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How to choose a strategy for investing in overseas property /Material prepared for RBC Real Estate. Georgiy Kachmazov, Managing Partner, Tranio/

How to choose a strategy for investing in overseas property /Material prepared for RBC Real Estate. Georgiy Kachmazov, Managing Partner, Tranio/

Many investors who invest in overseas property, tend to high returns. However, not everyone understands that a higher initial yield implies greater risks, that is, the likelihood of a decrease in income in the long run.

We recommend clients to assess risks in advance and think through an investment strategy with an optimal balance of profitability, reliability, labor costs and other factors of investment efficiency. Most Tranio customers have a simple rental business in a stable location, with a long-term rental contract and management through a management company. In this article we will look at how to ensure the best profitability with such a strategy.

Why simple rental business

Typical investors who use the services of Tranio are successful entrepreneurs from Russia, Brazil, Iran or China. As a rule, in their homeland they have an active business that makes the main profit. From overseas property, they prefer to receive passive income with minimal involvement in management. This investment is not so much for profit, but with the aim of preserving capital and protecting it from the political and economic risks of its country.

Most customers do not plan to sell their profitable real estate in the short term. This property provides investors with a personal pension fund and serves as a guarantee of the financial well-being of their children. Another important motive – a residence permit in the United States or European countries, which provide such an opportunity to real estate buyers.

Value added projects, construction or redevelopment, are usually not suitable for our investors. Investments in them are associated with high risks, among which are cost overruns, difficulties in obtaining permits, an overpriced purchase price, and a long search for a buyer. The investor is required to actively participate in the project and certain qualifications in the construction business. Development projects are effective as the main type of activity, and not as a tool to preserve capital.

Thus, we recommend non-core investors a simple rental business: to buy real estate and lease it. This is a low-risk and easy-to-implement strategy.

Budget and object types

We recommend considering investments in overseas property with a budget of 200 thousand euros. Cheaper, with rare exceptions, it is difficult to buy a liquid object. In this segment, we recommend buying residential apartments. Among their advantages is high liquidity and stable demand.

With a budget of over 2.5 million euros, it is worth targeting commercial properties, primarily commercial real estate and nursing homes.

Regardless of the budget, 50–60% of the value of the property can usually be taken on credit, so you can start investing in profitable real estate from 100 thousand euros of your own funds.

Types of commercial real estate and their parametersTranio data (average recommended indicators) *

Types of
objects
Yield,
% per annum
The term of
the contract
rent
Benefits disadvantages
From 300 thousand euros
Apartments (short term rental) 5–7 From 1 day High liquidity; in comparison with long-term lease – the yield is higher and there are no problems with the eviction of tenants; more potential rental growth Risks of management and downtime;compared to long-term lease – faster wear
Apartments (long term rental) 2–3 From 1 year High liquidity; high demand from tenants, stable even during a crisis Risks of management and downtime; problems with the eviction of tenants
Student housing 4–6 From 6 months High demand from tenants Compared with apartments – lower liquidity, difficult to repurpose
From 2.5 million euros
Apartment buildings 3-5 From 1 year High liquidity, growth potential of capitalization Low yield, many tenants, problems with eviction, we need a management company
Street shops 3-4 3–10 years old High liquidity, growth potential of capitalization Low yield
Supermarkets 5–6,5 12–15 years old High yield, long contracts The closer the contract expiration date, the lower the liquidity
From 10 million euros
Nursing home 5–6,5 20–25 years old Growth in the number of pensioners, long-term contracts Difficult to repurpose
Shopping centers 4–6 5–15 years old High yield Risks of management with a large number of tenants
Hotels 4–6 10–20 years old High yield Difficult to repurpose

* Average indicators for objects:

  • in prosperous areas of major European cities;
  • new facilities or after major repairs;
  • rental contracts at the beginning of the term.

Location

From the location of the object is directly dependent on the risks and profitability of investments. We recommend investing in countries with a developed economy and a stable political system. Austria, Great Britain, Germany, USA, France and Switzerland are the least risky: in these countries the probability of hyperinflation, the fall in national currencies and the decline in GDP are the least.

Most Russian clients prefer Germany because of geographical proximity, and also because, compared with the other countries listed, profitability in Germany is slightly higher, credit conditions are better, and taxes are slightly lower. But other countries from this list are also of interest: for example, some investors choose the United States because they expect more capitalization there, others fear a weakening of the German economy due to political events, and still others are buying income property in countries where their business or personal interests .

We also advise you to take into account the currency in which the investor’s family spending in 5–10 years will be nominated . For example, if you have residential property in the UK and your children study there, then it is worth looking at the objects whose rental income is generated in pounds sterling.

Among settlements, it is better to choose either megalopolises and their prosperous suburbs, or cities of medium size with a growing population, a developed labor market and a potential for economic growth. We advise you to focus on proven locations, which already have a successful investment experience compatriots. For example, successful options are the Western European capitals and major cities of West Germany.

The choice of the area depends on the type of property. For example, it is better to buy street shops on the main streets with heavy traffic, and retail and warehouse premises – on the outskirts of a large city near the highway.

Tenants and Leases

If you rent residential property, then middle-class people with a good credit history and stable income are preferable as tenants. And in the segment of commercial real estate the least risky objects that have already been leased to large corporate tenants working in the market for tens or hundreds of years are least risky. The probability of bankruptcy of such tenants is less than that of small private companies. Information about the financial status of tenants can be requested from lawyers in the process of examination of the object (Due Diligence).

Objects with a large number of tenants (for example, apartment buildings or shopping centers) are not suitable for foreign non-core investors. In our experience, if there are more than five tenants, this significantly increases the risk of management and increases the requirements for the professionalism of the management company. It is best to buy property with a single tenant.

An important condition of the lease is the separation of costs for the maintenance of the object between the owner and the tenant: who pays tax on real estate, utilities, insurance and other expenditure items. We advise to reduce risks by buying objects in which the maximum operating costs assigned to the tenant. Agreements of this type are called NN Lease (Double Net Lease) or NNN Lease (Triple Net Lease), their differences from other options are shown in the table:

Type of lease Owner’s expenses
Repair of the facade
and building
structures
Maintenance
and service
Insurance Real estate tax
Gross rent lease
N Lease
(Single Net Lease)
·
NN Lease
(Double Net Lease)
· ·
NNN Lease
(Triple Net Lease,
equivalent in Germany —Dach & Fach)
· · ·
Absolute NNN Lease · · · ·

It is recommended to acquire objects with long-term (10–20 years) rental contracts without the right of termination, and with a fixed rental rate without reference to the operating indicators of the tenant’s business. Keep in mind that such an agreement imposes obligations on both sides: it is not only that the tenant guarantees stable rent for the entire term, but also that the owner does not have the right to evict the tenant before the expiration of the contract.

Long-term contracts provide the investor with additional insurance against price corrections, from which even the most reliable real estate markets are not protected. If you have invested in an object with a 15–20-year contract, then with a high degree of probability the period of price reduction will fall on the first 10 years of ownership, since real estate market cycles replace each other every 7–10 years . In case of hard contracts for 15–20 years, price fluctuations will not affect your income, since it is impossible to terminate the contract or reduce the rent. Thus, you can wait until the market recovers, and exit the project with a successful market situation.

Even with long-term contracts, it is usually possible to index rental rates in accordance with inflation, that is, annually raise them by about 1–2% . With the positive development of the market this has its drawbacks. For example, if the real estate market grows by 4% every year, and after 10 years you would like to donate an object that is significantly more expensive than inflation, you will not be able to do this, because the contract limits you. Therefore, investors who believe in the rise of the market in the long term, it is better to buy objects with five-year contracts (for example, commercial property on pedestrian streets) and index the rental price at the end of the contract.

Cost growth potential

Low risk assets in Western markets are sold with an initial rental yield of 3 to 7%. We consider buying objects with an initial yield of more than 7% unjustified and disadvantageous for a foreign investor: in such projects it is highly likely that any risk is realized on the horizon of 5–10 years , the cost of eliminating which will be higher than the risk premium at the entrance.

In addition, markets with a low level of risk and profitability (as a rule, these are centers and prestigious districts of large cities) are becoming more expensive than those that are characterized by high initial profitability and associated high risks.

For example, as a retrospective analysis of real estate prices in the USA showed by Tranio , from 2001 to 2015 objects with an initial yield of 3% grew in price by an average of 5% per year, with a yield of 5% – by 4.7%, with a yield of 7 % – only by 3.5% per year, and objects with a yield of 9% could fall in price. At the same time, among the objects that became cheaper, the ones that had a lower yield lost the least in value. The probability of price falling is higher for objects with a higher initial yield, so taking into account the likelihood of the realization of this risk, objects with an initial yield of 3–7% result in a higher total yield.

For the forecast of price increases, the development prospects of the district are also important. The real estate where the gentrification occurs is the fastest growing – the process by which industrial areas are transformed into prestigious residential areas, the territory is improved, the infrastructure is developed, and low-income people are replaced by more affluent. At the same time, the most advantageous areas are located close to the city center or have convenient transport links to the center.

Optimum profitability depends not only on risks, but also on the duration of the investment. The shorter the term, the greater the initial yield makes sense within the range of 3–7% . For example, without taking into account a loan with a 20-year investment period, the highest total return (taking into account the growth of capitalization) is achieved with an initial yield of 3.8–5.8% ; and if the investment period is 10 years, then the optimal initial yield is 4.5–6.5% . This conclusion Tranio analysts received as a result of a study of 100 pairs of “profitability – capitalization increase” for residential and non-residential real estate in Germany. 

Credit

You can increase profitability with a mortgage.

The money raised by the mortgage is cheaper than the tenant pays the rent. For example, when buying investment property in Germany, you can count on a loan of up to 60% of the value of the object at 2-3% per annum. With a rental yield of 6.5%, the return on invested capital, taking into account the loan, can reach 8-10% .

In general, the cheapest loans are at a floating rate without the possibility of early repayment, and the most expensive ones are at a fixed rate, allowing early repayment.

It is better to take a loan for a long period (10-15 years) : the longer the term, the more expensive the money, but the less risk that the negative market conditions affect the refinancing conditions. In the case of commercial real estate, it is recommended to draw up a mortgage under a scheme whereby interest is paid first and the loan body closer to the end of the loan term. It is desirable that by the end of the term not less than 40–50% of the body be extinguished .

It is not worth refinancing an object and borrowing too much. But one should not borrow too little, since it would be strange not to use the opportunity to get a loan at a lower price than the tenant pays.

Tax optimization

As for the optimization of the tax on income, individuals in Europe and the United States pay it in proportion to the amount of income, and real estate worth up to 1 million euros is easier to issue to an individual. A more expensive property is more profitable to register for a company, because legal entities usually have a flat and lower income tax rate. It is also easier for companies to reduce the taxable base due to depreciation and deductions on loans from the bank and the founder.

Best of all, if the transaction can be organized so as to pay taxes only in the country where the property is located. Such a possibility depends on the tax residency of the investor, interstate agreements on the avoidance of double taxation, form of ownership and other factors. Tranio consultants, with the help of tax advisors, help each client individually structure the transaction and arrange a loan on optimal terms.

Exit from the project

The usual tenure of ownership of a real estate before the sale is 5–20 years . As a rule, you need at least 13-14 years for the object to pay off and start making a profit. In some countries, investors are guided by the term for the sale after which the capital gains tax is not paid (for example, in Germany it is 10 years).

Whether it will be possible to profitably sell real estate in many years is one of the key risks of an investment, which is often not taken into account by clients who are interested in high returns. They are attracted by offers with an initial yield of 8% and higher; typical examples are parking or housing for students on the periphery. The key disadvantage of such facilities is low liquidity, that is, small demand for purchases. If you are going to sell them, you will have to significantly reduce the price, which ultimately eliminates the high initial yield.

With a planning horizon of 10–20 years, we recommend considering commercial real estate with an initial yield of 5% (while observing the remaining recommendations from this article). Most often, their value grows by 2-3% per year with the market or even faster. These are reliable objects that can be profitably sold ahead of schedule if your plans change. And under a stressful scenario, such real estate loses less in value than more risky objects with a high initial yield.

However, if you are going to sell the property in 1-3 years , then it is best to buy the most profitable property in the region with growth potential. Today, Spain is considered one of these locations in Europe with its central markets in Madrid and Barcelona. However, it is impossible to say whether the growth of these markets will continue in the next 10–20 years , so for long-term investments aimed at preserving capital, it is better to choose more predictable locations.

If you plan not to sell real estate, but leave it to your heirs, then it is important to choose the correct format of ownership in order to optimize inheritance taxes. For example, in France there are no inheritance and gift taxes if the object is registered for a civil real estate company (SCI). And in the UK, inheritance tax is not subject to real estate issued to an offshore company.

Here is a summary of Tranio’s key recommendations for overseas property investors:

  Residential Properties Non-residential property
Min budget 300 thousand euros 2.5 million euros
Types of objects Apartments, accommodation for students Commercial real estate on crowded streets, supermarkets, nursing homes
Country Austria, Great Britain, Germany, USA, France, Switzerland
Cities Large settlements with good demographics and potential for economic growth
Areas Places with good ecology and infrastructure, popular with the middle class; surroundings of universities, medical centers and business districts Near transport arteries and public transport stops, in places where other objects of a similar profile gather
Capitalizationgrowth potential Tall Average
Investment Term From 10 years
Optimum initial
yield
4–6%
(can be increased by a loan)
LTV (share of borrowed funds
from the value of the object)
60%
Credit The cheapest loans – with a floating rate without the possibility of early repayment; should choose a scheme in which interest is paid off first, and the body closer to the end of the term
Loan terms 10–15 years old
Tenants Representatives of the middle class, families with children, students, office workers, pensioners Large trading networks and management companies that have been operating in the market for several decades and are in good financial shape
Type of lease NN or NNN (maximum operating costs for the tenant); non-negotiable long-term contract
Lease term 1 day (short term),
1 year (long term)
5–20 years old

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