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Many investors who invest in overseas property, seeking high returns. However, not everyone understands that a large initial yield means high risks, that is, the probability of lower income in the long term.

We recommend customers to evaluate the risks and strategy of investing with an optimal balance of reliability, profitability, labor and other factors of efficiency of investments. Most customers Tranio simple suitable rental business in a stable location with long term lease contract and management through the management company. In this article, we’ll look at how to provide the best yield with this strategy.

Why is a simple rental business

The typical investors who use the services Tranio successful entrepreneurs from Russia, Brazil, Iran or China. Usually at home they have an active business that brings the main income. From foreign real estate they prefer to receive passive income with minimal involvement in management. It is an investment not only for profit, but to preserve capital and protect it from political and economic risks of his country.

Most customers do not plan to sell their rental property in the near future. This property provides investors with a personal pension Fund and a guarantee of financial well-being of their children. Another important motive — a residence permit in the U.S. or Europe, which provide the opportunity home buyers.

Our investors are usually not suitable projects value added — construction or redevelopment. Investments in them are associated with high risks, including exceeding budgets, difficulties with registration of allowing documents, inflated purchase price and the long search for a buyer. The investor also requires active participation in the project and specific qualifications in the construction business. The project development effective as a primary occupation and not as a tool for capital preservation.

Thus, non-core investors, we recommend a simple rental business: to buy property and rent it out. It’s low risk and simple to implement strategy.

Budget and types of objects

We recommend that you consider investing in overseas property with a budget from 200 thousand euros. Cheaper, with rare exceptions, it is difficult to buy liquid object. In this segment we recommend to buy residential apartments. Among their advantages — high liquidity and stable demand.

With a budget of over 2,5 million Euro is to focus on commercial — primarily retail properties and nursing homes.

Regardless of budget, 50-60% of the property value you can usually take a loan, so investing in rental property can start and 100 thousand euros of own funds.

Types of commercial real estate and their parameters
Tranio data (average recommended values)*

Types
objects
The yield,
% p
Time
contract
rent
Advantages Disadvantages
From 300 thousand euros
Apartment (short term rental) 5-7 From 1 day High liquidity; compared to the long-term lease — higher yield and no problems with the eviction of tenants; the potential for rental growth Risks and management of downtime; compared to a long-term lease — more rapid wear
Apartment (long term rent) 2-3 Than 1 year High liquidity; high demand from tenants, stable even during the crisis Risks and management of downtime; problems with the eviction of tenants
Student housing 4-6 From 6 months High demand from tenants Compared to apartments — lower liquidity, it is difficult to repurpose
From 2.5 million euros
Apartment houses 3-5 Than 1 year High liquidity and growth potential of the capitalization Low yield, lots of tenants, problems, eviction, need a management company
Street shops 3-4 3-10 years High liquidity and growth potential of the capitalization Low yield
Supermarkets 5-6,5 12-15 years High yield, long-lasting contracts The closer the expiry date of the contract, the lower the liquidity
From 10 million euros
Nursing home 5-6,5 20-25 years The growth in the number of pensioners, long-lasting contracts It is difficult to repurpose
Shopping malls 4-6 5-15 years High yield Risks management for a large number of tenants
Hotels 4-6 10-20 years High yield It is difficult to repurpose

* Average values for objects:

  • in affluent areas of major European cities;
  • new objects, or after major repairs;
  • rental contracts at the beginning of the period of validity.

Location

The location of an object is directly dependent risks and investment returns. We recommend investing in countries with developed economies and stable political system. Least risk differ Austria, UK, Germany, USA, France and Switzerland; in these countries less likely hyperinflation, the fall of national currencies and reduction of GDP.

Most Russian customers prefer Germany because of geographical proximity, but also because compared to the other listed countries, the yield in Germany is a bit more, lending conditions are better and the taxes are a little lower. But other countries on this list are also of interest: for example, some investors choose US because they are expecting that there more of capitalization, others fear the weakening of the German economy due to political events, while others acquire profitable real estate in the countries where their business or personal interests.

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We suggest to consider also the currency in which are denominated expenses of the investor’s family in 5-10 years. For example, if you have residential property in the UK and there your children, you should look to objects rental income from which is generated in pounds sterling.

Among other localities it is better to choose big cities and their affluent suburbs or mid-sized cities with a growing population, and a developed labour market and potential economic growth. We recommend to focus on proven locations that already have a successful investment experience compatriots. For example, a good options of Western European capitals and major cities of West Germany.

The choice of area depends on the type of property. For example, street shops it is better to buy on the main streets with heavy traffic, and commercial-warehouse — on the outskirts of major cities near the route.

Tenants and lease agreement

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

Objects with a large number of tenants (e.g., apartment houses or shopping malls) are not suitable foreign non-core investors. In our experience, if the tenant is more than five, it significantly increases the risk of management and increases the demands on the professionalism of the management company. It is best to buy property with the sole tenant.

An important condition of the tenancy agreement — division of costs of the facility between the owner and the tenant: who pays for property tax, utilities, insurance and other costs. We suggest to reduce the risks by buying objects in which the maximum operating expenses charged to the tenant. Contracts of this type are referred to as a NN Lease (Double Net Lease) or NNN Lease (Triple Net Lease), their differences from other variants shown in the table:

Type of lease The cost of the owner
Repair of the facade
and construction
designs
The contents
and maintenance
Insurance Tax
real estate
Gross Rent Lease
N Lease
(Single Net Lease)
·
NN Lease
(Double Net Lease)
· ·
NNN Lease
(Triple Net Lease,
a counterpart in Germany —Dach & Fach)
· · ·
Absolute NNN Lease · · · ·

It is recommended to buy items c long term (10-20 years) rent contracts non-cancellable, and with hard rental rate without reference to the operating performance of the business of the tenant. Keep in mind that this contract is binding on both parties: it is not only that the tenant ensures stable rents for the whole of this period, but that the owner has no right to evict the tenant until the expiration of the contract.

Long term contracts give the investor extra insurance on price adjustments, which are not protected by even the most robust real estate markets. If you have invested in an object with a 15-20-year contract, then with high probability the period of lower prices will occur in the first 10 years of ownership, since the cycles of the real estate market follow each other every 7-10 years. Under strict contracts for 15-20 years, price fluctuations will not affect your income, as it is impossible to terminate the contract or reduce the rent. Thus, you will be able to wait until the market recovers, and to leave the project in good conditions.

Even with the long contract it is usually possible to index rents in line with inflation each year to increase them by about 1-2 %. If a positive market development in this has its disadvantages. For example, if the housing market continues to grow every year by 4 %, and in 10 years you would like to pass an object significantly more than the growth of inflation — you will not be able to do that, because you limit the contract. Therefore, investors who believe in market growth in the long run, it is better to buy properties with five-year contracts (e.g., commercial real estate, and pedestrian streets) and to index the rent at the end of the contract.

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The potential of growth of cost

Low-risk assets in Western markets are sold with an initial rental yield of 3 to 7 %. To buy objects with an initial yield of over 7% we believe it is unnecessary and disadvantageous for a foreign investor: in such projects a high likelihood that on the horizon of 5-10 years implemented any risk, the cost of liquidation which will be higher than the risk premium on the entrance.

In addition, markets with low risk and return (as a rule, malls and prestigious areas of major cities) are becoming more expensive faster than those that are characterized by a high initial yield and the associated high risks.

For example, as shown by Tranio retrospective analysis of real estate prices in the United States, from 2001 to 2015, the objects with an initial yield of 3% rose in price by an average of 5 % per year, with a yield of 5% is 4.7 %, with a yield of 7 % — only 3.5% per year, while objects with a yield of 9% could fall in price. Among the falling objects was lost in the value of those that had a lower yield. The probability of falling prices is higher for objects with higher initial returns, so that taking into account the probability of this risk event objects with an initial yield of 3-7% result in greater overall returns.

For the forecast of price growth are also important prospects for the development of the district. Fastest expensive real estate where there is gentrification — the process by which industrial areas are transformed into residential, ennobled territory, developed infrastructure and a population with low-income displaced by the more affluent. The most advantageous areas which are close to the city centre or have good transport links to the centre.

Optimal yield depends not only on risks, but also from the date of investment. The smaller the period, the greater the initial yield makes sense in the range of 3-7 %. For example, without taking into account the loan with a 20-year investment period the highest total returns (including capitalization growth) is achieved at an initial yield of 3.8–5.8 per cent; and if the investment period is 10 years, the optimal initial yield of 4.5–6.5 %. Such conclusion analysts Tranio received as a result of study of 100 pairs of «yield — increase in capitalization» for residential and non-residential property in Germany.

Credit

You can increase yield with a mortgage.

The money raised through mortgages, are 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 project cost by 2-3% per annum. When you rent yield of 6.5% return on invested capital based on the loan can reach up to 8-10 %.

In the General case, the cheapest loans — variable rate with no possibility of early repayment, and the most expensive with a fixed rate, allowing early repayment.

Better to take a loan for a long term (10-15 years) longer-term, the more expensive the money, but the lower the risk that adverse market conditions will affect the terms of refinancing. In the case of commercial property it is recommended to arrange a mortgage scheme in which first to pay interest and principal — towards the end of the loan term. It is desirable that the end of the term repaid at least 40-50 % of the body.

It is not necessary to re-credit facility and to borrow too much. But should not be too small as it would be strange not to use the opportunity to take the credit cheaper than paying tenant.

Tax optimization

Regarding the optimisation of tax on income of physical persons in Europe and the United States to pay its proportional to the amount of income and real estate value of 1 million euros is easier to draw on a person. More expensive item cheaper to register a company because of legal entities typically flat and the lower rate of income tax. Also companies are easier to reduce taxable income through depreciation and deductions on loans from the Bank and of the founder.

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It is best if a deal could be organized so that to pay taxes only in the country of location of the property. This possibility depends on the tax residency of the investor, interstate agreements on avoidance of double taxation, forms of ownership, and other factors. Tranio consultants with tax advisors help each client individually to structure the transaction and arrange loan at the best conditions.

The output of the project

The usual period of ownership of income property before sale — 5-20 years. As a rule, you need at least 13-14 years, the facility has paid off and started to make a profit. In some countries, investors rely on a term in the sale after which there is paid a tax on capital gains (for example, in Germany it’s 10 years).

Whether it will be profitable to sell the property after many years — one of the key investment risks, which often do not account for customers who are interested in a high yield. They are attracted by offers with an initial yield of 8% and above; typical examples are Parking or housing for students on the periphery. The key disadvantage of such facilities is low liquidity, that is, little demand for the purchase. If you are going to sell them, will significantly reduce the price, which ultimately eliminates the high initial yield.

When the planning horizon is 10-20 years we suggest to consider a commercial property with an initial yield of 5 % (subject to the other recommendations of this article). Often their cost is growing at 2-3% per year with the market or even faster than him. It is a robust object that can be profitable to sell before the planned date if your plans change. But under the stress scenario, such a property less losses in value, the more risky projects with high initial returns.

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

If you don’t plan to sell the property and to leave it to heirs, it is important to choose the right format of possession, in order to optimize inheritance tax. For example, in France there are no taxes on inheritance and donation, if the object is registered at the civil company real estate transactions (SCI). And in the UK inheritance tax exempt property, designed for offshore company.

Here is a summary of the main recommendations Tranio for investors in overseas property

  Residential property Non-residential real estate
Minimum budget 300 thousand euros 2.5 million euros
Object types Apartments, housing for students Commercial real estate on the crowded streets, supermarkets, nursing homes
Country Austria, UK, Germany, USA, France, Switzerland
City Major population centres with good demographics and growth potential
Areas Places with good environment and infrastructure, popular among the middle class; the surrounding area universities, medical centers and business districts Close proximity to transport arteries and public transport, in places where other facilities of a similar profile
Growth potential
capitalization
High Average
Investment period 10 years
The optimal initial
yield
4-6 %
(you can improve credit score)
LTV (leverage ratio
of project cost)
60 %
Credit Cheapest loans — variable rate with no possibility of early repayment; you should choose the scheme in which the first repayment percentage, and the body is closer to the end of the term
Loan term 10-15 years
Tenants The middle class, families with children, students, office workers, pensioners Big retailers and management companies, which operate in the market for several decades and are in good financial shape
Type of lease NN or NNN (for a maximum of operating expenses to tenants);
a long-term contract without the right of termination
The term of the lease 1 day (short-term),
1 year (long-term)
5-20 years

Georgy Kachmazov, managing partner Tranio