) be consulted to assess the condition of the structure. In the case of smaller buildings, the assessment can sometimes be completed by a home inspector. A larger commercial building may require a building assessment report where a consulting engineer, or some other individual with expertise with building components and mechanics, would carry out a thorough analysis of a building and provide a report.

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Lesson 5 | Page 20 of 23

Condition of the Site Site condition typically refers to the state or condition of land for a building. The quality of a site, for both existing and future structures, can potentially pose a great deal of risk for the value of an investment, particularly if the land is found to have environmental contamination. Issues regarding a commercial site could also include areas unrelated to the structure itself that require various improvements. These may pertain to parking lots, storage facilities, security fencing, or even surface requirements to improve the property’s condition (for example, removal of debris). These are all factors that can impact the financial returns of a property.

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Lesson 5 | Page 21 of 23

Ontario Building Code Changes When a commercial property is being considered by an investor, it may not always be a new structure or even one in good condition. Some investors are interested in a reduced purchase price with the intent of renovating. When renovations are made, they must comply with the Ontario Building Code, as well as other standards. In addition to the Ontario Building Code, an investor would also need to consider changes the structure may require in order to comply with the Accessibility for Ontarians with Disabilities Act (AODA) for any new renovations and additions. The costs associated with retrofitting a commercial property must be considered, and a third-party professional should be referred to provide estimates regarding what changes are required and what they may cost.

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Lesson 5 | Page 22 of 23

A salesperson is working with a buyer who is interested in purchasing a four-storey residential apartment building. The building is approximately 45 years old and has undergone several repairs within that time, including the installation of an elevator, renovations to the parking area, and updates to the exterior building façade with a finishing material that will enhance the building’s energy efficiencies. Despite these enhancements, the property is not considered to be in good overall condition. The buyer, however, recognizes that this property is located in an area with substantial projected growth. As the property’s asking price was recently reduced due to its condition, the buyer plans to invest the excess capital and other cash reserves to further renovate the property in preparation for upcoming economic developments in the neighbourhood. To reduce risk associated with the building’s condition, which third-party professionals should the salesperson recommend to the buyer? There are four options. There are multiple correct answers.

1

Property inspector

2

Business analyst

3

Environmental site assessor

4

Consulting engineer

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Lesson 5 | Page 23 of 23

Congratulations, you have completed the lesson! Completion of this lesson has enabled you to: • Identify financial risks associated with commercial real estate • Identify market risks associated with commercial real estate • Identify business risks associated with commercial real estate • Identify building risks associated with commercial real estate There are four sections on this page with a summary of the key topics that were discussed in this lesson.

Financial risks of commercial real estate

Financial risks can impact both sellers and buyers of commercial real estate. Financial risk can relate to changes to interest rates, operating costs, sales activities, and government policies, among other considerations. Understanding financial risks enables you to provide insight when speaking about and referring clients to third-party professionals for financial matters.

Market risks of commercial real estate

Market risks may include current or changing vacancy rates, market conditions, and lease agreements. Recognizing how market risks can pose risk to an investor can enable you to convey this information to clients and provide competent service.

Business risks of commercial real estate

Business risks can include taxation, economic decline, and shifting investment climates. Recognizing how building risks can impact an investor enables you to understand when to direct your client to appropriate third-party professionals for matters related to business risk.

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Building risks of commercial real estate

Building risks can impact various costs associated with a commercial investment property and the health and safety of the occupants. It is important for you to recognize how these risks can affect the investment opportunity and when to refer your client to the appropriate third-party professional.

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Lesson 6 | Page 1 of 21

Lesson 6: Legislation, Due Diligence, Disclosure, and Responsibilities of the Salesperson, Seller, and Buyer This lesson includes topics related to the considerations in commercial properties in general, such as a salesperson’s duties, obligations, and disclosures for sellers and buyers. This lesson also includes key legislation governing commercial leases and commercial investment properties.

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Lesson 6 | Page 2 of 21

You are required to act in the best interest of your client, and to treat all other parties fairly, honestly, and with integrity. Although the various requirements of a salesperson working in the real estate industry have been discussed, this information is included as a refresher to ensure that the full scope of obligations are recognized. Upon completion of this lesson, you will be able to: • Describe the salesperson’s duties and obligations for due diligence and disclosure • Define the key legislation governing commercial leases and commercial investment properties Throughout this lesson, you will participate in decision points to test your knowledge on the topics presented.

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Lesson 6 | Page 3 of 21

A salesperson, whether new to the profession or not, must act within a standard expected of a knowledgeable, proficient salesperson. When working with both clients and customers, a salesperson is in a position of trust and must exercise due care when giving advice or providing information, since they should know this will be relied upon. This is essential for you to understand, as failure to meet these obligations can result in termination of any representation or service agreements and the possibility of disciplinary action or, in the extreme, litigation.

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Lesson 6 | Page 4 of 21

Best Interest of Clients As you have previously learned, you are obligated to act in the best interests of your seller and buyer clients. Knowing that investment properties require significant capital and detailed financial analysis related to financial returns, you should ensure that your clients are provided sufficient time to arrange funding and are encouraged to consult with third-party professionals, as required. When assisting sellers, you will need to obtain and provide various due diligence documents (such as leases, financial statements, tax bills, bank statements, and service contracts, among others) that can be provided to buyers to ensure appropriate due diligence can be carried out during the transaction. When assisting buyers, it is important that they are given the required due diligence documents and a suitable amount of time to review these documents to make an informed decision.

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Lesson 6 | Page 5 of 21

Documenting Services and Relationships You will be required to document the nature of your relationship and services to be provided to buyers, sellers, landlords, and tenants. This must be done at your earliest practicable opportunity and no later than when an offer is made. In relation a seller or a landlord client, you will be obligated to complete a seller representation agreement (a listing agreement), which specifies the services to be provided to the seller client. When representing a seller or a landlord as a customer, you will be required to prepare a seller customer service agreement, which specifies the services that your customer is expected to receive from you or your brokerage. This same process would occur for buyer or tenant clients and customers using representation or customer service agreements, as appropriate.

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Lesson 6 | Page 6 of 21

Estimating Property Value In real estate, salespersons often provide opinions of value, either orally or in a single page letter format, regarding the worth of a property. Typically, the single page, letter format lacks the detailed analysis that would be carried out in a Comparative Market Analysis (CMA). While it can be natural to try and provide an honest response to any inquiries, it is important that you do so only when you have the appropriate level of education, knowledge, and experience, and are obligated to refer your client to the appropriate third-party professional otherwise. Opinions of value often lack the detailed analysis and supporting documents of a CMA, which was discussed in PreRegistration. Once an analysis is carried out (i.e., the CMA), then an opinion can be reasonably formed and defended. While you can provide an opinion of value, it is important for you to refer your client or customer to the appropriate third-party professional. Services from others involved within the real estate transaction may include appraisers, lawyers, and tax specialists.

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Lesson 6 | Page 7 of 21

Ontario Fire Code Retrofitting The topic of renovations or retrofit requirements for commercial properties has been discussed in Pre-Registration. However, it is important to restate this information within the context of commercial investment properties. When amendments to the Ontario Fire Code are made, they are considered retroactive, meaning that these amendments must be incorporated into any existing building to which they would apply. In terms of cash flow, the impact of this can sometimes be costly, as upgrades and renovations may need to be carried out to satisfy these changes. If a buyer is purchasing a commercial property, they should have the property assessed by a building inspector to determine if the building complies with the latest requirements of the Ontario Fire Code. Insurance companies may also have requirements that must be met prior to insuring a property. Some of these may be related to sprinkler, security, or electrical systems.

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Lesson 6 | Page 8 of 21

Role of Third-Party Professionals During Due Diligence Obligations As previously discussed, there may be several third-party professionals involved when selling or buying investment properties. A lawyer would provide advice regarding the transactional documents and the quality of the title being acquired by the investor. An accountant could provide advice on various taxation matters affecting the transaction and the operation of the investment property. An environmental site assessor could provide insight into the environmental condition of the property and identify potential risks. Finally, a building assessor or various inspectors would provide advice and guidance to the investor regarding the technical and physical condition of the property. These are just a few of the various third-party professionals that could be required to address specific due diligence issues surrounding a property.

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Lesson 6 | Page 9 of 21

Providing Financial Statements When representing a seller, you need to ensure that they understand the importance of providing up-to-date and accurate financial information to a buyer. This can sometimes be challenging, as a seller may believe their financial information to be accurate or adequate for the process. For example, a seller may be confident that they provided accurate financial information, but may have mistakenly included the same information about a certain revenue stream at two different instances within the financial statement. When representing a buyer, you need to ensure that your buyer understands the significance of receiving up-todate and accurate information from the seller, and then take steps to analyze these documents so that your buyer will clearly understand the financial components of the business. When representing both sellers and buyers, a third-party professional, such as a lawyer or an accountant, would likely be required during the exchange and assessment of financial statements. In your role as salesperson, you will facilitate this exchange but may not assess the documents yourself. Additional documents required as a component of financial due diligence could include rent roll, tenant status report, income statements, or other documents to verify operating expenses.

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Lesson 6 | Page 10 of 21

Investment Property Tax Considerations Two major components to identifying taxable income at the point of a sale are recaptured capital cost allowance and the calculation of a capital gain. When working with a seller, you should encourage them to seek advice from their accountant before listing the property in order to accurately estimate the net proceeds of the sale. In the context of real estate, capital gain refers to profits that result from the sale of a property (for example, when the sale price is higher than the purchase price). When a property is sold, that part of the selling price that exceeds the purchase price or amount of the mortgage is considered a capital gain. The capital gain can be reduced by the adjusted cost base (ACB). The ACB is typically comprised of the costs of capital improvements made to the property by the owner, the acquisition and disposition costs, and any other allowable expense. Fifty per cent of the gain becomes a taxable capital gain and must be declared as income on the seller’s income tax return. Capital cost allowance (CCA) is a deduction claimed for depreciable assets when determining taxable income. CCA is intended to reduce the taxes payable during the holding period.

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Lesson 6 | Page 11 of 21

Due Diligence and Disclosure Obligations for Sellers Due diligence for commercial real estate is far more extensive and expensive than for residential properties, particularly with large, complex transactions. Prospective commercial sellers must carefully assess all risks associated with a business and/or a property sale, with particular emphasis on due diligence. Due diligence typically focuses on financial, legal, structural, and environmental considerations. Most are customized to suit individual circumstances, but ultimately the goal is full knowledge of relevant facts. Due diligence can range from a straightforward direct inquiry by the prospective owner to a team of accounting, legal, and other professionals scrutinizing every aspect of a business or investment property, and developing a substantial, customized audit.

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Lesson 6 | Page 12 of 21

Salesperson’s Due Diligence and Disclosure to Buyers As previously discussed, when working with a buyer client, the brokerage and the salesperson must ensure that the obligations regarding disclosure and privacy are followed. Certain disclosures must be made to a client. These include, but are not limited to: • The details of all material facts: You must make a reasonable attempt to determine all material facts and disclose those facts to the client at your earliest practicable opportunity. • You would also disclose any direct or indirect interest of the salesperson or brokerage in the transaction. When working with a customer, you must disclose the following: • Any material facts known or that ought to be known by the salesperson • Any direct or indirect interest held by the salesperson or brokerage related to a trade This will be the case in all real estate transactions, which also include commercial investment properties. It is important for you to recognize and understand the various due diligence obligations and disclosures required to provide conscientious and competent service to sellers and buyers.

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Lesson 6 | Page 13 of 21

A salesperson is working with an investor who is interested in purchasing an industrial warehouse. The investor has selected a property and is prepared to submit an offer based on the salesperson’s recommended offer price. The investor is aware that based on the requirements of their lender, a third-party professional’s value estimate will be required. What will the financial lender require before committing to advance funding? There are three options. There is only one correct answer.

1

An opinion of value for the property by the salesperson

2

An appraisal by an accredited appraiser

3

A Comparative Market Analysis of the property

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Lesson 6 | Page 14 of 21

A salesperson is speaking with a client who acquired a commercial property several years ago and has recently sold the building for $1,329,684. The adjusted cost base was determined to be $1,000,000. The client has consulted with their accountant, who has verified that the cost of the sale was $59,832. The capital gain through this sale was therefore $329,684. What is the taxable capital gain of the commercial property sale? There are three options. There is only one correct answer.

1

$664,842

2

$164,842

3

$329,684

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Lesson 6 | Page 15 of 21

As discussed in Pre-Registration, you will encounter legislation that you must adhere to in order to legally and ethically provide due diligence for your client. Understanding legislation, such as the REBBA’s Code of Ethics, the Residential Tenancies Act, the Commercial Tenancies Act, the Statute of Frauds, and the Short Forms of Leases Act, will assist you with your due diligence obligations when representing both clients and customers.

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Lesson 6 | Page 16 of 21

Residential Tenancies Act The Residential Tenancies Act (RTA), is a complex piece of legislation spanning numerous provisions that not only impact residential premises, but also care homes and land lease properties. The purpose of this legislation is to provide protection to residential tenants from unlawful rent increases and unlawful evictions, to establish a framework for the regulations of residential rents, to balance the rights and responsibilities of residential landlords and tenants, and to provide for the adjudication of disputes and for other processes to informally resolve disputes. Under the RTA in Ontario, the tenant will enjoy the majority of the rights and privileges of a relationship with a landlord. This is why it is important for you to recommend that your buyer reviews the RTA thoroughly, either personally or in consultation with a lawyer, if they intend to lease to residential tenants following a property purchase. Investors need to understand that the RTA and ongoing provincial government guidelines will impact the potential profitability of their investment in residential properties.

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Lesson 6 | Page 17 of 21

Commercial Tenancies Act The Commercial Tenancies Act outlines the specific obligations, rights, and the relationship between a commercial landlord and their prospective tenants. As previously discussed, residential tenants have more statutory rights than their commercial counterparts. Consequently, clearly distinguishing the two is vital. Principal use is the primary consideration (for example, what the premises are being used for) in distinguishing residential from commercial tenants. Commercial leasing arrangements are largely a matter of contract rather than being statutorily mandated like residential tenancies, and whatever the landlord and tenant lawfully agree to will usually represent their lease relationship. Unlike disputes between residential tenants and landlords, parties to a commercial lease must look to the courts for resolution rather than the Landlord and Tenant Board.

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Lesson 6 | Page 18 of 21

Statute of Frauds The Statute of Frauds of Ontario requires certain types of contracts to be in writing to be enforceable. Transactions in real estate are typically contracts that need to be evidenced in writing. While verbal contracts may also be valid (e.g., such as a lease of less than three years’ duration), for all practical purposes of security, liability, and equity, most commercial landlords will require a written lease agreement and evidence of insurance coverage prior to allowing a commercial tenant any entry onto their property. A salesperson must be familiar with the Statute of Frauds, as compliance is a component of competence and due diligence.

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Lesson 6 | Page 19 of 21

Short Forms of Leases Act The Short Forms of Leases Act is an act that enables the simplification of written contracts. When working with commercial clients, you will encounter leases that state the agreement is drafted pursuant to the Short Forms of Leases Act. This legislation provides for the use of selected short form wordings in lieu of lengthy wordings, provided that the lease document is sealed and made in accordance with a prescribed format. The use of the Short Forms of Leases Act allows for the extraction of broad legal jargon into sentences that a typical lay person can understand. It will be important for you to understand the meaning and purpose behind documents that have been drafted pursuant to the Short Forms of Leases Act and that these are still binding documents, which are to be treated in the same way as conventional lease documents.

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Lesson 6 | Page 20 of 21

A salesperson is working with a buyer client who is interested in purchasing a retail property for their own use. The seller of this property, a family friend of the buyer, has agreed to the asking price but insists that a formal contract is not needed. The salesperson has strongly urged the seller to reconsider but they have refused. Based on this information, the salesperson reviews the Statute of Frauds with the buyer. Which of the following statements about the Statute of Frauds is accurate? There are four options. There is only one correct answer.

1

The Statute of Frauds requires all contracts involving real estate to be approved by the Real Estate Council of Ontario (RECO).

2

The Statute of Frauds would require that this real estate contract must be in writing in order to be enforceable.

3

The Statute of Frauds requires all contracts involving real estate to be drafted on a form provided by the Ontario Real Estate Association (OREA).

4

The Statute of Frauds requires all real estate contracts, to be enforceable, must be in writing.

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Lesson 6 | Page 21 of 21

Congratulations, you have completed the lesson! Completion of this lesson has enabled you to: • Describe the salesperson’s duties and obligations for due diligence and disclosure • Define the key legislation governing commercial leases and commercial investment properties There are two sections on this page with a summary of the key topics that were discussed in this lesson.

Describe the salesperson’s duties and obligations for due diligence and disclosure

In order to act in the best interest of your client, and to provide an adequate level of service to a customer, you must provide competent and conscientious service, and abide by all legislative requirements and industry standards regarding due diligence and disclosure. This includes providing accurate information and recognizing when to refer your client or customer to an appropriate third-party professional.

Define the key legislation governing commercial leases and commercial investment properties

The process of a commercial real estate transaction is a multi-faceted and a complicated process. The process involves the preparation and analysis of numerous documents, and knowledge of legislative requirements, among other things. In investment property transactions, leasing-related documents are important, as returns on the investment are largely dependent on rents. A thorough review and understanding of existing leases must be undertaken.

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Lesson 7 | Page 1 of 9

Lesson 7: Recognizing Seller or Buyer when a Corporation or Partnership is Involved This lesson discusses commercial transactions when a corporation or partnership is involved, and the salesperson’s duties related to verification, binding signatures, requirements under FINTRAC, and third-party involvement.

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Lesson 7 | Page 2 of 9

When working with investment properties, you will often encounter corporations and partnerships as the sellers and buyers in the transaction, as opposed to a person. It is important for you to understand the ways in which your obligations may change in terms of signing and receiving documents on behalf of a corporation or a partnership. Upon completion of this lesson, you will be able to: • Describe the process to identify the seller or the buyer when a corporation or partnership is involved Throughout this lesson, you will participate in decision points to test your knowledge on the topics presented.

© 2021 Real Estate Council of Ontario

Lesson 7 | Page 3 of 9

Both corporations and partnerships are forms of business ownership entities and have the authority to enter into contracts. Although the process for representing these types of sellers and buyers will be similar, there are key differences that you will need to be aware of when representing these types of owners.

© 2021 Real Estate Council of Ontario

Lesson 7 | Page 4 of 9

Verifying the Existence of a Corporation or a Partnership When representing a corporation or a partnership in the sale or the purchase of a property, you must verify the identity of the business entity and determine if the seller or the buyer has the authority to represent the entity in a transaction. When a corporation is formed under the Business Corporations Act, a document called the articles of incorporation is issued by the province. This document is an evidence of the corporation’s legal existence. You should ask to see either this document or the actual corporation registration document to verify the identity of a corporation. The articles of incorporation are also required for FINTRAC purposes, as it will confirm the identity and names of the officers and directors of the corporation. In addition, the names and addresses of all beneficial owners must also be obtained. Beneficial owners are persons who own or control directly or indirectly, 25% or more of the share of the corporation. Copies of these documents must be retained by the brokerage as part of their FINTRAC obligations. Whenever there is concern regarding an individual’s authority to act, expert advice should be sought. © 2021 Real Estate Council of Ontario

Partnership is a relationship involving two or more individuals or entities with the intention of making a profit. The partners provide funding and are involved through personal efforts in achieving specific business and profit goals. A partnership is normally formalized through a partnership agreement where all partners can be liable for the actions of the other. The income of a partner is calculated at the partnership level for taxes, and each partner must report their own profit/losses. A partnership is not defined in the Income Tax Act but must be registered under the Partnerships Act of Ontario to qualify for this status. A limited partnership differs from a partnership in that the investment arrangement limits a partner’s liability to the amount invested, while also limiting profits made. Limited partners are not responsible for project management. They must be registered and have a general partner (whose liability is not restricted to individual capital investment). The management and general operation of the project is handled by the general partner.

© 2021 Real Estate Council of Ontario

Lesson 7 | Page 5 of 9

Determining the Signing of a Corporation or a Partnership You are also responsible for determining who is responsible for the signing of documents in the course of the transaction. Although this may seem straightforward, there are many different configurations that could exist. Corporations, for example, must be represented by a person who is authorized to act on their behalf. Depending on the corporate structure, this individual may be an officer of the corporation (for example, a CEO, a CFO, or a COO), a member of the board of directors, or a person who is designated by the board of directors. In regard to the latter, this designation can be granted through a letter signed by an officer of the corporation or a corporate resolution, which grants the authority to the individual to acquire, sell, or lease property on behalf of the corporation. There can be several different individuals with decision making authority in a partnership. However, as one partner can bind all others to an agreement, it is essential to perform due diligence with respect to signing authority. You must obtain a copy of the partnership registration document and, if available, a copy of the partnership agreement, which will stipulate the authority of the partner or partners.

© 2021 Real Estate Council of Ontario

Lesson 7 | Page 6 of 9

FINTRAC Requirements for Verifying Identity FINTRAC, an agency of the Canadian government, sets out requirements concerning receipt of funds (for example, receiving deposits relating to real estate transactions) and client identification of those involved in the transaction. FINTRAC details both procedural matters, as well as forms to be completed. Responsibilities under FINTRAC extend to all real estate brokerages, brokers, and salespersons. You must verify the identities of the parties in the transaction to meet FINTRAC requirements. Typically, this verification is confirmed through government issued photo ID, (such as a driver’s licence, a passport, a permanent resident card, etc.). The information from these documents is recorded often on forms developed by the real estate industry and kept on file by the brokerage for a minimum of five years. Alternate methods and forms of verifying identity are authorized by the legislation and have been discussed in earlier courses. An alternate form (for example, OREA Form 631) may be required for identification verification involving corporations or other entities.

© 2021 Real Estate Council of Ontario

Lesson 7 | Page 7 of 9

Third-Party Involvement in Commercial Transactions When working with an individual who is acting on behalf of a corporation intending to purchase an investment property (e.g., an apartment building), you must verify the identity of the corporation. This is normally accomplished by obtaining a copy of the articles of incorporation. In addition, the identity of the individual must also be verified in the usual manner (i.e., government issued photo identification or reviewing other documents as discussed earlier in the Pre-Registration phase). Next, you must confirm that the third-party representative has the authority to represent the corporation. If the individual is identified within the articles of incorporation as an officer, they would have this authority. However, in some cases, they may also be an employee of the company. When the third-party is not an officer of the corporation, their authority to act can be confirmed through a resolution of the board of directors appointing the © 2021 Real Estate Council of Ontario

individual as a representative of the corporation for the purposes of acquiring an investment property. In lieu of a corporate resolution, a letter signed by an officer of the corporation, granting the individual the authority to represent the corporation during the transaction, will also suffice. Similar obligations would apply when working with a partnership. You would need to verify the identity of the individual and review a copy of any partnership agreement that may grant the individual the authority to act on behalf of all partners. Remaining partners in the partnership may also be considered third parties and, as a result, their identity must also be verified in order to comply with FINTRAC obligations.

© 2021 Real Estate Council of Ontario

Lesson 7 | Page 8 of 9

A salesperson is representing a logistics business, working directly with the chief operating officer (COO) who is acting on behalf of the partnership. Before entering into negotiations, the salesperson will need to ensure that this individual has signing authority and can act on behalf of the other partners. The salesperson is aware that a partnership arrangement is different from an individual buying a property, and additional information will be required. Which of the following statements regarding partnership agreements is accurate? There are four options. There is only one correct answer.

1

In a limited partnership, each partner shares equal responsibility over management and operations. One of the participants in the arrangement will unilaterally control the venture.

2

The duration of a partnership is constrained to a specific project.

3

Each participant in a partnership has a distinct, identifiable owned or assigned interest in the venture.

4

A partnership agreement is not defined in the Income Tax Act.

© 2021 Real Estate Council of Ontario

Lesson 7 | Page 9 of 9

Congratulations, you have completed the lesson! Completion of this lesson has enabled you to: • Describe the process to identify the seller or the buyer when a corporation or partnership is involved The following is a summary of the key topic that was discussed in this lesson: Representing corporations or partnership clients You will often encounter buyers who are operating within corporations or partnerships towards the purchase or the sale of real estate. An important part of due diligence obligations is to ensure that the correct parties are verified and signing the appropriate information, in addition to confirming the status of the corporation and the partnership itself. © 2021 Real Estate Council of Ontario

Lesson 8 | Page 1 of 6

Lesson 8: Summary Practice Activities

This lesson provides a series of activities that will test your knowledge on the entire module.

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Lesson 8 | Page 2 of 6

This lesson provides summary practice activities. Throughout this lesson, you will participate in decision points to test your knowledge on the topics presented.

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Lesson 8 | Page 3 of 6

A salesperson is working with an investor who is interested in purchasing a commercial property. The cost of the building is $4,300,000 and the anticipated net operating income from this property is $988,770. The buyer intends to provide a down payment of 40 per cent, or $1,720,000, and have the remaining cost leveraged through financing at an interest rate of 5.5 per cent. Based on the information, what is the loan-to-value ratio of this investment? Leverage Ratio or Loan-To-Value Ratio: ____Loan____ Value

There are four options. There is only one correct answer.

1

0.60

2

0.40

3

1.66

4

0.22

© 2021 Real Estate Council of Ontario

Lesson 8 | Page 4 of 6

A salesperson is working with an investor for a commercial property purchase. The investor is comparing the length of time required for them to achieve a return on their investment. There are three different options for them to consider. Option One requires an initial investment of $150,000, with an annual cash flow before tax of $10,500. Option Two offers a monthly cash flow of $900, after an initial cash outlay of $135,000. Option Three offers an annual cash flow of $14,000, after an initial cash outlay of $166,000. What is the shortest payback period and which option would it apply to? There are four options. There is only one correct answer.

1

12.5 years; Option Two

2

14.3 years; Option Two

3

11.8 years; Option Three

4

14.3 years; Option One

© 2021 Real Estate Council of Ontario

Lesson 8 | Page 5 of 6

A salesperson is speaking with a client who acquired a commercial property several years ago and has recently sold the building for $2,545,354. The adjusted cost base was determined to be $2,000,000. The client has consulted with their accountant, who has verified that the cost of the sale was $119,664. The capital gain through this sale was therefore $545,354, of which 50 per cent is considered taxable. What is the taxable capital gain of the commercial property sale? Taxable Capital Gain: Capital Gain x 50%

There are three options. There is only one correct answer.

1

$272,677

2

$1,272,677

3

$59,832

© 2021 Real Estate Council of Ontario

Lesson 8 | Page 6 of 6

Congratulations, you have completed the lesson!

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Module Summary | Page 1 of 3

Module Summary

This lesson contains a summary of the entire module.

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Module Summary | Page 2 of 3

Congratulations, you have completed this module! This lesson will present a summary of Learning Objectives.

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Module Summary | Page 3 of 3

There are seven sections on this page with a summary of the key topics that were discussed in this module.

Client Requirements and Characteristics of Users and Investors

Users and investors will have different criteria of what determines a suitable commercial investment property. You must recognize how these differences will be reflected in your client’s objectives, expectations, and time frames when working with either a user or an investor. Completion of this lesson has enabled you to: • Identify a client’s requirements when addressing investment properties • Define and identify the characteristics of a user when addressing investment properties • Define and identify the characteristics of an investor when addressing investment properties

Types of Leverage

Leverage is an important topic in real estate investment, as it will determine the way in which a property could be financed and, as a result, what sort of financial yield will be realized. You need to determine the way in which an investor plans to finance a property and provide advice regarding its viability. Often, a third-party professional would also be involved in this process. Completion of this lesson has enabled you to: • Explain the concept of using leverage for an investment property, and define the different types of leverage

Returns and Risk

Risk is typically viewed as a primary consideration in any real estate investment. The ability to forecast, and in some way quantify, the impact of various influences on an investment property is broadly described as risk analysis. Understanding the way risk can impact returns and cash flow enables you to better assist with the wants and needs of your clients. Completion of this lesson has enabled you to: • Identify the importance of analyzing returns in investment properties

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• Identify the importance of analyzing risks for a user of investment properties • Identify the importance of analyzing risks for an investor in investment properties

Advantages and Disadvantages of Investing in Commercial Real Estate

Investing in commercial real estate can be a complicated process that requires a great deal of thought, but notable financial yields can be realized, if done prudently. It is important for you to provide a holistic picture to your clients about possible advantages and disadvantages of commercial real estate and investment properties. Completion of this lesson has enabled you to: • Describe factors to consider when investing in commercial real estate • Describe the advantages of investing in commercial real estate • Describe the disadvantages of investing in commercial real estate

Risks Associated with Acquiring Commercial Real Estate

When representing sellers or buyers, it is important to provide information regarding the various types of risks they may encounter. Understanding the different risks to an investment property enables you to provide insight to your client regarding what to expect throughout the duration of their investment. Completion of this lesson has enabled you to: • Identify financial risks associated with commercial real estate • Identify market risks associated with commercial real estate • Identify business risks associated with commercial real estate • Identify building risks associated with commercial real estate

Legislation, Due Diligence, Disclosure, and Responsibilities of the Salesperson, Seller, and Buyer

Working in real estate involves awareness of numerous legislated requirements and guidelines, which you must adhere to in order to perform competent and conscientious service to your client. Completion of this lesson has enabled you to: • Describe the salesperson’s duties and obligations for due diligence and disclosure • Define the key legislation governing commercial leases and commercial investment properties

© 2021 Real Estate Council of Ontario

Corporation and Partnership

Corporations and partnerships are two important ownership structures, which you may encounter when working with commercial investment properties. Understanding the ways in which these structures differ from that of individual clients, including your obligations when determining authority to act, enables you to perform your compliance requirements when working with these entities. Completion of this lesson has enabled you to: • Describe the process to identify and confirm the authorized signing authority, when a corporation or partnership is involved

© 2021 Real Estate Council of Ontario

V7.1

Module 2: Fundamentals of Investing in Commercial Real Estate Disclaimer: This is a reference document which contains pages from the Accessible eLearning module. You should complete the eLearning module to proceed to the next step. Please note that the accessible module on the LMS only contains the interactive pages and you need to go through the content of this document thoroughly to attempt the interactive activities in the module. Please use Adobe Acrobat Reader (Recommended version 9 or above) to navigate through this PDF. Real Estate Salesperson Program © 2021 Real Estate Council of Ontario. All Rights Reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or in any means – by electronic, mechanical, photocopying, recording or otherwise without prior written permission, except for the personal use of the Real Estate Salesperson Program learner.

© 2021 Real Estate Council of Ontario

Module 2: Fundamentals of Investing in Commercial Real Estate In the previous module, you learned about purchasing commercial real estate as an investment. In this module, you will learn about the different commercial investment property types and their benefits and challenges, the fundamentals of financing commercial investment properties, the various types of commercial leases, and the critical information to know as part of due diligence while representing a buyer interested in purchasing a commercial property. To check your understanding of this module, you must complete all the activities in the online module. While navigating through the online module, click the Legislation button to view laws and regulations related to this module. The contents of the thumbnails Accessible PDF.

and References from the module are added to support your learning throughout this

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Menu: Fundamentals of Investing in Commercial Real Estate

Number of Lessons

Lesson Number

7 Lessons

Lesson Name

Lesson 1

Commercial Investment Property Types | Benefits and Challenges

Lesson 2

Financing Commercial Investments

Lesson 3

Commercial Leases

Lesson 4

Critical Information for Commercial Property Investment

Lesson 5

Additional Due Diligence to Perform for the Purchase of a Commercial Property

Lesson 6

Summary Practice Activities Module Summary

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Lesson 1 | Page 1 of 17

Lesson 1: Commercial Investment Property Types | Benefits and Challenges

This lesson introduces the various types of commercial properties and delves into the benefits and challenges associated with each property type. A salesperson should be aware of the characteristics of each property type to be able to advise a buyer to select a suitable property based on their requirements.

© 2021 Real Estate Council of Ontario

Lesson 1 | Page 2 of 17

Most investment decisions are rooted on a credible, logical footing. Investors seek the guidance of informed professionals. It is your task to quantify alternate proposals, forecast relevant financial data, and provide meaningful summaries for investor buyers to arrive at a logical conclusion. Therefore, it is important for you to understand the different types of commercial investment properties and the benefits and challenges of investing in each of them. Upon completion of this lesson, you will be able to: • Identify the different types of investment properties • Identify the advantages and disadvantages of each property type Throughout this lesson, you will participate in decision points to test your knowledge on the topics presented.

© 2021 Real Estate Council of Ontario

Lesson 1 | Page 3 of 17

You should know the scope and breadth of the commercial real estate investment market. You need to understand the characteristics of each investment property type to be able to give appropriate advice to investor buyers. Failing to understand the requirements of a potential investor or failing to introduce them to properties that best suit their interests can damage your relationship with them.

© 2021 Real Estate Council of Ontario

Lesson 1 | Page 4 of 17

Types of Commercial Investment Properties, I When working in commercial real estate, you should know the characteristics of the different types of commercial properties. The following four sections contain information on the different types of commercial investment properties.

Mixed-use properties A mixed-use development involves three or more significant revenue-producing uses including retail, office, residential, entertainment, and/or cultural. Each use must be viewed as stand-alone, and not ancillary to another. For example, the retail component must have adequate tenant mix to draw clientele beyond the development itself and not simply convenience shopping for residents.

Multi-unit residential properties A multi-unit residential property contains two or more separately contained living areas, such as a duplex (two-family dwelling), a triplex, or a building with many units. The purchase or sale of a multi-unit residential property having five units or more is considered a commercial transaction by more lenders. Therefore, lenders apply more stringent rules when assessing a transaction, which often results in financing challenges.

© 2021 Real Estate Council of Ontario

The multi-residential market in Ontario, as with other sectors of the commercial marketplace, is influenced by supply and demand. The multi-residential investment market is governed by the Residential Tenancies Act (RTA), whereas the other types of commercial property investments are regulated by the Commercial Tenancies Act.

Stand-alone commercial buildings Certain retailers will only locate stores in freestanding buildings, rather than in regional or community shopping centres, attached buildings in a small strip development, or a town centre complex. These are called stand-alone commercial buildings. Cost, size, amenities, fewer restrictions, and enhanced exposure prompt investors to choose stand-alone buildings. These are usually found in downtown areas, arterial roads, and near shopping centres.

Retail plazas and shopping malls A retail plaza is a single-storey or multi-storey structure with retail on the ground floor, usually with separate entrances for each unit. A shopping mall, on the other hand, is an indoor structure. The entrances to the retail units housed within a mall are usually from a common hallway. The upper storeys of retail plazas and shopping malls can often be devoted to office space.

© 2021 Real Estate Council of Ontario

Lesson 1 | Page 5 of 17

Types of Commercial Investment Properties, II The following three sections contain information on the additional types of commercial investment properties.

Commercial condominiums located within a condominium complex A commercial condominium unit is an individually owned unit that is part of a larger multi-unit building. A unit is that portion of the property so designated in the condominium description and broadly described as the space defined by boundaries, including all the land, structures, and fixtures within that defined space. Today’s office condominiums offer a variety of facilities and services. Those focused on premium business/professional applications may include shared boardrooms, reception area and meetings room space, full building video surveillance, entry pass card systems, computer server, fibre optic lines, IT support, and fully featured telephone systems.

© 2021 Real Estate Council of Ontario

Industrial properties Industrial real estate is broadly defined as property used for the processing and manufacturing of goods. Industrial real estate includes all land and buildings, either used or suited for industrial purposes. Light industrial property is usually classified as warehouses and non-offensive manufacturing operations. Electronics assembly and distribution centres are examples of light industry. In contrast, heavy industrial property includes operations such as machine works, steel, and chemical plants. Automotive assembly and metal fabrication also fall under heavy industrial property.

Vacant lands The term land typically refers to raw acreage, raw land, vacant land, or unimproved land, because no alteration for specific purposes has occurred. Vacant land, as a commercial market sector, is focused on development activities involving planning, application, and development processes. Investors who are interested in constructing new buildings prefer vacant land, as they will not have to bear demolition charges or tax rates associated with developed sites.

© 2021 Real Estate Council of Ontario

Lesson 1 | Page 6 of 17

A buyer, with prior experience of investing in retail plazas and commercial office condominiums, wants to expand their portfolio. They would like to venture into residential properties that have a commercial component. Which of the following property types should the salesperson suggest to the buyer? There are four options. There is only one correct answer. 1

Mixed-use property

2

Commercial condominium

3

Retail plaza

4

Stand-alone commercial building

© 2021 Real Estate Council of Ontario

Lesson 1 | Page 7 of 17

The more knowledgeable you are about the various types of properties, the better equipped you will be to provide advice to buyer client, to promote and protect their best interests, and to avoid misrepresentation. Failing to understand a buyer’s requirements may lead to showing the buyer an inappropriate property type, thereby wasting valuable transaction or due diligence time.

© 2021 Real Estate Council of Ontario

Lesson 1 | Page 8 of 17

Benefits of Investing in and Potential Challenges of Commercial Properties There are specific benefits and potential challenges of investing in each commercial property type. However, there are a few benefits that apply to most of them. Common benefits include: • Multiple income streams Commercial properties, such as mixed-use properties, multi-unit residential properties, retail plazas, shopping malls, etc., have multiple tenants, and provide investors with multiple streams of income. • Consistent cash flow Commercial properties with multiple tenants typically generate a strong cash flow. This remains the case despite occasional vacancies and late rent payments. • Tenant quality Commercial buildings tend to attract high-quality tenants who may sign longer leases. These tenants are often experienced business members, operate mature businesses, are willing to pay higher rents, and commit to longer leases.

© 2021 Real Estate Council of Ontario

Lesson 1 | Page 9 of 17

Potential Challenges of Investing in Commercial Properties The following are common potential challenges of investing in commercial properties: • Higher insurance and taxation The amount of property tax payable for a property is determined by its value as assessed by the Municipal Property Assessment Corporation (MPAC). Various types of properties within a municipality are taxed at different rates. Commercial properties are generally taxed at a higher rate than other property types. Insurance rates are based on the insurer’s evaluation of the risk estimated for a property and all its components. Commercial properties generally have higher insurance rates as compared to residential properties. • High capital requirement The down payment requirements for commercial buildings can be substantial, often in excess of 30 per cent of the purchase price. Also, as commercial buildings are often costlier than residential buildings, lenders tend to be conservative in their lending policies; they generally require more equity and have higher lending rates for © 2021 Real Estate Council of Ontario

commercial investment applications. Lenders are usually concerned about the income potential of a property and will only consider those applications that demonstrate that they can generate sufficient income to pay off the loan. • High maintenance and operating cost As multi-unit commercial buildings are usually large and have multiple assets, they require maintenance and management; the operating costs tend to be higher than that for residential buildings.

© 2021 Real Estate Council of Ontario

Lesson 1 | Page 10 of 17

Benefits of Investing in Specific Commercial Property Types, I Now that you have learned about the common benefits and potential challenges of investing in commercial properties, let us understand about the specific benefits of investing in each property type. The following four sections contain information on the specific benefits.

Mixed-use property Desirability Mixed-use properties are highly desired by tenants. For example, consider a mixed-use property that has retail outlets including a grocery store, a coffee shop, a drug store, a multiplex, and a gym on the ground floor, plus five upper levels of residential units. Proximity to the retail units would make the property attractive for residential tenants and vice-versa. This property type is consistently in demand and easier to lease.

© 2021 Real Estate Council of Ontario

Multi-unit residential property with over five units Higher revenue generation Multi-unit residential properties have greater opportunities for capital appreciation and revenue generation when compared to a single-unit home. Stability Given that demand remains high for residential properties, multi-unit residential properties can be viewed as a fairly stable investment vehicle. Returns can be projected with reasonable accuracy.

Stand-alone commercial buildings Ease of management Unlike investors of a unit in a commercial condominium, investors of stand-alone buildings are the sole owners of the property with control over the operating expenses. Stand-alone buildings may have multiple occupants, but are generally of the same type, such as offices. High demand A stand-alone commercial building is considered more valuable than a unit in a multi-unit building, as they are usually larger and permit varied uses, which are not restricted by commercial condominium rules.

© 2021 Real Estate Council of Ontario

Retail plazas and shopping malls Capital appreciation This property type is valuable because of its high demand and its potential for above average income. As a result, capital appreciation of this property type is likely. Synergy between occupants Tenants with complementary characteristics often benefit from each other’s business activities and, in turn, benefit the investor. For example, if there is a pharmacy and a doctor’s office within the same retail plaza, they would complement each other, as the patients from the doctor’s office can get their prescriptions from the pharmacy within the same building, and the pharmacy will often subsidize the doctor’s rent just to be nearby.

© 2021 Real Estate Council of Ontario

Lesson 1 | Page 11 of 17

Benefits of Investing in Specific Commercial Property Types, II The following three sections contain information on the additional specific benefits.

Commercial condominium unit within a condominium complex Low acquisition cost The capital required to purchase a unit in a commercial condominium complex is usually less than the amount required to invest in a free-hold or free-standing property. Shared services The availability of shared services within the building attracts tenants. Common hallways, lobbies, washroom areas, meeting rooms, board rooms, reception services, audio-visual equipment, etc., are some examples of shared services. This is called economies of scale, where services that would usually be expensive for a single owner to bear become affordable due to expense sharing.

© 2021 Real Estate Council of Ontario

Industrial property Higher yields Due to the longer leases, fewer market fluctuations, and less turnover, industrial property benefits investors with a greater return on investment. Even though the rental rates for industrial properties are often below residential and commercial properties, investors make up for this difference due to the larger sized buildings and longer tenancy agreements. Low maintenance cost The maintenance costs of an industrial property are usually borne by the tenant and the investor is relieved of this cost. This is because most industrial leases are net leases. Net leases will be discussed in detail later in this module.

Vacant land Multiple development options Vacant land has a variety of development options such as: • Build to suit: Developments to suit a tenant’s specification in exchange for a long-term lease commitment • Build and sell: Developments on the speculation that it would appeal to a broad segment of the marketplace • Build and hold: Developments to rent out to tenants and hold to take advantage of capital appreciation

© 2021 Real Estate Council of Ontario

Low property taxes, insurance, and maintenance costs Vacant land is taxed at a lower rate than developed property. Insurance rates and maintenance cost can be minimal, as there are no buildings or structures on the property. Revenue generation from vacant land A vacant piece of land can be used for recreational purposes, parking, storage, and so on, if zoning permits, and can thereby generate a temporary or seasonal income. Agricultural land is often leased to a nearby farmer, pending the investor’s finalization of development plans.

© 2021 Real Estate Council of Ontario

Lesson 1 | Page 12 of 17

Potential Challenges of Investing in Specific Commercial Property Types, I Now that you have learned the benefits of investing in specific commercial property types, this topic will focus on the potential challenges of investing in each of these commercial property types. The following four sections contain information on the potential challenges of investing in commercial property types.

Mixed-use properties Property management Potential for conflict between various types of tenants exist in mixed-use properties. For example, disagreements may arise between the residential, commercial, and retail occupants, regarding parking. Different leasing types within the same building While the retail and commercial tenants come under the Commercial Tenancies Act, the residential tenants fall under the Residential Tenancies Act (RTA). This means different leasing types will have to be used. The Commercial Tenancies Act is favourable to the investor. For example, the owner of a mixed-use property may charge additional rent from commercial tenants, but would normally not apply additional rent to residential tenants. Additional rent is any amount that the tenant has to pay that is over and above the base rent specified in the lease. It could be an actual expense the investor owner may incur, such as repair or maintenance work at the property or an increased property tax. With commercial leases, the investor can

© 2021 Real Estate Council of Ontario

recover these expenses, whereas they may not be able to do so for residential leases. You will learn more about additional rent later in this module.

Multi-unit residential properties Restrictions on the landlord-tenant relationship With a residential property, a landlord may encounter difficult tenants. However, the buyer must follow the steps laid out in the RTA before evicting difficult tenants. Tenant disagreements Properties that have multiple tenants tend to have more tenant disagreements, due to various reasons, such as noise, clutter, smells, and parking. The investor may need to spend a significant amount of time and effort to settle these conflicts.

Stand-alone commercial buildings The potential challenges of investing in stand-alone commercial buildings are high capital investment, high maintenance and operating costs, high taxation, and insurance rates.

© 2021 Real Estate Council of Ontario

Retail plazas and shopping malls with retail on the ground floor and offices above Vulnerable revenue A downturn in the retail market could lead to rent defaults. Retail tenants are dependent on foot traffic and the spending habits of their customers. Appeal Retail plazas and shopping malls require effort and money invested to maintain their overall appeal in order to attract tenants and their customers.

© 2021 Real Estate Council of Ontario

Lesson 1 | Page 13 of 17

Potential Challenges of Investing in Specific Commercial Property Types, II The following three sections contain information on the additional potential challenges of investing in commercial property types.

Commercial condominium unit located within a condominium complex Parking Customers may have to use shared parking, as exclusive parking for each unit may not be available. This could lead to disagreements between tenants. Conflicts or competing interests As commercial condominiums have multiple occupants, chances for conflicts or competing interests will exist unless specifically addressed in a lease agreement. Signage/Advertising Usually, this property type may allow for signage only on common building directories in the lobby. Tenants may not be allowed to customize their signage or have it prominently displayed to attract customers.

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Industrial: Light and heavy Difficulty in finding new tenants Vacancies in industrial properties can be difficult to fill, as it may not be easy to find another tenant who finds the property suitable for their requirements. For example, design characteristics unique to a chemical manufacturing unit may not appeal to other industrial users looking for a building to accommodate manufacturing and assembly. Contamination Industrial properties have to contend with increased vulnerability from contamination issues associated with industrial processes.

Vacant lands No income If vacant land is not put to temporary or seasonal revenue generating methods while it is being considered for future development, it produces no income. Potential for contamination Vacant land may be contaminated and will require an Environmental Site Assessment (ESA). Vacant land is often vulnerable to trespassing and illegal dumping of waste material, some of which may be hazardous and could result in costly environmental clean up by the owner. Costly professional inspections

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To ensure that the vacant land is suitable for development, various studies, such as municipal, sewage capacity, storm water, acoustics, etc., are required. Trespassing and unlawful use Large areas of vacant land are difficult to monitor and there could be occurrences of trespassing or other unlawful activities on or near the property, resulting in liabilities for the owner and/or investor. Government approval There could be complex government approval procedures required for land development. The Planning Act is the overriding legislative framework for land development in Ontario. This could include subdivision approval and severances, development plans, compliance with the official plan, site plan approval, permit costs, etc.

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Lesson 1 | Page 14 of 17

A buyer is interested in investing in a mixed-use property – a building that houses residential apartment units, retail stores, and office space in a prime downtown location. Although an experienced commercial investor, they are seeking the salesperson’s guidance to understand the characteristics of mixed-use properties, as they do not have prior experience in this property type. Which of the following statements could be part of the salesperson’s advice regarding investing in mixed-use property? There are four options. There are multiple correct answers. 1

Mixed-use properties are easier to manage than other commercial investment properties.

2

Mixed-use properties provide for multiple income streams.

3

Mixed-use properties have multiple development options, such as build to rent, build to sell, build to hold, etc.

4

Mixed-use properties would involve different leasing types within the same building.

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Lesson 1 | Page 15 of 17

Personal Choice Investment discussions often display a tendency toward the norm or average, but nothing is average in a world of unique products and investors. Individuals tolerate different degrees of risk. Some investors may risk gambling, while others seek safe harbours. Emotional temperament, individual backgrounds, hidden traits, personal preferences, and/or past events can also affect investment decisions. Historical circumstances may mould future decision making. Extensive experience with specific investment properties or trading areas may overshadow logical and rational processes.

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You should be aware of the investor’s personal choice in order to source properties that might interest them. You may invest a considerable amount of time and effort into sourcing properties, but if those properties do not meet the investor’s requirements, the effort invested will be in vain.

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Lesson 1 | Page 16 of 17

Estimating Future Value of Property Types The common denominator for most investment acquisitions lies in the present value of the future benefits arising out of ownership. Asset selection in the real estate market has become increasingly formalized. Analysts pose probing questions on real estate just as they would with other investment options: • What types of capital activities fall within the investment strategy of the buyer? • Is real estate worthwhile as a capital asset? • Assuming a positive response, what types of property enhance investment objectives and further investment goals and business strategies? • Given a specific type of real estate investment, what properties are the best investments within that particular type based on maximizing returns with tolerable levels of risk?

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You can now benefit from yield models that provide for the rational analysis of all investment property through detailed comparisons, cash flow before tax and cash flow after tax analysis, present value calculations, and internal rates of return. You should be able to estimate the future value of property types in order to provide competent service to buyers. The future value of a property is not an exact science. Ensure that the buyer understands that it is only an analysis based on the current market conditions and is subject to change due to a variety of variables. If you fail to explain or perform these calculations correctly, you may provide misleading information on the investment opportunity.

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Lesson 1 | Page 17 of 17

Congratulations, you have completed the lesson! Completion of this lesson has enabled you to: • Identify the different types of investment properties • Identify the advantages and disadvantages to an investor of each property type There are two sections on this page with a summary of the key topics that were discussed in this lesson.

Different types of investment properties

There are several types of commercial investment property types, such as mixeduse property, multi-unit residential buildings, stand-alone commercial buildings, retail plazas, shopping malls, commercial condominiums, industrial property, and vacant land. You should be aware of the characteristics of each property type to advise investors so that they can make informed investment decisions.

Advantages and potential Each commercial property type has its benefits and potential challenges as an challenges to an investor investment opportunity. An investor may have a personal choice for a specific property type. You should of each property type

consider an investor’s interest and requirements to seek out properties that could be the right investment for them. You should also understand the importance of estimating the future value of an investment to assist the investor in their decision making.

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Lesson 2 | Page 1 of 20

Lesson 2: Financing Commercial Investments This lesson outlines the importance of identifying the sources of financing commercial investment properties. A salesperson should have knowledge of the lender’s qualifying process and the additional fees associated with commercial lending to advise buyers correctly.

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Lesson 2 | Page 2 of 20

Due diligence is important in all transactions, but in commercial transactions it takes on a higher meaning than it does for residential transactions. Residential transactions involve mortgage default insurance. For example, if the borrower defaults, an insurance agency would step in and make the payment to the lender. Commercial transactions have no such insurance, and hence, commercial lenders are very cautious. Lenders perform a stringent qualifying process before lending money to commercial investors. You should be able to guide potential commercial investors to appropriate sources of financing and ensure that they have all the due diligence documents required for the lender’s qualifying process. Upon completion of this lesson, you will be able to: • Identify sources of funding and financing • Describe the lender’s qualifying process • Identify additional qualifying factors for financing commercial investments Throughout this lesson, you will participate in decision points to test your knowledge on the topics presented.

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Lesson 2 | Page 3 of 20

Unlike residential transactions, where almost all financing comes from institutional or traditional lenders, such as financial institutions and insurance companies, commercial transactions are likely to require other lending sources. Traditional lenders are often reluctant to engage in commercial transactions because of the risks involved, requiring investors to seek other sources of financing. You should be aware of alternative sources of funding to better advise investors.

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Lesson 2 | Page 4 of 20

Financing from Lenders and Related Challenges When working in commercial real estate, there is much to consider when working with a buyer who requires financing from lenders. For example, if the buyer is interested in a property that is valued at one million dollars, but they have only $250,000 for the down payment, they will need to borrow the remaining $750,000. On assessing the property and the buyer, a traditional lender may be prepared to lend only $500,000. In cases where a traditional lender does not advance the required amount, you should be able to help the buyer find another source for the remaining amount. There are certain challenges that a buyer may face while dealing with commercial lenders. A commercial lender may charge a higher rate than what the buyer anticipates. Also, approval time frames for commercial lending are usually longer than that for residential transactions. The time frame for approving the application could be between 30 to 60 days or longer. © 2021 Real Estate Council of Ontario

Lesson 2 | Page 5 of 20

Seller Take-Back Mortgages and Private Lenders Investor buyers will expect you to have knowledge of the various sources of financing that may be available to them in commercial transactions, including non-traditional lenders. This screen provides information on procuring financing from other sources of funding and financing. Both the seller take-back method and procuring of financing from private lenders are used when traditional lenders do not approve the required mortgage amount. The following two sections contain information on the two sources of funding and financing.

Seller take-back The seller take-back mortgage is a popular negotiating tool, particularly when financing proves difficult through conventional lenders and/or if seller participation provides a better overall package in negotiations. In this method, the seller of the property extends a loan to the buyer to advance the sale secured by a mortgage registered on the title of the property. Buyers may find this type of financing attractive, as it can avoid certain costs, paperwork, and regulations as required by the conventional lenders.

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Private lenders Private lenders loan money in the form of a registered mortgage secured against the real property. They may offer greater scope given more relaxed lending criteria, safety margins, or other approval considerations. In addition, application forms, underwriting requirements, and the mortgage approval process may also be simplified. However, buyers need to be aware of the limited legislation imposed on such lenders. You should ensure that the buyer’s lawyer is involved in all aspects of the mortgage transaction.

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Lesson 2 | Page 6 of 20

Financing from Other Sources To complement your knowledge of seller take-back mortgages and private lenders, this screen will focus on a few institutions or organizations that provide financing, such as the Business Development Bank of Canada, Canada Small Business Financing Program, insurance companies, trust companies, and credit unions. The following five sections contain information on the other sources of financing.

The Business Development Bank of Canada The Business Development Bank of Canada is a federal crown corporation. Their purpose is to provide funding to facilitate and foster business development within the country. They lend money to those who require it to find an income producing building or to start up a business.

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Canada Small Business Financing In addition to in-house mortgage, lenders may avail themselves of the Canada Small Business Financing Program. This federal financing program was created to assist entrepreneurs by way of loans, including capital leases, when establishing and improving small businesses. The federal government guarantees 85 per cent of lenders’ losses due to default.

Insurance companies Insurance companies are considered institutional lenders and are required to follow federal regulations while approving mortgages. They lend money from their various resources and view mortgages as longterm debt instrument assets.

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Trust companies Trust companies are owned almost entirely by the chartered banks and provide access to other financial markets, which banks may not be able to access. They behave like any other lender but may be relieved from the strict government controls that apply to banks.

Credit unions Credit unions are non-profit, member-owned organizations. As they are a “membership” organization, they often behave like a private lender and may be relieved from the strict government controls that banks face. They tend to have lower fees and interest rates, as they pass on savings to their members. Credit unions may provide high-ratio mortgage options without a large down payment requirement.

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Lesson 2 | Page 7 of 20

Assuming Existing Financing Another approach to financing for a commercial buyer would be to assume existing financing. This method has several advantages: • Often, the lender may not require an Environmental Site Assessment (ESA) or the building condition report, resulting in some cost saving associated with the fees. • This method is convenient, as there is no requirement for sourcing a financing option. • Often, there are discharge penalties associated with a mortgage. If a mortgage is terminated before its term expires, a lender will charge a discharge penalty. When a buyer assumes an existing mortgage, there will be no

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penalty to the seller. It is also advantageous for the buyer, as it saves both time and costs and helps to close the transaction in an easy and smooth manner. Example: An investor wants to purchase a building that is listed for $1,000,000 and can provide a down payment of $250,000. The seller has a mortgage balance of $750,000, which the buyer is ready to assume. A condition is inserted in the agreement of purchase and sale, making the offer conditional on the buyer being approved by the lender to assume the existing mortgage. A qualifying process may be required to assume existing mortgage and the process can vary according to specific circumstances. For example, a buyer is interested in an investment property listed for $10,000,000 with a mortgage of $5,000,000, an amount the buyer is willing to assume. If the buyer may have been planning on getting a loan of $2,500,000 due to a shortfall, you could advise the buyer to approach the lender to assume the existing mortgage on the property and to increase the total mortgage to $7,500,000. The advantage of this approach is that the interest rate on the existing $5,000,000 will be blended with the interest rate on the new $2,500,000, which can result in a combined lower overall rate than if a new mortgage were to be taken out on the $2,500,000. In addition, there may be reduced administrative costs associated with the arrangement of these two loans given the existing first mortgage.

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Lesson 2 | Page 8 of 20

A buyer is considering investing in a small retail mall. The purchase price for this property is $2,500,000 and the lender has approved a new first mortgage for $1,500,000. The buyer, who does not have an existing mortgage, is providing a down payment of $750,000 and requires an additional $250,000 to complete the transaction. They do not have access to any other funds. Which of the following methods can the salesperson suggest to the buyer to complete the transaction? There are four options. There are multiple correct answers. 1

Seller take-back

2

Private lenders

3

Bank mortgage

4

Assume existing financing

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Lesson 2 | Page 9 of 20

You are now familiar with the various sources for financing commercial investments. All commercial lenders have a qualifying process in place before they agree to approve a buyer’s application. The lender’s qualification process focuses on two main criteria: 1. The quality of the property, which includes the: • Physical condition of the property • Stability of the property’s income stream 2. Borrowing qualifications of the investor, which includes: • Credit worthiness • Debt service coverage ratio • Personal covenant It is important for you to know the lender’s qualifying process and to be able to perform basic calculations, such as the debt coverage service ratio (which will be explained later in this lesson), while servicing commercial investors.

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Lesson 2 | Page 10 of 20

Down Payment Requirements: Residential Versus Commercial In a residential transaction, the investor often has reduced obligations with respect to down payment. The Canada Mortgage and Housing Corporation (CMHC) or the Mortgages Act will allow as little as a five per cent down payment. Anything over 80 per cent is considered a high ratio mortgage, in which case the mortgage must be insured to reduce the risk of the lender, should default in mortgage payments by the borrower occur. Unlike residential properties, commercial investment properties are not covered by mortgage default insurance. This leads to stricter down payment requirements. It is also important to note that for commercial investments, there are no set limits on the down payment. The required minimum down payment may start at 25 per cent, but it could go up to any number, based on the lender’s discretion and the quality of the borrower’s covenant or qualifications. It is easier to obtain financing for owner-occupied properties than commercial investment rental properties, as buildings owned and occupied by the investors tend to be better maintained. Lending institutions favour the former as well. © 2021 Real Estate Council of Ontario

Lesson 2 | Page 11 of 20

Debt Service Coverage Ratio It is important for you to understand the concepts of net operating income (NOI) and total debt service (TDS) to understand debt service coverage ratio better. • NOI: NOI is the income obtained from a property after all the revenue from operating it is collected and all the operating expenses are paid • Total debt service: Total debt service is the sum of the principal and the interest payments in one year The debt service coverage ratio is calculated by dividing NOI by the total debt service. NOI ÷ Total Debt Service = Debt Service Coverage Ratio Example:

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In a scenario where the NOI is $70,000 and the total debt service is $50,000, the debt coverage service ratio will be: $70,000 ÷ $50,000 = 1.4 Debt service coverage ratio is frequently used by loan and mortgage underwriters to establish whether a business or rental property can handle a specific debt payment level. This ratio should be above “1” for income to properly address the total debt service. Lenders often require a debt service coverage ratio of 1.2 or higher, when considering loan applications for rental property and other commercial ventures. Debt service coverage ratio in the example above exceeds the lender’s requirement of 1.2. In this case, the lender would likely take a closer look at the investor’s application to assess their risk position.

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Lesson 2 | Page 12 of 20

The Importance of Assessing the Stability of Income The next step in the lender’s qualifying process is assessing the stability of income. Continuing the example illustrating debt service coverage ratio from the previous screen helps to explain this concept. The NOI in the example was $70,000 and debt service coverage ratio was 1.4. $70,000 ÷ $50,000 = 1.4 In this scenario, a lender is likely to consider funding and will proceed to assess the income stability of the property. To do that, the lender will look more closely at the NOI calculations and apply market standards to determine whether the property income can be expected to be consistent for the life of the loan. The stability of income is assessed by examining leases to determine their anticipated duration and the revenue generated by rent. Lenders may also consider the building’s quality and its vacancy experience to further understand the quality of the income stream. Once a lender is assured of the quality of leases involved, which protect both the investor and themselves, they will then assess the quality of the tenants. A tenant’s quality or creditworthiness is dependent on their ability to pay the rent. The creditworthiness of the building is also assessed. This is dictated by vacancy rates, the overall condition and maintenance standards of the building, insurance eligibility, and taxation. © 2021 Real Estate Council of Ontario

Lesson 2 | Page 13 of 20

A buyer is interested in a property that has a net operating income (NOI) of $60,000 and a total debt service of $40,000. What will the debt service coverage ratio be for this transaction? There are three options. There is only one correct answer. 1

1.5

2

0.67

3

2.4

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Lesson 2 | Page 14 of 20

In addition to the requirements to qualify for a mortgage, the investor must meet other qualifying factors and pay specific fees to obtain financing for a commercial investment. It is important that you let the investor know about these additional charges or fees involved in the qualifying process, so that they can discuss borrowing costs with potential lenders and factor those costs into their business plan. If you miss informing the investor about these additional costs, the investor may not allocate the required funds to make the payments. This could result in the investor losing confidence in your advice and impact the integrity of the transaction.

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Lesson 2 | Page 15 of 20

Environmental Site Assessment (ESA) Once the lender is satisfied with the creditworthiness of the borrower and the stability of the income stream associated with the property, they will consider the condition of the property and environmental issues associated with it, if any. Environmental issues are a stand-alone due diligence topic, but they tie in closely with financing. In commercial transactions, lenders rarely approve financing without a Phase 1 ESA. Investors would be expected to conduct their due diligence about the environmental safety of the site and set aside adequate funds to recruit a third-party professional to conduct an ESA. You are responsible for making sure investors are aware of the requirement to conduct an ESA. You may also be required to obtain cost estimates for the process from a third-party service provider.

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Lesson 2 | Page 16 of 20

Additional Fees and Reports, I Along with the costs associated with environmental assessments, an investor should also be prepared for other fees associated with assessing the condition of a building. Lenders may require a variety of reports to verify that a building is in good condition. As you learned in PreRegistration, there are also additional closing costs, such as legal fees, title insurance fee, land transfer tax, insurer fee, etc. You will now learn about a few additional fees and reports that a lender may ask for to verify the condition and value of the property. The following four sections contain information on additional fees and reports.

Building inspection A building inspection, also called obtaining a Building Condition Report, is a technical assessment of the property. This assessment typically includes checking the condition of the doors, windows, ceilings and walls, plumbing, roof structure, roofing, and so on.

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Application fee When a lender expects to be paid for the time they spend in considering a borrower’s application, they charge an application fee. The amount involved depends on the lender.

Real estate appraisal Real estate appraisal, property valuation, or land valuation is the process of developing an opinion of value for real property, and is primarily performed by an appropriately qualified professional, at the request of a lender. Commercial real estate transactions require appraisals to estimate the value of the property. An appraisal report can be used to establish a list price for a property. The investor is responsible for the appraisal fee.

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Legal fees Legal fees include fees for the professional services provided by the lawyer for costs involved in conducting a title search, drafting the title deed, preparing the mortgage, registration fees, in addition to other disbursements.

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Lesson 2 | Page 17 of 20

Additional Fees and Reports, II The following four sections contain information on additional fees and reports.

Title insurance An investor will receive a title or a deed representing their ownership, upon purchasing real estate. Title insurance will protect the investor from losses related to survey and municipal issues, fraud occurring prior to closing or during the insured transaction, compliance with zoning bylaws, and previous non-compliance with certain reciprocal agreements.

Land transfer tax Land transfer tax is an amount that an investor will be required to pay on the purchase of real estate in Ontario. Municipalities may levy their own land transfer taxes in addition to the provincial tax. Brokers and salespersons are advised to check with the municipality to determine if a local LTT will be applicable. This amount is based on the price paid for the land, in addition to the amount remaining on any mortgage or debt assumed as part of the arrangement to buy the land.

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Insurer fee Insurer fee is an administrative fee paid to the insurer to cover their costs associated with the insurance application.

Mortgage broker fee Mortgage brokers can receive fees for services provided to the borrower or the lender. Borrower fees are typically associated with commercial mortgages requiring additional services by the broker. This fee is typically determined according to the mortgage amount.

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Lesson 2 | Page 18 of 20

Prepayment Privileges A prepayment privilege extends a right to a mortgagor to pay all or part of a mortgage prior to its maturity or ahead of schedule, usually without the risk of penalty. Mortgage prepayments are not guaranteed and must be negotiated with the lender. Unless otherwise specified, the mortgagor agrees to make payments according to a specified schedule, within the mortgage agreement. It is important that you understand prepayment privileges and have a high-level discussion with buyers to ensure that they understand this privilege. Always direct them to third-party professionals, such as mortgage brokers or lawyers, for further information. You will learn more about prepayment privileges later in this course.

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Lesson 2 | Page 19 of 20

A buyer is interested in investing in vacant land for a redevelopment project. The purchase price of the property is $4,000,000 with a $1,500,000 down payment. The buyer has a shortfall of $500,000, which they plan to make up by borrowing from a private lender. The buyer and their salesperson have reviewed multiple due diligence documents regarding the property and have visited the land as well. The buyer is anxious to close the transaction but is wondering whether they should first get a third-party professional to conduct a Phase 1 Environmental Site Assessment (ESA) for the property. Choose the appropriate advice for the salesperson to give to the buyer? There are four options. There is only one correct answer. 1

Recommend that the buyer get an ESA done before entering into an agreement of purchase and sale.

2

Recommend that an ESA be done, as lenders rarely approve mortgage applications without a Phase 1 ESA.

3

Advise that since all other due diligence documents are in place, the buyer need not spend more money on getting an ESA performed.

4

Explain that since the buyer is planning to develop the land, they could carry out an ESA as part of the redevelopment plan and that ESA is not required before closing the transaction.

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Lesson 2 | Page 20 of 20

Congratulations, you have completed the lesson! Completion of this lesson has enabled you to: • Identify sources for financing commercial investments • Understand the lender’s qualifying process • Identify additional charges/reports required for commercial investments There are three sections on this page with a summary of the key topics that were discussed in this lesson.

The sources for financing

Commercial investments often require high down payments and investors will require guidance to select an appropriate financing source. You should be aware of the various sources of financing available to be able to help investors depending on their requirements.

The lender’s qualifying process

To secure financing, an investor will need to provide the documents required by the lender. You should be able to advise an investor on which documents may be requested.

Additional fees and reports required

In a commercial transaction, there are additional fees and reports required, which an investor should be aware of. You should have a conversation with the investor regarding these additional costs at the outset of the transaction to ensure they allocate funds for the fees.

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Lesson 3 | Page 1 of 14

Lesson 3: Commercial Leases

This lesson provides an overview of the various types of commercial leases. A salesperson should be aware of the characteristics of each type of commercial lease and should be able to identify clauses within these leases that might affect the buyer’s income in terms of rent, operating expenses, etc.

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Lesson 3 | Page 2 of 14

Commercial transactions involve leases and rent structures that are different from residential transactions. This lesson focuses on commercial leases and how they impact an investor’s income. It is important for you to be familiar with the various types of commercial leases and related clauses to ensure that the investor maximizes returns from their commercial investment. Upon completion of this lesson, you will be able to: • Describe the different types of rents and leases incorporated into commercial leases and how they impact value • Explain the circumstances that require a personal guarantee or indemnifier • Identify clauses that might affect the investor’s income Throughout this lesson, you will participate in decision points to test your knowledge on the topics presented.

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Lesson 3 | Page 3 of 14

A commercial lease is any lease involving a property that is principally used for a business activity. For example, a small home office within a residential structure does not affect the residential status of the property. In contrast, a structure that has a commercial enterprise on the ground floor and two upper apartments will be identified as commercial for the lower units and residential for the upper units. Commercial leases will be used for the units on the ground floor. While discussing commercial leases, the buyer will be referred to as the “landlord” or “owner” whenever the discussion details future scenarios involving landlords and tenants. The type of commercial lease involved in a transaction is usually dictated by the landlord, and the tenant is subject to it. It is your responsibility to understand the characteristics of commercial leases and ensure that the buyer recognizes their rights and obligations with respect to a lease.

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Lesson 3 | Page 4 of 14

Types of Commercial Leases Commercial leases are categorized based on how rent and operating expenses are charged. You should be aware of the characteristics of all types of commercial leases to be able to provide competent service to the buyer. The following six sections contain information on the different types of commercial leases.

Gross lease A gross lease is an agreement in which the tenant pays a fixed rent and the owner pays all the operating expenses associated with the property. Landlords usually do not prefer this lease arrangement, as sudden increases in the operating costs must be absorbed by the owner under a gross lease.

Base and additional rents Base rent is the basic rent payable by a tenant under a lease. Additional rent, as the name suggests, is owed by the commercial tenant in addition to the base rent. It represents the proportionate share of operating costs, as defined within the lease document.

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Net lease A net lease provides that the tenant pays a portion of expenses associated with the leased premises. This lease is sometimes referred to as a semi-gross lease. Landlords prefer net lease arrangements, as sudden increases in operating costs can be effectively passed through to the tenant under a net lease.

Double net lease In this agreement, the tenant pays maintenance and operating expenses, plus property taxes. However, it usually excludes structural repairs to the external structure.

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Triple net lease (or net-net-net lease) A triple net lease is an agreement in which the tenant pays all expenses. The true triple net lease places all responsibilities on the tenant, with the landlord simply receiving rental cheques and depositing them. The terms of double net and triple net leases are not legally defined. The operating expenses included in these types of leases can vary widely throughout Ontario. There are no standards in the marketplace as to what operating costs should be included; therefore, it is recommended that the term “net” lease be used. A detailed description of the operating expenses being charged back to the tenant must be included in any landlord and tenant agreements to avoid confusion and misrepresentation.

Percentage lease A percentage lease, found primarily in the retail sector, provides that the tenant must pay a fixed minimum monthly rent, plus a percentage of the gross monthly income. Percentage rent establishes a type of partnership between the landlord and the tenant. The lease document sets out both the minimum rent and the percentage rent and the methods for calculating this type of rent.

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Lesson 3 | Page 5 of 14

Components of a Lease: Tenant Quality and the Landlord’s Due Diligence Obligation One of the components of a lease is tenant quality. Some factors that a landlord should consider are: • Number of years in business The landlord should ascertain whether the tenant is a new entrant or has been running a long-standing business, which is relocating. Long-standing businesses usually prove to be good tenants. • Credit check The landlord should ensure due diligence by performing a credit check on the principals of the business, as well as the business itself.

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• Financial statements To verify the revenue that a potential tenant is generating, the landlord could request them to provide their financial statements. It is recommended to obtain the financial statements for a minimum of three years. In case a business is new and has no credit history, the landlord could ask for a copy of the company’s business plan, which would include a pro forma financial statement. Landlords could also request a personal assurance or guarantee. In some cases, the tenants may be asked to pledge assets as security, in case of defaults. Personal assurances will be explained in detail later in this module.

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Lesson 3 | Page 6 of 14

An investor owns a mixed-use property that has residential apartments on the upper floors and retail units on the ground floor. The retail floor currently has a dollar store, a drug store, and a pizza shop. As one unit on this floor has become vacant, the investor is considering leasing out the space to a recently launched specialty coffee shop. Which of the following would be appropriate advice for a salesperson to give to the landlord? There are four options. There are multiple correct answers. 1

Suggest that the owner perform a credit check on the principal of the business.

2

Advise that the owner perform a credit check on the business.

3

Advise the owner to request a copy of the company’s business plan.

4

Advise the owner not to consider a new business, as their record is unproven.

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Lesson 3 | Page 7 of 14

You are now familiar with the landlord’s due diligence and the concept of personal assurances. In this topic, you will explore in detail the situations that require personal assurances. Personal assurance on leases is a due diligence item that the investor may sometimes have to exercise. It is encountered under two circumstances when the tenant is a corporation: • The tenant renting the property is new, and has no credit history • The tenant does not make enough income or has a questionable credit history These circumstances pose a risk of rent default to the landlord. In such situations, you should recommend that the landlord request a personal assurance on leases as an added measure of security, should the tenant default. You should also advise the investor to consult with a lawyer before attempting to draft clauses for a lease agreement. It is important for you to understand the various types of personal assurances to guide the investor in this regard.

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Lesson 3 | Page 8 of 14

Types of Personal Assurances There are three different types of personal assurances on leases based on the legal obligations of the assurer. The following three sections contain information on the different types of personal assurances.

Guarantor A guarantor is someone who is prepared to assume the liability and obligations of the tenant, in the event of the tenant’s default on the lease. An agreement between the guarantor and the landlord is typically required at the time the lease is signed or renewed. A landlord usually seeks a guarantee when a corporate tenant lacks sufficient assets to fund any default. However, such a guarantee involving a third party is limited, as it extends only to the tenant’s obligation. If the tenant is deemed by law to have no obligation to make payments in case of a bankruptcy or insolvency, then the guarantor is released from the obligation as well.

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Indemnifier An indemnifier is an individual or entity that is obligated to fulfill the terms of a lease agreement on behalf of the tenant should the tenant default. An indemnifier’s obligation extends beyond the bankruptcy of the tenant and will remain in effect for the entire term of the lease. This arrangement provides that the indemnifier agrees to indemnify or reimburse the landlord in case the tenant fails to perform their obligations, as per the lease. Indemnity agreements go further to imply that the indemnifier is obligated to the lease the same as the tenant. Indemnity survives any bankruptcy or insolvency of the tenant (i.e., if the tenant declares bankruptcy, the indemnifier will still be obligated to make payments on behalf of the tenant for the remaining term of the lease).

Co-tenant Another method to protect the landlord is the creation of a co-tenancy. Essentially, the proposed guarantor becomes a co-tenant with the tenant, and is jointly and severally responsible for all obligations as the tenant to the lease. The landlord can look to the co-tenant in the case of the tenant’s bankruptcy or insolvency.

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Lesson 3 | Page 9 of 14

Requirement of Personal Guarantee from the Principal of a Business In a transaction where the landlord signs a lease with an incorporated business, they may request the principal of the company to provide a personal guarantee to support the lease. The lease will still be between the landlord and the company, but the principal of the company would guarantee the performance of the company’s lease obligations. If the company defaults on the lease, then the principal of the company will be held personally responsible for the default. The principal of a business could be the owner of the business, a director of the company, or a shareholder.

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Lesson 3 | Page 10 of 14

A buyer has invested in a retail plaza, which currently has a vacancy. The owner of a new clothing line has expressed formal interest in leasing the space. This potential tenant has started out their newly incorporated business only a few months ago, but appears to have a solid business plan in place. The buyer, however, is unsure about leasing the space to a new business with unknown prospects. What types of assurance should the salesperson recommend to a buyer who wants to protect themselves against tenant bankruptcy or insolvency? There are three options. There are multiple correct answers. 1

Indemnification

2

Personal guarantee

3

Co-tenancy

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Lesson 3 | Page 11 of 14

There are various types of commercial leases. Investor buyers new to commercial leasing may have queries regarding the amount of rent that can be charged, or their ability to change or escalate rent during the term of the lease. Certain clauses in commercial leases can affect the investor’s income beyond the payment of rent. It is important for you to be aware of these clauses so that you can advise the investor accordingly. You should also ensure that the investor understands their rights and obligations with respect to these clauses. Note that you should always recommend that the investor consult their lawyer for advice on the contents of a commercial lease.

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Lesson 3 | Page 12 of 14

Clauses that Affect the Investor’s Income Clauses that affect the investor’s income are a fundamental component of commercial leasing agreements. The following four sections contain information about the clauses.

Rent escalations A landlord and a tenant may agree that rent will be increased on an annual basis or after a period agreed to in the lease. This is called a rent escalation. There could also be a clause that permits the landlord to increase additional rent, based on the specific operating expenses, if the cost of those items rises during the term of the lease. For example, a tenant may agree to pay a part of the owner’s property taxes. Should the municipality increase taxes mid-year, the tenant’s share would increase proportionately.

Pass-through expense Pass-through expense is the apportioned cost borne by the tenant for capital investments to the property. For example, if an HVAC unit must be replaced, the landlord may have the ability to charge the cost back to the tenants. Pass-through expenses are often a source of disagreement between the landlord and the tenant. Often, lease clauses settle on a middle-of-the-road position in which any capital improvements that favourably affect operating expenses are included with © 2021 Real Estate Council of Ontario

the pass-through. For example, the replacement of the HVAC unit could reduce electricity bills and prove beneficial for the tenant.

Special assessment Special assessment is the landlord’s ability to levy a financial obligation on the tenant in addition to the monthly payment. The landlord should specify the terms of special assessment within the lease agreement itself. An example of special assessment is supplementary rent.

Supplementary rent If base rent assures the landlord a minimum rent and additional rents cover the tenant’s pro-rated share of operating costs, then economic uncertainties still loom on the horizon from the landlord’s perspective. For example, the purchasing power of dollars collected, the interest rate on mortgages, extraordinary increases in expenses coming during a tenancy period, etc. Supplementary rent can involve a percentage arrangement or have various indexes that can be applied to the base rent, thereby ensuring the landlord a consistent amount of rent.

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Lesson 3 | Page 13 of 14

A buyer is considering investing in a multi-unit office complex. The seller discloses that some of the leases would be expiring in the near future. The buyer considers which businesses could be potential tenants, and tenants who are renewing their leases. The current seller has been absorbing capital improvement expenses on their own, but in the future, the buyer would like to share capital expenditures with the tenants. While drafting the new leases, what clause should the salesperson recommend that the landlord include in the lease? There are three options. There is only one correct answer. 1

Pass-through expense

2

Rent escalation

3

Supplementary rent

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Lesson 3 | Page 14 of 14

Congratulations, you have completed the lesson! Completion of this lesson has enabled you to: • Understand the different types of commercial leases • Explain the circumstances that require a personal guarantee or indemnifier • Identify clauses within commercial leases that may affect the investor’s income There are three sections on this page with a summary of the key topics that were discussed in this lesson.

The different types of commercial leases

There are various types of commercial leases. You have the obligation to ensure that the buyer understands the characteristics of the lease that they enter into or refer them to a third-party professional for further advice.

Investors may sometimes have to enter into leases with tenants who are new in the The circumstances that business or have a questionable credit history. In these situations, you should require a personal guarantee or indemnifier recommend that the buyer request personal assurances in the form of a guarantor, indemnifier, or a co-tenant on the lease.

The clauses within commercial leases that may affect the investor’s income

Commercial leases can contain clauses that will affect the investor buyer’s income. It is your obligation to ensure that the buyer understands these clauses and that they consult with a lawyer and/or an accountant to review the impact of these clauses on their business income.

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Lesson 4 | Page 1 of 21

Lesson 4: Critical Information for Commercial Property Investment This lesson details the sources for obtaining critical information related to the purchase of a commercial property. A salesperson should understand how to obtain information through rent rolls, income analysis, income and expense statements, technical reports, etc., to enable the buyer to make an informed decision regarding the transaction.

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Lesson 4 | Page 2 of 21

When trading in commercial real estate, there is certain critical information that you need to discuss with a potential investor before they can proceed with the transaction. This includes financial information with respect to the property, as well as lease related benefits and obligations that would affect the investor. It is part of your due diligence obligation to seek these details for the investor, which means you need to be aware of the sources of this information. Upon completion of this lesson, you will be able to: • Identify the sources for critical information related to the purchase of a commercial property • Identify critical information relating to leases and sustainability of income Throughout this lesson, you will participate in decision points to test your knowledge on the topics presented.

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Lesson 4 | Page 3 of 21

The more information a buyer has regarding an investment property, the better informed they will be before making an investment decision. Information regarding the current revenue, operating expenses, maintenance costs, etc., will help them in this regard. As a co-operating salesperson, you should be aware of the various documents that the buyer should have access to for the purpose of due diligence. Otherwise, they may make their decision based on inadequate information. In this topic, you will learn about the documents and other sources of information that will help the buyer understand their potential investment better.

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Lesson 4 | Page 4 of 21

Rent Rolls A rent roll is a document maintained by the owner of a tenanted building that has the details of all the tenants. The most important information included in rent rolls are current rent details and rent escalation terms that the landlord may be able to take advantage of in the future. Ideally, rent roll reports concisely show tenant names and locations within the property, base rent and pass-through charges, total rent due, amount and date of last payment, lease expiration date, and any current outstanding balances.

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Lesson 4 | Page 5 of 21

Income Analysis Income analysis, as the name suggests, is an analysis of the income generated by the property. To obtain information through income analysis, you should request that the seller provides an accounting of all the revenue streams within the property. This includes items such as: income from rent, parking, percentage rent, additional fees included in additional rent (such as a management fee), and miscellaneous revenue sources (such as tenant contribution towards seasonal decor).

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Lesson 4 | Page 6 of 21

Income and Expense Statements Financial statements for a property include all its income and expense documents and balance sheets. To obtain meaningful information from this source, you should request the seller provide financial statements of the property for at least three years. The information contained in financial statements will have a detailed accounting of income and expenses associated with the property. This will enable a third-party professional, such as an accountant, to provide the buyer with a clear picture of the property’s revenue and expenses.

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Lesson 4 | Page 7 of 21

Technical Reports As discussed earlier in this module, Environmental Site Assessments (ESA) and other technical reports, such as building inspection reports, provide due diligence information to potential investors. There are a few other technical reports that can help the investor in this regard. The following three sections contain information on the other technical reports.

Fire inspection report A fire inspection is a physical examination of the device or system installed for fire safety to determine if it will perform as intended. This report will include information on portable extinguishers, fire alarm system, hoses, etc.

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Insurance report The commercial property insurance coverage is designed to protect commercial property from natural disasters, theft, equipment breakdown, repair costs, lost revenue, etc. This report will include details of any such damage and the costs involved.

Sprinkler service report This report examines sprinkler presence, reliability, effectiveness, and impact. It may also include cases of sprinkler failures and ineffectiveness. Sprinkler service may sometimes be a sub-category of the fire inspection report, but the inspection is normally conducted by independent third-party professionals.

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Lesson 4 | Page 8 of 21

Current Tenants and the Seller The seller of a property is required to provide all the requested due diligence documents pertaining to the property. However, you may need to approach the tenants of the property for additional information or to verify details such as rent, rent escalations, capital improvements, etc. You may also need to check if there are any issues at the building that may affect the buyer’s business. Note that you must always obtain the seller’s consent before approaching tenants of a property. Sellers may have rules in place about you approaching tenants, as they may not want to alarm the tenants due to a potential sale.

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Lesson 4 | Page 9 of 21

Owners of Neighbouring Properties Once you have all the required information from the current tenants of the building, you can explore the option of obtaining information from the owners or occupants of the neighbouring properties. You may need to contact them for additional information, such as: • Noise originating from the property, if any • Possible onsite construction projects that may affect traffic flow • Environmental issues at the property that may migrate into neighbouring properties • Improvements, such as large signs at the site, that may restrict the visibility of neighbouring properties • Insufficient parking, resulting in customers using the neighbouring properties Note that the seller’s permission is not required to contact the owners of neighbouring properties.

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Lesson 4 | Page 10 of 21

City/Township Offices or Websites You may need to contact the city or township offices, municipal offices or websites to: • Confirm if the property complies with zoning bylaws • Determine if there are any outstanding enforcement actions against the property or the seller • Confirm if the property has appropriate business licences • Check if there are any outstanding tax payments If there are outstanding work orders against the property that the seller is unable or unwilling to satisfy, the investor will need to assess the cost for complying with those work orders and their impact on the purchase price.

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Lesson 4 | Page 11 of 21

A buyer is considering investing in a retail plaza. The seller is a reputable figure in the market and has provided the buyer with all the necessary due diligence documents. The buyer reviews the documents along with their salesperson and finds that the cost of capital improvements made during the last year was quite high. The buyer is keen to interview the existing tenants to determine if the improvements have had an impact on the operational efficiency of the building. Which of the following approaches should the salesperson suggest? There are three options. There is only one correct answer.

1

The buyer need not approach the tenants. The seller is quite reputable, and if their records state that capital improvements have been made, that should be good enough.

2

The buyer should obtain the seller’s permission first and then approach the tenants to obtain the necessary information.

3

The buyer should visit the property after business hours and check with the tenants directly regarding the capital improvements.

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Lesson 4 | Page 12 of 21

An investor must always assume existing, fixed-term tenancies in the building that they are planning to buy if the expiry date of the lease is later than the completion date of the sale. Since the bulk of the income an investor will obtain from a tenanted property is through its current occupants’ leases, it is very important for the investor to review these leases and to confirm relevant information. You should have a basic knowledge about the information contained within the leases and ensure that the investor buyer is aware of their rights, obligations, privileges, and benefits under each lease agreement that they will be assuming. Failure to do so may result in the investor completing the transaction without having a full understanding of their rights and obligations under each lease, which may lead to financial hardship, among other challenges. In this topic, you will learn about the information originating from commercial leases that you should be aware of to provide competent and conscientious service to investors.

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Lesson 4 | Page 13 of 21

Terms of a Lease Terms of a lease are the conditions that a landlord and a tenant agree to abide by for the duration of a lease. Details specified in leases will help the investor understand how much income they can expect from each tenant while they occupy the property in accordance with the lease. Here are some clauses that are common to all commercial leases: • Parties to the lease: These are the parties involved in the contract, i.e., the lessor (the owner or landlord) and the lessee (the renter or tenant) • Intent of the lease: This is the summary of the terms acceptable to the landlord and the tenant who are looking to negotiate a commercial lease • Premises: This is a description of what is being leased, i.e., buildings and other infrastructure, such as greenhouses, wells, and fencing • Lease period: This is the period for which the agreement of the lease will be applicable to the landlord and the tenant As part of the new landlord’s due diligence, investors should be aware of their obligations and rights in accordance with the leases. © 2021 Real Estate Council of Ontario

Lesson 4 | Page 14 of 21

Renewal Privileges Commercial leases may sometimes contain renewal privileges on expiration, with a clause to the effect of “provided the tenant is not in default, the tenant may renew this lease for one additional term of five years.” Sometimes the clause will stipulate the number of renewal terms; for example, three additional terms. Usually when a lease is renewed, rent and other items can be re-negotiated. The clause will often state that the terms and conditions of the renewal will be re-negotiated by the parties before the renewal term takes effect. It is important for an investor to review renewal clauses within tenants’ leases, because they will need to abide by the terms of these renewal clauses as the new landlord. Lease renewal could be beneficial for the landlord, as: • It provides a continuity of revenue • It avoids the process of finding a new tenant

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• It avoids vacancy costs • It can allow rent increments, if the renewal clause provides for it Lease renewals may prove to be a potential challenge to the investor, as: • The original lease signed by the seller and the tenant may have a clause that states that rent cannot go higher than a set percentage. This may not reflect the market rent.

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Lesson 4 | Page 15 of 21

Arbitration Clause In case the investor owner and a tenant cannot come to an agreement regarding the renewal terms, they should look at a dispute resolution mechanism, which is often binding arbitration. As mentioned earlier, some leases may include renewal terms. If renewal terms are not included, the investor will have the option to renegotiate the terms. Tenants normally give a six-month notice to the landlord in case they are planning to not renew the lease. If they do choose to renew their lease without having a renewal privilege stated in the original lease, both parties will need to negotiate the terms of the renewal. Negotiations can also be carried out without a face to face meeting through emails, involvement of salespersons, or lawyers, etc. If satisfactory terms cannot be negotiated, an arbitrator, acting under the Arbitration Act, will convene a hearing and make a decision, which will be binding on all parties. A clause permitting binding arbitration must be included in the original lease agreement. It is important that you ensure that investors understand the dispute resolution mechanism within the lease, including its application to renewals.

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Lesson 4 | Page 16 of 21

Exclusivity Terms Previously, you learned about “use-restriction,” where leases may contain a clause that restricts businesses from offering similar products or services in the same mall or commercial outlet. Exclusivity terms are similar to userestrictions, but more stringent. In commercial leases, tenants may sometimes include an exclusivity clause prohibiting a competitive business from occupying space in the building. Landlords would normally want to curtail such limitations, but under certain circumstances they will agree. An exclusive use grants one tenant a use that prohibits a similar use anywhere else in the centre at issue. For example, a real estate brokerage, with an exclusivity clause in their lease that prohibits another brokerage from leasing space in the same complex, has four more years remaining in their lease. If a vacancy arises in the complex within four years, the landlord is not able to lease the space to another brokerage, as that would violate the exclusivity terms in the lease of the current tenant.

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Lesson 4 | Page 17 of 21

Demolition If an investor considers buying a property for redevelopment, the existing building or a portion of the existing building may have to be demolished. Demolition involves certain costs and risks. Costs • Demolition permit must be obtained from the municipality • Fees for third-party professionals, such as a construction company or a consulting engineer Risks • The building may be declared heritage, in which case it cannot be demolished without obtaining permission from the municipal council • Municipality may impose restrictions on the disposal and removal of materials that may cause environmental harm • There may be significant restrictions on the proposed new building You should inform investors regarding the costs and risks involved in demolition and refer them to a third-party professional to thoroughly investigate the impact of demolition on the transaction. © 2021 Real Estate Council of Ontario

Lesson 4 | Page 18 of 21

Damage and Destruction There could be instances where an investor is considering a property in a damaged condition. Damage and destruction could be caused by natural calamities or accidents. It is very important for an investor to understand the extent of the damage, as they will need to consider the cost involved and adjust their proposed purchase price. Cost estimates may be obtained from a third-party service provider, like a contractor or a consulting engineer. While drawing out new leases, certain parameters can be outlined, referring mainly to a proportion of the space damaged (or tenants displaced), upon which the landlord need not reconstruct. When showing damaged properties, you should ensure that the investor is aware of the additional costs that may be required. If there are damaged areas within the property that will not be reconstructed, it must be taken into consideration when calculating the new rentable versus useable space. This will be used to determine a tenant’s proportionate share of the operating expenses or additional rent.

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Lesson 4 | Page 19 of 21

Expropriation Expropriation is the seizure of private property by a public agency for a public use or benefit. Any level of government – municipal, provincial, or federal – can expropriate a piece of land, which may result in the loss of rental income due to the reduction in size of the affected building or property. This is an infrequent problem, but when it does occur, the landlord and the tenant each have their own separate rights to compensation, and these should not be merged. Expropriations that substantially inhibit the operable capability of a shopping centre, an office building, or a major industrial building are somewhat rare because of imputed cost. Including an expropriation clause in the lease will ensure that the tenant does not sue the landlord in case the property is expropriated. You should be aware of this clause, as it is common in commercial leases.

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Lesson 4 | Page 20 of 21

An investor has purchased a thriving shopping mall. A current tenant, who has a popular seafood restaurant franchise, has one year remaining on their lease. They have an exclusivity clause that prohibits the presence of any other restaurant that serves fish dishes. There is now a vacancy in the plaza, and the buyer has been approached by two potential new tenants. One is a shoe retailer and the other is a seafood restaurant, which would be a competitor to the existing restaurant. The buyer prefers the seafood restaurant, as it has the potential to draw more people to the plaza. Which of the following should the salesperson suggest to the buyer in this scenario? There are three options. There is only one correct answer.

1

Explain that it would be beneficial to consider the seafood restaurant business as the new tenant for the shopping mall, as the present restaurant’s lease expires in one year.

2

Advise the owner to lease the premises to the shoe retailer, as the present restaurant tenant has an exclusivity clause in their lease.

3

Recommend that the buyer ask the present restaurant owner to waive the exclusivity provision in their lease and rent out the premises to the seafood restaurant.

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Lesson 4 | Page 21 of 21

Congratulations, you have completed the lesson! Completion of this lesson has enabled you to: • Identify the sources for obtaining critical information related to commercial properties • Identify critical information relating to leases and sustainability of income There are two sections on this page with a summary of the key topics that were discussed in this lesson.

The sources for obtaining critical information related to commercial properties

Investors will require information regarding an investment property, such as income and expense statements, rent rolls, technical reports, etc., before making an informed decision regarding the transaction. It is part of your due diligence obligation to obtain all such information regarding the investment property for investors.

Critical information relating to leases and sustainability of income

The bulk of the income an investor will make from a tenanted property is through its current occupants’ leases. Hence, it is important for investors to review these leases, to confirm and identify relevant information. You should ensure that your investors are aware of their rights, obligations, privileges, and benefits under each lease agreement.

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Lesson 5 | Page 1 of 14

Lesson 5: Additional Due Diligence to Perform for the Purchase of a Commercial Property This lesson outlines additional due diligence items required for purchasing commercial property. A salesperson should be able to provide information to the buyer related to current vacancies, existing management, and maintenance details, local market data, rent history, etc.

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Lesson 5 | Page 2 of 14

It is important to review existing leases, as they provide details regarding vacancies, management, maintenance, rental history, and so on. In this lesson, you will learn about critical information that emanates from leases, which the buyer, third-party professionals, and you will need to investigate as part of due diligence. Upon completion of this lesson, you will be able to: • Review additional due diligence items Throughout this lesson, you will participate in decision points to test your knowledge on the topics presented.

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Lesson 5 | Page 3 of 14

Due diligence is a commonly accepted business practice that verifies key facts concerning a real estate transaction. A simple example of due diligence in residential sales would involve the buyer requiring a home inspection. With commercial real estate, due diligence is far more expansive, particularly with large, complex transactions. Prospective commercial buyers must carefully assess all risks associated with a business and/or property acquisition, with emphasis on factors impacting ongoing income stability. It is important for you to be aware of these risks and the due diligence items in order to guide buyers correctly and to ensure they do not make misinformed or underinformed decisions. Failing to alert a buyer about material facts and latent defects regarding the property may prompt the buyer to cancel the transaction and, in the extreme, sue you or the seller for damages. In this topic, you will learn about various due diligence items that you may need to check for a buyer.

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Lesson 5 | Page 4 of 14

Validating Current Vacancies Commercial properties with multiple units may sometimes have vacant space. If there are vacancies in your buyer’s potential investment property, it is important for you to check if those spaces are actually vacant or simply unoccupied. There could be a valid lease agreement in place for a space that is just not occupied. It could also be that the space is under a conditional offer to lease, which has not yet been completed. If a space is indeed vacant, the investor may want to understand the reasons as to why the space is vacant. Vacancies usually occur due to: • Lack of demand • Poor physical condition of the building • Age of the building • Functional obsolescence, such as loss of property value due to style, space, or a particular design feature • Unusual layout, such as floor areas broken up by columns • Limited facilities, such as insufficient parking, unavailability of technical requirements like IT, electrical service, signage, or elevators

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Lesson 5 | Page 5 of 14

Reviewing Management and Maintenance Costs Reviewing the level of maintenance and management at a potential investment property is part of an investor’s due diligence for risk mitigation. An investor should review all records that gives an indication of the level of maintenance being applied to the building. They can also check for existing maintenance contracts that the seller has entered into. These contracts need not be necessarily assumed, but the investor can review them and make decisions accordingly. For example, consider a scenario where the seller has signed a contract with a company to perform routine HVAC maintenance. The investor can choose to continue the services of that company, if it is beneficial for them. The investor would also need to know the major capital investments made on the property. For example, if the seller has replaced the HVAC system recently for a cost of $35,000, it is advantageous for the investor, as they might not have to replace the unit for the next 20 years or so. © 2021 Real Estate Council of Ontario

In terms of management, the investor can check if the seller has been managing the property on their own or if they have contracted the task to a professional property manager. If a property manager is in charge, the investor may want to meet with the person to determine the regular maintenance activities and other issues impacting the property. Note that the seller’s consent should be obtained before meeting the property manager. You should be aware of the maintenance and management costs at the investor’s potential investment property and alert them if the amount is unusually high.

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Lesson 5 | Page 6 of 14

Local Market Conditions While working with commercial transactions, you need to ensure that an investor understands the local market conditions, as they relate to this type of real estate. You may sometimes have to assemble a part of this information or may just include a provision in the agreement of purchase and sale suggesting that the investor engage a thirdparty professional to perform this assessment. The following four sections contain information on the nature of the local marketplace.

Local market data Local market data includes information such as vacancy rates, volume of units sold or leased, average selling prices by property type, volume of leasing transactions, average cost per square feet or metre by use type or category, and duration of leases.

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Current available spaces This is the amount of vacant space available in the community that the investor would be competing with. It is sometimes expressed as a percentage of the overall space in the community.

Absorption rates Absorption rate is the rate at which a vacant space is released and occupied. The higher the absorption rate, the better it is for an investor.

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New buildings Information on outstanding building permits can be gathered from the municipal office. This will help the investor understand how many similar buildings will be added to the market that the investor will be competing with.

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Lesson 5 | Page 7 of 14

Collecting Rental Histories Sometimes the current market value of rent could be significantly different from the contractual rent that the current owner has entered into. You should inform the investor regarding current market rents being charged in the community through market research. If the information sourced suggests that the rent per square foot at similar properties is higher, then the investor may be able to increase the rent when the leases are renewed. In case the market rates are lower, the investor should expect lower income on lease renewals.

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Lesson 5 | Page 8 of 14

The Importance of Seeking Advice from Third-Party Professionals You will assist and guide an investor buyer through every step of the transaction. However, there may be legal or technical concerns that you may not be able to address. In such situations, you should always recommend that the investor seeks advice from third-party professionals. The Code of Ethics requires that whenever you are not able to provide a service or advise investors, you must always refer them to a professional who can. When purchasing a commercial property, the most typical third-party professionals would include: • Accountants

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• Architects • Building assessors • Building inspectors • Contractors • Environmental site assessors • Fire inspectors • HVAC technicians • Lawyers • Property managers • Sprinkler system technicians

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Lesson 5 | Page 9 of 14

Review the Current Physical Status of the Building or Improvements While considering a commercial investment, there may be improvements to the property besides the principal building itself, which may lend value to the transaction. This includes secondary buildings, such as storage facilities, maintenance sheds, paid parking lots, security fencing, security systems, etc. The buyer investor will be interested in the condition of the secondary buildings or improvements in addition to the property itself. You should ensure that the investor gets ample opportunity to carry out a proper assessment of these improvements.

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Lesson 5 | Page 10 of 14

Reviewing the Economic Life of the Property An investor will always be interested in the future costs of owning a building. The remaining economic life of a building is assessed by trying to understand what the additional requirements are to keep the building functioning as intended. This could include energy efficiency improvements, replacement, or refurbishment of capital assets, such as resurfacing parking areas, maintenance and repairs of roofs, etc. You need to ensure that the investor understands both the current and the future financial obligations of investing in a property.

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Lesson 5 | Page 11 of 14

Environmental Status Environmental due diligence is a formal process that assesses real estate for potential risk of environmental contamination, such as soil or groundwater contamination or the presence of hazardous materials. When representing an investor, you should check for environmental issues at the property. In a case where contamination is disclosed by the seller, recommend that the buyer seeks advice from third-party professionals on an estimation of the costs for assessment and remediation. You should perform due diligence on these considerations to ensure that the buyer will be investing in an environmentally safe property for their employees or future tenants.

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Lesson 5 | Page 12 of 14

A buyer is interested in investing in a shopping mall downtown. It is a large property, of about 500,000 sq. ft. in area. The buyer has reviewed the existing leases, but is also interested in obtaining information concerning the local market conditions to estimate a realistic purchase price and potential cash flow from rent. Which of the following would be important information for the buyer to gather about market conditions before purchasing the property? There are four options. There are multiple correct answers. 1

Current available spaces

2

Absorption rates

3

Building condition report

4

New buildings

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Lesson 5 | Page 13 of 14

A buyer is considering investing in an industrial property. The current tenant manufactures dye for the textile industry using many types of flammable liquids. The seller has stated that the sprinkler system is appropriate for the type of manufacturing process being carried out. The buyer, however, is concerned about the operational efficiency of the system. The salesperson has a general understanding of sprinkler systems, but is not qualified to comment on the adequacy of the existing system. What should the salesperson do to address the buyer’s concern? There are three options. There is only one correct answer. 1

Let the buyer know about how sprinkler systems work in general. Afterall, they are all quite similar.

2

Ask the buyer to get more information regarding the sprinkler system from the seller.

3

Suggest that the buyer retain the services of a qualified sprinkler system technician to assess the adequacy of the current system.

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Lesson 5 | Page 14 of 14

Congratulations, you have completed the lesson! Completion of this lesson has enabled you to: • Review additional due diligence items • Advise clients on the importance of seeking advice from third-party professionals There are two sections on this page with a summary of the key topics that were discussed in this lesson.

Additional due diligence In commercial transactions, certain information that emanates from the leases should be thoroughly investigated by the investor as part of due diligence. It is your items responsibility to ensure that an investor is given the opportunity to perform these due diligence activities.

The importance of seeking advice from third-party professionals

Investors may have legal or technical queries during various stages of a transaction. Although you may guide an investor along the steps with your understanding of these issues, you should always refer investors to third-party professionals when you are not able to provide competent service or advice.

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Lesson 6 | Page 1 of 6

Lesson 6: Summary Practice Activities

This lesson provides a series of activities that will test your knowledge on the entire module.

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Lesson 6 | Page 2 of 6

This lesson provides summary practice activities. Throughout this lesson, you will participate in decision points to test your knowledge on the topics presented.

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Lesson 6 | Page 3 of 6

An investor is planning to invest in a shopping mall in a prime downtown location, with the transaction due to be completed in a few weeks. The investor has checked certain due diligence documents and has verified details about the property with its current tenants, with the seller’s permission. As there are a few more additional due diligence items on the investor’s check list, they have requested their salesperson to source the relevant documents for them. Which of the following statements correctly match the appropriate information source with the information they provide? There are five options. There are multiple correct answers.

1

Municipal offices can provide information regarding possible onsite construction projects that may affect traffic flow.

2

City/township office can provide information regarding zoning compliance.

3

Owners/occupants of neighbouring properties can provide information regarding insufficient parking at the property.

4

Owners/occupants of neighbouring properties can provide information regarding outstanding enforcement actions, if any, against the property or the seller.

5

Owners/occupants of neighbouring properties can provide information regarding improvements on the property that affect nearby buildings.

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Lesson 6 | Page 4 of 6

A buyer has purchased a retail plaza near the financial district. As a few leases are due to expire shortly, the buyer is considering tenant applications. They ask their salesperson to review their current leases and due diligence documents to check for options to maximize their returns on the investment. The salesperson finds that the seller is making significant payments as part of operating and maintenance expenses, which could be saved by simply using a different lease type. In order to ensure that the client maximizes their return on investment, which type of commercial leases could the salesperson suggest to their buyer? There are three options. There are multiple correct answers. 1

Gross lease

2

Net lease

3

Percentage lease

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Lesson 6 | Page 5 of 6

An investor wants to purchase a freestanding building in the downtown area to grow their investment portfolio. They require financing from a lender to complete this transaction. The building has a net operating income (NOI) of $75,000 and the total debt service is $50,000, making the debt service coverage ratio 1.5. What advice should the salesperson offer to the investor buyer, based on the debt service coverage ratio, as next steps? There are four options. There are multiple correct answers.

1

Let the investor know that no lender would consider the loan application, as the debt service coverage ratio is above 1.2.

2

Let the investor know that lenders are likely to consider their loan application, as the debt service coverage ratio is above 1.2.

3

Inform the investor that they need to ensure the due diligence documents are in place for the lender’s qualifying process.

4

Suggest that the investor start looking at other properties with similar characteristics, as this property is not a good investment.

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Lesson 6 | Page 6 of 6

Congratulations, you have completed the lesson!

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Module Summary | Page 1 of 3

Module Summary This lesson contains a summary of the entire module.

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Module Summary | Page 2 of 3

Congratulations, you have completed this module! This lesson will present a summary of Learning Objectives.

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Module Summary | Page 3 of 3

There are five sections on this page with a summary of the key topics that were discussed in this module.

Identify Common Types of Commercial Investment Properties

There are different types of commercial properties. Each property type has its own set of benefits and potential challenges that should be considered before making an investment. An investor may have a personal choice for a specific property type. You should consider an investor’s interests and requirements to seek out properties that could be the right investments for them. Completion of this lesson has enabled you to: • Identify the different types of investment properties • Identify the advantages and disadvantages to an investor of each property type

Identify the Fundamentals of Financing for Commercial Investment Property

Commercial investments demand high down payments. An investor buyer will require your guidance to select an appropriate financing source and assemble due diligence documents to qualify for the lender’s approval process. You should be aware of the various sources of financing to help an investor, based on their financial requirement, and ensure they have all the documents in place for the lender’s qualifying process. You should also discuss additional costs with the investor at the onset of the transaction to facilitate the allocation of funds. Completion of this lesson has enabled you to: • Identify sources of funding and financing • Describe the lender’s qualifying process • Identify the additional qualifying factors for financing commercial investments

Identify the Types of Commercial Leases

There are different types of commercial leases. You have the obligation to ensure that the investor understands the characteristics of the lease that they are entering into.

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If an investor enters into leases with tenants who are new to their business or have an unstable credit history, it is your responsibility to recommend that they request for personal assurances in the form of a guarantor, indemnifier, or a co-tenant on the lease. Commercial leases may also contain clauses that could affect the investor’s income. It is your obligation to ensure that the investor understands these clauses. Completion of this lesson has enabled you to: • Describe the different types of rents and leases incorporated into commercial leases and how they impact value • Explain the circumstances that require a personal guarantee or indemnifier • Identify clauses that might affect income

Identify Critical Information to Know for the Purchase of a Commercial Property

Before investing in a property, all buyers would like to ensure that the building is in good financial health. It is part of your due diligence obligation to obtain documents, such as income and expense statements, rent rolls, technical reports, etc., to assist the buyer in making an informed decision about the transaction. You should also ensure that the buyer is aware of their rights, obligations, privileges, and benefits under each lease agreement. Completion of this lesson has enabled you to: • Identify the sources for critical information related to the purchase of a commercial property • Identify critical information relating to leases and sustainability of income

Identify Additional Due Diligence Items for the Purchase of a Commercial Property

In commercial transactions, certain information that emanates from the leases should be thoroughly investigated by the investor as part of due diligence. It is your responsibility to ensure that the investor is given the opportunity to perform these due diligence activities. The investor may have legal or technical queries during various stages of a transaction. Although you may guide the investor along the steps with your understanding of these issues, you should always refer the investor to third-party © 2021 Real Estate Council of Ontario

professionals when you are not able to provide a service or competent advice yourself. Completion of this lesson has enabled you to: • Review additional due diligence items

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V7

Module 3: Understanding Mortgage Calculations Disclaimer: This is a reference document which contains pages from the Accessible eLearning module. You should complete the eLearning module to proceed to the next step. Please note that the accessible module on the LMS only contains the interactive pages and you need to go through the content of this document thoroughly to attempt the interactive activities in the module. Please use Adobe Acrobat Reader (Recommended version 9 or above) to navigate through this PDF. Real Estate Salesperson Program ©2021 Real Estate Council of Ontario. All Rights Reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or in any means – by electronic, mechanical, photocopying, recording or otherwise without prior written permission, except for the personal use of the Real Estate Salesperson Program learner.

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Module 3: Understanding Mortgage Calculations In the previous module, you learned about the fundamentals of investing in commercial real estate. The module discussed types of commercial investment properties and ownership options. It identified critical information for the purchase of a commercial property, as well as the fundamentals of financing such property. This module provides an in-depth review of investing in commercial real estate. It explores how financing options can affect an investor’s choice of property and the role of the salesperson and a lender during the purchase process. You will need to understand definitions of the key concepts used in the purchase of commercial property. This module provides opportunities to complete a series of mortgage calculations using a financial calculator or an app. To check your understanding of this module, you must complete all the activities in the online module. While navigating through the online module, click the Legislation button to view laws and regulations related to this module. The contents of the thumbnails Accessible PDF.

and References from the module are added to support your learning throughout this

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Menu: Understanding Mortgage Calculations

Number of Lessons Lesson Number

6 Lessons Lesson Name

Lesson 1

Identify Key Terms Used in Commercial Property Finance

Lesson 2

How Financing Impacts an Investment Property and Influences an Investor’s Selection

Lesson 3

Debt Service

Lesson 4

Calculating Mortgage Payments

Lesson 5

Summary Practice Activities Module Summary

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Lesson 1 | Page 1 of 13

Lesson 1: Identify Key Terms Used in Commercial Property Finance

This lesson introduces definitions used in commercial property accounting and purchases. These definitions describe the practices and principles used in mortgage calculations. It also describes the issues that can affect a property’s cash flow.

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Lesson 1 | Page 2 of 13

There are a number of key terms used in mortgage calculations for a commercial investor. Many of these terms have abbreviations and are frequently used in financial calculations and documents. The terms used include amortization, return on investment, return on equity, cash flow before tax and after tax, leverage ratio, and debt service coverage ratio. Commercial properties are rarely debt-free and understanding the reasons for this will enable you to provide an investor with the best possible guidance on how to leverage a loan. Another issue to discuss with an investor is a property’s cash flow. Maintaining a good cash flow is vital to reducing debt in the long term. It is important that you discuss the factors affecting a commercial property’s cash flow so that an investor can avoid making mistakes and placing their investment at risk. These factors include the costs of arranging financing, early discharge, and operating expenses such as property taxes, management fees, insurance, and utility costs. Being familiar with these terms and the reasons behind investor debt will mean that you will be able to accurately calculate commercial mortgages, alert buyers to potential errors, and answer client questions. Upon completion of this lesson, you will be able to: • Identify key terms in financial and mortgage calculations • Identify factors affecting a commercial property’s cash flow Throughout this lesson, you will participate in decision points to test your knowledge on the topics presented.

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Lesson 1 | Page 3 of 13

When working with buyers who invest in commercial properties, you will need to be knowledgeable about the terms and definitions used in commercial financing. These terms will allow you to discuss commercial mortgage options with investors of a commercial property.

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Lesson 1 | Page 4 of 13

Definitions of Financial Terms, l Commercial investment is filled with industry-specific phrases and terms, particularly in the area of finance and lending. You will need to understand these terms so that you can provide your buyers with information to enable them to make an informed choice for their business and investment goals. The following four sections contain information about the topic. Interest rates Interest rates are set by individual lenders and are guided by the raising and lowering of the bank’s prime rate. The banks’ prime rates are influenced by the policy interest rate of the Bank of Canada. The Bank of Canada sets the policy interest rate according to the overall health of the economy. For example, a soft or slowing economy may prompt the Bank of Canada to hold or lower the policy interest rate to stimulate growth. A growing economy may prompt the bank to hold or increase interest rates to rein in growth and curb inflation. For the commercial real estate sector, interest rates can affect: • The amount an investor or user can borrow and, consequently, invest in property or expand their operations • Property prices

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• Flow of capital • Supply and demand for capital • An investor’s required rates of return on investment and equity Interest charged on a commercial mortgage loan is a tax deduction for an investor. Amortization of a mortgage Most mortgages have an amortization period and a term. The amortization period is the length of time it will take to pay back the loan at the given interest rate. An investor can amortize a loan for fewer years, which increases the monthly payments and reduces the overall cost of interest. Most investors will select an amortization period that will allow some positive cash flow before tax in order to ensure there is enough income generated by the property to pay the mortgage. This is why it is important for an investor to understand the impact of the amortization period on their cash flow. The longer the amortization period, the lower the annual debt service (ADS), and the higher the cash flow generated.

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Net operating income Net operating income (NOI) is a calculation that analyzes the profitability of an income-generating real estate investment. NOI is all revenue from the property, minus all operating expenses. NOI is the income before annual debt service and tax liabilities are addressed.

Cash flow before tax Cash flow before tax (CFBT) is the net operating income minus the annual debt service. It is the amount of revenue collected after all expenses associated with the property are paid but which are still subject to taxes. CFBT is an important figure for you to know when presenting potential properties to a buyer. The CFBT allows you to calculate the return on equity (ROE), also known as cash on cash and, therefore, compare the profitability of each property. To do this, you will access each property’s net operating income and then factor in a buyer’s mortgage requirements.

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Lesson 1 | Page 5 of 13

Definitions of Financial Terms, II The following three sections contain information about the topic. Cash flow after tax Cash flow after tax (CFAT) is the after-tax position of the income-producing property. It is the amount of revenue an investor can realize after addressing tax liabilities. This will be unique to each investor or corporation, based on their specific tax circumstances and strategy. A professional tax advisor can offer advice and explain the tax consequences of each real estate investment.

Return on investment Return on investment (ROI) is a performance measure used to evaluate the efficiency of an investment. ROI measures the amount of return on a particular investment, relative to the investment’s cost. To calculate ROI, the net operating income of an investment is divided by the value of the investment. The result is expressed as a percentage or a ratio.

© 2021 Real Estate Council of Ontario

Return on equity Return on equity (ROE) is the measure of financial performance calculated by dividing cash flow before tax (CFBT) by equity investment (down payment) for a single period. In a corporate structure, a shareholder’s equity is equal to a company’s assets minus its debt; ROE could be thought of as the return on net assets. ROE is considered a measure of how effectively management is using a company’s assets to create profits. The formula for ROE is CFBT divided by equity equals return on equity, which is also called the equity capitalization rate. This is also referred to as cash on cash by some investors.

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Lesson 1 | Page 6 of 13

A salesperson is representing an investor who wants to buy a commercial property as an investment. The investor explains that they are new to the commercial property market and would like to better understand common financial terms ahead of their meeting with a lender. Which among the following statements are true? There are five options. There are multiple correct answers. 1

Amortization is the length of time it will take to pay back a loan. A lender may offer a shorter amortization period, which may increase the monthly payments but reduce the repayment time frame.

2

Return on equity is a performance measure used to evaluate the efficiency of an investment. It directly measures the amount of return on a particular investment, relative to the investment’s cost. To calculate this, the benefit (or return) of an investment is divided by the cost of the investment. The result is expressed as a percentage or a ratio.

3

Return on investment is the measure of financial performance calculated by dividing cash flow before tax (CFBT) by equity investment (down payment) for a single period. In a corporate structure, a shareholders' equity is equal to a company’s assets minus its debt; it could be thought of as the return on net assets. It is considered a measure of how effectively management is using a company’s assets to create profits. The formula for this is CFBT divided by equity equals return on equity, which is also called the equity capitalization rate. It is also referred to as cash on cash by some investors.

4

Net operating income is a calculation that analyzes the profitability of an income-generating real estate investment. It is all revenue from the property, minus all operating expenses. It is income before annual debt service and tax liabilities.

5

Cash flow before tax is the net operating income minus the annual debt service. In other words, it is the amount of revenue collected after all expenses associated with the property are paid but which are still subject to income taxes.

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Lesson 1 | Page 7 of 13

When working with commercial property investors, you will need know the financial situations common to this type of investment. For example, most investment properties are seldom debt-free, and the operating expenses will vary from property to property. You will identify the financial considerations of a buyer and provide them with accurate information depending on their investment property objectives. A salesperson must use accurate information when offering a buyer financial guidance and always comply with the Code of Ethics under the Real Estate and Business Brokers Act (REBBA), including providing conscientious and competent service and disclosing material facts.

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Lesson 1 | Page 8 of 13

Why Commercial Properties are Seldom Debt-Free The main reason commercial investment properties are seldom debt-free is that the majority of investors decide to invest a portion of their financial assets in a property and borrow the remaining funds to purchase the property, which can take several years to pay off. Cash flow is another factor that can affect debt levels. Cash flow is derived from two sources: ongoing rental income (operations cash flow) and the eventual sale of the property (sale proceeds cash flow). Cash flow represents all monies flowing from an investment. Cash flow is fundamental to building wealth from an investment perspective. To determine cash flow before tax (CFBT), an investor must first calculate the net operating income (NOI) of a property and deduct the annual debt service. This represents the principal and the interest payments for one year on the mortgage for the property. The resulting number is CFBT. If the investor over-leverages the property (gets too large of a mortgage for the property to carry) or if interest rates go up, the investor may have a negative cash flow requiring them to borrow more or invest some of their own funds

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to carry the property. If a negative cash flow persists for too long, the investor may lose ownership of the property to the lender. If the cash flow is diminished or nonexistent, the owner cannot pay their debts. Even if an investor has not over-leveraged a property, cash flow can increase or decrease due to fluctuations in vacancy rates, unforeseen expenses, such as repairs and other economic variables. Other reasons for investment property debt include: • An investor may require funds for the purchase price, as well as for building modifications, repairs, and infrastructure. These additional costs are usually taken from the cash flow and can add to the property’s debt load. • Unexpected events, such as repairs or requests from tenants for modifications, can impact cash flow and increase debt. • Economic growth could mean that an investor has to lower leasing rates to be competitive resulting in reduced cash flow. • Economic contraction may result in tenants going out of business, causing empty units, and leading to a significant decrease in cash flow and reliance on an injection of the investor’s own cash.

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Lesson 1 | Page 9 of 13

Commercial Financing and Early Discharge In some instances, commercial lenders may charge a borrower fees to consider their mortgage application and to advance the loan (negotiable depending on the lender). A mortgage broker may also charge an investor a lending fee for use of their services, plus a fee for the commercial appraisal of the property and the legal fees to process the mortgage. All of these fees are paid by the investor before completing the purchase of commercial property. Early discharge is the term used by lenders to describe a borrower paying off a mortgage ahead of the due date. A lender will charge a borrower a fee for early discharge, and the fee could range from a three-month penalty to the full cost of the interest for the balance of the term of the mortgage. Mortgage prepayment, if permitted in the terms of a mortgage, typically requires three months’ interest penalty or the difference between the interest rate for the existing mortgage and the current rate for a comparable remaining term (if the current rate is lower than the rate on the mortgage), whichever is greater.

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Interest cost estimates are an important consideration regarding financing or negotiations on the sale of a property. An investor should determine the cost of an early discharge and then consult with an accountant to see if it is a good financial decision.

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Lesson 1 | Page 10 of 13

Commercial Property Vacancy Rates Vacancy rates can have a significant impact on cash flow. When vacancy rates are high, tenants have more choice and, therefore, may be able to negotiate more competitive terms for a lease. For an investor, this may mean reducing lease rates and providing amenities (such as leasehold improvements, a period of free rent, or free parking) to acquire tenants. When vacancy rates are lower, an investor can increase lease rates because tenants have less choice and less room to negotiate. Vacancy rates are something a lender will assess when considering an investor’s loan application. In addition, a lender may use their own data to adjust the vacancy rate figures from an appraiser. As an example, a lender may change an appraiser’s figures from five per cent to eight per cent to address their forward view of the marketplace.

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Lesson 1 | Page 11 of 13

Operating Expenses An investor must calculate revenue and operating costs to determine monthly cash flow. These figures are also required for a lender, who will use normal market costs when reviewing an investor’s application or financial statements. Costs include: • Property management: Commercial properties usually use offsite management companies. Property management companies charge a portion of gross operating income, depending on size of property, number of units, gross income, and location. It is important for an investor to calculate property management costs, even if they decide to manage the property themselves. Not including accurate costs can impact the net operating income and the cash flow before taxes. • Utility costs: With multi-residential or office properties, an investor should ask the owner for utility bills and then verify the owner’s utility rates and charges with utility companies. Utility costs vary from one municipality to another, from building to building, and according to the use of the building. Finally, an investor should analyze utility costs closely for month-to-month variations.

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• Taxes: An investor needs to understand which taxes they will have to pay and the amounts for each type. Taxes include property taxes, which can vary from one municipality to another, HST following the purchase, and income tax.

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Lesson 1 | Page 12 of 13

A salesperson is meeting an investor buyer who is purchasing an investment property. The investor is considering placing a down payment of 20 per cent of the total price of the property and borrowing the rest. However, the investor is not entirely sure about their strategy and wants their salesperson to offer their opinion. Which among the following would be appropriate advice to provide the buyer? There are five options. There are multiple correct answers.

1

Explain that commercial properties are seldom debt-free due to the amount borrowed and costs associated with financing and operations. However, the debt is enabling them to control a larger asset with a smaller portion of their own money invested as equity.

2

Tell the investor that they should borrow more money so that they can buy more properties with the same amount of capital, and they do not need to worry about debt levels or short-term cash flow.

3

Tell the buyer to pay off the mortgage early because it will be easier to sell their investment. Indicate that they do not need to be concerned about an early discharge fee because their lawyer can insert a clause to ensure no such fee is charged.

4

Recommend that the buyer meet with their accountant to get accurate information on their debt level and cash flow in the first year of their investment.

5

Tell the investor that investment growth is a common strategy, and that they should both invest and borrow more to upgrade their investment property and then increase lease rates. This, in turn, will allow them to prepay their mortgage.

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Lesson 1 | Page 13 of 13

Congratulations, you have completed the lesson! Completion of this lesson has enabled you to: • Identify key terms in financial and mortgage calculations • Identify factors affecting a commercial property's cash flow There are two sections on this page with a summary of the key topics that were discussed in this lesson.

Identify key terms used in financial and mortgage calculations

Understanding financial terms and key performance indicators will enable you to understand a buyer’s investment objectives and find appropriate properties for their consideration. This information will also enable you to have informed discussions about a buyer’s business plan, mortgage application, and financial projections of the proposed investment.

Discuss the key factors affecting a commercial property’s cash flow

Most commercial investment properties carry debt. Understanding the reasons behind commercial property debt will enable you to provide information about the pros and cons of commercial property investment to a buyer. It will also allow you to assist with mortgage selection and provide guidance as your buyer prepares a financial plan.

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Lesson 2 | Page 1 of 16

Lesson 2: How Financing Impacts an Investment Property and Influences an Investor’s Selection This lesson explores the importance of investors understanding financing options. It explores how mortgage financing can influence an investor’s selection of properties and the role of third-party professionals in commercial property transactions.

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Lesson 2 | Page 2 of 16

In order to best serve your investor clients, you will need to understand commercial property financing options and how financing impacts an investor’s goals and property cash flows. This will allow you to guide an investor so that they have the knowledge to work with a lender and clearly understand the importance of cash flows within their financing model. In addition, when working with commercial property investors, you need to be able to recognize the risks involved with commercial borrowing and what could happen if an investor defaults on their loan. You are already aware of the importance of third-party professionals, such as mortgage brokers, lawyers, and accountants, and their role in advising investors. With commercial property investment, some third-party professionals play a greater role in transactions, such as lawyers and accountants. Finally, understanding how mortgage financing can be influenced by factors such as the investor profile, property and lender type, and cash flow means that you will be in an ideal position to select properties that meet your buyer’s needs. Upon completion of this lesson, you will be able to: • Describe the importance of an investor understanding financing options • Describe how mortgage financing can influence an investor’s selection of a property Throughout this lesson, you will participate in decision points to test your knowledge on the topics presented.

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Lesson 2 | Page 3 of 16

Financing has a significant impact on an investor’s goals and cash flows because the type and size of a property an investor can buy depends on the amount they can borrow. In turn, the size of their mortgage payments will impact the investment's cash flow. Investors must understand the consequences of defaulting on a mortgage or other loan terms. The consequences can be severe and, therefore, it is important that investors work with third-party professionals, such as mortgage brokers, lawyers, and accountants.

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Lesson 2 | Page 4 of 16

Impact of Financing on an Investor’s Goals and Cash Flow For an investor, financing is a tool to buy a property they cannot afford with their own capital alone. Financing will always impact an investor’s goals and cash flow because an investor must pay back the debt and the cost of borrowing. However, the impact will depend on the amortization period and interest rate on the mortgage. In commercial real estate, the success or failure of an investment often hinges on favourable debt servicing terms. Leverage is the use of borrowed funds to make an investment real estate property in the hope of making a profit, in addition to the monies necessary to pay for borrowed funds. Leverage contributes directly to the yield realized on the equity invested in the commercial property. Positive leverage is achieved when an investor borrows funds, invests them, and gains a higher rate of return than the rate at which they were borrowed. However, the consequence of increased mortgage financing can be unpleasant if an investor lacks information or takes unnecessary risks, such as selecting the wrong property or not managing leases properly. These may result in diminished cash flow. Few real estate investments can consistently tolerate a high leverage ratio if there is not enough cash flow to pay the mortgage. © 2021 Real Estate Council of Ontario

Lesson 2 | Page 5 of 16

Consequence of Negative Cash Flow When faced with negative cash flow, an investor is forced to use capital reserves to pay their mortgage. Sometimes, this strategy reflects a conscious trade-off by an investor in the hopes of property value appreciation and, hence, a profit when the investor sells the property. Consequently, financial pain may be short lived and may not seriously impact the investor’s goals. However, if a negative cash flow continues for some time and an investor does not have capital reserves, the mortgage debt will exceed the market value of the property. In addition, interest rates may have increased by the time a mortgage is due for renegotiation. The likely scenario is one of three possibilities: • The investor will want to sell the property to try to recover whatever equity they can from the investment. • The investor may want to turn the property over to the bank. • The bank will exercise its legal right as appropriate in a default situation.

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Lesson 2 | Page 6 of 16

Consequences of Default and Other Loan Terms Default is a failure to fulfill obligations set out in the mortgage agreement. The most common default is failure to make payment, but there are other types of default. The consequences of defaulting on a mortgage payment or other mortgage terms can be severe. You should discuss the consequences with an investor in general terms. You should advise your buyer to review their mortgage terms carefully and discuss them with the lender. There are other types of default. For example, an investor can default if any covenant is not satisfied, such as the obligation to pay property taxes, the requirement to insure and to maintain the property in a good state of repair, or the stipulation to pay condominium common expenses. Other terms relevant to loans are: • Relief – Ontario’s Unconscionable Transactions Relief Act provides a borrower with court relief, should the interest rate charged be excessive. • Offset – Offset refers to an increase in a mortgage interest rate being offset by an increase in the amortization of the mortgage. • Extension of mortgage amortization – This is the refinancing of a mortgage so that it has a longer loan period, extending the amortization of the loan. © 2021 Real Estate Council of Ontario

Lesson 2 | Page 7 of 16

Potential Consequences of Default Most lenders have policies for action on default before resorting to legal recourse. Non-legal default remedies vary, but most establish timelines to communicate with the investor borrower, address payment problems, and seek to mitigate the situation, if possible. In some instances, debt consolidation may be appropriate. Immediate direct negotiations can often avoid costly legal disputes, maintain client relationships, and ultimately achieve the lender’s primary goal of an adequate return on funds invested. Lenders may pursue various legal actions regarding default. The following six sections contain information about six types of action that can be pursued by the lender. Power of sale Power of sale is a clause written into a mortgage note authorizing the lender to sell the property in the event of default in order to repay the mortgage debt. Ideally, the lender sells the property at market value to repay the mortgage debt. In Ontario, power of sale is the usual remedy of choice for a lender when an investor defaults on a mortgage.

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Quit claim deed From a legal perspective, the quit claim deed is a legal document wherein a person agrees to release any right that they may possess in a parcel of land. In the case of a mortgagor, the release involves the equity of redemption. This approach may be appropriate if no practical solution exists for the mortgagor to keep the property and the mortgagee agrees to provide them with a general release. The mortgagee then takes title to the property and the matter is at an end. A quit claim deed does not involve either covenants or undertakings and is a simple relinquishing of whatever rights or interests are vested in the mortgagor. If equity exists, the mortgagor could potentially bargain with the lender for a payment to satisfy equity in return for giving the quit claim deed. Even in the absence of any equity, this approach may prove best, given time and cost considerations. However, the mortgagee, in accepting a quit claim deed, not only acquires rights concerning the property, but also any problems associated with it and has no further recourse against the mortgagor.

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Suing for possession To sue for possession is a legal remedy available to the lender on the mortgagor’s default, typically combined with other actions, such as payment, possession, and power of sale. The mortgagor, until default, has quiet possession of the property unless provided otherwise in the mortgage or associated standard charge terms. The mortgagee has rights to take action for possession immediately upon default. No time limits are presently included in the Mortgages Act or in the vast majority of mortgages. In power of sale, ample notice must be given to the mortgagor before power of sale can commence. Possession can be effected peaceably (i.e., access to a vacant property) or by taking legal action for possession (i.e., sue for possession) and obtaining a writ of possession, which is enforced by the Sheriff. Such an action is commonly combined with a further action; for example, judgment for judicial sale or foreclosure.

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Judicial sale A judicial sale is an action to sell a mortgaged property through the court. It requires the court to sell the property and apply the proceeds to the mortgage debt. The lender must sue the borrower in court and wait for the courts to issue judgment. In addition to taking more time than a power of sale, it requires more legal work by the lender’s lawyers. Judicial sale is not a popular action in Ontario, as lenders prefer power of sale given the speed and lower costs. Suing for payment This is typically referred to as an action on the covenant, that being the implied covenant in the charge document relating to payment: that the charger or the charger’s successors will pay, in the manner provided by the charge, the money and interests it secures. Actions on other covenants can also be taken, such as the promise to pay taxes or the obligation to insure the improvements on the land.

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Foreclosure Foreclosure means suing the borrower for both possession of the property and payment of the debt. This is a lengthy process that involves going to court and leaving an investor with no funds if the lender sells the property. If a lender takes possession of the property, there is still a period of time in which an investor can redeem the property by paying off the mortgage (including the debt, any service charges, and outstanding interest) with the existing lender. Lenders may choose foreclosure when the value of the property is lower than the debt level and they are willing to hold onto the property until its value recovers. Foreclosure puts pressure on the investor to pay because it carries serious consequences, such as the loss of any interest in the property or equity in the property, and the loss of the right to redeem the property.

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Lesson 2 | Page 8 of 16

Role of Third-Party Professionals in Preventing Default The consequences of defaulting on a mortgage payment or other mortgage terms can be severe. You must discuss the consequences with an investor in general terms. You should advise the buyer to review their mortgage terms carefully and discuss them with the lender. Most importantly, you must advise them to seek the assistance of thirdparty professionals when required. The following four sections contain information about the role of third-party professionals. Role of a mortgage brokerage A mortgage brokerage is involved in packaging mortgages, obtaining approvals, ensuring that the mortgage commitment instructions are followed through, securing requested documentation, and addressing any last-minute issues at closing. Key strengths include market awareness for custom design mortgage loans to suit a borrower’s needs, negotiating ability to finalize terms/conditions between lender and borrower, and closing skills to gain commitment and acceptance by both parties.

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Role of an accountant An accountant will assist an investor with taxation, including tax deduction of the loan value, depreciation, and mortgage interest payments. They will also ensure that the investor’s budget takes into account mortgage and tax implications. An accountant can assist with strategies regarding transaction financing and succession planning.

Role of a lawyer An investor should get independent legal advice to minimize liabilities in the transaction. A real estate lawyer can assist an investor by drafting and analyzing agreements of sale, purchase, and associated offers. They will also prepare a preliminary title review for an investor at the time of deal negotiation before drafting the final offer. Both a lawyer and an accountant can be involved with assessing Harmonized Sales Tax (HST) and Land Transfer Tax. Applicability of these taxes on the property being considered for purchase should be confirmed. A lawyer will provide accurate information about the HST legislation, and make sure that the Ontario and any applicable municipal land transfer taxes are paid.

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Additional responsibilities of a lawyer Property surveys are reviewed by a lawyer, who will also review adjacent property titles to make sure there are no contraventions of the Ontario Planning Act. Detailed off-title searches are also done to make sure no outstanding payments exist on tax, water, or other utilities. A lawyer may review existing tenancy agreements and leases to avoid any unforeseen issues at the time of completion of the purchase transaction. All documents are executed at the time of closing.

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Lesson 2 | Page 9 of 16

A first-time investor is considering buying an apartment building that is forecast to appreciate in the next five years. They do not have a lot of capital and are exploring a proposed mortgage of $1.8 million with an interest rate of 5.45 per cent amortized over 30 years. The salesperson assists the investor with financial projections and notes that the annual return on the property would be 5.6 per cent. They explain to the investor that if their mortgage is approved, they will have a leverage ratio of 50 per cent, but this could increase in the coming years if interest rates and vacancy rates increase and values decline. Which of the following would be suitable advice for the salesperson to give to the investor? There are five options. There are multiple correct answers.

1

Advise the investor to make a slightly larger capital investment, as it would help in slightly reducing their leverage and not risk mortgage default should they encounter irregular (reduced) cash flows over a short period of time.

2

Tell the investor that the economy will likely continue to grow. Therefore, they can count on a strong cash flow and the property increasing in value in the coming years. The investor does not need to be concerned if there is an increase in interest rates or the impact of such an increase on their investment.

3

Point out that the return on their investment is relatively low given the cost of borrowing. If interest rates increase when their mortgage is renewed, they could risk mortgage default, or even power of sale if the economy has stalled.

4

Suggest that the investor not be excessively concerned about cash flow and use their own funds to cover costs if cash flow is poor. By counting on the value of the investment appreciating in a few years, the investor will receive a hefty sum when selling the property.

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5

Indicate that the apartment building is a great investment, and that the investor should consider reducing their investment and borrowing more. The higher payments should not pose a problem, given property value projections two to three years from now.

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Lesson 2 | Page 10 of 16

It is important that you understand the type of investor you are representing and their objectives. Some investors seek revenue from a property, while others wait for the property to grow in value. It is also important that you understand the key elements of a commercial property purchase that a lender examines as part of vetting a borrower. A lender will examine the property condition and type, as well as the type of investor applying for a mortgage.

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Lesson 2 | Page 11 of 16

Financing Based on Investor Profile The term “investor profile” describes a buyer’s resources, equity, portfolio, and risk tolerance. An investor profile determines properties that are appropriate for the investor, given their tolerance for risk, anticipated returns, holding period, and the amount of capital the investor has to invest. You need to understand the two main types of investors. This would allow you to effectively meet your buyer’s needs. The first is a value investor who is happy to be patient and wait for the appreciation and capital growth of the property. The other is an income investor who places a priority on cash flow from the property, starting immediately from the first month of ownership. Income investors are less concerned about the long-term capital growth of the property. Matching an investor’s profile with a lender may take time. Some lenders prefer to lend on apartment buildings, while others may prefer land development or industrial. The investor and their property preferences must be © 2021 Real Estate Council of Ontario

matched with the appropriate type of lender. When this happens, a detailed analysis of both the property and the investor is undertaken in an attempt to assess the lender’s risk. If a lender proceeds, a detailed, conditional lending package will be offered. The package usually contains many requirements to satisfy the lender. Some of these are loan-to-value ratio and debt service coverage ratio (DSCR). If the risk is judged to be high, then the loan-to-value ratio is likely to be reduced; for example, 50 per cent leverage ratio. If the risk is low, the loan-to-value ratio could be increased to 65 per cent.

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Lesson 2 | Page 12 of 16

Condition of the Property Depending on the condition of the property, a lender may require that certain improvements be carried out first. These could include a new driveway, roof repairs, or an upgrade of the HVAC system. These requests from the lender are to ensure the property will be attractive to renters and that the investor will be able to maintain rental income. An unkept building with liabilities such as a broken driveway is not attractive to tenants. A lender will develop a timeframe within which improvements must occur. Finally, insurance will be required to protect the lender from a variety of risks beyond the usual property damage and public liability. For example, there may need to be insurance on major assets like HVAC and roof repair/replacement. Insurance is a requirement of a lender’s mortgage application and the mortgage may not be advanced if adequate insurance is not in place. Also, if an investor has a history of poor property maintenance and difficult relations with insurance companies (e.g., insurance fraud), it may be difficult for the investor to obtain building insurance.

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From a lender’s perspective, the investor profile will be reviewed to determine what level of debt service coverage (DSCR) should be applied. The DSCR is always greater than 1 and could range from 1.1 to 1.5. It is also influenced by the economic environment at the time of lending and will be further explored in the later screens.

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Lesson 2 | Page 13 of 16

Influenced by Property Type When it comes to commercial property investments, residential multi-unit properties are easier and quicker to finance compared to office complexes or industrial buildings. They are therefore attractive to a larger number of investors. This is because they are covered by insurance from Canada Mortgage and Housing Corporation (CMHC). Lenders are more willing to approve loans at higher lending ratios to investors for residential apartments. Lenders can be more methodical when providing loans for industrial and office retail properties, because they are not covered by insurance from CMHC. Each property type poses unique challenges to an investor and will affect the amount of funds a lender will advance.

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Lesson 2 | Page 14 of 16

Influenced by Lender Type One of the most important factors regarding lender type is the lender’s safety margin. This is defined as the variance between the value of the property and the mortgage. An increase in the value of the property or additional mortgage payments will increase the safety margin. However, a decline in property value will reduce the safety margin. An investor making a larger down payment is better able to satisfy a lender’s requirement for a larger safety margin. The amount of down payment will determine what type of property can be purchased. An example of a lender establishing a safety margin is the amortization period of the mortgage. The lender may insist that the mortgage be amortized over a period shorter than that requested by a borrower. This means that

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more net operating income will be required for debt servicing because the lender would want to recover the loan in a shorter period of time and reduce their risk. A lender will also adjust and vary interest rates and debt coverage ratios, depending on the amount of cash flow projected in an investor’s loan application. The interest rates can also vary based on the borrower profile, the amount of equity they have, and the property profile. Leverage ratios will be determined by a lender. In setting the leverage ratio, a lender will consider the loan-to-value figure, which will include the amount of equity required. All factors a lender considers are based upon their perceived risk associated with the property type. A salesperson must be aware of the differences between lender types. They can be private lenders, banks, pension fund lenders, and insurance company lenders. They all have different thresholds for the amount of money they will loan, as well as timeframes. For example, insurance companies will loan larger amounts for longer periods of time, compared to banks or private lenders. The private lender will provide smaller loan amounts over a short term and charge higher fees and interest rates.

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Lesson 2 | Page 15 of 16

A salesperson is representing an investor who wants to buy a commercial property as an investment. The investor is new and cost-conscious and tells the salesperson they are looking at a purchase price of close to $1 million with a down payment of $200,000. They are keen on buying a small shopping centre or retail outlet, given the resurgence in bricks and mortar outlets. However, they may consider residential property if the location and condition meet their needs. Which property type would best suit the investor’s profile and would likely be approved by a lender? There are four options. There is only one correct answer.

1

A residential condominium with commercial lease space on the ground floor. This property is about 15 years old, in the suburbs, and slightly higher than the investor’s budget. It requires a new boiler and HVAC system. The fact that the building is somewhat run-down has led to disgruntled lease holders and some empty units.

2

A small shopping plaza near an industrial park on the edge of the suburbs. This property is exactly within the buyer’s price range. The area has an inconsistent level of foot traffic, and most of the current lease holders are fast food businesses, as well as a nail parlour, a convenience store, and a used computer store.

3

A condominium building with eight units not far from the city centre and near a local hospital. The purchase price is priced according to the market at $1.2 million and appraisal should support the value. The building is five years old and requires minimal maintenance.

4

A large, one-storey department store that has been refurbished to lease sections of floor space to highend niche retail outlets. This property requires strong management and marketing skills to meet tenant

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expectations. It is within the buyer’s budget and includes an Italian leather store, a delicatessen, a Canadian outdoors and winter clothing store, and a Japanese furniture shop.

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Lesson 2 | Page 16 of 16

Congratulations, you have completed the lesson! Completion of this lesson has enabled you to: • Describe the importance of an investor understanding financing options • Describe how mortgage financing can influence an investor’s selection of a property There are two sections on this page with a summary of the key topics that were discussed in this lesson.

Describe the importance of an investor understanding financing options

Understanding how cash flow impacts the investor’s goals will enable you to present suitable properties and provide some guidance to their financial planning. You will understand the impact of default and other loan terms, in addition to the role of thirdparty professionals in commercial property transactions.

Describe how mortgage financing can influence an investor’s selection of a property

An investor’s profile and their selection of property can either be approved or turned down by a bank, depending on the bank’s assessment of the investor and their safety margin. It is important that you take into account all aspects of a lender’s profile and a property, as well as a lender’s safety margin, when representing a buyer.

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Lesson 3 | Page 1 of 14

Lesson 3: Debt Service

The lesson explains the concept of debt service on an investment property and the factors that impact the annual debt service. The lesson describes what a lender is looking for to ensure that service obligations will be met.

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Lesson 3 | Page 2 of 14

A salesperson must understand how debt servicing works, because for most investors one of their first conversations about debt servicing will be with you. Therefore, you need to understand mortgage calculations so that you can answer an investor’s questions and, if required, attend meetings with a buyer and a lender. You will also need to understand how debt servicing impacts the purchase of an investment property. With this knowledge, you will be able to support an investor during their business planning and mortgage application process. Debt service is affected by the quality of a property and a lender will often require assurance that there is sufficient net operating income to support a requested mortgage. Finally, you should understand the application of the debt service coverage ratio by lenders so that you can help your buyer ensure that there is a steady and adequate cash flow to cover all debt. Upon completion of this lesson, you will be able to: • Explain the impact of debt service on an investment property • Indicate what impacts the annual debt service • Indicate what a typical lender is looking for in a debt service coverage ratio Throughout this lesson, you will participate in decision points to test your knowledge on the topics presented.

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Lesson 3 | Page 3 of 14

The vast majority of commercial investors borrow money to buy an investment property. Such a large loan must be serviced regularly with payments to the lender. It is important that investors understand the consequences of debt service on an investment property, and the factors that impact the debt service.

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Lesson 3 | Page 4 of 14

Quality of an Investment Property Financial institutions establish lending criteria for various types of properties. One important criterion for lenders is the quality of a property. The reason a lender uses the quality of a property to assess a mortgage applicant is because they want to ensure that a property is in good condition and is competitive in terms of presentation and appearance. A property that is attractive and well-maintained will attract tenants more readily than one that is run-down. A lender may require certain repairs to the investment property before approving a mortgage. This could mean that the investor must borrow more money to carry out the repairs. In addition, the investor may have to pay a larger down payment or pay a higher interest rate on their mortgage if they borrow more.

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Lesson 3 | Page 5 of 14

Lender Holdback A lender holdback refers to funds not being advanced by the lender until specific requirements and/or conditions are met by the borrower. A lender typically requires a holdback of funds involving resale properties until certain work is completed or repairs are made to a property being considered for mortgage financing. These requirements or conditions usually relate to the quality of the property, because a lender will want to see that the quality is high to retain and to attract tenants. This could apply when the electrical service needs to be upgraded, the furnace replaced, siding installed, or structural changes made. Normally, when a holdback is required, a specified time limit is set for completion of work along with a re-inspection of the property.

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Lesson 3 | Page 6 of 14

Lender’s NOI Requirements Your role is to guide the buyer and to ensure that they understand each stage of the purchase process. For new investors, this requires ensuring that they understand the key financials a lender is looking for before they approve a mortgage. The key here is the net operating income (NOI) to annual debt service and debt service coverage ratio. A lender will analyze the property’s income, the length of leases, and the quality of tenants to evaluate the risk of a loan. The higher the property income, the better the debt service coverage, and the higher the debt service ratio, the more motivated the lender may be to approve a loan. With this information, an investor knows what kind of safety margin is required to meet debt service requirements should their NOI decrease.

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A lender aims to ensure that the NOI will meet debt service obligations. For a lender, this means determining the NOI and that a safety margin exists if the NOI falls. A lender does this by looking at debt service coverage ratios and financial statements. A safety margin indicates that the investor can still pay their mortgage even if there is a fall in their net operating income. Typically, a lender will require a debt service coverage ratio higher than 1.0 (for example, 1.2, 1.3, or 1.4) in order to provide a cushion so that if the NOI declines, the buyer will still be able to pay their mortgage. A lender wants an appropriate spread between the NOI and the annual debt service. An example is an NOI of $100,000, and the annual debt service is $80,000, will result in a 1.25 debt coverage ratio. This would meet the test of most lenders in economically stable times. In times of uncertainty, the ratio will be much higher.

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Lesson 3 | Page 7 of 14

Application of the Debt Service Coverage Ratio by Lenders For commercial lenders, the debt service coverage ratio (DSCR) is a significant ratio and a key consideration when analyzing the level of risk attached to an investment property. The debt service coverage ratio is defined as net operating income (NOI) divided by annual debt service (ADS). DSCR = i. e. ,

Net Operating Income Annual Debt Service

$120,000 (NOI) = 1.2 (DSCR) $100,000 (ADS) © 2021 Real Estate Council of Ontario

By calculating a DSCR, a lender will be able to determine whether the NOI generated by a property will comfortably cover loan repayments, including payments on fees and interest, as well as principal. The importance of the DSCR to an investor’s mortgage is that it is the financial measurement used to decide whether they should receive a loan based on the level of cash flow the investment generates, and whether this is adequate to cover the mortgage costs.

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Lesson 3 | Page 8 of 14

A cautious, first-time investor is planning to purchase an office building with historically good occupancy rates. The buyer has spent a significant amount of time with their accountant reviewing the financials. The net operating income (NOI) of this property is $845,000. Based on the lender’s criteria of the debt service coverage ratio, the buyer believes the property can support monthly mortgage payments of principal and interest (blended) of $58,680. The lender typically this formula to calculate the debt service coverage ratio: Debt Service Coverage Ratio(DSCR) = NOI/Annual Debt Service (ADS) i.e., 1.2 = $845,000 ÷ ($58,680 × 12)

Immediately ahead of a meeting with the lender, the investor’s lawyer calls to tell them that some tenants may not renew at the end of their lease. However, your research shows a buoyant market and no reason for concern. The investor says that they are now hesitating about proceeding with the investment ahead of a meeting with their lender. Which of the following would be appropriate to discuss with the investor? There are four options. There are multiple correct answers.

1

Review the debt service coverage ratio with the buyer, and reiterate that their ratio of 1.2 is positive, leaving room for debt service even if the property is short of tenants for a period of time.

2

Tell the investor that when they calculate their debt service coverage ratio, they must only account for the loan they are applying for, and not for any other debt attached to the property.

3

Suggest that the investor not be excessively concerned about cash flow and that they can use their own funds to service debts if cash flow is poor. By counting on the value of the investment appreciating in a © 2021 Real Estate Council of Ontario

few years, the investor will receive a good return when selling the property and will be able to cover any outstanding debts.

4

Indicate that in the coming months the investor may be able to improve his debt service coverage ratio by exploring a number of possibilities, including higher leasing rates for new tenants, sourcing more competitive property management contracts, or by tightening other aspects of their budget, such as marketing.

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Lesson 3 | Page 9 of 14

Net Operating Income and Annual Debt Service Lenders often require a debt service coverage ratio of 1.2 or higher when considering loan applications for rental property and other commercial ventures. In other words, for $1.00 of debt service, a net operating income of $1.20 is available to service that debt. Example: A buyer is seeking financing for an existing rental property. The lender requires a minimum debt service coverage ratio (DSCR) of 1.2. A reconstructed operating statement has been prepared based on the previous year’s income and expenses. The net operating income (NOI) is $28,373. The borrower is seeking a loan with monthly payments of $1,670 per month. DSCR =

$28,373 $28,373 NOI = = = 1.42 12 x $1,670 $20,040 ADS

A 1.42 DSCR is greater than the lender’s requirement of 1.20, which means the buyer would qualify for this loan if this metric was the sole consideration.

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Lesson 3 | Page 10 of 14

Low and High Ratios A ratio of 1.2 is generally the minimum requirement for investors by most lenders in Ontario. A ratio lower than that will likely not be approved by a lender because the available cash to service the debt is small, and any changes in the economy or business could diminish the net operating income and make it difficult or impossible to service the debt. A ratio greater than 1.2 is attractive to a lender and increases the appeal of the investor applicant because it minimizes the lender’s risk. It also minimizes the investor’s risk and makes it more likely that they can make mortgage payments even if the debt service coverage ratio falls slightly.

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Lesson 3 | Page 11 of 14

Buyer’s Equity or Down Payment The amount of the down payment is determined by the lender, even though it is being made by the investor. The lender will consider elements discussed earlier, such as loan to value ratio and the safety margin. The property that the investor is interested in will be appraised on behalf of the lender by a third-party professional appraiser, and this will also influence the market value and loan amount. A lender will then loan the lesser of the two: the purchase price or the appraised value. You must be knowledgeable enough to discuss with the investor the final sale price of the investment, including all closing costs so that they are financially prepared to complete the transaction.

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Lesson 3 | Page 12 of 14

How NOI is Calculated and Restructured Statements As you learned earlier, net operating income (NOI) is a calculation used to analyze the profitability of incomegenerating real estate investments. NOI equals all revenue from the property, minus all reasonably necessary operating expenses. NOI is calculated by totaling the real estate revenue and deducting operating expenses. NOI is a before-tax figure, appearing on a property’s income and cash flow statement; it excludes principal and interest payments on loans, capital expenditures, depreciation, and amortization. When an investor is considering buying a property, it is important that they have access to what is called a restructured statement (also called a normalized financial statement). A restructured statement shows costs that are applicable to and can be used in the general marketplace. Therefore, it does not include item costs that are applicable to a previous owner. This document is an important part of an investor’s financial preparation, so that they understand the costs of owning the property. To create a restructured statement, an accountant will obtain a seller’s financial statement from their accountant for tax purposes and remove items that are only applicable to that owner. The accountant will attempt to restructure the statement so that it is more generic and unique to the operation of the investment property.

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Lesson 3 | Page 13 of 14

An investor has $850,000 equity and wants to be approved for a mortgage of $1,000,000, with monthly payments of $9,625, to acquire an income property that has a net operating income (NOI) of $185,750. The lender has a guideline of 1.35 for debt service coverage ratio (DSCR). What is the DSCR in this scenario? Will the investor qualify for the mortgage based on the DSCR? Debt Service Coverage Ratio = NOI ÷ ADS

There are four options. There is only one correct answer.

1

Yes, the investor will qualify for the mortgage with the lender because the DSCR is higher than the lender’s guideline of 3.00.

2

Yes, the investor will qualify for the mortgage with the lender because their DSCR is higher than the lender’s guideline of 1.35.

3

Yes, the investor will qualify for the mortgage with the lender because the DSCR is lower than the lender’s guideline of 1.35.

4

No, the investor will not qualify for the mortgage with the lender.

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Lesson 3 | Page 14 of 14

Congratulations, you have completed the lesson! Completion of this lesson has enabled you to: • Explain the impact of debt service on an investment property • Indicate what impacts the annual debt service • Indicate what a typical lender is looking for in a debt service coverage ratio There are two sections on this page with a summary of the key topics that were discussed in this lesson.

Impact of the debt service ratio on an investment property

You must understand the impact that servicing the debt has on an investment property, so that you can discuss this confidently with buyers. An investment must produce enough net operating income to support mortgage payments. This means a debt service ratio of 1.1 or higher for most lenders.

Indicate what a typical lender is looking for in a debt service coverage ratio

Part of your work will be to understand what lenders seek when they examine the finances of a potential borrower. A key element is the positive debt service coverage ratio, based on net operating income and annual debt service. A higher ratio is more appealing to a lender, while a lower ratio may not be acceptable. Part of the financial preparation is the presentation of restructured statements for the investment property.

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Lesson 4 | Page 1 of 14

Lesson 4: Calculating Mortgage Payments

This lesson explains in detail the steps necessary to calculate a mortgage. The lesson presents variations for the learner, including changes in the amortization period and the amount of principal.

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Lesson 4 | Page 2 of 14

Although lenders are ultimately responsible for providing an investor with a mortgage calculation, an investor will often ask you to produce mortgage calculations for the various properties in which they are interested. By being able to perform these calculations, you will be able to assist an investor in determining which property they can afford and which is the most attractive investment. You can also assist an investor to calculate the annual amount of the blended mortgage payments, including both principal and interest. Some mortgages have variations to their payment options. These include a change of interest rate, the amortization period, the amount of the principal, and in the frequency of payments. Knowing how to apply variations to mortgage payment calculations will allow you to explain an amortization schedule and how it applies when using the calculator. You will also be able to work with an investor to explore the amount of principal and interest paid within a specific period, and the remaining balance of the mortgage at the end of the term.

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Upon completion of this lesson, you will be able to: • Calculate mortgage payments and apply variations to a mortgage payment • Use an amortization schedule and know how it applies when using a calculator • Describe how mortgage financing can influence an investor’s selection of a property Throughout this lesson, you will participate in decision points to test your knowledge on the topics presented.

© 2021 Real Estate Council of Ontario

Lesson 4 | Page 3 of 14

Calculating a mortgage payment will require the use of a financial calculator or online tools. The reason why a simple, scientific calculator could prove inadequate is because commercial and investment real estate usually involve rental income, which involves investment compounding. This aspect is best calculated on a financial calculator. A simple calculator may be able to perform the same calculation, but it is likely to take much longer and is less efficient. As a salesperson, you should have some knowledge of using a financial calculator. There are over 10 models of financial calculators across many brands and they will have all the functions necessary, but each is distinct in that, they have different keystrokes and the inputting will vary. Once you decide on the model you intend to use, it is recommended that you go through the user manual for the respective financial calculator to educate yourself on the use of keystrokes.

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Lesson 4 | Page 4 of 14

The Financial Calculator and Online Tools A salesperson is routinely involved in mortgage discussions and financing options. Calculator techniques can help in quickly addressing borrower questions. Financial calculators have flexibility when analyzing mortgage terms, calculating principal, interest and balances outstanding, and applying different payment frequencies to tailor mortgage payments for borrowers. Calculations are for general discussion purposes only with an investor. Clients must discuss specifics with appropriate lenders, mortgage brokers, or other professionals. Typically, calculators can store and calculate using 12-digit numbers and display to two decimal places, unless modified by the user. Keep in mind that lender mortgage tables and calculations may differ slightly from calculator results. There are various online tools a salesperson can use for mortgage calculations. These include websites accessible through local real estate boards, lender websites, and apps available from the App Store and Google Play. Most of these tools are fast and easy to use.

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Lesson 4 | Page 5 of 14

Using a Financial Calculator To perform the mortgage calculations in this module, you need a financial calculator. You can buy any brand you like and make sure that you read the user’s guide to get familiar with the functions of your calculations. The basic terms (icons) involved will be as follows: • Period per year (P/YR) • Number of periods in your calculation (N) • Present value (PV) • Annual interest (I/YR) • Periodical payment (PMT) • Future value (FV) Initially, make sure that the calculator is set to End Mode, and not Begin Mode when calculating a Canadian mortgage. However, in general, the learner can switch between the Begin Mode (used when payments occur at the beginning of each period) and End Mode (used when payments occur at the end of each period). In a typical calculation, the rate given is a posted rate that the bank will compound twice a year, not in advance. That is, it is a nominal rate with a period per year (P/YR) of two. However, mortgage payments are made monthly (PMT) in this whole module, which is also a common payment frequency in real life. To convert the semi-annual rate (calculated twice a year) to a monthly nominal rate (set to 12 times a year), you have to do the following calculation: • Set the period per year to two (P/YR = 2) • Store the stated interest rate to the nominal rate (NOM%) • Solve for the annual effect rate (EFF%) • Change the period per year to 12 (P/YR = 12) • Solve for the new nominal rate (NOM%) under 12 periods per year

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Once you have converted the rate, you can enter the other known variables of N, PV, PMT, and FV. The remaining one is the unknown, which is also the answer you want to find out. For example, if the mortgage is a fully amortized one for 25 years, for an amount of $400,000 (PV), the N will be 300 (25 years x 12 months), and FV will be zero (a fully amortized mortgage has a future value of zero). After entering all the known variables, you can solve for the payment (PMT). If you are the borrower, the PV should be positive, as it is the money you will get from the bank on closing, and the payment will be negative, as it is the money you have to pay. If you are the bank, then PV should be negative, as you have to pay to the borrower on closing, but the payment will be positive. The rule is simple – positive for money received and negative for money paid out. Note: The names of the registries, such as PMT, EFF%, and NOM%, may not be the same in all financial calculators. Please refer to the user’s guide for the names used in your calculator. For most financial calculators, you will need to clear all registries in your calculator (such as “Shift C”) after each calculation; otherwise, old information may corrupt new information and you will obtain incorrect answers.

© 2021 Real Estate Council of Ontario

Lesson 4 | Page 6 of 14

Blended Mortgages, Including Principal and Interest The typical mortgage in Ontario is a blended payment mortgage made up of principal and interest. Borrowers make one monthly payment towards both principal and interest. For example, a figure of $5,672.32 is the total monthly mortgage payment. To calculate the annual amount of the blended payment mortgage, multiply the monthly payments by 12, and the result is $68,067.84 (annual debt service). Since it is a blended payment including both principal and interest payment, a salesperson will have to use a calculator or software to find out the interest portion and the principal portion separately. A salesperson should be aware of the federal Interest Act. Under the Interest Act, interest in a blended mortgage payment can only be calculated semi-annually and not in advance as a maximum. When you are dealing with a mortgage (which is a loan to real estate), by law it cannot be compounded more than semi-annually and not in advance. Alternatively, an investor could get an interest-only loan, whereby the interest only is covered in payments throughout the term of the mortgage. © 2021 Real Estate Council of Ontario

Lesson 4 | Page 7 of 14

An investor has a first mortgage of $786,500 at a 3.95 per cent interest rate for a threeyear-term and amortized over 21 years. What would the monthly mortgage payments be? There are four options. There is only one correct answer. 1

$4,583.87

2

$23,116.42

3

$4,582.19

4

$4,464.40

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Lesson 4 | Page 8 of 14

Changes in the Interest Rate or Amortization Period An investor will face a change in interest rate when their mortgage is up for renewal at the end of the term, or if they refinance. This may or may not mean a change in the amortization period. A change in the amortization period may depend on the investor and lender requirements. In a full amortization scenario, the number of periods is declining towards zero as the mortgage is paid off. To understand a change in interest rate, here is an example. An investor is considering the refinancing of a multiunit residential apartment building. A lender will advance the mortgage and offers the investor two options. One will save the investor money: 1. $475,000 mortgage @ 9.25 per cent with a term of 20 years and an amortization of 20 years. 2. $475,000 mortgage @ 9.00 per cent with a term of 15 years and an amortization of 15 years. The amount of interest saved can be determine by performing the following calculations.

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Option 1: N (total number of periods) = 20 x 12 = 240 I (nominal monthly interest rate after conversion) = 9.0766% PV (Present Value) = $475,000 FV (Future Value) = 0 You will get the PMT (Payment) as –$4,297.13, the negative sign indicates the money is a payout. The total interest paid for the entire amortization period could be calculated as follows: Monthly payment of $4,297.13 x 240 payments = $1,031,311 less the original amount of $475,000 indicates total interest paid of $556,311 (rounded). Option 2: N (total number of periods) = 15 x 12 = 180 I (nominal monthly interest rate after conversion) = 8.8357% PV (Present Value) = $475,000 FV (Future Value) = 0 You will get the PMT (payment) as –$4,771.46, the negative sign indicates the money is a payout. The total interest paid for the entire amortization period is $383,863.63. The interest difference is $556,312.16 – $383,863.63 = $172,448.53. That is, $172,448.53 in interest is saved by choosing the 15-year mortgage option. The total interest paid for the entire amortization period could be calculated as follows: Monthly payment of $4,771.46 x 180 payments = $858,863 (rounded) less the original amount of $475,000 indicates total interest paid of $383,863 (rounded).

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Lesson 4 | Page 9 of 14

Change in the Amount of Principal Typically, a commercial investor cannot pay off a lump sum or reduce their mortgage principal during the term of their mortgage. There are more options available in residential mortgages. However, when a commercial mortgage comes up for renewal, an investor can decide to increase or reduce their mortgage. This results in a change in the amount of principal.

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Lesson 4 | Page 10 of 14

An investor is facing a changing interest rate. They have $1,793,500 mortgage for a threeyear-term and an amortization over 21 years first at an interest rate of 9.75 per cent. The new interest rate is 8.25 per cent. How much money will the investor save on the cost of interest between the two rates over the full amortization period? There are three options. There is only one correct answer.

1

$2,370,219

2

$423,795

3

$564,953

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Lesson 4 | Page 11 of 14

Calculating the Amount of Principal or Interest Paid There are times when an investor will want to know the financial figures for a specific period of time. This requires the calculation of the amount of principal and interest paid during a period within the overall amortization period. To determine these figures, here is an example. An investor has a $950,000 mortgage with an interest rate of 7.8 per cent, amortized over a period of 20 years with blended monthly payments. You would perform this calculation to calculate the amount of principal and interest paid in the first six-month period. N (total number of periods) = 20 x 12 = 240 I (nominal monthly interest rate after conversion) = 7.6762% PV (Present Value) = $950,000 FV (Future Value) = 0

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You will get the PMT (payment) as –$7,755.81, the negative sign indicates the money is a payout. The total principal paid in the first six months is $10,235.41. The total interest paid in the first six months is $36,299.43.

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Lesson 4 | Page 12 of 14

Calculating the Remaining Balance of the Mortgage at the End of the Term When a mortgage loan reaches the end of its term, it is time for renewal. An investor must know the balance of the mortgage ahead of renewal. To determine the remaining balance of a mortgage at the end of the term, here is an example. Five years ago, an investor had a $1,250,000 mortgage with an interest rate of nine per cent, amortized over a period of 20 years. You offer to calculate the remaining balance of the mortgage now that it has reached the end of its term.

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You should have these figures for your calculation: N (total number of periods) = 20 x 12 = 240 I (nominal monthly interest rate after conversion) = 8.8357% PV (Present Value) = $1,250,000 FV (Future Value) = 0 You will get the PMT (payment) as –$11,114.87, the negative sign indicates the money is a payout. Once the payment is calculated, an amortization to the end of the first five-year term or 60 payments would indicate the amount of outstanding principal at the end of the term. This is the amount that is still owed on this mortgage after five years of payments.

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Lesson 4 | Page 13 of 14

An investor acquired an income property for $3,800,000 and was approved for a 65 per cent leverage ratio resulting in a mortgage of $2,470,000 at an interest rate of 6.85 per cent amortized over 18 years and with a seven-year term, seven years ago. How much principal was paid in total over the seven-year term? There are four options. There is only one correct answer. 1

$1,839,946.18

2

$1,032,296.94

3

$630,054

4

$1,662,350.76

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Lesson 4 | Page 14 of 14

Congratulations, you have completed the lesson! Completion of this lesson has enabled you to: • Calculate mortgage payments and apply variations to a mortgage payment • Use an amortization schedule and know how it applies when using a calculator • Describe how mortgage financing can influence an investor’s selection of a property There are three sections on this page with a summary of the key topics that were discussed in this lesson.

Calculating a mortgage payment

Being able to calculate a mortgage payment allows you to provide an important service to your clients. They may often want to know figures when deciding how much capital to invest into a property ahead of applying for a loan. However, it is important to note that while your calculations can assist an investor, they must request final figures from a lender.

Applying variations to a mortgage payment

Variations in a mortgage payment are important considerations for an investor. A lower interest rate can result in significant savings for an investor.

The amortization schedule and how it applies when using the calculator

At times, an investor will request mortgage figures and may ask for your assistance with calculations. These can include calculating the amount of principal paid within a specific period of time. It is important that an investor understands that they should always ask their lender or accountant for final figures.

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Lesson 5 | Page 1 of 6

Lesson 5: Summary Practice Activities

This lesson provides a series of activities that will test your knowledge on the entire module.

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Lesson 5 | Page 2 of 6

This lesson provides summary practice activities. Throughout this lesson, you will participate in decision points to test your knowledge on the topics presented.

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Lesson 5 | Page 3 of 6

A first-time investor intends to invest in a shopping centre in a busy neighbourhood. Your role is to advise them on the key stages of the property search, mortgage application, and meeting with a lender. It is important that they understand the key elements of the profile property they are interested in, their own profile as an investor, and the lender type. Identify which of the profiles apply to the investor. There are five options. There are multiple correct answers. 1

Tolerance risk, amount of capital, holding period

2

The extent to which a loan is protected by property values or operating income

3

Able to maintain rental income

4

Level of debt service coverage ratio (DSCR) that should be applied

5

The safety margin is the value of the loan and the cash flow from the investment property

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Lesson 5 | Page 4 of 6

An investor is considering an investment property that they believe will appraise for $4,200,000. The investor would like to purchase this property using their 30 per cent equity investment. The property currently has a net operating income (NOI) of $375,000 and the monthly mortgage payments at the posted rate of 7.25 per cent by the lender would indicate about $22,555.17 based upon a 21-year amortization for commercial mortgage of $2,940,000. The lender requires a minimum of 1.35 on the debt service coverage ratio (DSCR) and a 65 per cent leverage ratio on any commercial mortgage to be considered. What is the DSCR and the leverage ratio for the investor based upon their desired approach? Will the investor qualify and be approved for the commercial mortgage based upon this lender’s lending criteria? DSCR =

NOI Annual Debt Service (ADS)

There are three options. There is only one correct answer. 1

Yes, the investor will qualify based on lender’s criteria for leverage ratio.

2

No, the investor will not qualify for loan because the DSCR is above the lender’s criteria (standards).

3

No, the investor will not qualify for the loan because although the DSCR is within the lender’s criteria, the leverage ratio is above the lender’s standards.

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Lesson 5 | Page 5 of 6

An investor has a $1,875,000 first mortgage on a commercial income property at an interest rate of 7.35 per cent amortized over 21-years, and monthly payments of principal and interest with a five-year term. The investor wants to know the total principal and interest they will have paid over the fiveyear term? There are four options. There is only one correct answer. 1

$1,645,643

2

$869,769

3

$640,415

4

$229,357

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Lesson 5 | Page 6 of 6

Congratulations, you have completed the lesson!

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Module Summary | Page 1 of 3

Module Summary

This lesson contains a summary of the entire module.

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Module Summary | Page 2 of 3

Congratulations, you have completed this module! This lesson will present a summary of Learning Objectives.

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Module Summary | Page 3 of 3

There are four sections on this page with a summary of the key topics that were discussed in this module. It is important that you familiarize yourself with the definitions of mortgage and Definition of Key Mortgage Calculation calculation terms. The definitions allow you to be financially literate and perform mortgage calculations to assist an investor. However, an investor should always seek Terms

final numbers from their lender. With the ability to perform calculations, you will be able to assist an investor with identifying factors that impact a commercial property’s cash flow. Completion of this lesson has enabled you to: • Identify and define the financial and mortgage calculation terms • Identify the factors which affect a commercial property’s cash flow

How Financing Impacts an Investment Property and Impacts an Investor’s Goals

An important part of commercial investment is helping new investors understand financing options. You should be aware of how financing impacts the investor’s goals, so that you can provide this information to an investor. You should also discuss the riskier side of investing, and ensure that a buyer understands the potential consequences of default and other loan terms. Completion of this lesson has enabled you to: • Describe the importance of an investor understanding financing options • Describe how mortgage financing can influence an investor’s selection of a property • Describe the role of third-party professionals, such as mortgage brokers, accountants, and lawyers

Debt Service

Commercial mortgage financing is complex, and a borrower has to fulfill a series of requirements to successfully qualify for a loan. A lender will look at the investor’s credit history and score, amount of capital, and experience. They will also take into account the type and quality of the property an

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investor wants to buy, and the property’s potential for covering mortgage payments. A lender requires assurance that there will be sufficient income to support mortgage payments, and that an investor can meet the debt service coverage ration of the lender. Completion of this lesson has enabled you to: • Explain the impact of debt service on an investment property • Indicate what impacts the annual debt service • Indicate what a typical lender is looking for in a debt service coverage ratio

Calculating Mortgage When working with commercial investors, it is important that you know how to perform mortgage calculations so that you can calculate a mortgage payment. This can be Payments performed with a financial calculator or online tools.

You should also ensure that you are able to calculate a change of interest rate and a change in the amortization period, as well as a change in the amount of principal and frequency of payments. Completion of this lesson has enabled you to: • Indicate what a typical lender is looking for in a debt service coverage ratio • Calculate a mortgage payment • Describe how to apply variations to a mortgage payment • Describe the amortization schedule and how it applies when using a calculator

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V7

Module 4: Property Analysis and Valuation Fundamentals Disclaimer: This is a reference document which contains pages from the Accessible eLearning module. You should complete the eLearning module to proceed to the next step. Please note that the accessible module on the LMS only contains the interactive pages and you need to go through the content of this document thoroughly to attempt the interactive activities in the module. Please use Adobe Acrobat Reader (Recommended version 9 or above) to navigate through this PDF. Real Estate Salesperson Program ©2021 Real Estate Council of Ontario. All Rights Reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or in any means – by electronic, mechanical, photocopying, recording or otherwise without prior written permission, except for the personal use of the Real Estate Salesperson Program learner.

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Module 4: Property Analysis and Valuation Fundamentals In the previous module, you learned about the complexities of mortgage calculations, including their components, influencers, and their application in investment transactions. In this module, you will learn the different approaches to analyze a property, the elements of supporting documents, and how to apply these analyses in investment contexts. To check your understanding of this module, you must complete all the activities in the online module. While navigating through the online module, click the Legislation button to view laws and regulations related to this module. The contents of the thumbnails this Accessible PDF.

and References from the module are added to support your learning throughout

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Menu: Property Analysis and Valuation Fundamentals

Number of Lessons Lesson Number

6 Lessons Lesson Name

Lesson 1

Components of Property Analysis

Lesson 2

Property Analysis from Three Different Perspectives

Lesson 3

Profit and Loss Statement

Lesson 4

Application of Property Analysis

Lesson 5

Summary Practice Activities Module Summary

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Lesson 1 | Page 1 of 19

Lesson 1: Components of Property Analysis

This lesson introduces the different value approaches of property analysis and provides a basic overview of a property analysis worksheet. The salesperson will be required to identify how to approach different kinds of properties depending on their individual characteristics and how to use documents to accurately prepare a property analysis worksheet.

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Lesson 1 | Page 2 of 19

It is imperative that you understand the process and methodology of property analysis and when to apply different approaches based on an investor buyer’s objectives. This means not only understanding the purpose of property analysis on a step-by-step basis, including basic calculations, but also knowing the context for each approach. Being knowledgeable about property analysis will help you market properties for investors and buyers in an effective manner. Upon completion of this lesson, you will be able to: • Identify approaches to value and their application • Identify considerations when completing a property analysis Throughout this lesson, you will participate in decision points to test your knowledge of the topics presented.

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Lesson 1 | Page 3 of 19

As any buyer or investor will be primarily interested in the return that a property is going to generate, you must be knowledgeable about valuation methods and their application for different types of properties. At the same time, the seller’s perspective will be based on recent market history when attempting to sell a property.

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Lesson 1 | Page 4 of 19

Difference Between Market Value and Investment Value It is important for you to understand your investor buyer and their objectives for investing. During a transaction, you may be required to complete a property analysis worksheet, and one consideration would be whether to calculate the investment value or the market value of a property. Depending on their goals, the investor buyer will be more interested in one of these two perspectives, which will dramatically change how you will calculate and present an investment opportunity to them. In theory, market and investment values can be the same, but this is generally not the case. The following two sections contain information about the topic. Investment value Investment value refers to a return on a property investment that satisfies the requirements of the investor. The value of the investment is based more on the goals of the investor than on the details of the property. As such, emphasis is placed on cash flow after tax and individual tax liability when calculating the investment value. For example, an investor may need to be assured that they will achieve an eight per cent return on their investment. By calculating the return on investment, which will be discussed, you will be able to better select potential investment properties in a way that satisfies the needs of your buyer.

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Market value Market value is the price a typical buyer would be willing to pay for a property, and what a typical seller would accept when the property is exposed to the open market. This is assuming that neither the buyer nor the seller is under any undue pressure to sell or to buy. It is contextualized in relation to the typical buyer or investor rather than the specific circumstances of a buyer or an investor and developed using a reconstructed operating statement. You will need to understand how to calculate and understand these figures.

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Lesson 1 | Page 5 of 19

Overview of the Income Approach and Capitalization You will need to know about the income approach to value and capitalization because it reflects investment return. As any buyer will always want to know the prospective return on investment, you should understand how rate of return is calculated and how it is applied to a reconstructed financial statement to come up with an estimate of value. The income approach to value is a method of valuation that is used to estimate either market value or investment value through a process known as capitalization. The specifics of capitalization will be discussed later, but for now, it is best to understand it as the rate of return that is expected to be generated on an investment property, and is the mathematical process of converting income to an estimate of value. The formula for calculating a rate of return or what is formally known as an overall capitalization rate (OCR) is net operating income divided by value, or the purchase price of a property. Example:

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A buyer tells you that the property they are considering has a net operating income (gross operating income (GOI) minus operating expense = NOI) of $75,000, and that their required return on investment (their OCR), is eight per cent. The value of the property can be determined by dividing the NOI by the OCR. Net Operating Income = Value of the property OCR i.e., $75,000 = $937,500 8% If the buyer pays more than this value, they would not be able to achieve an eight per cent OCR. You should be able to appreciate the significance of return on investments from an investor’s perspective and know what the acceptable returns have been in the market. For example, if an investor is looking for an eight per cent OCR in an area where the average cap rate is no more than five per cent, you should inform the buyer that the market conditions would not support their expected rate. You must be knowledgeable about market conditions and what other investors in the area have found to be an acceptable OCR.

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Lesson 1 | Page 6 of 19

Overview of Direct Comparison Approach Another valuation method that you should understand is the direct comparison approach. Here, you will compare similar properties to estimate the fair market value of a property. You must be careful when choosing comparable properties. In a residential setting, it is easier to find comparable properties because of the nature of subdivisions, but commercial properties require more scrutiny due to their disparate shapes and sizes. When comparing revenue-producing properties, you will always focus more on the revenue and the return on investment (ROI) than on the physical characteristics of the building. Raw attributes like square footage and the age of the building still need to be considered, but they should be viewed in combination with the components of property analysis that focus on the return on investment.

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Lesson 1 | Page 7 of 19

Overview of Cost Approach and its Application The cost approach to value is based on the theory of substitution, or the notion that no informed buyer will pay more for an improved property than the price of acquiring a vacant site and constructing a building of equal utility and value. This valuation method requires estimates of land value, the current cost of constructing the improvements, and the accrued depreciation of the property. The depreciation is then subtracted from current construction costs to obtain an estimate of the improvement value. This valuation method is most effective when used for newer buildings that have less depreciation and more easily measured construction estimates. It is especially useful for properties where sales and income data are difficult to find or to ascertain, such as industrial and special-purpose properties (e.g., churches, libraries). The cost approach method is best applied when used in concert with other methods. The cost approach to value relies on the same basic formulas as the income approach to value, but it is a little more complicated as it also needs to account for the depreciation to achieve an accurate improvement value estimate.

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Lesson 1 | Page 8 of 19

Example for Overview of Cost Approach and its Application A buyer is looking for a return on investment (ROI) of 14 per cent on an industrial building lot. The value of the three-acre lot is estimated to be $675,000 and the zoning bylaws permit the construction of a building with a maximum area of 75,000 sq. ft. The building costs, including soft and hard costs, are $52.00 per sq. ft. What would the net operating income (NOI) of the property need to be to achieve the buyer’s expected return? In order to calculate the NOI, you will need to use the formula NOI = Value x Rate. Building cost: $52.00 per sq. ft. x 75,000 sq. ft. = $3,900,000 Land cost: $675,000 Total cost (Value): $4,575,000 Required NOI: $4,575,000 x 14% = $640,500 The buyer would need annual net rent of $8.54 per sq. ft. ($640,500 ÷ 75,000 sq. ft.) When using the cost approach to estimate the value of an existing property, depreciation is factored into the scenario to account for the effective age of the subject property. For example, in the given scenario, the building

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cost reflects the cost of constructing a brand-new building. However, if the subject property had an effective age of 20 years, then the cost to create new one would have to be reduced by the effective age. In this scenario, we are not estimating the value of an existing property, only the cost to create a new one. Therefore, no depreciation is required.

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Lesson 1 | Page 9 of 19

A salesperson should understand the difference between market value and investment value in order to best assist their buyer to negotiate a fair price during a transaction. Which of the following statements are true about market value and investment value? There are four options. There are multiple correct answers. 1

An appraiser working for a bank will work towards developing investment value of the property

2

Investment value may differ from one investor to another

3

Market value emerges from research of recent sales activities in the market by looking at the best comparable properties

4

Investment value always equals market value

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Lesson 1 | Page 10 of 19

A buyer approaches a salesperson about an industrial building lot. The value of the fouracre parcel is estimated to be $806,000. The zoning bylaw permits the construction of a building with a maximum area of 91,740 sq. ft. The building costs, including hard and soft costs as well as development charges, total $60.43 per sq. ft. A potential tenant would pay $10.25 per sq. ft. base rent. Calculate the return on investment (ROI) for this property. There are three options. There is only one correct answer. 1

15%

2

17%

3

20%

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Lesson 1 | Page 11 of 19

You will need to understand how to prepare a property analysis worksheet for a prospective investor buyer. The first thing to keep in mind is that a property analysis worksheet differs from an income statement that a seller may provide to their salesperson; this document may have been prepared by the seller’s accountant for taxation purposes and would be unique to the seller’s individual situation. The property analysis, on the other hand, does not focus on the seller’s tax obligations and instead calculates income and expenses to arrive at a generic NOI that may be achievable by anyone. The property analysis worksheet is meant to be an analytical document that can be used by investor buyers to perform various analyses on whether they should buy a property.

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Lesson 1 | Page 12 of 19

Identifying Other Income Sources A property can generate multiple sources of revenue based on the characteristics of the building. From an investment perspective, the principal source of revenue for a property would be the tenant rent, but there could also be other sources of revenue. These include laundry, parking, vending machines, billboards, storage space, and roof space rental for communications antennae and advertising. Some sources of revenue can be incidental. For example, an owner may rent out the side of their building to a company next door that wants to use it as advertising space because they do not have exposure to a street. This would be considered an incidental, secondary source of income that would not be tied directly to the owner’s business, which is collecting rent from tenants. When analyzing a property for purchase, you would need to consider all its income sources to evaluate how stable the investment is. For example, if a property had 10 tenants on leases, it would be defined and predictable revenue for the owner; however, if the income was coming out of a vending machine, a washer/dryer, or a billboard, the revenue would not be predictable and would not be an amount that could sustain the owner’s property. In fact, if a large percentage of the owner’s revenue from the property is dependent on unpredictable sources, it will not give an accurate representation of the revenue it may generate in the future. For example, consider a property that generates a large percentage of its revenue from its parking lot. If the municipality closes off the road to the property or if vehicle density in the area decreases, the parking lot will become redundant and revenue will drop. Similarly, a property that earns significant revenue from a billboard will not generate the same level of income when a neighbouring property builds a taller tower that affects the billboard’s visibility, rendering it unattractive for advertising purposes. © 2021 Real Estate Council of Ontario

Lesson 1 | Page 13 of 19

Requirement that Cash Business be Disclosed in Property Analysis The truth of many investment properties/businesses is that cash revenue has a habit of not being properly disclosed and recorded. Here is an example of a situation where you may run into issues with an investor buyer in relation to other income: An owner is trying to sell a laundromat and the revenue coming out of it is primarily in cash. A salesperson asks the owner to give an income statement that can be shared with prospective buyers. The income statement shows a gross annual revenue of $30,000, but the owner had mentioned to the salesperson that the business was earning about $100,000 a year. The salesperson asks the owner about this discrepancy explaining that they can only present to a buyer an amount that can be verified. To do otherwise would be in violation of Sections 21 and 38 of the Code. All revenue that is stated has to be formally stated and must be verifiable. Cash revenue is usually identified as “other income” on a property analysis worksheet or an income statement and the sources must be disclosed to a potential buyer. Other income is not included in the calculations for potential rent income, but it does need to be included in the final accounting for the amount to be accurate on a property analysis worksheet. You will likewise not apply the usual deductions for property vacancy and credit losses when recording other income, as they are not normally affected by rental occupancy levels.

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Lesson 1 | Page 14 of 19

The Importance of Using Documents to Verify Income You will need to verify all of an owner’s reported income. If an owner’s income statements show they earn $20,000 every year in laundry revenue, they will be required by the Canada Revenue Agency to maintain records that support those figures. Bank statements likewise need to show the amount of deposited cash. You can use a variety of documents to verify income information, including a tenant ledger/rent roll, leases, cash deposit books, and/or bank statements. © 2021 Real Estate Council of Ontario

Lesson 1 | Page 15 of 19

The Importance of Viewing a Minimum of Three Years’ History of Income Looking at the income of a single year can be somewhat distorted. Example: The income statement for a 20-unit apartment building for a single year shows that the owner of the building did not have any vacancies during that period. The building was fully leased, required minimum maintenance, and its operating expenses had no anomalies. You want to show this income statement as evidence that the property is performing exceptionally; however, a prudent buyer will want to look at a minimum of three years’ statements. The buyer will want to consider other years to evaluate the reasons for the owner’s success in the current year. Perhaps the reason for the owner’s success is because they invested in making the building energy efficient two years ago, or because the new leases in the building require the tenants to pay for their utilities whereas the owner previously absorbed those costs. To ensure a buyer receives the true financial picture of a property, you must perform a trend analysis of at least three years to assess how well or poorly the building is being managed.

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Lesson 1 | Page 16 of 19

© 2021 Real Estate Council of Ontario

Prepare the Property Analysis Worksheet and Calculate NOI When listing a property, you will be required to take the income and expenses of the building and recreate the information in a manner that would allow any prospective buyer to understand the amount of profit they may be able to generate with the property. You would remove tax-related calculations and expenses that are not related to the property, so that the analysis could apply to any investor. You would then be able to use this worksheet in the marketing of the building. With a property analysis worksheet, you will be collecting information about the revenue of the property. Lines 1 through 5 focus on income and are listed as Potential Rental Income, Vacancy & Credit Losses, Effective Rental Income, Other Income, and Gross Operating Income, respectively. Lines 6 through 23 focus on operating expenses (Real Estate Taxes, Utilities, and Contract Services), and can optionally include insurance, management, payroll, repairs, legal, advertising, and miscellaneous costs. Lines 24 through 28 focus on cash flow analysis and include Gross Operating Income, Total Operating Expenses, Net Operating Income, Annual Debt Service, and Cash Flow Before Taxes. When the owner subtracts all their expenses from the generated revenue, they get the net operating income (NOI)— the amount of money that would be available to the owner after the building has collected all its revenue and paid all its operating expenses. For an investor, this is an important number as it tells them how much money is available for their use. The investor could use NOI to pay their mortgage as mortgage debt is not included in operating expenses; it is unique to the owner.

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Lesson 1 | Page 17 of 19

The owner of a 10-unit apartment building approaches a salesperson with the intention of listing the building for sale. Upon inspecting the building, the salesperson determines that there are 12 parking spots, two vending machines, and two washing machines and dryers. The owner is willing to disclose bank statements and rent rolls for the previous five years. Which of the following items should be considered by the salesperson when preparing a property analysis worksheet? There are four options. There are multiple correct answers. 1

Rent roll

2

Cash statements for vending machine

3

Income statements

4

Cash statements for washers and dryers

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Lesson 1 | Page 18 of 19

A salesperson is trying to sell a strip mall retail complex. The effective annual rental income for the property is $386,432 and the owner is realizing $1,000 a month in other income. The owner’s annual operating expenses are $135,922. Calculate the NOI for this property based on these figures. There are three options. There is only one correct answer. 1

$262,510

2

$238,510

3

$251,510

© 2021 Real Estate Council of Ontario

Lesson 1 | Page 19 of 19

Congratulations, you have completed the lesson! Completion of this lesson has enabled you to: • Identify approaches to value and their application • Identify considerations when completing a property analysis There are two sections on this page with a summary of the key topics that were discussed in this lesson.

Approaches to value and their application

You must be able to recognize when to calculate for market and investment value, depending on whether you are analyzing a property for an individual or a general audience. Further, there are specific scenarios where it is important to use each valuation method— the income approach, cost approach, and direct comparison approach.

You must always verify the information you are receiving from a seller. Whether it is their Considerations when completing income/expense statements, other income, or cash business, all these statements need to match the recorded data. a property analysis

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Lesson 2 | Page 1 of 15

Lesson 2: Property Analysis from Three Different Perspectives This lesson outlines how a salesperson can tailor their approach to a property based on who will be examining the analysis. It also offers a step-by-step explanation of the individual lines of property analysis documents. The salesperson will be required to understand how the property analysis will be adjusted based on whether it is being made for a buyer or an owner, and how these calculations serve as the foundation for important income or expense information.

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Lesson 2 | Page 2 of 15

You should know the step-by-step process for filling out and calculating each line of a property analysis worksheet, and be able to reconstruct sections of the worksheet based on whether you are preparing an analysis for an owner or a buyer, and on their specified goals for an investment property. Sometimes those reconstructions can be as simple as eliminating expenses, but there are several other situations that could affect property analysis, including the use of pro forma statements. Upon completion of this lesson, you will be able to: • Identify different income and expense perspectives • Define the steps to complete a property analysis worksheet, using a sample worksheet provided Throughout this lesson, you will participate in decision points to test your knowledge on the topics presented.

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Lesson 2 | Page 3 of 15

You should know and understand how to adjust income and expense statements based on who you are preparing a statement for. This would mean not only adjusting income and expense statements for owners and buyers, but also knowing what the reconstruction represents and how it can be influenced by the financial forecast or projections.

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Lesson 2 | Page 4 of 15

Owner’s Perspective Income and expense from an owner’s perspective will usually be a detailed itemization of the owner’s actual revenue and expenses used to calculate tax liability. In order to create this, an owner will identify income from all relevant sources: legitimate business expenses defined by the Income Tax Act. The resulting number would be considered cash flow before tax (in other words, net operating income – annual debt service), the amount on which the owner would have to consider taxable income for that property. That document can then serve as a base for a reconstructed financial worksheet or a property analysis worksheet. An owner’s overall objective is to know the real profit associated with owning and operating a piece of real estate. You should always verify information about income and expenses reported in a statement; you must take steps to verify that the owner’s representation is accurate and must not rely solely on information provided by the owner. To do so, you may review property tax documentation or financial statements and tax returns prepared by an accountant. If the seller states major renovations, you can confirm the cost for the renovations with the respective service providers and view detailed contracts and paid receipts. You can also review insurance reports or any other third-party reports to verify the information provided by the owner.

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Lesson 2 | Page 5 of 15

Understanding and Preparing the Reconstructed Financial Worksheet The reconstructed financial worksheet, or reconstructed operating statement, typically represents a one-year analysis of income and expenses drawn from an owner’s statement, but, crucially, is free of owner influences. The owner’s personal situation could impact the income and expenses of a property. For example, consider an owner who owns 10 properties. A landscaping vendor may provide services at a highly discounted rate for obtaining contracts at all 10 properties. But an investor who purchases one of these 10 properties will not be able to obtain landscaping services at this rate. You should know the significance of the reconstructed operating statement, as it is often used to make an owner’s income statement more applicable to a larger audience. The owner’s income statement would show actual revenue received, but a reconstructed operating statement would use potential rental income and assume that a building was fully occupied. The document is meant to show a financial picture of the cash flow that any person could recreate. An expense needs to be deducted from an owner’s income statement that is used for taxation purposes. The statement shows an annual expense of $12,000 for leasing a half-ton truck for maintenance purposes. It is a legitimate expense from a taxation perspective, but the prospective buyers of that building may not need a half-ton © 2021 Real Estate Council of Ontario

truck. Therefore, this expense would be unique to the owner and not the building and would be removed from the owner’s operating statement. The reconstructed worksheet will itemize income and expenses unique to the building and give the buyer a perspective of what the cash flow from the building will be, with clarity of the expenses of the owner that may not pertain to the operation of the building.

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Lesson 2 | Page 6 of 15

Understanding and Preparing the Reconstructed Financial Worksheet The reconstructed financial worksheet, or reconstructed operating statement, typically represents a one-year analysis of income and expenses drawn from an owner’s statement, but is free of owner influences. You should know the significance of this document, as it is often used to make an owner’s income statement more applicable to a larger audience. The following four sections contain information about how the reconstructed worksheet is created. Potential income The first step in preparing a reconstructed worksheet is calculating the potential income, which could be different from the owner’s declared income. For example, the owner may not be taking advantage of the lawful rent increases permitted under the Residential Tenancies Act (RTA). You would need to understand what the potential revenue of the building could be independent of the current owner.

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Allowance for vacancy and bad debt An allowance for vacancy and bad debt is applied in the reconstructed worksheet. A landlord or owner may have no vacancies currently, but there is a likelihood that a rental unit will experience a vacancy at some future time. To adjust for this consideration, you will deduct a vacancy rate from the potential rent. Canada Mortgage and Housing Corporation (CMHC) estimates that an appropriate vacancy rate is anywhere between two per cent and five per cent. Net potential revenue and net operating income (NOI) Subtracting vacancy and credit loss from potential rent will result in the net potential revenue, also called gross operating income. When the operating expenses are subtracted from the net potential revenue, also called the gross operating income, you have calculated NOI, which is the amount of income that anybody who buys the building should be able to achieve.

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Expenses You will look at expenses such as insurance and taxes, as these numbers will stay constant regardless of the owner. You will then subtract any expenses that is unique to the owner. Excluded items usually include business taxes, depreciation, the cost of borrowing, and owner-related expenses that do not relate to the new owner’s operating criteria.

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Lesson 2 | Page 7 of 15

Preparation and Use of Pro Forma Statements Occasionally, a reconstructed worksheet will resemble a pro forma statement—typically used to secure financing or to attract investors for a start-up business. It is an estimate of income and expenses. In real estate, a property’s pro forma statement is essentially its cash flow projections. It is an important document that investors will consider when looking to buy a property. Example: An owner is selling an eight-unit apartment building and provides the salesperson with financial statements related to the building. However, the owner also has a proposal to add four more units to the building. On the reconstructed worksheet, the salesperson would therefore include revenue that may be realized from the four new units, even though the event has not yet occurred. Revenue from these four units would be considered a pro forma estimate and would be part of a reconstructed worksheet. Your involvement with pro forma statements can be quite common. Pro forma statements should be viewed cautiously, as it is often unclear who prepared the projections. If it is an owner or a businessperson who made the projections, then lenders and others may be less likely to rely on them due to the bias involved in their preparation. There is especially a potential for overestimating revenue and underestimating expenses. However, if the pro forma statement was prepared by an accountant and was based on historical market research, you could reasonably rely on its accuracy. Verification of the information used in the statement is always recommended.

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Lesson 2 | Page 8 of 15

Buyer’s Perspective From a buyer’s perspective, you need to look at a reconstructed worksheet where income statement expenses may be unique to the owner but may not be relevant to the buyer. That statement would not represent the financial position or cash flow for anyone other than the owner. You will remove items on the expense statement that would not be applicable to anybody else who may own the building. This reconstructed worksheet shows the figures that anybody who buys the building should be able to achieve.

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Lesson 2 | Page 9 of 15

A ceramics distributor has listed their 3,000 sq. ft. commercial building, which they had occupied for the last several years, for sale. If a potential buyer or investor were to rent the premises to new tenants, the buyer or investor would be able to generate an annual rental income of $48,000. Currently, the owner has annual operating expenses of $18,000, which includes maintenance, utilities, insurance, and property taxes. In addition, the owner leases a delivery truck for $8,000 per year with $4,000 in operating costs. The owner has also renovated the building this year and spent $12,000 on materials and labour. What is the estimated net operating income on the property? There are three options. There is only one correct answer.

1

$30,000

2

$18,000

3

$6,000

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Lesson 2 | Page 10 of 15

Once you have determined the goals of your property analysis and the end user, you will need to individually fill out the different lines in a property analysis worksheet based on the specifications of the property. These individual lines require some simple calculations and the property analysis worksheet will serve as a guide. However, it is important to understand what each of the terms represent and why they are important to the property analysis process.

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Lesson 2 | Page 11 of 15

Property Analysis Documents A significant part of the property analysis worksheet is the reconstructed financial worksheet. The property analysis worksheet has the ability to function from both the seller’s and the buyer’s perspectives. You will need to understand how to prepare a property analysis worksheet to analyze income and expenses from previous years to see if the recorded data is logical or if there are any anomalies. You must take care to accurately calculate these figures and verify the information that you are given. You will also be using a reconstructed operating statement for your calculations. This document represents a oneyear analysis of income and expenses derived from an owner’s statement that has been adjusted to show typical revenues and expenses. Those adjustments are made based on research related to comparable properties. The reconstructed operating statement can also provide the basis of extended cash flow forecasts for a 5 to 10-year period.

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Lesson 2 | Page 12 of 15

Steps for Completing a Property Analysis Worksheet Now that you have reviewed the terms used in a typical property analysis worksheet, let us look at how these elements come together in a typical worksheet. The following six sections contain information about where the item appears on the form. Effective Rental Income Effective rental income estimates what the potential income will be in a particular time frame. It equals potential rental income minus any vacancy and credit losses.

Gross Operating Income Gross operating income is effective rental income plus other income. Other income sources could be parking, laundry, and signage.

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Operating Expenses Operating expenses are typically the following: real estate taxes, property insurance, property management costs, payroll, expenses/employee benefits, repairs and maintenance, utilities, accounting and legal costs, real estate leasing remuneration, advertising/licences/permits, supplies, and miscellaneous. Of course, not all of these expenses may find their way to the reconstructed worksheet. It would depend on the needs and objectives of the end user. For example, the new owner may not require the same number of employees as the existing owner; therefore, the payroll expense would need to be adjusted.

Annual Debt Service The annual payments for principal and interest equals annual debt service.

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Net Operating Income The net operating income is the gross operating income less operating expenses.

Cash Flow Before Tax The cash flow before tax equals the net operating income less the annual debt service.

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Lesson 2 | Page 13 of 15

Property Analysis Formulas and Terms Continued One of the most important sets of formulas are cash flow before and after tax, as they represent the final number that will be taxed and the after-tax income that the investor can use. You may use it to help an investor estimate the cash flow they can expect to receive from a property. The following three sections contain information on the various types of property interests. Cash flow before tax Also known as operating cash flow, cash flow before tax is calculated by subtracting the annual debt service (ADS) from the net operating income. Annual debt service is the sum of all debt payments in a specific year and in the case of a mortgage, it may be the interest portion of the payment that is recognized as an expense. For instructional purposes we will be considering both the principal and the interest components of a mortgage payment as debt service. This may vary depending on the requirements of the reader of the financial statements. Expert advice should be sought if cash flow before tax is being calculated on behalf of a client. Example: An owner has annual mortgage payments of $120,000 and their NOI is $199,781. Cash flow before tax is

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calculated by subtracting the annual debt service (ADS), which includes principle and interest, from the NOI. Formula: $199,781 (NOI) - $120,000 (ADS) = $79,781 (Cash Flow Before Tax)

Cash flow after tax Cash flow after tax is simply cash flow before taxes less the tax liability, which will be determined based on an individual’s marginal tax rate.

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Review owner’s statements if available You should always review the owner’s actual statements, if available, when completing the property analysis worksheet. If they are not available, you will need to obtain other documents such as the owner’s income tax returns, expense receipts, and property tax documents to assist with the preparation of the worksheet.

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Lesson 2 | Page 14 of 15

An owner contacts a salesperson about listing their eight-unit commercial building. The potential rental income is $115,200, other income is $9,000, the vacancy and bad debt allowance is three per cent, and the operating expense is $48,500. The owner currently has a mortgage of $500,000 amortized over 25 years at 10 per cent and repayable in blended monthly payments of $4,472. Select the options with correct calculation. There are six options. There are multiple correct answers.

1

Effective rental income is $111,744

2

Gross operating income is $120,744

3

Net operating income is $72,244

4

Annual debt service is $53,664

5

Cash flow after tax is $18,580

6

Cash flow before tax is $18,580 - tax liability of the owner

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Lesson 2 | Page 15 of 15

Congratulations, you have completed the lesson! Completion of this lesson has enabled you to: • Identify different income and expense perspectives • Define the steps to complete a property analysis worksheet There are two sections on this page with a summary of the key topics that were discussed in this lesson.

Income and expense perspectives

You will need to understand when to customize a property analysis worksheet. This can often just mean deleting expenses that will not be relevant to all buyers, but it can also require an understanding of how a property could change in the future.

Steps for completing a property analysis worksheet

You will need to understand the individual line items of a property analysis worksheet and how the information in income statements and other supporting documents can be used to complete the various formulas and requirements of property analysis. This is an essential part of any transaction involving investment properties.

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Lesson 3 | Page 1 of 11

Lesson 3: Profit and Loss Statement

This lesson discusses and elaborates on two different documents that are essential in separate transactional circumstances to understand the investment quality and to make projections about a property’s future earning potential. The salesperson will be required to explain the purpose of income statements and balance sheets and how they can provide a snapshot about the financial position of a property.

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Lesson 3 | Page 2 of 11

You should know about the supporting documents you will encounter when trying to sell an investment property, such as a profit and loss statement and a balance sheet. You will learn about the different characteristics of each of these documents, how they can be used to assess a property’s financial health through tools like horizontal and vertical analysis and ratio analysis, and who prefers to use each of these documents. Upon completion of this lesson, you will be able to: • Describe the purpose of a profit and loss statement • Describe what a balance sheet is and when it may be used Throughout this lesson, you will participate in decision points to test your knowledge on the topics presented.

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Lesson 3 | Page 3 of 11

The first of these documents is a profit and loss statement. You should know and understand how to read and interpret a profit and loss statement, which is also known as an income statement. This document can be used to make determinations about whether an investment property made a profit or loss over a period of time. It can also indicate the investment property’s cash flow, and even provide information about the future value.

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Lesson 3 | Page 4 of 11

Profit and Loss Statement A profit and loss statement or an income statement is a supporting document for a reconstructed worksheet. It is prepared by an accountant to determine the tax liability of the existing owner and is therefore not necessarily a cash flow statement. It does not reflect the overall financial picture of the property, just a specific time period. Even though accounting has a standard procedure for people to follow, you should be alert to the possibility that what one accountant or reader sees in a document can be significantly different from what someone else sees. Here are some individual characteristics of a profit and loss statement:

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• Details revenue and expenses: A profit and loss statement is a summary of the income and expenses over a defined period (typically one year). • Identifies if property generates a profit or loss: A profit and loss statement reflects whether a business made a profit or loss in a specified period. • Is used by analysts to determine available cash flow and compare performance: A profit and loss statement is used to evaluate the performance of an investment property by matching the revenue earned during a given time period with the expenses incurred in obtaining that revenue. • Gives indication of future value: You will need to understand that the income statement does not directly give an indication of future value, but by using the income approach with a provided item such as the net operating income, you can estimate the value.

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Lesson 3 | Page 5 of 11

Vertical and Horizontal Analysis There are two methods used in the analysis of a profit and loss statement. The following two sections contain information on the various types of property interests. Horizontal Analysis Horizontal analysis is a method of identifying trends in an income statement by placing two different years’ profit and loss statements side by side and comparing each individual item. This is a way of tracking whether income has increased or decreased.

Vertical Analysis Vertical analysis is another method of identifying trends in profit and loss statements, but instead of comparing two different statements, it looks at various line items within the same financial statement. This method is most often used with income statements where expenses are stated as a percentage of gross revenue. For example, vertical analysis may be used to analyze the percentage of salary expenses in relation to the gross income. The vertical analysis would be comparing one item (e.g., wages) vertically

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upwards to the owner’s gross income to see any changes.

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Lesson 3 | Page 6 of 11

An owner approaches a salesperson about listing their five-unit commercial building and provides the salesperson with a profit and loss statement for this purpose. How should the salesperson use the information in the profit and loss statement to list the building? There are five options. There are multiple correct answers. 1

Use it as a supporting document for the reconstructed worksheet

2

Use it as a cash flow statement

3

Use it to obtain the overall financial picture of a property

4

Use it to determine the profitability of the investment property

5

Use it to determine an estimation of future value

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Lesson 3 | Page 7 of 11

An investor who is considering purchasing a property asks their salesperson to determine whether the seller’s provided income and expenses for the past two years demonstrate a favourable trend. The salesperson conducts a vertical analysis of the seller’s statements. Which of the following can be achieved with a vertical analysis of the seller’s income and expense statements? There are four options. There is only one correct answer.

1

Compares a line item to other income statements

2

Indicates how much income has increased or decreased in a year

3

Compares different amounts within the same statement

4

Identifies significant trends based on period-to-period comparison

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Lesson 3 | Page 8 of 11

The profit and loss statement is a record of the income and expenses of an investment property over a period of time. The balance sheet, on the other hand, provides a snapshot of an investment property’s financial health for a specified moment in time. It only considers one year and shows what the property is worth and what it owns at one point in time. It may not necessarily indicate the profitability of the investment. Third-party professionals are more likely to rely on the balance sheet, but you will need to be aware of simple accounting and financial statements when dealing with investment properties.

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Lesson 3 | Page 9 of 11

The Balance Sheet While salespersons are generally more interested in profit and loss statements as they prefer to see the bottom lines, third-party professionals, such as accountants and lenders, tend to rely on balance sheets. It is a summary of a property owner’s assets, liabilities, and equity and can show whether an owner needs a loan or can comfortably pay their bills. The following three sections contain information on the various types of property interests. First statement of choice A balance sheet is useful for analysis, as it can paint a picture with respect to how well assets are being used. For example, the statement may reveal a balance of $200,000 in cash. The accountant may want to know why that money has not been used for business expansion or to invest in a property that can produce a higher yield.

Snapshot of financial position A balance sheet is only relevant to one particular period in time. Items can change quite rapidly, rendering the statement inaccurate. For example, if the owner prints a balance sheet for their company on a particular day, it might show specific data; but if that very afternoon the owner were to pay their tax bills, the balance sheet would no longer be accurate, as the tax liability would have been satisfied. The owner would have to produce a new balance sheet reflecting that tax payment.

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Financial ratios Financial ratios are a tool that can be applied to information in the balance sheet. These ratios are a swift and effective means of assessing financial strengths and weaknesses of a property. Key ratios can be grouped under liquidity, debt, and profitability. You would not be expected to make any analysis based on ratios, but you must understand that important information can be gleaned through the balance sheet, which can help in the decision-making process. The six ratios are as following: Current ratio: A ratio of current assets to current liabilities, which helps determine whether a business can meet short-term obligations. The formula is current assets divided by current liabilities. Acid test ratio: This is a variation of the current ratio that addresses only the most liquid assets of a company. Debt ratio: A ratio of total liabilities to total assets, which measures the proportion of assets financed by borrowings and can provide an indication of excessive debt. Debt service coverage ratio: This ratio compares NOI to total debt service. It is frequently used by loan underwriters to establish whether or not a business is capable of handling debt payments. The debt service coverage ratio is arrived at by dividing NOI by total debt service (principal and interest payments). The ratio

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should be in a positive range (i.e., above “1”) in order for income to properly address total debt service. Gross profit ratio: The gross profit ratio (also referred to as a margin when quoted in percentage terms) is a business indicator based on gross profit divided by gross revenue. The gross profit ratio is not designed for brokerage operations, but can be creatively adapted. As a recommended method, gross profit (gross revenue less all real estate remuneration payments), can be expressed as a ratio of gross revenue. Net profit ratio: A ratio based on the net profit (i.e., income before taxes) after payment of all expenses. It is often referred to as the bottom- line margin or return on sales (when expressed in percentage terms). Limitations detailed under gross profit ratio apply.

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Lesson 3 | Page 10 of 11

A seller provides their salesperson with a balance sheet to gauge the financial health of his building. Which of the following characteristics of the investment property can the salesperson determine, based on the balance sheet? There are four options. There are multiple correct answers.

1

Changes in income, expenses, and equity

2

The health of the investment property from perspectives of equity, cash, and debt analyses

3

Whether the investor has the strength to borrow and whether they need to borrow

4

The full financial picture of the property

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Lesson 3 | Page 11 of 11

Congratulations, you have completed the lesson! Completion of this lesson has enabled you to: • Describe the purpose of a profit and loss statement • Describe what a balance sheet is and when it may be used There are two sections on this page with a summary of the key topics that were discussed in this lesson.

Profit and loss statement

You will need to understand the purpose of a profit and loss statement, or income statement, and how you can use vertical or horizontal analysis to determine whether a property has made a profit or a loss over a specified period of time.

Balance sheet

You will need to understand what a balance sheet is, and how it differs from the profit and loss statement. The two documents differ in terms of their purpose, the people who prefer using them, and the duration of period they account for. Through ratio analysis, a balance sheet can be useful in determining the present financial health of a business, but you should understand that the figures are only a snapshot.

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Lesson 4 | Page 1 of 14

Lesson 4: Application of Property Analysis

This lesson addresses miscellaneous terms and concepts related to property analysis, including rule-of-thumb measurements, multipliers, and return on and return of investment.

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Lesson 4 | Page 2 of 14

Before investing in a property, an investor buyer will want to determine how the property is performing and how soon they can expect to recover their initial investment. There are several evaluation methods that you can employ to help the buyer understand the earning potential of a property. In this lesson, you will learn about three popular measurement types used to evaluate a property. These methods allow a buyer to gauge how soon they may be able to recapture their investment and how profitable the investment is likely to be. You will also learn about the common metrics used to measure commercial/industrial properties. Upon completion of this lesson, you will be able to: • Define various other terms used in financial analysis • Define other valuation methods Throughout this lesson, you will participate in decision points to test your knowledge on the topics presented.

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Lesson 4 | Page 3 of 14

You should know and understand the three popular measurement types (best understood as benchmarks rather than precise measurements), which can be calculated using information from a property analysis worksheet. Cash on cash, payback period, and break-even ratio are all evaluation methods that are used when comparing investment properties. The methods only take into consideration the investor’s capital and how long it could take for them to recapture the amount. Though the measurements are not precise, they offer a ballpark figure that can help you and the investor understand if the property is performing well. The reason why these three measurements are referred to as popular methods is because you are required to make several assumptions about the property in the reconstructed/property analysis worksheet while calculating cash flow before tax (CFBT). For example, the methods would not consider potential rent versus actual rent. What one person may believe to be an adequate vacancy rate may not appear so to another person. Similarly, CFBT— which is the prime consideration in the calculations—would not take into account the tax liabilities of the investment and the investor.

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Lesson 4 | Page 4 of 14

Cash on Cash Analysis Cash on cash analysis, or the equity capitalization rate, is a measure of profitability that helps answer an important question: How well is the investor’s capital performing? It is the relationship between a single year’s cash flow before taxes net operating income (NOI) minus annual debt service and the equity invested in that property. Once the building owner has collected all of the revenue and paid all the bills, the remaining amount would represent their NOI. The owner would then pay their mortgage; what is left would be the cash flow before tax

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(CFBT), (i.e., the amount the owner would pay income tax on). Cash on cash measurement is simply CFBT as a percentage of the owner’s investment, their equity. Cash on Cash = CFBT ÷ Investor’s Initial Investment Example: An investor pays $1,000,000 for a building and has $250,000 as down payment. The investor’s CFBT was $30,000 for this building. The $30,000 is a percentage of the owner’s invested capital, or $250,000 (as this was the amount that came out of the investor’s own pocket), which would be 12 per cent. This would allow the investor to estimate the return/profit they would be able to achieve on their personal investment. If the investor had invested the $250,000 in a bank, it would have earned a three per cent return, but by investing the money in a building, the investor is getting a 12 per cent return. Investors have numerous options for their capital and you should be able to compare the real estate investment to their other options. Even though the cash on cash method is useful as a comparison tool for most investors as it delivers a simple return on equity (ROE) number, it has limitations. This method does not consider potential for capital appreciation and it is a simple single period static indicator. Another limitation with cash on cash analysis is that properties will produce similar results even if they are completely different in terms of location, quality of tenants, structure, quality of construction, and need for repairs.

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Lesson 4 | Page 5 of 14

Payback Period The payback period, is the number of years of cumulative cash flow before taxes it would take to equal the initial investment or, alternately, the amount of time needed for an investor to recoup their initial investment. Like cash on cash, there are limitations, but the only figures required to calculate this number are the amount of equity investment and the cash flow before taxes. The formula for payback period is: Payback Period = Equity Investment ÷ CFBT for one year

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Example: An owner has paid $1,000,000 for a building and they are receiving $100,000 in CFBT every year. Based on those figures, it would take 10 years for the building to be worth more than the initial investment. Payback period does not consider the type of property; it only accounts for the invested capital. This measurement method also has limitations. Payback period is only concerned with the time it takes to recover the initial investment and delivers the number of years it will take for the investor to recover their money. There is no consideration given to capital appreciation, after tax amounts, or the factors that can affect income and expenses. Further, similar results can be obtained despite fundamental differences in properties, and there is no allowance for time value of money.

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Lesson 4 | Page 6 of 14

The Break-Even Ratio The third measurement, the break-even ratio, is a financial ratio used for property comparisons that is based on the gross operating income. The break-even ratio calculates what the investor would be left with after accounting for expenses and debt service. If gross operating income is higher than the total obligations, it would mean the investor is making a gross profit. The break-even ratio is a handy tool for you to estimate if the property is performing well. Break-Even Ratio = Operating Expenses + Debt Service ÷ Gross Operating Income The performance measure will show the revenues from the property that are already committed and therefore what margin is left for gross profit. Example: The operating expenses of a building are $132,982 and the debt service is $79,740. The obligations are therefore $212,722. The gross operating income of the property is $272,000.

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Break-Even Ratio = 132,982 + $79,740 = 0.7820 $272,000 The formula represents that for every dollar that comes in, 78.2 cents is already committed. A favourable breakeven ratio is one that is further away from $1.00. The lower the better. If the gross operating income for this property was $185,000 the break-even ratio would be: Break-Even Ratio = $132,982 + $79,740 = 1.1498 $185,000 This means that the break-even ratio is high, as for every dollar that comes in $1.15 is going out. The ratio represents a problematic situation, as no business can survive when expenses are greater than revenue.

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Lesson 4 | Page 7 of 14

Return of/on Investment Every investor has two expectations with their investments: first, that they will be able to recover their investment, and second, that they will be able to make a profit on it. Two terms that represent these concepts are return of investment and return on investment. The following two sections contain information on the various types of property interests. Return of investment Return of investment represents the investor’s recapture of the capital invested in the property. Example: An investor buys a property for $1,000,000 and holds it for a period of one year, then sells it for $1,100,000. The $1,000,000 out of this sale represents the return of investment.

Return on investment Return on investment represents the profit the investor makes on the property. Example: An investor buys a property for $800,000. A year later, it is sold for $880,000. The return on investment is the profit achieved on this sale, which is $80,000, a return on investment of 10 per cent.

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Lesson 4 | Page 8 of 14

Investors use more than a single tool, ratio, or metric to confirm their interest in an investment. It has to perform well on all indicators of profit and value. Which of the following descriptions is true for the financial analysis term, “cash on cash”? There are three options. There is only one correct answer.

1

The relationship between a single year’s cash flow before taxes net operating income (NOI) minus annual debt service divided by the equity invested in that property.

2

The amount of time needed for an investor to recoup their initial investment.

3

The measurement used for property comparisons that is based on the gross operating income. It calculates what the investor would be left with after accounting for expenses and the annual debt service.

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Lesson 4 | Page 9 of 14

It is important for you to understand that commercial and residential real estate work in slightly different ways when it comes to valuation figures. In commercial investments, values are often reduced to a dollar value per sq. ft or square metre. On the other hand, in residential sales, you would talk in absolutes. For example, a salesperson who sold a detached residential home would say that the property on a certain street sold for $525,000. But while referring to the sale price of a warehouse, they would not use an absolute figure but would be more likely to say that the property sold for $5 per sq. ft. You should be knowledgeable with the different ways commercial properties may be evaluated. You should also be able to recognize the unique value considerations of properties while applying a market value square footage.

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Lesson 4 | Page 10 of 14

Price Per Square Foot/Metre Price per square foot/metre is the most common metric used to measure commercial and industrial sites. The formula is the area of the investment property multiplied by the price per sq. ft./metre. For large land parcels, it would be expressed as price per acre. Example: Assume that condominiums in Toronto are averaging a sale price of about $1,000 per sq. ft. and an investor buyer is looking at a 700 sq. ft. unit/suite. Therefore: 700 sq. ft. × $1,000 per sq. ft. = $700,000 If industrial properties are being sold for $285 per sq. ft. and the buyer needs a 100,000 sq. ft. building, the property’s estimated value would be as follows: 100,000 sq. ft. × $285 per sq. ft. = $28,500,000 est. value You must be aware that properties have unique characteristics and that applying a standard market value square footage can be a mistake. For example, industrial lots are selling for $80 per sq. ft. in a particular area. However, a lot belonging to a seller in this area has a stream running through it. This factor can impact the development potential of the property and create an element of risk, as the industrial process could contaminate the stream. In this situation, you may have to re-evaluate the price.

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Lesson 4 | Page 11 of 14

Price Per Suite/Unit The second valuation method is the price per suite/unit, and it is most often used when selling apartment buildings and establishing an estimate of value using a per unit or suite evaluation based on market research. Formula: Price Per Suite/Unit = Cost of the Property ÷ Number of Units Example: A 100-suite/unit apartment building sells for $9,500,000; therefore: 9,500,000 ÷ 100 units/suites = $95,000 per unit/suite or per door

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Lesson 4 | Page 12 of 14

Cost Per Door The third valuation method you should know is cost per door, even though it is applicable in fewer situations than the other two multipliers. Cost per door is particularly important in student income properties, which are a big part of the investment market in some areas of Ontario. A building may, for instance, have 25 apartments, with each apartment rented to three different students who each occupy their own bedroom and share a common room. But as they each occupy their own room, the bedrooms become individual revenue units. As an example, a building is being used as student accommodation and each of the 25 units have three student bedrooms that are leased individually. The expression of “cost per door” has more significance as each bedroom is an individual revenue unit. If the sale price of a building is $5,000,000, the multiplier calculation would be $5,000,000 ÷ (25 x 3) or $66,666 per door.

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Lesson 4 | Page 13 of 14

A salesperson lists a student housing building with an asking price of $4,000,000. The building has 20 apartments, each containing four student bedrooms that are individually leased. What multiplier would the seller’s salesperson use based on the following equation: $4,000,000 ÷ (20 x 4)? There are three options. There is only one correct answer. 1

Price per sq. foot/metre

2

Price per suit/unit

3

Cost per door

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Lesson 4 | Page 14 of 14

Congratulations, you have completed the lesson! Completion of this lesson has enabled you to: • Define various other terms used in the financial analysis • Define other valuation methods There are two sections on this page with a summary of the key topics that were discussed in this lesson.

Terms used in financial analysis

The attractiveness of a property will depend on how well it is performing and how soon a potential buyer or investor can expect to recapture their initial investment. Three methods—cash on cash, payback period, and break-even point—are useful measurement tools that you can employ to gauge how well a property is performing. Yet, each method has limitations and will not offer the most precise calculations about the profitability of a property.

Other valuation methods

In commercial real estate, the value or cost of a property can be represented as price per square foot, price per unit/suite, or cost per door. You have to consider the unique characteristics of a building or lot before applying a standard market research-sourced square footage rate to the property.

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Lesson 5 | Page 1 of 6

Lesson 5: Summary Practice Activities

This lesson provides a series of activities that will test your knowledge on the entire module.

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Lesson 5 | Page 2 of 6

This lesson provides summary practice activities. Throughout this lesson, you will participate in decision points to test your knowledge on the topics presented.

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Lesson 5 | Page 3 of 6

A buyer approaches a salesperson about a property they are interested in and wants to know the property’s value in relation to the asking price. The building is selling for $17,000,000 and has a net operating income (NOI) of $950,000. The average market capitalization rate is currently estimated at 7.5 per cent and the investor is comfortable with this rate. The salesperson estimates the value of property by employing the income approach to value. Which of the following would be the correct answer? There are four options. There is only one correct answer.

1

$12,666,667

2

$1,275,000

3

$29,666,667

4

$1,266,667

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Lesson 5 | Page 4 of 6

An owner approaches a salesperson about listing their building and provides income statements for the last five years. But the statements have been prepared by an accountant and are only useful for tax liability purposes. The salesperson needs to prepare a reconstructed financial worksheet to make it universally applicable for buyers or investors. What figures would be included on a reconstructed financial worksheet that would not be on an income statement? There are four options. There are multiple correct answers.

1

Actual revenue received

2

Potential rental income

3

Allowance for vacancies and bad debt

4

Cash flow after tax

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Lesson 5 | Page 5 of 6

A buyer approaches a salesperson about an investment property and enquires whether it would be a good investment. The operating expenses of the building are $128,764 and the annual debt service is $74,568. The gross operating income of the property is $264,000. Break-even ratio is calculated as follows: Operating Expenses + Annual Debt Service ÷ Gross Operating Income = Break-Even Ratio Based on these figures, what is the break-even ratio that this investor would achieve for this one period? There are three options. There is only one correct answer. 1

77%

2

75%

3

76%

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Lesson 5 | Page 6 of 6

Congratulations, you have completed the lesson!

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Module Summary | Page 1 of 3

Module Summary This lesson contains a summary of the entire module.

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Module Summary | Page 2 of 3

Congratulations, you have completed this module! This lesson will present a summary of Learning Objectives.

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Module Summary | Page 3 of 3

There are four sections on this page with a summary of the key topics that were discussed in this module.

Components of Property Analysis

When representing prospective buyers, you should be able to recognize the needs of an investor buyer, whether to calculate for market or investment value, and whether to analyze the property for a specific individual’s requirements or for a general audience. Depending on the characteristics of the property, this analysis can involve the application of valuation methods such as the income approach to value, the direct comparison approach, and the cost approach. You also need to understand the complexities of a property analysis worksheet—how they are completed, what they represent, and how they can be repurposed in listing a property—especially as it relates to the owner’s net operating income and expenses. Completion of this lesson has enabled you to: • Identify approaches to value and their application • Identify considerations when completing a property analysis

Property Analysis from Three Different Perspectives

You must understand how to adjust income and expense statements based on who you are preparing a statement for. That means not only knowing how to interpret and scrutinize statements, but also how to eliminate expenses and prepare a reconstructed financial worksheet for potential investors. You must understand the step-by-step approach to completing a property analysis worksheet as it relates to various calculations involving income and expenses. This worksheet allows you to create a document that is not only appealing to an investor, but also gives them an accurate sense of the property’s present and future value. Completion of this lesson has enabled you to: • Identify different income and expense perspectives • Define the steps to complete a property analysis worksheet

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Profit and Loss Statement

When trying to sell an investment property, you will need to know about other supporting documents, such as a profit and loss statement and balance sheet. These two documents differ in the longevity of their use, the professionals who prefer them, and the different equations used for each. The profit and loss statement reflects whether a business made a profit or loss in a specified period. Using horizontal and vertical analysis and valuation methods like income approach to value, you will be able to estimate the value of a property. A balance sheet, on the other hand, is just a snapshot and can very quickly become dated based on income, expenses, and equity fluctuations. You can use a tool called financial ratios to determine the performance of a business based on its equity, cash, and debt positions. Completion of this lesson has enabled you to: • Describe the purpose of a profit and loss statement • Describe what a balance sheet is and when it may be used

Application of Property Analysis

You need to know about the three popular measurements—cash on cash, payback period, and break-even ratio—which are equations based on calculated assumptions that can be used to determine the earning potential of a property and how quickly an investor could recover their initial investment. These are good methods for determining these values, but they need to be used with other methods to ensure accuracy. You need to be able to differentiate between return on investment and return of investment, which are part of a property analysis. You will also need to be able to apply three kinds of multipliers—price per square foot/metre, price per suit/rent, and cost per door—which are shorthand metrics used to estimate value in specific property analysis contexts depending on the type, shape, and size of a property. Completion of this lesson has enabled you to: • Describe various terms used in property analysis • Define other valuation methods

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V7

Module 5: Capitalization Foundations Disclaimer: This is a reference document which contains pages from the Accessible eLearning module. You should complete the eLearning module to proceed to the next step. Please note that the accessible module on the LMS only contains the interactive pages and you need to go through the content of this document thoroughly to attempt the interactive activities in the module. Please use Adobe Acrobat Reader (Recommended version 9 or above) to navigate through this PDF. Real Estate Salesperson Program ©2021 Real Estate Council of Ontario. All Rights Reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or in any means – by electronic, mechanical, photocopying, recording or otherwise without prior written permission, except for the personal use of the Real Estate Salesperson Program learner.

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Module 5: Capitalization Foundations Previously, you learned about the fundamentals of property analysis, valuation, and various calculations, including net operating income, applicable to investment properties. In this module, you will learn about the process of converting net operating income into an indication of value. Along with the basics of capitalization, you will also learn how to use capitalization techniques in value estimates for commercial property and their role in investment analysis. When trading in investment properties, a lack of data will often be a major challenge for you while seeking detailed financial analysis. In this module, you will also learn about the gross income multiplier, a popular measurement that serves as a valuable reference point in property valuations. To check your understanding of this module, you must complete all the activities in the online module. While navigating through the online module, click the Legislation button to view laws and regulations related to this module. The contents of the thumbnails Accessible PDF.

and References from the module are added to support your learning throughout this

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Menu: Capitalization Foundations

Number of Lessons

Lesson Number

5 Lessons

Lesson Name

Lesson 1

Analyzing an Investment Property Using Direct and Yield Capitalization

Lesson 2

Methods to Establish Overall Capitalization Rates

Lesson 3

Advantages and Disadvantages of Overall Capitalization and Gross Income Multiplier

Lesson 4

Summary Practice Activities Module Summary

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Lesson 1 | Page 1 of 16

Lesson 1: Analyzing an Investment Property Using Direct and Yield Capitalization This lesson outlines the basics of capitalization, expands on the definitions of direct and yield capitalization, and underlines the difference between the two. The lesson will also address the relationship of net operating income to value.

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Lesson 1 | Page 2 of 16

When trading in investment properties, you will be aiding your clients in the valuation of properties. A common method used for valuation is the application of a capitalization rate, also known as the cap rate. Once your investor has a property under consideration, you can discuss whether the asking price is suitable by using the current cap rate for comparable properties and the net operating income the property generates. A detailed comparison between direct and yield capitalization methods offers a prelude to discounted cash flow analysis discussed in the next module. Upon completion of this lesson, you will be able to: • Define direct and yield capitalization • Describe how direct and yield capitalization are used to complete an analysis of investment properties Throughout this lesson, you will participate in decision points to test your knowledge on the topics presented.

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Lesson 1 | Page 3 of 16

The income approach to property valuation is based on the principle of anticipation, meaningthe present value is a function of anticipated future benefits. With investment properties, anticipated future benefits in terms of cash flow can be analyzed through either direct capitalization or yield capitalization to arrive at an estimate of value. Knowing how to use capitalization in estimating the value of a property will enable you to explain the relationship between the income a property can earn and its value at any given time.

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Lesson 1 | Page 4 of 16

Direct Capitalization The most common question you are likely to encounter from an investor is about the profitability of an investment property. An investor would also want to know how a property compares to another, or even to other investment options, such as savings bonds or government secured bonds. You will be able to answer the questions by calculating the overall cap rate of the property. For example, there are two properties; Property A is valued at $908,000 and is expected to bring in $54,480 in net operating income annually, while Property B, valued at $1,200,000, could earn $96,000 per year. The two properties can be compared based on the overall cap rates to identify which is the better investment. © 2021 Real Estate Council of Ontario

The term overall cap rate refers to capitalization and more specifically, direct capitalization. Simply, this means the rate of return generated on a real estate investment. Overall cap rates are often determined by what similar properties have sold for, as well as in comparison to other types of investments, like Canada Savings Bonds, stocks, or guaranteed investment certificates. Direct capitalization is generally preferred by appraisers, assuming enough market data to establish an overall capitalization rate, as it is market driven and has limited assumptions. However, it should not be used as the sole indicator of an investment’s strength because it does not consider the time value of money and future cash flows, among other factors. The method is suitable for small commercial properties or properties with stabilized and predictable income, and when there is enough supply of comparable sales to extract overall capitalization rates. An important thing to note about direct capitalization is that it reflects only a one-year return and does not consider inflation, expected resale value, income in the future, or anything beyond the scope of the one year.

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Lesson 1 | Page 5 of 16

Yield Capitalization Typically, investors invest in a property for the long term. Several factors, such as inflation, increases in rent, and repair costs can change the return on the property from year to year. From this perspective, direct capitalization has significant limitations, since it values a multi-year investment based on a single year’s performance. While the method may be suitable for small commercial properties with stabilized income, it cannot be relied upon for complex commercial properties, which might take some years to get stabilized. A more suitable method for such scenarios is called yield capitalization.

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Yield capitalization is the method of converting income over an extended period, instead of a single year, into a current value. The most used procedure for yield capitalization is discounted cash flow analysis, where future years of income are discounted using a discount rate. The discount rate is also referred to as a rate of return. Salespersons often use yield capitalization to value complex commercial properties, which will take several years to become stabilized. For example, a commercial building with several vacancies or below-market value leases could take a few years to lease the vacant space and increase the existing leases to market value. In addition, a newly acquired property requiring significant upgrading and modernization could take a few years to complete the work so that it could be leased at the appropriate market value. Office towers, shopping centers, or properties with high vacancies and proposed projects are key examples of such properties. Unlike direct capitalization, yield capitalization does not require stable market conditions over the holding period – the period for which an investor holds the investment before they sell it – since the resulting value accounts for future expected changes in rental rates, vacancy, and operating expenses.

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Lesson 1 | Page 6 of 16

Yield Versus Direct Capitalization Here are some key distinctions between direct and yield capitalization: 1. Direct capitalization is traditionally associated with market value estimates and concentrates on static indicators; for example, a one-year snapshot view of the property. On the other hand, Yield capitalization has gained popularity in establishing both investment and market value estimates and relies on discounted cash flows (DCFs). 2. The users of direct capitalization are the appraisers seeking market value estimates based on comparable sales. Yield capitalization is used by portfolio managers and real estate investment analysts; it is now increasingly used by salespersons and appraisers too. 3. Direct capitalization is calculated based on ratios established in the marketplace, such as sale price and net operating income, or constructed when market data is limited. Yield capitalization uses a model based on discounted cash flows using a selected discount rate to arrive at investment value. 4. Direct capitalization uses simple calculations, incorporating both the return of and return on investment. Yield capitalization involves complex calculations with various assumptions. Discounting is a key component in calculations. 5. Direct capitalization relies on stabilized income and expenses using a property analysis worksheet. Yield capitalization depends on forecasted income and expenses for operations and sale proceeds cash flows using operating and sale proceeds cash flow worksheets. While there are distinct differences between the two methods, it is best to use both the methods for the analysis of investment properties. You should not rely solely on one method.

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Lesson 1 | Page 7 of 16

A salesperson is preparing to discuss yield and direct capitalization with a buyer interested in investing in a property. Which of the following statements are true regarding direct and yield capitalization? There are four options. There are multiple correct answers.

1

The direct capitalization approach may be useful when a few comparable sales are available in establishing the rate.

2

Rates used in the direct capitalization approach are commonly referred to as income rates.

3

Yield capitalization provides an estimate of value based on operations and sale proceeds cash flows.

4

Yield capitalization is often used to value small commercial properties with stabilized and predictable income.

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Lesson 1 | Page 8 of 16

When using the direct capitalization method, the net operating income is divided by the overall capitalization rate to identify the estimated value of an income-producing property. In fact, direct capitalization is highly dependent on overall cap rate selection. As you have learned earlier, an overall capitalization rate can identify and express the profitability of a real estate investment. The overall cap rate expresses the relationship between net operating income for a single year and the value of the property.

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Lesson 1 | Page 9 of 16

Relationship of Net Operating Income to Value If you trade in investment properties, you will need to understand how to calculate the overall capitalization rate and to be able to perform calculations so that you can properly advise a seller or a buyer. The overall capitalization rate is calculated by dividing a single year’s net operating income (usually current or previous year) by the value of the property. The formula for this is as follows: Overall Cap Rate = Net Operating Income ÷ Value The resulting percentage reflects the relationship between the net operating income to value. Example: A property recently sold for $1,000,000 and had a net operating income of $100,000. The overall cap rate for the property can be calculated as follows: Net Operating Income ÷ Value = Overall Cap Rate $100,000 ÷ $1,000,000 = 10%

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Lesson 1 | Page 10 of 16

Using Direct Capitalization to Calculate Property Value When comparing two properties, it is important to ensure they are very similar in terms of location, size, nature of the property (residential versus commercial), lease term (short-term or long-term), and other such factors. The properties should also have comparable amenities, features, and investment grades. You should also ensure that the single year’s income for one property is consistent with that of the other property. For example, if you are looking at last year’s income statement for Property A, then the same year’s statement must be looked at for Property B. Example: A salesperson wants to estimate the value of Property A for an investor. The value can be estimated using the data from one of the other two properties as follows: 1. The NOI for property A is $75,000 with a lease term of 8 years and 3 tenants. 2. The NOI for property B is $100,000 with a lease term of 6 years and 4 tenants. The value of this property is $1,250,000. 3. The NOI for property C is $375,000 with a lease term of 3 years and 15 tenants. The value of this property is $3,750,000. The salesperson evaluates the data and finds that Property B is more like Property A than Property C, as the lease terms and the number of tenants is similar. The salesperson uses the overall capitalization rate, also known as the overall cap rate, derived from value and net operating income information of Property B to find out the value of Property A. Net Operating Income ÷ Value $100,000 ÷ $1,250,000 = 8% Value of Property A: Net Operating Income ÷ Rate = $75,000 ÷ 8% = $937,500

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Lesson 1 | Page 11 of 16

Using Yield Capitalization, I Yield capitalization has gained increased popularity with large investors and portfolio managers because of its practicality. Since it considers a specified investment holding period, instead of a single year, it accounts for future expected changes in rents, vacancy, and operating expenses. Instead of the overall capitalization rate, yield capitalization relies on the internal rate of return (IRR) calculation. Example: A salesperson is representing a buyer interested in investing in a property. The salesperson is provided with five years of projected income, costs, and vacancy rates for the property. Using the data, the salesperson calculates the

© 2021 Real Estate Council of Ontario

projected cash flows (net operating incomes) for five years. Through a mathematical process called discounting, they use a discount rate to bring the future five-year projected cash flows to a present day value. If that present value is less than the initial investment, then the IRR would be less than zero. However, if the present value of the income projected over the five years is the same as the initial investment, then the IRR would be zero. It would logically follow that if the present value of the future cash flow is greater than the initial investment, then the IRR would be more than zero. Assuming the overall capitalization rate, sometimes called the market rate, is six per cent, if the IRR calculated is higher than the market rate, it indicates that this investment property performs better than the average. If the IRR calculated is less than six per cent, then your investor would be advised to avoid buying such a property as a greater return on investment could be achieved elsewhere in the marketplace.

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Lesson 1 | Page 12 of 16

Using Yield Capitalization, II Yield capitalization is associated with value estimates and can be used for estimating either market value or investment value, depending on assumptions and criteria used. The duration, timing, and amount of cash flows are critical to establishing present value under this approach. The discounted cash flow approach has become popular with salespersons, given the preponderance of irregular income streams in real estate investments. Other yield capitalization models do exist and are widely discussed in the appraisal theory. For example, models based on stable incomes or regular incomes with constant amount changes over forecasted periods. However, most have limited applicability to real estate investment analysis, given unpredictability and variability of cash flows. Fortunately, discounted cash flow techniques handle both regular and irregular cash flow. You will learn more about these calculations in the next module.

© 2021 Real Estate Council of Ontario

Opponents to yield capitalization criticize this method because of the assumptions and estimates used. The calculations involve assumptions, like an estimated increase in a property’s rent or an increase in operating expenses. The assumptions play a significant role in impacting the investor’s decision to invest in a property. While opponents to this method point to reliance on assumptions, the proponents insist on the sophistication of this method in deriving detailed cash flow estimates. Regardless of its criticism, the use of forecasted cash flows has gained popularity with large investors and portfolio managers.

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Lesson 1 | Page 13 of 16

Overall Capitalization Rate and Value As you have learned earlier, the overall cap rate is an expression of return on investment and has an inverse relationship to value. Assuming the net operating income remains the same, if the overall capitalization rate increases, the value decreases, and vice versa. For example, if an investor is expecting a higher rate of return, they would expect to pay less for the property. However, a seller is more likely to employ a lower overall cap rate that gives their property a higher valuation. When representing an investor, you will have to explain to the client the relation between expected returns and the value of the investment. Example: An investor is considering buying a six-unit apartment building for which they want a seven per cent rate of return. The net operating income of the building is $75,000. They ask the salesperson how much they would have to pay for the building to achieve their expected rate of return. The salesperson calculates the value of the property by dividing the NOI with the rate, which comes out to be approximately $1,071,428. However, the salesperson informs the

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investor that a seven per cent return in the current marketplace is aggressive and that the seller is demanding a five per cent overall cap rate. With the reduced overall cap rate, the value of the property would now be $1,500,000. A small variance in the overall cap rate can have a substantial impact on the estimated value. A two per cent decrease in the overall cap rate, in the given example, has increased the sale price by $428,572.

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Lesson 1 | Page 14 of 16

A salesperson is analyzing four comparable properties to identify an appropriate overall capitalization rate to be used to estimate the value of a property being considered by an investor. The overall capitalization rate can be calculated by using the formula: Net Operating Income ÷ Value of the Property. 1. A property at 43 East River with a sale price of $187,500 and net operating income of $16,225. 2. A property at 31 Riverside with a sale price of $172,500 and net operating income of $15,920. 3. A property at 608 River with a sale price of $189,500 and net operating income of $18,390. 4. A property at 845 River Road with a sale price of $193,200 and net operating income of $19,935. Which of the sales most closely approximates an overall cap rate of 10 per cent? There are four options. There is only one correct answer.

1

43 East River

2

31 Riverside

3

608 River

4

845 River Road

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Lesson 1 | Page 15 of 16

A salesperson is representing an investor who states that regardless of the property they purchase, they are expecting a nine per cent return on their investment. The salesperson selects a small neighbourhood strip mall that has been on the market for a few months, which reports a net operating income of $62,000. Using the investor’s expected rate of return, the salesperson calculates the purchase price of the property to be approximately $689,000. However, the seller’s salesperson informs them that they will only accept an offer of $950,000. Will the overall capitalization rate, indicated by the seller’s expected sale price, be higher or lower than the investor’s expected return? There are two options. There is only one correct answer. 1

Higher

2

Lower

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Lesson 1 | Page 16 of 16

Congratulations, you have completed the lesson! Completion of this lesson has enabled you to: • Define direct and yield capitalization • Describe how direct and yield capitalization are used to complete an analysis of investment properties There are two sections on this page with a summary of the key topics that were discussed in this lesson.

Defining direct and yield capitalization

The income approach is widely applied in the valuation of income-producing properties using either direct or yield capitalization methods. Direct capitalization is the process of converting a single year’s expected income into value, by dividing net operating income by an overall capitalization rate. Yield capitalization is the method of converting income over a given period (instead of a single year) into a current value. Depending on the property type, income characteristics, and other factors, one or both methods of capitalization may be appropriate.

Using direct and yield capitalization to complete an analysis of investment properties

The overall capitalization rate is the most widely applied direct capitalization method. The rate expresses the relationship between net operating income for a single year and the value or purchase price of the property. Yield capitalization, on the other hand, uses discounted cash flow analysis, where each future year of income is reduced to its current value using a discount rate. You will learn more about this method in the next module.

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Lesson 2 | Page 1 of 11

Lesson 2: Methods to Establish Overall Capitalization Rates

This lesson describes the different methods of obtaining overall capitalization rates. The learner will get conversant with the key components of the overall capitalization rate and how various factors can affect the rate.

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Lesson 2 | Page 2 of 11

In the income approach to valuation, the anticipation of profit or a property’s future earning potential plays a significant role in the selling price of an investment property. Similar to how realistic projections of revenues and expenses are required to obtain a reasonable estimate of net operating income, a realistic basis for deriving the overall capitalization rate is necessary for a reasonable opinion of property value. Several factors impact overall capitalization rates, and there are numerous methods for extracting the rate. It is a leading practice for a salesperson to rely on market-extracted overall capitalization rates and leave more complex calculations to appropriately trained professionals. Upon completion of this lesson, you will be able to: • Define overall capitalization rate • Describe the different methods of obtaining overall capitalization rates • Identify the formulas in which overall capitalization rates are used Throughout this lesson, you will participate in decision points to test your knowledge on the topics presented.

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Lesson 2 | Page 3 of 11

Overall Capitalization Rate as a Blended Rate The overall capitalization rate is deemed to include a real return (cost of funds without risk; for example, bond rate), as well as a risk factor. Hence, the use of the term “overall”; in other words, components of the rate are not broken down. The overall capitalization rate is best described as a blended rate, consisting of two parts: • The rate of return on an investment (discount rate) • The rate of return of the investment (recapture rate) As you have learned earlier, return on investment measures how much money or profit is made on an investment as a percentage of the cost of that investment. Return of investment, or the recapture rate, is the rate at which the invested capital will be returned over the investment holding period.

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The overall cap rate reflects the recapture of the original investment over the investment holding period, as well as the rate of return (yield) on the original investment. Typically, the rate is based on market research, using the net operating income and the sale price of comparable properties. The underlying assumption is that both the discount and recapture rates are implicitly included in that market-generated rate. Example: An investor is interested in investing in an office building. The investor’s salesperson suggests that an overall cap rate of 10 per cent would be appropriate in valuing this property. Based on research, the salesperson explains to the investor that the overall cap rate represents eight per cent cost of capital and two per cent risk associated with this type of asset.

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Lesson 2 | Page 4 of 11

Factors Impacting Overall Capitalization Rate When trading in investment properties, a seller or a buyer is likely to ask you what they should consider a good rate for selling or buying a property. You will need to explain to the seller or the buyer that there is no definitive answer to what constitutes a “good” overall cap rate. You should further explain that there is no such thing as a universal overall capitalization rate, also referred to as overall cap rate, or even a good or a bad overall cap rate. For example, an eight per cent overall cap rate for a rental property in one city might represent a great opportunity but applied to a different area it might be a risky proposition. Overall cap rates depend on individual markets. When working with an investor, you will need to analyze various factors. Typically, sellers would prefer a lower overall cap rate and buyers would prefer a high rate to make a higher return on their investment. Several factors can affect an overall cap rate, such as: • Location: The location of a property has a significant bearing on its overall cap rate. For example, there are two properties with similar characteristics; one is in a metropolitan area while the other is in a suburban © 2021 Real Estate Council of Ontario

area. The first property is likely to have a lower overall cap rate than the second one because of its highmarket value and the ability to generate a higher-rental income, partially offset by the higher cost of maintenance and higher taxes. • Property types: Properties can be residential, industrial, retail, or office. Further, these could be apartment buildings, single-family, multi-family, or commercial properties. The type of property has an impact on overall cap rates. For example, in the case of multi-family homes, real estate investors rarely face vacancy rates above five per cent, which means these investment properties have lower risks, higher values, and, therefore, lower overall cap rates. The overall cap rates are inextricably tied to property value; property values are, in part, determined by the level of risk. • Available inventory: The lower the inventory, the higher the demand. The number of properties available to buy in an area impacts overall cap rates. • Interest rates: Fluctuating interest rates affect the overall cap rate even with no change to the property itself. For example, an increase in interest rates will lead to a rise in the cost of debt, which, in turn, decreases net operating income, and hence the property’s value. As a reminder, the rates generally depend on the context of the property and the market. While the overall cap rate is valuable for comparing the relative value of similar real estate investments in the market, it should not be used as the sole indicator of an investment’s strength.

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Lesson 2 | Page 5 of 11

A salesperson is representing an investor who is a cautious investor looking for a property with a stable income and low risk. The salesperson shortlists three properties for the investor. The overall cap rate can be calculated using the following formula: Net Operating Income (NOI) ÷ Value. Which of the three properties would the salesperson say is better for the investor? There are three options. There is only one correct answer.

1

A 10-unit, Class B office building is available with an asking price of $900,000. The property is fully rented, needs no major repairs, and is professionally managed. The location also has good long-term prospects for population and economic growth. The total monthly rent is $850/unit, and the monthly operating expenses are $3,600. Finally, the net operating income per month is $4,900.

2

A 15-unit building priced at $850,000 is in an up-and-coming neighbourhood. Due to its location and high turnover rate, the monthly rent is $7,800 ($520/unit), which is lower than similar properties in the nearby areas. The monthly operating expenses are $3,000, while the net operating income per month is $4,800.

3

A 12-unit vacant building priced at $600,000 is located in a growing neighbourhood. Other investors in the area are renovating and remodeling their properties and raising rents. There is an opportunity to add value to generate a greater return. The proposed renovation is valued at $300,000 ($25,000/unit), after which the new rent can be $700 per month for each unit. The monthly operating expenses are $3,200 and net operating income per month is $5,200.

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Lesson 2 | Page 6 of 11

The most critical step in the calculation of capitalization is the estimation of an appropriate overall capitalization rate. As you have learned earlier, overall cap rate plays a significant role in determining the value of a property. Even a small variation in an estimated overall cap rate can lead to a considerable difference in market value. While the formula for calculating the overall cap rate is simple, extracting the rate is a complex process. There is no standard method for overall cap rate extraction since different income and expense projections can be used while calculating net operating income. There are several methods an appraiser can use to estimate a reliable overall capitalization rate. In this section, you will learn about two of the most used methods: market-extracted and research-constructed.

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Lesson 2 | Page 7 of 11

Market-Extracted Method The most common method used for deriving overall capitalization rates is the market-extracted method. As the name suggests, the market-extracted method is built on direct market evidence. Market-extracted rates are an average of several property transactions that can vary widely in terms of location, lease terms, property condition, and other factors. The market-extracted method is considered the most reliable because it relies on deriving overall rates from the marketplace by reviewing net operating income and sale price of comparable properties. This method assumes that there is a current and readily available net operating income and sale price data on comparable income-generating properties. Here is an example of developing a market-extracted rate: 1. In sale 1 the sale price was $189,500 and the net operating income was $19,391. The market-extracted rate for sale 1 would be $19,391 (I) divided by $189,500 that equals to 0.1023 or 10.23%. 2. In sale 2 the sale price was $187,550 and the net operating income was $19,941. The market-extracted rate for sale 2 would be $19,941 (I) divided by $187,550 that equals to 0.1063 or 10.63%. 3. In sale 3 the sale price was $182,555 and the net operating income was $18,931. The market-extracted rate for sale 3 would be $18,931 (I) divided by $182,555 that equals to 0.1037 or 10.37%. 4. In sale 4 the sale price was $183,528 and the net operating income was $19,032. The market-extracted rate for sale 4 would be $19,032 (I) divided by $183,528 that equals to 0.1037 or 10.37%. Based on the data provided, the market overall cap rate is approximately 10.40% (average of the four rates). Various agencies, organizations, and larger commercial brokerages provide market research on overall capitalization rates. The net operating income of each comparable property should be calculated and estimated in the same way as the net operating income of the subject property is estimated. Additionally, you should ensure that the comparable property has similar characteristics in terms of quality, location, investment grade, date of sale, and occupancy. The market-extracted method has its roots in the direct comparison approach to value discussed in the Property Analysis and Valuation Fundamentals module. When these factors have been considered fully, and similar comparable properties are available, the market-extracted rate is considered reasonably reliable. However, this method has its limitations in the event of a lack of suitably comparable data.

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Lesson 2 | Page 8 of 11

Research-Constructed Method Given the issues with the market extraction method, salespersons often rely on other methods for deriving the overall cap rate. The overall cap rate can be constructed for specific types of property based on investor expectations, as opposed to strict reliance on market activity. Research-constructed rates are sometimes used to verify market-extracted rates. The formula for calculating the research-constructed market rate is as follows: Research-Constructed Overall Cap Rate = Expected Rate + Risk Rate Real estate overall capitalization rates traditionally align with the mortgage market. Therefore, investor expectations are derived from analysis of mortgage markets (and other debt instruments), with a risk factor added to this amount. Typically, risk includes allowances for inflation, illiquidity of real estate investments, and the need to manage the project. 1. Investor expectation for a secure investment (for example, prime mortgage or bond rate) is 8.50% and the risk associated with this investment is 4.50% 2. The research-conducted overall capitalization rate would be 8.50%(investor expectation for a secure investment) + 4.50% (risk associated with the investment) = 13.00%.

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Lesson 2 | Page 9 of 11

Key Formulas Overall cap rate is the most popular measure through which real estate investments are assessed for their profitability and return potential. Here is a quick summary of the overall cap rate formulas: Estimate value: Net Operating Income ÷ Overall Cap Rate = Value Example: A property has a net operating income of $100,000 and an overall cap rate of seven per cent. The value of the property is: Value = $100,000 ÷ 7% = $1,428,571 © 2021 Real Estate Council of Ontario

Estimate overall capitalization rate: Net Operating Income ÷ Value = Rate Example: Suppose a building has a stabilized net operating income of $1,000,000 and a sale price of $17,000,000, therefore the overall capitalization rate at the time of sale is 5.9 per cent. OCR = $1,000,000 ÷ $17,000,000 = 5.9 per cent Estimate net operating income: The net operating income of a rental property would be rent less expenses. Calculating income of a comparable property can be challenging, as it requires information from the income and expense statement. However, it can be estimated by multiplying the sales price or value by the overall cap rate. Value x Overall cap rate = Net Operating Income Example: Suppose a property sold for $250,000 at a 20 per cent overall cap rate. You can estimate the net operating income by multiplying the value by the overall cap rate: NOI = $250,000 x 20% = $50,000

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Lesson 2 | Page 10 of 11

An investor is considering buying a retail store expected to generate $500,000 in net operating income. In the area, there are three existing comparable income-generating retail stores: • Store 1 has a net operating income of $250,000 and a sale price of $3 million • Store 2 has a net operating income of $400,000 and a sale price of $3.95 million • Store 3 has a net operating income of $185,000 and a sale price of $2 million The overall cap rate can be calculated using the following formula: Net Operation Income ÷ Value Using the market-extracted method, which of the following overall cap rate should be applied to the subject property? There are three options. There is only one correct answer. 1

9.23%

2

9.80%

3

10%

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Lesson 2 | Page 11 of 11

Congratulations, you have completed the lesson! Completion of this lesson has enabled you to: • Define overall capitalization rate • Describe the different methods of obtaining overall capitalization rates • Identify the formulas in which overall capitalization rates are used There are three sections on this page with a summary of the key topics that were discussed in this lesson.

Defining overall capitalization rate

The overall capitalization rate is deemed to include a real return (cost of funds without risk; for example, bond rate), as well as a risk factor. The term “overall” refers to the fact component parts of the rate are not broken down. Also, the overall capitalization rate is said to be a blended rate consisting of return on investment and return of investment.

Different methods of obtaining overall capitalization rates

The most common method used for deriving overall capitalization rates is the market-extracted method, which is built on direct market evidence. Market-extracted rates are an average of several property transactions that can vary widely in terms of location, lease terms, property condition and other factors. In the absence of comparable sales data, you would rely on the research constructed method. In this method, the overall cap rate can be constructed for specific types of property based on investor expectations, as opposed to strict reliance on market activity.

Formulas in which overall capitalization rates are used

The key formulas used for calculating the overall cap rate and value of a property are: Net Operating Income ÷ Overall Cap Rate = Value Net Operating Income ÷ Value = Overall Cap Rate Value x Overall Cap Rate = Net Operating Income

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Lesson 3 | Page 1 of 12

Lesson 3: Advantages and Disadvantages of Overall Capitalization and Gross Income Multiplier This lesson defines the concept of gross income multiplier as a measure of the value of an investment property and outlines its challenges and benefits in relation to overall capitalization.

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Lesson 3 | Page 2 of 12

One of the most critical steps in valuating real estate for clients is the ability to decide how much time and how many resources to allocate for conducting further analysis of investment opportunities. Property comparisons are more difficult when complete financial information for a property is not available. In such a scenario, you can use the gross income multiplier when comparing similar properties. In this lesson, you will learn about the multiplier and its benefits and challenges when compared with the overall capitalization method. Upon completion of this lesson, you will be able to: • Define gross income multiplier • Identify the advantages and disadvantages of overall capitalization rate and gross income multiplier Throughout this lesson, you will participate in decision points to test your knowledge on the topics presented.

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Lesson 3 | Page 3 of 12

When trading in investment properties, a lack of data is a serious obstacle in arriving at a detailed financial analysis of a property. In such a scenario, you would rely on basic ratios to compare properties to help an investor plan. The gross income multiplier is one such ratio that can provide clarity in the event of vague circumstances. However, it is important to fully understand the limitations, strengths, and weaknesses affecting both the reliability and accuracy of this method. You will also learn about the advantages and disadvantages of the overall capitalization rate and gross income multiplier.

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Lesson 3 | Page 4 of 12

Gross Income Multiplier When working with real estate investors, you will perform market value analysis calculations for evaluating a property. The process usually begins with a quick ranking of the available properties so that you can spend time in a more in-depth analysis of the best options. One of the methods to get an indication of the value of an incomeproducing property is the gross income multiplier approach. As the name suggests, the method is based on determining a property’s income-generating capacity. The value of a property, using a gross income multiplier, is calculated by dividing the property’s sale price by its gross annual income. The ratio indicates how many times the value of the property is greater than the gross income it delivers to the investor. The gross income multiplier method is based on a basic assumption that properties in the same area will be valued proportionally to the gross income that they can generate. When using the gross income multiplier, you should ensure that comparable sales are similar to the subject property being valued in terms of geographical, physical, and operational characteristics.

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Lesson 3 | Page 5 of 12

Calculating Gross Income Multiplier The first step in calculating a gross income multiplier is to select a few comparable properties from which enough information can be developed. The properties must be similar in terms of size, price, location, financing, expense ratios, and rents. You should ensure a high degree of comparability between the properties to ensure accuracy. For instance, you should look at the gross rents of the comparable properties to ensure that rents are collected on the same basis as the subject property. The formula for calculating the gross income multiplier is as follows: Gross Income Multiplier = Sale Price ÷ Gross Operating Income Example:

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An investor plans to purchase a rental property for $5,000,000 with a monthly gross rental income of $44,000. The property generates another $2,000 monthly in miscellaneous income, such as laundry receipts from the on-site, coin-operated laundry facility. The gross operating income of the property is $46,000 ($44,000 + $2,000) x 12 = $552,000 Gross Income Multiplier = Sale Price ÷ Gross Operating Income = $5,000,000 ÷ $552,000 = 9.06 The gross income multiplier of the property is 9.06, which means the property will be sold for nine times its gross operating income. The lower the multiplier, the better it is for the investor, as that would mean that the gross income generated by the property is larger compared to its value. The method has its limitations, as it does not consider expenses like utilities, taxes, maintenance, and vacancies. However, the multiplier is most frequently used to assess properties quickly before more detailed analysis. Typically, you will use the method to determine a rough estimate of a property’s value. The method is considered appropriate particularly for small investment properties, such as small apartment buildings that have similar operating characteristics and expenses.

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Lesson 3 | Page 6 of 12

Exercise Caution when Using Gross Income Multiplier The reliability of the gross income multiplier as an indicator of value is often questioned because of differences in properties, such as size and age. When using the gross income multiplier, you should consider the limitations of the method and ensure the following: • The properties used for comparison must be similar in terms of physical characteristics, location, and investment potential. For example, the properties must have similar operating expense ratios. • The comparable properties must be assumed to have been rented around similar time, considering volatility in the rental market. • Gross income or gross rent must be identified (gross income may include items other than rent, such as laundry or parking income).

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• The income and multiplier used are consistent with both the comparable properties and the subject, for example, an income multiplier based on effective gross income is applied to the subject’s effective gross income, not the potential gross income. Despite its limitations, the gross income multiplier is popular as a starting point for real estate valuation. By obtaining estimates of gross income multipliers from the comparable properties and ensuring that the difference among the estimates is not excessively large, one can reliably estimate the current market value.

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Lesson 3 | Page 7 of 12

A salesperson is checking various investment options for an investor who requires a gross income multiplier of 8.70 per cent or better. The investor is prepared to pay the listed price provided the multiplier is as per their expectations. The gross income multiplier can be attained using the following formula: Sale Price ÷ Gross Operating Income. Based on the following information, identify the one that would meet or exceed the investor’s investment criterion. There are four options. There is only one correct answer.

1

2

3

4

Gross operating income: $103,000 Sale price: $893,000 Gross operating income: $127,000 Sale price: $1,107,900 Gross operating income: $95,600 Sale price: $1,023,000 Gross operating income: $44,300 Sale price: $399,500

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Lesson 3 | Page 8 of 12

Overall Capitalization Rate (OCR) Versus Gross Income Multiplier Both overall capitalization rate and gross income multiplier are metrics used for analyzing a property and determining its value. However, the difference between them lies in the different values used in their calculation. The overall capitalization rate measures the relationship between net operating income and selling price, whereas the gross income multiplier is the relationship between gross income and selling price. The overall cap rate is not a multiplier but a rate of annual return. Since the overall capitalization rate accounts for vacancies and operating expenses, it is considered more accurate than the gross income multiplier. However, when estimating and comparing different properties quickly, investors may not have full occupancy or expense information readily available, which can make the gross income multiplier a more useful method to promptly evaluate investment properties.

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Lesson 3 | Page 9 of 12

Advantages of Overall Capitalization Rate and Gross Income Multiplier Overall capitalization rate: • Offers reasonable reliability when detailed market research is done in establishing a rate • A widely accepted valuation method used by real estate investors, agents, appraisers, and even banks • Considers the operating expenses and the vacancies of the income property, making it an accurate and factual measurement of the property’s performance Gross income multiplier: • A simpler and easier to understand method than most other valuation methods • A useful initial screening tool when looking at several investment opportunities

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• Useful when detailed market income and expense profiles of commercial properties are not available; the method is particularly useful for single-family residential properties and other small investment properties, like a fourplex, when only sale prices and gross rents are known • When used and appropriately interpreted, the method omits subjective processes and personal judgment, which are part of other valuation techniques

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Lesson 3 | Page 10 of 12

Disadvantages of Overall Capitalization Rate and Gross Income Multiplier Overall capitalization rate: • Difficulty in determining the overall cap rate for a sold property because of lack of information about the operating expenses • The method does not consider individual cash flows beyond one year • Difficulty in calculating the overall cap rate when there is a lack of comparable data Gross income multiplier: • Does not consider the property’s vacancy rate or its operating expenses

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• Assumes uniformity in properties across similar classes; however, expense ratios among similar properties often differ because of several factors, such as deferred maintenance and property age • Does not consider net operating income, relying instead on gross income; however, two properties can have the same net operating income even though the gross incomes differ significantly; as a result, the method can easily be misused • Does not take into consideration the appreciation or depreciation of a rental property

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Lesson 3 | Page 11 of 12

A salesperson, working with an investor, is looking to calculate the selling price of a property that their client is considering. Through their research, the salesperson finds information on four recent sales from which they can calculate the gross income multiplier and use it to estimate the selling of the property of interest. The gross income multiplier can be calculated by using the formula: Sale Price ÷ Gross Operating Income. When considering the following, which properties provide sufficient information to calculate the gross income multiplier? There are four options. There are multiple correct answers.

1

A 14,000 sq. ft. office building with four tenants on net leases sold four months ago for $1,250,000. The listing information indicated the net operating income of $96,600, with an overall capitalization rate of 7.7 per cent.

2

An 8,600 sq. ft. office building with a single tenant sold six months ago and was leased for $12.00 per sq. ft. with the landlord paying all operating expenses. The parking income for the last fiscal year was $3,700. The building sold for $688,000.

3

A small neighbourhood strip mall sold this month and was comprised of 12,000 sq. ft. of leasable space and 10,500 sq. ft. of rentable space. The mall owner recovered all operating costs from the tenants by way of additional rent. Annual gross operating income, which includes rent, parking, and security, amounts to $172,000 and net operating income was $77,400.

4

A mixed-use building comprised of 4 retail units, 6 office units, and 20 residential apartments sold one year ago for $4,340,000. Monthly rent from all sources is $72,000, and income from parking, signage, and communications equipment amounts to $8,500 per year. The salesperson estimated the net operating income to be 54 per cent of gross operating income.

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Lesson 3 | Page 12 of 12

Congratulations, you have completed the lesson! Completion of this lesson has enabled you to: • Define gross income multiplier • Identify advantages and disadvantages of overall capitalization rate and gross income multiplier Gross income multiplier is a significant method to estimate the value of a property promptly. The formula commonly used to calculate the multiplier is: Gross Income Multiplier = Sale Price ÷ Gross Operating Income © 2021 Real Estate Council of Ontario

The gross income multiplier method is popular because it is based on market transactions, omits subjective processes and personal judgment, and is easily understood. Both the gross income multiplier and the overall capitalization rate are useful in estimating the value of prospective investment properties. Each method uses different inputs in estimations. While the two methods have some similarities, they are also inherently different and have associated advantages and disadvantages. The availability of relevant data determines which of the two methods is better to use. You should understand the requirements of each metric to know which method to apply in different situations and obtain the most accurate evaluation of a property’s worth.

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Lesson 4 | Page 1 of 6

Lesson 4: Summary Practice Activities

This lesson provides a series of activities that will test your knowledge on the entire module.

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Lesson 4 | Page 2 of 6

This lesson provides summary practice activities. Throughout this lesson, you will participate in decision points to test your knowledge on the topics presented.

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Lesson 4 | Page 3 of 6

An investor is interested in buying an apartment that is listed for $495,000. The property’s net operating income (NOI) is $39,500. As the apartment was built 30 years ago and has been owned by the same family, it requires updating to maintain its current rent or achieve rents as per market value. The investor asks their salesperson to find out if the asking price for the property is reasonable. Through some research, they discover that the overall cap rate of recently sold comparable properties was 9.2 per cent. The value of the building can be checked using the formula: Net Operating Income ÷ Overall Cap Rate. Which of the following would be the correct responses for the salesperson to provide to their investor? There are two options. There is only one correct answer. 1

The property is overpriced.

2

The property is worth the price.

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Lesson 4 | Page 4 of 6

A salesperson is working with a buyer who is considering purchasing their first investment property. The buyer has some ideas about overall cap rates and discusses these with their salesperson. Which of the following statements would be correct for the salesperson to say in explaining overall cap rates to the buyer? There are five options. There are multiple correct answers. 1

An eight per cent overall cap rate can be considered good.

2

A multi-family home is likely to have a lower overall cap rate than a single-family home investment.

3

The overall cap rate of a property will remain constant until the investor sells the property.

4

It is financially wise to buy a property solely based on a high overall capitalization rate.

5

Overall cap rates are challenging with non-income properties and do not work well with projecting future cash flow.

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Lesson 5 | Page 5 of 6

A salesperson is attempting to estimate the value of a 20-unit apartment complex by calculating the gross income multiplier of a comparable property. The sale price of the property, also a 20-unit apartment, was $850,000. Each unit is anticipated to be rented out for $525 per month. The expenses on the building amount to $55,000 annually. The gross income multiplier can be calculated using the following formula: Sale Price ÷ Gross Operating Income. What is the gross income multiplier of the comparable property? There are three options. There is only one correct answer. 1

14.8

2

8.35

3

6.75

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Lesson 4 | Page 6 of 6

Congratulations, you have completed the lesson!

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Module Summary | Page 1 of 3

Module Summary This lesson contains a summary of the entire module.

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Module Summary | Page 2 of 3

Congratulations, you have completed this module! This lesson will present a summary of Learning Objectives.

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Module Summary | Page 3 of 3

There are three sections on this page with a summary of the key topics that were discussed in this module.

Analyzing an Investment Property Using Direct and Yield Capitalization

When trading in investment properties, you will calculate property values to help investors make better decisions. The lesson discusses the two widely used methods of estimating the value of a property: direct capitalization and yield capitalization. Direct capitalization is a simple, single-period (typically a year) static indicator of value. This method should be used for small commercial properties or for properties that have stable income, such as multi-tenanted complexes. Yield capitalization is often used to value complex commercial properties over multi-periods (5 to 20 years), it is known as a dynamic indicator of value. Completion of this lesson has enabled you to: • Define direct capitalization and yield capitalization • Identify how direct and yield capitalization are used to complete an analysis of investment properties

Methods to Establish Overall Capitalization Rates

Several factors have an impact on overall capitalization rates of properties, and there are several methods used for extracting the overall capitalization rate. You should be aware of the standard methods and the benefits and challenges of each of these methods. Completion of this lesson has enabled you to: • Understand how various factors impact overall capitalization rates • Identify different methods of obtaining overall capitalization rates

Advantages and Disadvantages of Overall Capitalization and Gross

Apart from the overall capitalization rate, another method used to value property is the gross income multiplier, which is derived by analyzing several comparable, recently sold, properties in the area. The formula used for the calculation is:

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Income Multiplier

Gross Income Multiplier = Sale Price ÷ Gross Operating Income You are advised to never rely solely on a single method for assessing a property. There are some limitations you must consider while using the gross income multiplier. Completion of this lesson has enabled you to: • Define gross income multiplier • Identify the advantages and disadvantages of overall capitalization rate and gross income multiplier

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V7

Module 6: Operations Cash Flow Fundamentals Disclaimer: This is a reference document which contains pages from the Accessible eLearning module. You should complete the eLearning module to proceed to the next step. Please note that the accessible module on the LMS only contains the interactive pages and you need to go through the content of this document thoroughly to attempt the interactive activities in the module. Please use Adobe Acrobat Reader (Recommended version 9 or above) to navigate through this PDF. Real Estate Salesperson Program ©2021 Real Estate Council of Ontario. All Rights Reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or in any means – by electronic, mechanical, photocopying, recording or otherwise without prior written permission, except for the personal use of the Real Estate Salesperson Program learner.

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Module 6: Operations Cash Flow Fundamentals As you learned in the previous module, there are different methods used to establish capitalization rates. When trading in investments properties, you must also understand the nuances involved in assessing operations cash flow and being able to determine the net operating income and cash flow before tax on an investment property. Cash flow before tax sets the stage for an investor’s decision making with respect to a specific property. The question of tax liability and the investor’s abilities to reduce taxes payable will also be discussed when calculating cash flow after tax. You should also be aware of the need to refer the investor to other third-party professionals in situations where a detailed discussion of the subject matter is required. Often, these professionals will be accountants and lawyers. Whether the investor is a seller or a buyer, a tax advisor may give information or advice for action as per the specific case. To check your understanding of this module, you must complete all the activities in the online module. While navigating through the online module, click the Legislation button to view laws and regulations related to this module. The contents of the thumbnails Accessible PDF.

and References from the module are added to support your learning throughout this

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Module 6: Operations Cash Flow Fundamentals Number of Lessons

Lesson Number

6 Lessons

Lesson Name

Lesson 1

Effect of Type of Asset on Rate and Method for Calculating Capital Cost Allowance

Lesson 2

Calculating Capital Cost Allowance: Differences Between the Declining Balance Method and the Straight-line Method

Lesson 3

Forecasting Taxable Income and Cash Flows After Tax for Investment Properties

Lesson 4

Steps and Calculations to Complete an Operations Cash Flow Worksheet

Lesson 5

Summary Practice Activities Module Summary

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Lesson 1 | Page 1 of 17

Lesson 1: Effect of Type of Asset on Rate and Method for Calculating Capital Cost Allowance This lesson describes how a salesperson should identify that the capital cost allowance rate and calculation method may vary according to the asset type and explains rules that may apply to the calculation of capital cost allowance (CCA).

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Lesson 1 | Page 2 of 17

When trading in investment properties, you are required to provide conscientious and competent services and to promote and protect the best interests of your seller or buyer. Part of this due diligence will be for you to understand capital cost allowance (CCA) in order to identify various opportunities for an investor, and the various classes for purposes of CCA calculation. There are also rules in calculating CCA that you should be familiar with when trading in investment properties. Upon completion of this lesson, you will be able to: • Identify that the capital cost allowance rate and calculation method may vary according to the asset type • Describe rules that may apply to the calculation of capital cost allowance Throughout this lesson, you will participate in decision points to test your knowledge on the topics presented.

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Lesson 1 | Page 3 of 17

Capital Cost Allowance – Definition When trading in investment properties, it is important for you to understand capital cost allowance (CCA) to identify various opportunities for an investor to reduce taxes payable. You should not attempt to provide a detailed explanation of CCA to an investor if you do not have a fundamental understanding of depreciation costs calculations. Depreciation is the erosion of value over time, as the result of the use of the wasting asset. Straight line and declining balance are methods commonly used to calculate CCA or depreciation for various assets. Capital assets, though durable, have a limited lifetime and, at some point, will be replaced. Generally, the capital cost of a property is what the buyer pays for that property. Capital cost includes items such as delivery charges and applicable taxes. The Income Tax Act permits a deduction of part of the capital cost of the asset against the income from the business. CCA is the maximum rate set under the Income Tax Act that the taxpayer can claim for depreciation. CCA is not a cash flow item, but rather a matter of taxation and a tax-deductible expense. CCA acknowledges the existence of depreciation that is the result of wear and tear over the life of an asset and the ability to offset income in relation to the cost of that asset. Most CCA calculations are based on the declining balance method, but selected classes, such as leasehold improvements, use straight-line calculation.

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Lesson 1 | Page 4 of 17

Capital Cost Allowance – Depreciation The amount of depreciation allowed depends on the asset class. Most, but not all buildings qualify for a four per cent capital cost allowance (CCA) on a declining balance basis, as illustrated on the following page. One-half of that amount (two per cent) is permitted during the first year of purchase. The rate of CCA applied to each class is specified as a maximum rate. A taxpayer may therefore claim any CCA amount up to the maximum by multiplying the CCA rate by the balance in the class at the end of the taxation year. Only the amount of CCA actually claimed is deducted from the balance of the class and the remaining balance is carried forward into the next taxation year. Under the straight-line approach, the useful life of the depreciable assets must be estimated according to the regulations under the Income Tax Act. The annual CCA taken represents a pro-rated amount based on the estimate. In some cases, depending on the classification of the asset, which will be discussed later, some assets must be depreciated using the straight-line method, as opposed to the declining balance method.

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Lesson 1 | Page 5 of 17

Capital Cost Allowance (CCA) Classes The Income Tax Act and its regulations detail various classes for purposes of capital cost allowance (CCA) calculation. Real estate brokerages are normally concerned with categories such as Classes 8, 10, 10.1 (expensive automobiles), 12, 14, 14.1, and 45. The following describes these classes; however, due to the complexity of the various classes, brokers, salespersons, and their clients should consult with an accountant for specific queries regarding capital cost allowance. The percentage before every class is the rate at which an asset can be depreciated annually. This rate is established in the Income Tax Act and would be subject to change if the government see fit to amend the legislation. In the declining balance method, this percentage is applied to the undepreciated capital cost or UCC (explained below) at

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the end of each accounting period resulting in an amount of depreciation or capital cost allowance (CCA) that can be claimed as an income tax deduction. The UCC is also known as the book value or the depreciated value. It is the cost of the item minus the CCA claimed. UCC (Year 2) = UCC (Beginning of Year 1) – CCA (Year 1) UCC (Year 3) = UCC (Beginning of Year 2) – CCA (Year 2) The following are the type of asset included under each class: 1. Class 1 (4%): This includes most buildings acquired after 1987 unless they specifically belong to another class. Class 1 also includes the cost of certain additions or alterations to Class 1 buildings or certain buildings of another class after 1987. 2. Class 8 (20%): Examples of this class are furniture, appliances, and tools costing $500 or more per tool, some fixtures, machinery, outdoor advertising signs, refrigeration equipment, and other equipment used in business. This class also includes photocopiers and electronic communications equipment, such as fax machines and electronic telephone equipment. 3. Class 10 (30%): This includes motor vehicles, as well as some passenger vehicles unless they meet the Class 10.1 conditions. 4. Class 10.1 (30%): This includes passenger vehicles with a purchase price greater than $30,000 including HST. 5. Class (12%): This includes property such as tools, medical or dental instruments, and kitchen utensils that cost less than $500. This class also includes china, cutlery, linen, and uniforms, video cassettes, video laser discs, and digital video discs. 6. Class 14 (5%): This includes patents, franchises, concessions, or licences for a limited period. The total of capital cost for each of these assets is spread over the life of the asset. Professional advice is required. 7. Class 14.1 (5%): This includes farm quotas, business, professional, and fishing franchise concessions or licences for an unlimited period. 8. Class 45 (45%): This includes general purpose electronic data processing equipment (commonly called computer hardware) and system software for that equipment, including ancillary data processing equipment.

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Lesson 1 | Page 6 of 17

Land and Building Allocation In an agreement of purchase and sale, third-party professionals often request that a declaration of value be included with respect to land and buildings. This establishes values that are important to a seller for the calculation of the recaptured capital cost allowance (CCA) if appropriate. For the buyer, it establishes the value of the building available for future depreciation. As the cost of a building and improvements will normally be categorized under the CCA provision and the land will not, allocating the purchase price between land and improvements is necessary. As a rule, such allocations must be fair, reasonable, and defensible. Advice from a third-party expert is required. Seller and buyer perspectives on how this allocation occurs are usually different, owing to tax implications arising from the determination. The allocation of purchase price between land and building is a key negotiating point in many commercial transactions. The buyer seeks to maximize building allocation (plus chattels associated with the sale) to establish a high capital cost for future CCA calculations — the seller wants to minimize the allocation to avoid recapture. Generally, a reasonable, mutually accepted allocation, if defensible, should be sufficient in the agreement.

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Lesson 1 | Page 7 of 17

Value Allocation Occasionally, you will use municipal tax assessment ratios as a benchmark for the allocation. Alternatively, an appraiser may be retained to value the property and provide a supportable allocation between land and improvements. If a supportable allocation between land and building is not obtained, the Canada Revenue Agency (CRA) will reallocate the proceeds to its view of the fair market allocation between land and building. If the property is sold and improvements have no economic value, the seller may be able to allocate the full sale price to the land. The term “no economic value” generally means that the cost of demolition exceeds the building(s) value. From a taxation perspective, the position taken must be defensible. As a caution, the fact that the buyer sees no value in such buildings, owing to a different planned use for the property, does not in itself create no economic value and complex rules exist to re-allocate proceeds for tax purposes from land to building, potentially restricting a terminal loss amount. When trading in investment properties, you will need to advise on the value allocation by consulting with a thirdparty professional and understand the importance of including the allocation in the agreement of purchase and sale.

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Lesson 1 | Page 8 of 17

CCA Classes As you learned earlier, the Canada Revenue Agency (CRA) recognizes various classes for the purposes of calculating capital cost allowance (CCA). The rate of CCA applied to each class is specified as a maximum rate. A taxpayer may therefore claim any CCA amount up to the maximum by multiplying the CCA rate by the balance in the class at the end of the taxation year. Only the amount of CCA actually claimed is deducted from the balance of the class, and the remaining balance is carried forward and available for future CCA claims.

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Of the 21 different classes, the following classes are usually applicable to a real estate transaction. Expert advice from a third-party professional, like an accountant, is required when CCA becomes a material component of a transaction. Class 8 – 20% Class 8 includes miscellaneous tangible property; for example, non-structural equipment and chattels that are not included in other classes. Office equipment, stoves, fridges, dishwashers, and carpeting would also be included in this class. Office equipment is depreciated using the declining balance method and becomes an expense item on the investor’s operating statement. In addition to the building, other tangible assets involved in the operating of a real estate asset may also be depreciated and used to offset the taxable income produced by or through the operation of the building. Depreciation is a component of any successful real estate investment opportunity. You must understand its significance and discuss depreciation with the investor at a high level. Always be aware of the need to refer the investor to third-party professionals for a detailed discussion of the subject. Class 13 – Straight Line The calculation of CCA for Class 13 items uses the straight-line method, as opposed to the declining balance method. The straight-line depreciation method is used when calculating the depreciation for leasehold improvements and is typically claimed by the party that paid for the improvements. For example, if a tenant made the improvements and paid the costs, they would claim depreciation. However, if the landlord paid for the improvements as an incentive to attract the tenant, they would claim the depreciation. The useful life is usually determined by the duration of the lease including renewal periods. However, there are several rules associated with this type of depreciation and expert advice should always be sought from third-party professionals. Example of CCA Calculation: Straight Line Method Class 13 Year 1 – Year of Purchase (.10 x 80,000)

$80,000 -8,000

Balance Year 1 (Undepreciated Capital Cost)

$72,000

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Year 2 (.10 x 80,000)

-8,000

Balance Year 2 (Undepreciated Capital Cost)

$64,000

(Note: Assume a 10% capital cost allowance and that the SO% rule does not apply to these specific leasehold improvements. Special other rules apply that go beyond the scope of this text) When working with investors, it is important that you ensure that they understand the difference between straight line and declining balance methods, and how each applies to the investor’s business.

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Lesson 1 | Page 9 of 17

Declining Balance Method When trading in investment properties, it is important for you to understand that the declining balance method is the most frequently used method to calculate depreciation. Declining balance involves the reduction of the capital cost by a percentage, as set out for a particular class of property, with subsequent reductions always applied to the declining balance (undepreciated capital cost) within that class. There are rules applicable to the declining balance method. These rules will be discussed in detail later; but for the purpose of this illustration, the half-year rule means that in the year of acquisition, only 50 per cent of the cost of the asset can be depreciated. However, in subsequent years, the full amount of the undepreciated capital cost (UCC) will be subject to capital cost allowance.

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Example of Capital Cost Allowance: Declining Balance Method (Existing Corporation) A corporation begins the year with undepreciated capital cost (UCC) in a specific class of 550,000 with purchases and dispositions made during that year. The CCA for the applicable year and the UCC for the beginning of the following year are calculated below. UCC of class at beginning of year Add: Purchases during year Less: Lesser of Dispositions during year: Capital cost, or Proceeds at disposition

$50,000 +5,000 $3,000 $3,500 -3,000 52,000 -1,000

UCC Before Adjustment Less: 1/2 net amount (5,000 - 3,000) / 2) (refer Half-Year Rule) UCC Before CCA Less: CCA for class for the year Add: 1/2 net amount (refer the previous text) UCC of the class at beginning of the next year

51,000 -5,100 +1,000 $46,900

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Lesson 1 | Page 10 of 17

An investor owns a commercial property and has rented space to a tenant who requires renovations to suit their business needs. The renovations will be completed by the investor who, on the advice of their accountant, will depreciate the improvement cost for income tax purposes. What method would the investor’s accountant use to calculate the eligible depreciation expense? There are four options. There is only one correct answer. 1

The capital cost allowance method

2

The straight-line method

3

The declining balance method

4

The non-capital asset depreciation method

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Lesson 1 | Page 11 of 17

When trading in investment properties, you will need to understand the significance and benefits of depreciation and be able to discuss them at a high level with an investor. You should also be aware of when to refer the investor to third-party professionals for more detailed information.

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Lesson 1 | Page 12 of 17

The 50 Per Cent Rule and Available for Use The 50 per cent rule (also referred to as the half year rule) was implemented to correct the fact that assets purchased at the end of a taxation year would otherwise provide an amount in a class eligible for the maximum capital cost allowance in that year. This rule provides that 50 per cent of the acquisition costs of an asset may be depreciated during the year in which it was acquired regardless of the month of acquisition. By effectively reducing the capital cost allowance (CCA) on purchases made during the year, the tax advantage of a late purchase is reduced. The regulations under the Income Tax Act limit the amount of capital cost available for newly acquired assets to one-half of the normal amount of CCA for the year of acquisition. For newly acquired properties, the regulations were further amended for all taxation years following. The half-year rule now applies only to properties that are available for use. Otherwise, CCA is deferred to the following taxation year. The property must be used for generating income and the regulations set out requirements in that regard. CCA may be deducted in the year that the property was first used for generating income or 358 days following the taxation year in which the property was acquired.

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Example of Declining Balance Method – New Brokerage On October 1, 2000, ABC Realty Inc. began operations and purchased office furniture at a cost of $8,700. In the following year, additional office furniture costing $15,000 was purchased. The maximum CCA that can be claimed for both years, along with the UCC, is calculated as follows: Working Notes Office furniture is categorized under Class 8, with a 20% CCA rate and depreciation calculated by the declining balance method. The 50% Rule applies in both years due to the additions. Since no dispositions occurred in either year, only the net amount of additions is used for calculations. As ABC Realty Inc. started operations on October 1, 2000 (a leap year), the ratio for pro-rating is 92/366. 2000 Additions

$8,700

UCC, December 31, 2000 Less: (50% Rule) ½ net amount UCC before CCA

$8,700 -4,350 4,350

CCA at 20% pro-rated (4,350 x 0.20 x 92) / 366) Add: ½ net amount

-219 +4,350

UCC at January 1, 2001

$8,481

2001 Additions $15,000 UCC, December 31, 2001 Less: % net amount (15,000 x .50)

$15,000 $23,481 -7,500

UCC before CCA

15,981

CCA at 20% Add: % net amount

-3,196 +7,500

UCC at January 1, 2002

$20,285

If there are no additions or dispositions in 2002, the CCA is: $20,285 x 20 = $4,057

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Lesson 1 | Page 13 of 17

Taxation Year Less Than 12 Months In the first or last year of the operation of a business, or in a year in which there has been a change in the fiscal year, it is possible to have a taxation year of less than 12 full months. In such cases, capital cost allowance (CCA) must be pro-rated by the proportion that the number of days in the taxation year is to 365 (or 366 in a leap year). Example: A company is incorporated on June 1, and opens for business on the same day. They have purchased office furniture valued at $20,000, so Class 8 (20%), is available for use on the same day. In this case, the half-year rule would apply, so only 50 per cent of the value of the assets are eligible for depreciation in the year of acquisition. In addition, the eligible depreciation must be pro-rated over the number of days available for use in the taxation year.

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$20,000 x (20% ÷ 2) x 214 (pro-rated amount of days) = $428,000 $428,000 ÷ 365 days = $1,172.60 for CCA claim in Year 1 The undepreciated capital cost (UCC), or the carry forward amount into Year 2 would be $20,000 minus $1,172.60, which equals $18,827.40. In the second year of operation, the asset would now be depreciated at its full rate because it is no longer the year of start up and the year that the asset was acquired. $18,827.40 x 20% = $3,765.48 UCC = $18,827.40 – $3,765.48 = $15,061.92 (opening balance in Year 3)

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Lesson 1 | Page 14 of 17

Capital Cost Allowance as a Permissive Deduction The rate of capital cost allowance (CCA) applied to each class is specified as a maximum rate. A taxpayer may therefore claim any CCA amount up to the maximum by multiplying the CCA rate by the balance in the class (undepreciated capital cost, or UCC) at the end of the taxation year. Only the amount of CCA actually claimed is deducted from the balance of the class and the remaining balance is carried forward and available for future CCA claims. You should always advise an investor to consult with an accountant for expert advice on depreciation rates.

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Lesson 1 | Page 15 of 17

Disposition of an Asset When an asset is disposed of, the lesser of the original cost of the asset or what the asset was sold for is deducted from the outstanding undepreciated capital cost (UCC) within the specific asset class. In the declining balance method of calculating depreciation or capital cost allowance, the UCC is the remaining balance of the value of the asset to be depreciated in future taxation years. For example, consider a group of four properties owned by an investor with a UCC of $350,000 each. This group of properties represents an asset class. If the investor sells one of these properties, the lesser of the original cost of the asset or what the asset was sold for is deducted from the total outstanding UCC for this asset class. The remaining three assets within the asset class will be carried forward in the subsequent years for further depreciation. Asset Would Never be Reduced to Zero in Declining Balance Method When an asset is being depreciated using the declining balance method, the UCC is being reduced by a fixed percentage, therefore it would be mathematically impossible to reduce the UCC to zero. However, in the straightline method, the UCC is reduced each taxation year by a fixed amount, rather than a percentage amount, and eventually the total cost of the asset could be reduced to zero.

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Lesson 1 | Page 16 of 17

Peter and Mary Smith have purchased an industrial property containing 21,650 sq. ft. for $930,000. The acquisition price, which includes the cost of purchasing the asset, is $947,000. Class 1 buildings are depreciated at a rate of four per cent per year. The capital cost allowance (CCA) calculations are based on acquisition price. The building allocation value agreed to by the parties in the agreement of purchase and sale is 70 per cent of the acquisition price, with the remaining 30 per cent allocated to the land for CCA purposes. The 50 per cent or half-year rule must be applied for the first year of ownership and subsequent CCA calculations. What is the capital cost allowance permitted in year one? There are three options. There is only one correct answer. 1

$26,516

2

$13,258

3

$5,682

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Lesson 1 | Page 17 of 17

Congratulations, you have completed the lesson! Completion of this lesson has enabled you to: • Identify that the capital cost allowance (CCA) rate and calculation method may vary according to the asset type • Describe rules that may apply to the calculation of CCA There are two sections on this page with a summary of the key topics that were discussed in this lesson. As part of a salesperson’s regulatory obligations to protect and promote the best interest of

Identify that the the seller or the buyer and to provide conscientious and competent service, you are capital cost required to do the following when working with investors: allowance rate • Have a fundamental understanding of the various classes for purposes of CCA (CCA) and calculation as outlined in the Income Tax Act and its regulations calculation • Advise on value allocation by consulting with a third-party professional, and method may vary understand the importance of including the allocation in the agreement of purchase according to the and sale asset type • Ensure that investors understand the difference between straight line and declining balance methods, and the application of each in the operation of the investors business

The half-year rule and pro-rating of CCA in the year of start-up, and other rules may apply Describe rules that may apply to to the calculation of capital cost allowance the calculation of capital cost allowance

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Lesson 2 | Page 1 of 9

Lesson 2: Calculating Capital Cost Allowance: Differences Between the Declining Balance Method and the Straight-line Method This lesson defines the declining balance method for calculating capital cost allowance, explains certain restrictions in making these calculations, and explains recaptured capital cost allowance (RCCA).

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Lesson 2 | Page 2 of 9

When working with investors, you will need to differentiate between the declining balance method and the straightline method for calculating capital cost allowance (CCA). You should recognize certain restrictions on rental income and CCA, and the recapture of capital cost allowance as required by the Income Tax Act. Upon completion of this lesson, you will be able to: • Define the declining balance method for calculating capital cost allowance Throughout this lesson, you will participate in decision points to test your knowledge on the topics presented.

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Lesson 2 | Page 3 of 9

The most frequently used method to calculate depreciation is called the declining balance method. This method involves the reduction of the capital cost of an acquisition by a percentage, as set out for a particular class of property, with subsequent reductions always being applied to the declining balance or to undepreciated capital cost, within the property or the asset class.

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Lesson 2 | Page 4 of 9

Declining Balance Method The declining balance method of calculating capital cost allowance (CCA), commonly referred to as depreciation, is an accelerated depreciation method in which the CCA expense declines with the age of the fixed asset. The CCA expense under the declining balance method is calculated by applying an appropriate depreciation rate defined in the Income Tax Act to the undepreciated capital cost (UCC) of the asset at the start of the accounting period. The CCA is then deducted from the outstanding UCC. The remaining balance of the UCC then becomes the opening balance in the next accounting period. This is the most frequently used method to calculate depreciation. Not an Actual Loss Depreciation is used to reduce the amount of taxable income and is considered to be a non-cash item on an operating statement. It does not require a specific expense or cash outlay by the taxpayer, other than the original acquisition cost of the asset. The claim for depreciation would not reduce the amount of cash on the taxpayer’s balance sheet.

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Lesson 2 | Page 5 of 9

Restrictions When trading in investment properties, you will need to understand the restrictions on claims for capital cost allowance (CCA) deductions for rental properties: • The Income Tax Act distinguishes between rental income and business income. The determining factor involves the nature and extent of services provided to tenants (for example, a hotel operation versus a rental apartment building) and the size of the activity (for example, a large corporation owning numerous rental units versus an individual investor with a 12-plex). • Rental income is subject to rental property restrictions. CCA deductions for rental properties can neither create nor increase a loss on rental properties when held by individuals, partnerships, or selected corporations. The restriction does not apply to companies whose principal business is leasing and rental of properties (referenced as a principal business corporation). • CCA restrictions relating to leasing go beyond the scope of this program. CCA Restrictions—Rental Property

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CCA deductions on rental properties cannot create a loss, but can only be used to reduce taxable income to zero. The Income Tax Act restricts CCA on rental properties owned by individuals, partnerships, and certain types of corporations. A principal business corporation is defined as an entity whose principal business involves the leasing, rental, development, or sale of owned real property. As a result of Regulation 1100, the maximum allowable capital cost allowance is now limited to the total amount of taxable income before CCA. This requirement effectively eliminates the possibility of paper losses from CCA deductions. A paper loss occurs when the current price of an asset is lower than the price the owner actually paid. The paper loss may be erased if the value of the asset increases.

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Lesson 2 | Page 6 of 9

Recaptured Capital Cost Allowance At the time of sale, the Income Tax Act requires the recapture of capital cost allowances (CCA) if the value of the improvements has remained the same or increased since originally acquired. The recapture cannot exceed the capital cost deductions allowed. As a rule, if a building is sold and there is still outstanding undepreciated capital cost (UCC) after the sale price has been deducted, then a “terminal” loss can be claimed. If a negative UCC balance occurs due to asset disposition, recapture (referred to as income inclusion) occurs, even if assets remain in that particular class. This means that if a building sells for more than an investor paid for it and reduced the UCC to zero, then the investor would have to pay back all or a portion of the CCA that was claimed during ownership. If the value of the building has increased, then depreciation did not actually occur. Recapture must be declared as income. Deferral of recapture (postponing the repayment to later years) is possible in some

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instances; for example, if a replacement property is acquired within a specified time limit. In this instance, an amount equal to the recapture is applied against the UCC for new property. Recapture can occur either when analyzing taxable income from operations cash flows or sale proceeds at the point of disposition. An example is provided relating to the sale of property. As recaptured CCA will affect sale proceeds and consequently cash flows after tax, registrants must be aware of basic procedures used in establishing whether a recapture is being realized. Further, accurate forecasting of sale proceeds after tax is necessary when calculating an after-tax internal rate of return (IRR). Example of Recaptured Capital Cost Allowance Recaptured capital cost allowance, for purposes of a sale involving a typical investment-grade property, is calculated by establishing the lesser of improvement allocations at purchase or improvement allocations on sale, and deducting undepreciated capital cost improvement allocations on sale. Acquisition Price Less: Total Soft Costs Less: Original Land Allocation

$1,000,000 -0 -300,000

Improvement Allocation at Purchase

$700,000

Improvement Allocation on Sale (established at the point of sale)

$930,000

Improvement Allocation (lesser of the two allocations)

$700,000

Plus: Capital Improvements Less: Undepreciated Improvements at Sale

+0 -622,164

Recaptured Capital Cost Allowance

$77,836

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Lesson 2 | Page 7 of 9

The accountant for an existing business is preparing the year-end income tax return. The undepreciated capital cost (UCC) for office furniture from the previous year is $28,920. The office furniture has been depreciated at the rate of 20 per cent. UCC is the balance of the capital cost left for further depreciation at any given time. What will the UCC be at the end of this current taxation year and at the end of the next taxation year? There are no additions or dispositions in the class in either year. There are three options. There is only one correct answer.

1 2 3

Current year = $23,136 Next year = $4,627.20 Current year = $23,136 Next year = $18,508.80 Current year = $26,028 Next year = $23,425.92

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Lesson 2 | Page 8 of 9

An investor recently sold an investment property for $2,000,000. The negotiated land value was $900,000. The investor purchased the property 10 years ago for $1,200,000, and at the time the land was valued at $500,000. The undepreciated capital cost (UCC) at the time of sale was $650,000. Recall that when calculating recaptured capital cost allowance (CCA), it is the lesser of the improvement allocation (building cost) at purchase or sale minus the UCC at the time of the sale. How much CCA must be recaptured and shown as income on the owner’s income tax return? There are three options. There is only one correct answer. 1

$50,000

2

$60,000

3

$70,000

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Lesson 2 | Page 9 of 9

Congratulations, you have completed the lesson! Completion of this lesson has enabled you to: • Define the declining balance method for calculating capital cost allowance Here is a summary of the key topic that was discussed in this lesson. When trading in investment properties, you will need to understand the declining balance method for calculating CCA and recognize certain restrictions on rental income and the recapture of capital cost allowances, as required by the Income Tax Act. The salesperson should understand and be able to discuss the following: • Claims for depreciation are not considered a “cash” item and would not reduce the amount of cash on the taxpayer’s balance sheet • CCA restrictions relating to rental properties • Recaptured capital cost allowance

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Lesson 3 | Page 1 of 16

Lesson 3: Forecasting Taxable Income and Cash Flows After Tax for Investment Properties This lesson describes the different components of an operations cash flow worksheet for one year and reviews the different considerations that makes an investor’s tax liability unique.

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Lesson 3 | Page 2 of 16

When analyzing potential properties for investors, you need to be able to discuss an operations cash flow worksheet and its different components. For the purposes of this lesson, we will examine these calculations based on a single projected year. Upon completion of this lesson, you will be able to: • Describe the different components of an operations cash flow worksheet for one year • Describe different considerations for which an investor’s tax liability could be unique Throughout this lesson, you will participate in decision points to test your knowledge on the topics presented.

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Lesson 3 | Page 3 of 16

Operations cash flow is an important aspect of any investment property and determines the amount of cash being generated by the business. You should be familiar with aspects related to the operations cash flow worksheet for the property to assist a seller or a buyer; however, you must always recommend that they consult a third-party professional, like an accountant.

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Lesson 3 | Page 4 of 16

Overview of the Operations Cash Flow Worksheet As a salesperson, you will encounter the operations cash flow worksheet when assisting a client to analyze an investment property. The worksheet will enable you to find out the amount of cash flow that can be generated by the property after accounting for the annual debt service or mortgage payments. It will tell you the monthly and yearly income that can be expected from a property. Understanding the operating cash flow worksheet will be important to you when guiding the seller or the buyer. When guiding an investor buyer to select a property, you must be able to determine if the cash flow from the property is adequate for the investor’s individual circumstance. At the same time, when assisting a seller, you will determine the value of the property based on the cash flow it generates. You should also be familiar with the worksheet to be able to better communicate with the mortgage provider and other professionals in the field, if required.

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Lesson 3 | Page 5 of 16

Components of an Operations Cash Flow Worksheet When working with investors, you will need to understand the difference between the purchase price and the acquisition price. The purchase price is the amount that is paid for the property itself. The acquisition price is the total, final cost of purchasing the property, including any additional costs such as appraisal fees, legal fees, real estate remuneration, credit report charges, insurance fees, loan application fees, mortgage fees, property surveys and permit fees, licences, and utility connections. These additional costs are collectively referred to as the cost of acquisition. Acquisition Price The calculation to arrive at the acquisition price is as follows: Acquisition Price = Down Payment + Cost of Acquisition + Debt For purposes of completing exercises, assume that the acquisition price (building allocation only based on building/land ratio) is used for capital cost allowance (CCA) calculations. All costs of acquisition are included in the acquisition price for prorating purposes, unless otherwise indicated.

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Lesson 3 | Page 6 of 16

Components of an Operations Cash Flow Worksheet In the last module, you learned about the property analysis worksheet. The property analysis worksheet contains a detailed list of income and expenses related to the building and is a useful tool for you to compare different properties and their net operating income (NOI). The operations cash flow worksheet comes after the property analysis worksheet. It enables you to understand the cash flow generated by a property and whether it would suit the investor’s situation. The investor may fill out this document themselves or may accept your assistance in this regard. The following five sections contain information on the various types of property interests.

Acquisition price

Apart from the purchase price, the acquisition price will include other expenses such as the land transfer tax, the legal fees, the surveys, etc. It is the total initial investment and will be higher than the purchase price. When selling the property, the investor must consider the acquisition price of the property.

Annual debt service

The financing cost, which could be a mortgage or a loan payment.

Amortization of loan fees

Allowable loan fees are usually amortized over five years and include mortgage brokerage fees, standby or commitment fees, mortgage application fees, and appraisal fees. This item is mainly for tax purposes and salespersons will not be required to calculate the fees. You should recommend that your client seek advice from a third-party professional, such as an accountant.

Capital cost allowance (CCA)

CCA provides the owner of a property tax deductions that can reduce the amount of tax payable. You should have knowledge about the application of CCA but should recommend that clients consult third-party professionals for calculations and guidance.

Estimated tax liability

The estimated tax liability is subtracted from cash flow before tax and will tell the investor the actual cash that is available to them.

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Lesson 3 | Page 7 of 16

Components of the Operations Cash Flow Worksheet Scenario The following scenario illustrates income and expenses associated with an investment property and how various calculations, when applied to the information, will assist the salesperson when completing the operations cash flow worksheet and determining cash flow after tax. John and Barb Peters are considering the purchase of an industrial property containing 21,650 sq. ft., priced at $939,500. Tenants have gross leases at $11.60 per sq. ft. The building is fully occupied, and all operating expenses are paid by the owner. As a salesperson, you will need to assist the clients in determining cash flow after-tax projections at the end of year one. Selling Price: Selling price is $939,000. Acquisition price is $947,000 (including $17,000 in acquisition costs).

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Capital Cost Allowance (CCA) Calculations: Class 1 building depreciated at a rate of four per cent per year. CCA calculations are based on acquisition price. Building to land allocation is 70/30 for CCA purposes based on acquisition price. Rents: The current rent is considered market rent. A vacancy/credit loss factor of five per cent appears realistic. Other Income: Research indicates that additional income can be generated from advertising, roof rental for communication equipment, and rental of surplus parking spaces at $4,500 in the first year. Operating Expenses: Estimated to be 54 per cent of the gross operating income in year one. Financing: The lender is prepared to advance a mortgage of $697,000 at 7.75 per cent, amortized over 25 years with monthly payments of $5,208.83 and due in four years. Loan fees of $8,124 will be amortized over four years. Marginal Tax Rate: A tax rate of 42.3 per cent will be applicable. The following screens will show different components of a typical operations cash flow worksheet with numbers adapted from the above scenario.

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Lesson 3 | Page 8 of 16

Annual Debt Service Calculations An operations cash flow worksheet typically has a section where the acquisition price can be calculated, as seen in the following example: OPERATIONS CASH FLOW WORKSHEET CLIENT NAME

ACCQUISITION PRICE

John and Barb Peters

Down Payment

233,000

PROPERTY LOCATION

+ Cost of Acquisition

17,000

= Investment at Purchase

250,000

PROPERTY TYPE

+ Debt

697,000

Industrial

= Acquisition Price

947,000

I23, Industrial Way, Anycity, ON

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Operations Cash Flow Operations cash flow represents periodic monies received from the operation of the investment. Cash flow can be positive or negative. Appraisers and real estate registrants calculate a single year’s cash flow based on income and expense analysis to arrive at net operating income (NOI). Annual debt service is then deducted from NOI to arrive at cash flow before taxes (CFBT). Cash flow can be further analyzed from an after-tax perspective. Cash flow before taxes is frequently used in market value estimates, while cash flow after taxes is applied with investment value estimates, although this distinction should not be overemphasized as the lines are often blurred. Mortgage Details The mortgage payment is rounded to the nearest cent and then multiplied by 12 to arrive at annual debt service. You can calculate interest payments for forecasted years at the same time to save a calculation step later on (Interest on 1st Mortgage). MORTGAGE DETAILS 1st Mortgage • • • • • •

Beginning balance is 697,000 Term amortization is 25 # of payments per year are 12 Interest rate is 7.75 Payment is 5,208.83 Annual debt service is 62,505.96

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Lesson 3 | Page 9 of 16

Other Components of an Operations Cash Flow Worksheet 1. - Amortization of Loan Fees = 2,031 2. Income Before CCA = 56,955 3. - CCA = 13,258 Further sections included in a standard operations cash flow worksheet include: Amortization of Loan Fees As a guideline, allowable loan fees are usually amortized over five years and include mortgage brokerage fees, standby or commitment fees, mortgage application fees, and appraisal fees. Certain exceptions apply. For example, a mortgage term less than five years. If fees relate solely to the taxation year and the loan is arranged and

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extinguished in that period, amortization is not required for certain borrowing expenses. As financing options flourish, you are advised to rely on expert advice concerning the amortization and deductibility of loan costs. CCA (Capital Cost Allowance) As illustrated in Line 15 of the worksheet, CCA tells the owner of a property the tax sheltering opportunity available to them and how much they can apply to defer tax payments. Example of Capital Cost Allowance If a property was acquired at an acquisition price of $200,000, with a building/land allocation of S150,000/550,000, then the following would be the CCA calculation for the first two years. Undepreciated Capital Cost Before CCA – Year One = $150,000 Deduct Capital Cost Allowance for the Year: Class 1 [(4% x $150,000) ÷ 2] (Half-Year Rule Applies) = -3,000 Undepreciated Capital Cost Before CCA – Beginning of Year Two = 147,000 Deduct Capital Cost Allowance for the Year: Class 1 (4% x $147,000) = -5,880 Undepreciated Capital Cost Before CCA – Beginning of Year Three = $141,120

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Lesson 3 | Page 10 of 16

Tax Liability 1. 2. 3. 4. 5.

Income Before CCA = 56,955 - CCA = 13,258 Real Estate Taxable Income = 43,697 x Marginal Tax Rate = 0.423 Tax Liability = 18,484 (rounded)

CASH FLOWS 1. Net Operating Income = 111,818 2. - Annual Debt Service = 62,505.96 © 2021 Real Estate Council of Ontario

3. Cash Flow Before Tax = 49,312 4. - Tax Liability = 18,484 5. Cash Flow After Tax = 30,828 As illustrated, to calculate tax liability, multiply the real estate taxable income (Line 16) by the marginal tax rate (Line 17), which will equal the estimated tax liability (Line 18). While tax cash flow comparisons are popular, a frequent criticism involves their complexity. After-tax proponents argue that any investment analysis not acknowledging tax considerations, including the tax bracket of the investor, is woefully inadequate. They also contend that, while taxation principles are complex, calculators and software programs have made the exercise somewhat straightforward, provided that all assumptions are clearly stated. Skeptics point to the relative simplicity of cash flow before tax analysis and that investment analysts dealing with stocks and bonds rarely quote returns based on after-tax positions. Regardless, real estate is acknowledged as a unique commodity and tax sheltering remains a major consideration. If the taxpayer information is unavailable or there are complexities involved with a real estate acquisition, you should use before-tax analysis or simulate a typical investor’s tax position in arriving at after-tax returns.

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Lesson 3 | Page 11 of 16

An investor buys a property for a purchase price of $950,000. The investor puts a down payment on the property of $300,000 and requires a mortgage of $650,000. There is also $50,000 in additional costs, due to legal and accounting fees, environmental reports, real estate remuneration, and land transfer taxes. What is the investor’s acquisition price? There are three options. There is only one correct answer. 1

$1,000,000

2

$5,000,000

3

$2,000,000

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Lesson 3 | Page 12 of 16

Marginal Tax Rate 1. 2. 3. 4. 5.

Income Before CCA = 56,955 CCA = 13,258 Real Estate Taxable Income = 43,697 x Marginal Tax Rate = 0.423 Tax Liability = 18,484 (rounded)

Marginal Tax Rate Marginal rates vary by income and type of ownership (personal versus corporation). The effective rate applicable will also vary dependent on whether income relates to operational cash flows or disposition. Marginal tax rate refers to the tax rate applied on the next incremental dollar of income. You would be expected to have an understanding of the marginal tax rate and to be able to guide the investor based on inputs from the client or their accountant.

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Cash Flow Cash flow represents all monies flowing from an investment. Cash flow is fundamental to building wealth from an investment perspective. Cash flow is derived from two sources: ongoing rental income (operations cash flow) and appreciation in the value of the building at the point of disposition (sale proceeds cash flow).

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Lesson 3 | Page 13 of 16

Before-Tax and After-Tax Analysis Cash flow represents all monies flowing from an investment. Cash flow is fundamental to building wealth from an investment perspective. Cash flow is derived from two sources: ongoing rental income (operations cash flow) and appreciation in the value of the building at the point of disposition (sale proceeds cash flow). Both types of cash flow were analyzed in Land, Structures and Real Estate Trading when discussing the income approach to value. Operations Cash Flow Operations cash flow represents periodic monies received from the operation of the investment. Cash flow can be positive or negative. Appraisers and real estate registrants calculate a single year’s cash flow based on income and expense analysis to arrive at net operating income (NOI). Annual debt service is then deducted from NOI to arrive at cash flow before taxes (CFBT). Cash flow can be further analyzed from an after-tax perspective. Cash flow before taxes is frequently used in market value estimates, while cash flow after taxes is applied with investment value estimates, although this distinction should not be overemphasized, as the lines are often blurred. In reality, salespersons work in both worlds. Sale Proceeds Cash Sale proceeds cash flow represents the sale proceeds of the investment (reversion). (Registrants usually refer to this type of cash flow as sale proceeds cash flow.) Traditionally, sale proceeds have been viewed separately and treated as capital appreciation. This approach was particularly popular in inflationary periods when operations cash flows were either small or negative and investment decisions were made solely on anticipated sale gains. However, stable economic periods require a more all-encompassing perspective on investment return. Real estate investment analysis analyzes the interplay of both operations cash flow and sale proceeds cash flow when determining the yield on an investment property. Capital appreciation, while valid, is only one dimension within a larger picture. In real estate investment analysis, after-tax cash flow is preferred over before-tax cash flow, as it is thought to be the best measure of true cash flow realized by an investor. Further, after-tax cash flow is considered to be the most accurate comparison between various investment properties being considered.

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The following illustrates the effects of taxation when considering cash flows: After tax cash flow is better than before tax cash flow • The best measure of true cash flow realized by the investor. • The most accurate comparison between various investment properties being considered. Example of Operations Cash Flow: Before Tax versus After Tax • For property A operations CBFT is $88,000 and tax liability is -15,500. The operations CFAT for property A is $72,500. • For property B operations CBFT is $96,000 and tax liability is -28,500. The operations CFAT for property B is $67,500. • For property C operations CBFT is $100,000 and tax liability is -32,000. The operations CFAT for property C is $68,000. • For property D operations CBFT is $78,000 and tax liability is -12,700. The operations CFAT for property D is $63,300. Tax liability can vary substantially between properties based on such factors as mortgage interest payments and capital cost allowances. Conclusion: While Property C has the greatest before tax cash flow, Property A provides the best after tax cash flow.

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Lesson 3 | Page 14 of 16

Seek Expert Advice When working with investors, it is important that you recommend they consult with third-party professionals if the required information is beyond your level of knowledge and skill. The services of a tax expert should be sought for completion of all matters relating to taxation. Information and procedures provided are designed to increase awareness only. The impact of taxation on real estate investments can be significant. The amount of taxation varies, as investors are taxed according to income, based on the type of ownership. You should be reasonably conversant in overall taxation principles to counsel and assist your clients with decision making and to communicate effectively with other professionals involved in the transaction. However, such assistance must not exceed reasonable parameters no matter what the issue; for example, taxation, environmental issues, or legal concerns. If advice is required, the services of an appropriate expert should always be sought.

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Lesson 3 | Page 15 of 16

An investor has asked for a cash flow before-tax and after-tax analysis on any investment property brought to them for consideration. The investor’s accountant has informed the salesperson that the investor’s marginal tax rate is 42.5 per cent, and that the investor asks that this rate be used in the salesperson’s analysis of cash flows from investment properties. The salesperson shows the investor a property that has a net operating income (NOI) of $188,000 and monthly mortgage payments of $8,333.33. Please note that cash flow after-tax is cash flow before tax less any tax liability. What is the cash flow after tax for the investor? There are three options. There is only one correct answer. 1

$50,600.02

2

$108,100

3

$103,308.33

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Lesson 3 | Page 16 of 16

Congratulations, you have completed the lesson! Completion of this lesson has enabled you to: • Describe the different components of an operations cash flow worksheet for one year • Describe different considerations for which an investor’s tax liability could be unique There are two sections on this page with a summary of the key topics that were discussed in this lesson. When trading in investment properties, you must have a thorough understanding of the

Describe the different components of a cash flow worksheet and be capable of discussing this with different investors when they are analyzing potential properties. components of an A salesperson should be able to discuss the following with an investor: operations cash • The cash flow model and initial cash flow flow worksheet • Purchase price, acquisition price, and operations cash flow for one year • Amortization of loan fees and capital cost allowance

When working with investors, you must be able to discuss different considerations

Describe different regarding an investor’s tax liability, including: considerations for • Marginal tax rate and cash flow which an • Sale proceeds cash flow and before-tax and after-tax analysis investor’s tax • Seeking advice from tax experts when necessary liability could be unique

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Lesson 4 | Page 1 of 11

Lesson 4: Steps and Calculations to Complete an Operations Cash Flow Worksheet This lesson describes how a salesperson completes an operations cash flow for a single year in relation to selected investment properties and identifies the necessary steps and calculations to complete an operations cash flow worksheet.

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Lesson 4 | Page 2 of 11

When working with investors, you will need to have a fundamental understanding of the necessary steps and calculations to complete an operations cash flow worksheet. As you learned earlier in this course, a property analysis worksheet will also be used when calculating cash flow. For the purposes of this lesson, we will analyze cash flow for a single year in relation to selected investment properties. Upon completion of this lesson, you will be able to: • Identify the necessary steps and calculations to complete an operations cash flow worksheet Throughout this lesson, you will participate in decision points to test your knowledge on the topics presented.

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Lesson 4 | Page 3 of 11

When trading in investment properties, you will need to understand the various steps and calculations involved to successfully fill out an operations cash flow worksheet.

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Lesson 4 | Page 4 of 11

Information Included from the Property Analysis Worksheet While both the property analysis worksheet and the operations cash flow worksheet are separate documents with focus on distinct aspects, they are still connected. You will need some inputs from the property analysis worksheet when completing the operations of cash flow worksheet. You learned in detail the different items on the property analysis worksheet earlier in this course. The property analysis worksheet is typically filled out by salespersons to compare properties and determine the net operating income. The document will have a detailed analysis of the various income and expenses of the property. The property analysis worksheet precedes the operations cash flow worksheet. When comparing various properties for purchase, you will use the property analysis worksheet to determine which property generates a better net operating income (NOI). The operations cash flow worksheet is used once you have identified a few properties and want to better understand aspects related to cash flow and mortgage considerations. The worksheet will use information related to the NOI from the property analysis worksheet. Within the property analysis worksheet, you will find: • • • •

A summary of cash receipts and cash disbursements analysis prior to taxation is provided Different investment perspectives are addressed Different time periods can apply including past (actuals), current (reconstructed), and future (forecasted) Net operating income and cash flow before taxes are established

Function The worksheet provides a uniform detailed structure for the following: • Recording the owner’s actual income and expenses • Reconstructing the owner’s figures to reflect a typical property of a certain type • Forecasting possible scenarios based on individual investor needs

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Lesson 4 | Page 5 of 11

Calculating Net Operating Income To calculate the net operating income for the Peters’ first year of ownership, the following example is provided: • • • • • • •

Potential rental income is $251,140. The calculation is 21,650 sq. ft. x $11.60 per sq. ft. = $251,140 Vacancy and credit loss is – $12,557. The calculation is $251,140 x 5% = $12,557 Effective rental income is $238,583. The calculation is $251,140 - $12,557 = $238,583 Other income is + $4,500. It consists of advertising, roof rental, and parking $4,500 per year. Gross operating income is $243,083. This is a total of all the Items stated previously. Operating expenses is – $131,265. The calculation is $243,084 x 54% = $131,265 Net operating income is $111,818. The calculation is $243,083 – $131,265 = $111,818

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Lesson 4 | Page 6 of 11

Calculating Capital Cost Allowance The table below provides an example of how to calculate the Peters’ capital cost allowance (CCA) permitted in year one. • Acquisition price is $947,000. This is also referred to as the adjusted cost base. • Undepreciated capital cost (UCC) is $662,900. The calculation is $947,000 x 70% of the acquisition price = $662,900 • Improvements is 70% and land is 30% of the acquisition price. Improvements = $662,900 and Land = $284,000 • Class 1: 4% Marginal rate is $26,516. The calculation is $662,900 x 4% marginal rate = $26,516 (The half-year rule applies in the first year) • Max CCA permitted in Year 1 is $13,258. Half-year rule applies in Year 1: $26,516 ÷ 2 = $13,258

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Lesson 4 | Page 7 of 11

Calculate Cash Flow After Tax The following provides an example of how to calculate the Peters’ cash flow after tax at the end of year one. • Net operating income is $111,818. Net operating income is Line 7 on the operations cash flow worksheet. • Amortization of loan fee is -$2,031. Loan fees of $8,124 are amortized over the four-year period, with each year being $2,031. • Annual debt service is -$62,506. Annual debt service is calculated by adding interest rate and principal. Interest is $52,832 + principal $9,674 = $62,506 (Interest is only deductible for tax purposes.) • Income before capital cost allowance (CCA) is $56,955. This is calculated by Operations cash flow worksheet: Line 7 - (Line 9 + Line 10) - (Line 11 + Line 12 + Line 13) • CCA is -$13,258. The calculation of CCA is $662,900 undepreciated capital cost x 4% marginal rate = $26,516. Half-year rule applies in year one: $26,516 ÷ 2 = $13,258 • Real estate taxable income is $43,697. The calculation of real estate taxable income is income Before CCA 56,955 - CCA of 13,258 = 43,697 • CFBT (taxable income) is $49,312. The calculation is $111,818 - $62,506 = $49,312 • Income tax is -$18,484. The tax liability is determined with the advice of the investor’s tax expert, who is aware of the current tax rates, rules, and applications for both this investment category and the taxpayer’s unique circumstances and ownership structure. This amount will be paid to the Canada Revenue Agency. • Cash flow after tax is $30,828. The calculation is $49,312 – $18,484 = $30,828

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Lesson 4 | Page 8 of 11

Completed Operations Cash Flow Worksheet The following is an illustration of a completed operations cash flow worksheet, based on the scenario presented earlier and includes cash flow after tax. This document will be useful when you present the financial details of a property or multiple properties to an investor. OPERATIONS CASH FLOW WORKSHEET • • • •

CLIENT NAME: John and Barb Peters PROPERTY LOCATION: I23, Industrial Way, Anycity, ON PROPERTY TYPE: Industrial ACQUISITION PRICE Down Payment 233,000 + Cost of Acquisition 17,000 = Investment at Purchase 250,000 + Debt 697,000 = Acquisition Price 947,000 MORTGAGE DETAILS 1st Mortgage Beginning balance Term amortization # of payments per year Interest rate Payment Annual debt service TAXABLE INCOME Year__1_ Potential Rental Income - Vacancy & Credit Loss

697,000 25 12 7.75 5,208.83 62,505.96

251,140 12,557 © 2021 Real Estate Council of Ontario

= Effective Rental Income + Other Income = Gross Operating Income - Operating Expenses = Net Operating Income - Non-Operating Expenses - Interest 1st mortgage - Interest 2nd mortgage - Amortization of Loan Fees = Income Before CCA - CCA = Real Estate Taxable Income × Marginal Tax Rate = Tax Liability

238,583 4,500 243,083 131,265 111,818 NIL 52,832 NIL 2,031 56,955 13,258 43,697 0.423 18,484 (rounded)

CASH FLOWS Net Operating Income 111,818 - Annual Debt Service 62,505.96 = Cash Flow Before Tax 49,312 - Tax Liability 18,484 = Cash Flow After Tax 30,828

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Lesson 4 | Page 9 of 11

A salesperson presents a potential property priced at $1,600,000 to an investor. The salesperson suggests that the investor should consider speaking with their tax advisor about the advantages of applying capital cost allowance (CCA) to reduce taxable income. The investor prefers to use an 80/20 building to land allocation that will be negotiated between the investor and the seller in an agreement of purchase and sale. The property is a Class 1 asset with a marginal CCA rate of four per cent. The half-year rule will apply. What is the eligible CCA claim at the end of the first year of ownership? There are three options. There is only one correct answer. 1

$25,600 CCA

2

$32,000 CCA

3

$51,200 CCA

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Lesson 4 | Page 10 of 11

A salesperson presents a property to an investor client that is showing a net operating income (NOI) of $80,367. The investor client has an opportunity to get financing of $487,500, which will have an annual debt service of $45,585. If the investor client acquires this investment, they will have a tax liability of $13,324 according to their tax advisor. The allocation of improvement to land is 70/30 for capital cost allowance (CCA) purposes, based on acquisition price, and it is classified as a Class 1 asset with a marginal rate of four per cent. Cash flow before tax (CFBT) should consider mortgage payments, while cash flow after tax (CFAT) should additionally also consider tax liability. What are the investor’s cash flow before tax and cash flow after taxes figures on this investment? There are four options. There are multiple correct answers. 1

$34,782 CFBT

2

$41,052 CFBT

3

$21,458 CFAT

4

$13,324 CFAT

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Lesson 4 | Page 11 of 11

Congratulations, you have completed the lesson! Completion of this lesson has enabled you to: • Identify the necessary steps and calculations to complete an operations cash flow worksheet Here is a summary of the key topic that was discussed in this lesson. When working with investors, you will need to have a fundamental understanding of how to complete an operations cash flow worksheet. Key information for completing an operations cash flow worksheet includes: • Working with a property analysis worksheet prior to completing an operations cash flow worksheet • Calculating net operating income • Calculating capital cost allowance • Calculating cash flow before tax and after tax

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Lesson 5 | Page 1 of 6

Lesson 5: Summary Practice Activities

This lesson provides a series of activities that will test your knowledge on the entire module.

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Lesson 5 | Page 2 of 6

This lesson provides summary practice activities. Throughout this lesson, you will participate in decision points to test your knowledge on the topics presented.

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Lesson 5 | Page 3 of 6

The accountant for an existing business is preparing the year-end income tax return. The undepreciated capital cost (UCC) at the beginning of the year for the office computers is $125,500. This is a Class 45 asset, wherein the marginal rate for capital cost allowance (CCA) is 45 per cent on the declining balance method. What will the CCA and the UCC be for this asset at the end of the current year, and at the end of the following year? There are three options. There is only one correct answer.

1

2

3

Current year: $26,028 CCA $99,472 UCC Next year: $44,762.40 CCA $54,709.60 UCC Current year: $56,475 CCA $69,025 UCC Next year: $31,061.25 CCA $37,963.75 UCC Current year: $56,475 CCA $69,025 UCC Next year: $56,475 CCA $12,550 UCC

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Lesson 5 | Page 4 of 6

An investor recently sold an investment property for $3,750,000. The original allocation for land was 20 per cent of the acquisition price and the parties agreed to this allocation for the sale. The investor’s acquisition price for the property 10 years ago was $2,100,000 and, at the time, the undepreciated capital cost (UCC) was $1,680,000. The UCC at the time of sale was $1,075,200. What is the amount of recaptured capital cost allowance (RCCA) the investor would have to report as income, if any, to the Canada Revenue Agency? There are three options. There is only one correct answer. 1

$604,800

2

$1,025,000

3

$1,924,800

© 2021 Real Estate Council of Ontario

Lesson 5 | Page 5 of 6

An investor has asked for cash flow before tax (CFBT) and cash flow after tax (CFAT) analysis on any investment property brought to them for consideration. The investor’s accountant has informed the salesperson that the investor’s marginal tax rate is 43.5 per cent, and that the investor asks that this rate be used in the salesperson’s analysis of cash flows from investment properties. The salesperson shows the investor a property that has a net operating income (NOI) of $268,700, with the annual mortgage payments total of $185,500. What is the cash flow before and after tax for the investor? There are three options. There is only one correct answer. 1 2 3

CFBT = $83,200 CFAT = $47,008 CFBT = $832,000 CFAT = $45,008 CFBT = $83,700 CFAT = $48,000

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Lesson 5 | Page 6 of 6

Congratulations, you have completed the lesson!

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Module Summary | Page 1 of 3

Module Summary

This lesson contains a summary of the entire module.

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Module Summary | Page 2 of 3

Congratulations, you have completed this module! This lesson will present a summary of Learning Objectives.

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Module Summary | Page 3 of 3

There are six sections on this page with a summary of the key topics that were discussed in this module.

Identify that the Capital Cost Allowance (CCA) Rate and Calculation Method may Vary According to the Asset type

A salesperson has a regulatory obligation to protect and promote the best interests of the seller client and provide conscientious and competent service. You are required to do the following when working with investors: • Understand the nuances involved in assessing operations cashflow, and be able to determine the net operating income and cash flow before tax on an investment property • Be mindful of the need to refer an investor client to other third-party professionals when more detailed discussion of a subject is required • Understand CCA in order to identify various opportunities for an investor to reduce taxes payable • Determine the allocation of value with respect to land and buildings during negotiation of an agreement of purchase and sale • Understand the significance and benefits of depreciation, and be able to discuss with an investor at a high level Completion of this lesson has enabled you to: • Identify that the CCA rate and calculation method may vary according to the asset type, and understand the various classes for purposes of CCA calculation as outlined in the Income Tax Act and its regulations

Describe Rules that may Apply to the Calculation of Capital Cost Allowance (CCA)

A salesperson must understand that expert advice is essential when speaking with investors about depreciation rates. It is important that you suggest the investor to consult with an accountant. Completion of this lesson has enabled you to: • Describe the half-year rule and pro-rating of CCA in year of start-up or first year of acquisition, and other rules that may apply to the calculation of capital cost allowance

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• Ensure that investors understand the difference between straight line and declining balance methods, and the application of each

Define the Declining Balance Method for Calculating Capital Cost Allowance (CCA)

When working with investors, you will need to differentiate between the declining balance method and the straight-line method for calculating CCA, recognize restrictions on rental income and CCA, and understand how to calculate recapture of capital cost allowance as required by the Income Tax Act.

Describe the Different Components of an Operations Cash Flow Worksheet for One Year

When working with investors, you will need to be able to discuss an operations cash flow worksheet and its different components when you are analyzing potential properties. You should understand:

Completion of this lesson has enabled you to: • Determine how the rate and method for calculating capital cost allowance will vary depending on the specific asset

• The four components of the cash flow model • The difference between the purchase price and the acquisition price • How to calculate estimated tax liability, guided by the investor’s tax advisor Completion of this lesson has enabled you to:

• Describe the different components of an operations cash flow worksheet for one year When working with investors, you should recommend they consult with third-party Describe Different professionals if the required information is beyond your level of knowledge and skill. The Considerations services of a tax expert should be sought for completion of all matters relating to taxation. for Which an The impact of taxation on real estate investments can be significant.

Investor’s Tax Liability Could be Unique

A salesperson should be able to discuss different considerations regarding an investor’s tax liability, including: • Marginal tax rate and cash flow • Sale proceeds cash flow and before-tax and after-tax analysis Completion of this lesson has enabled you to: • Describe different considerations for which an investor’s tax liability could be unique

© 2021 Real Estate Council of Ontario

Identify the Necessary Steps and Calculations to Complete an Operations Cash Flow Worksheet

When working with investors and investment properties, you will need to have a fundamental understanding of the necessary steps and calculations to complete an operations cash flow worksheet. Key information for completing an operations cash flow worksheet includes: • Working with property analysis worksheet prior to completing an operations cash flow worksheet • Calculating net operating income • Calculating capital cost allowance • Calculating cash flow before and after tax Completion of this lesson has enabled you to: • Identify the necessary steps and calculations to complete an operations cash flow worksheet

© 2021 Real Estate Council of Ontario