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Real estate profit today could mean trouble later

Andrew Allentuck, Family Finance
Financial Post
June 4, 2011

Situation: Couple's debt four times family income

Strategy: Pay off debts, diversify portfoliio

Solution: Less risk, good chance of achieving goals

In Ontario, a couple we'll call Oscar, 40, and Nancy, 33, are raising two children, ages 6 and 8. The parents, both in real estate, bring home about $120,000 a year after business expenses and income tax. They are thriving in their commission sales work and have three rental properties of their own worth $320,000. With their home, two cars, one RV and other property investments, their assets total $732,700. But acquiring those assets has been expensive, for they owe $634,000. Their debt-to-income ratio could put them into a serious squeeze as interest rates rise. In effect, they are living a bet that bricks and mortar will one day yield a big capital gain that compensates for the time, risk and effort of holding real estate.

Oscar wants to add more properties. "Our plan is to build our real estate business to its maximum potential over the next 10 years, to acquire eight more rental properties and have all of them paid in 15 years and to be able to retire, if we want to, by the time I am 55."


Family Finance asked Derek Moran, who heads Smarter Financial Planning Ltd. of Kelowna, B.C., to work with Oscar and Nancy. "The amount of debt this family holds is scary," he says. "They are coping for now. An interest-rate squeeze or a run of vacancies could be devastating and their plan to build a real estate fortune could collapse. At present, the business is solid and very profitable. They know their market."

Oscar and Nancy collect $3,148 in rents each month from their three properties. From that gross revenue, they pay $1,161 for mortgage interest, $60 for utilities, $238 for property insurance and $414 for property taxes, total $1,873, for net rental income of $1,275 a month, or $15,300 a year, before depreciation. They put down only $8,000 for all three properties, giving them an annual net return on initial equity of 192%. It is the result of high leverage and it is evidence of high portfolio risk. If property prices were to drop by 10%, the rental properties would be worth less than what they owe. Oscar and Nancy could face cash calls from lenders.

They have other interest charges that total $2,619 a month for loans for their RV, car, home renovations, line of credit and their home mortgage. Add in living expenses and their monthly cost of living totals $10,000. Their budget balances, but they plan to add to their rental properties.


At the head of the debt reduction list is the couple's $30,000 RV (8.9% interest) that costs them $4,728 a year. Sell it and rent when necessary. Then pay down other debts, like their $17,000 car loan (3.9%). That costs $5,100 a year. It is partially deductible because the car is used for business. Next to go should be a $30,000 home-improvement loan (10.25%). That's $6,000 a year. Money saved from the RV loan and the car loan, approximately $819 a month, or $9,828 a year, can be put into paying off this high-cost debt. At this rate, it will be discharged in a little more than three years. The balance of savings can go to paying off the $7,000 student loan that is carried at prime.


Retirement is very far away. Moreover, Oscar and Nancy are likely to build up their rental business quite substantially in the next few decades. However, at age 55, they would be five years from the earliest time they could draw Canada Pension Plan benefits and 10 years from Old Age Security. The cost of taking CPP benefits at age 60 is a 36% reduction of age 65 benefits, so it would be good for the couple to have sufficient savings to get them to 65.

At age 65, they would be entitled to what can be assumed to be close to the maximum Canada Pension Plan benefits, currently $11,520 a year, and full annual OAS benefits, currently $6,322. It is too early to estimate what their present or future property or other assets will earn.

It is possible to suggest the amount of investment income that will be needed to support a budget of $5,000 a month, or $60,000 a year, after tax, which is roughly what Oscar and Nancy now spend after debt service and child care, RESP contributions and other family costs. If they pay an average tax rate of 20% on their pre-tax income, they would need $75,000 a year before tax.

When both are 65, two CPP benefits, $23,040, and two OAS benefits, $12,644, will total $35,684 a year. It is fair to assume the current rental mortgages will be paid off by retirement, so a further $3,148 a month times 12, or $37,776, can be added to cash flow. That's $73,460, which is almost enough to cover present living expenses projected to Nancy's age 90. All figures are in 2011 dollars.

Oscar and Nancy have $23,400 in their children's registered education savings plans and should boost contributions from the present $167 a month to $416 to qualify for the maximum Canada Education Savings Grant of the lesser of 20% of contributions or $500 per child. If they make full contributions and the RESPs grow at 3% a year over inflation and payouts are averaged for the two kids, each would have $50,800 for post-secondary education, Mr. Moran estimates.

Achieving the goals of educating their kids and retiring at age 55 is challenging but not impossible. The bigger question is whether they should take the large risks that go with early retirement. That would mean giving up perhaps a decade's worth of commission income. The property market could solve this problem for them. After all, as house prices and rents rise with inflation, the couple's rental income and pre-retirement commission income should pace the growth of the consumer price index.

Lack of diversification of investments adds to their portfolio risk. They have 74% of their total assets, including their house but excluding vehicles, in property. It is hardly a diversified portfolio. Moreover, 25% of their financial assets in RRSPs and other accounts are in cash earning almost nothing. "They have, in effect, balanced their at-risk real estate assets with a small amount of cash with substantial exposure to inflation," Mr. Moran says. "The balance is, in fact, lopsided and the interest return is so low that they are in effect paying for the privilege of holding cash. Oscar and Nancy need to sharpen their nonreal estate investment skills to provide the security they need."

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Monthly after-tax income $10,000


Home mort. $800

Prop. taxes, home and rentals $589

Utilities and maint. $1,060

Rental mortgages $1,962

Prop. ins. $238

Food and restaurants $930

RV loan $394

Car loan $425 Operating

loan $500

Home improve. loan $500

Student loan $118

Car fuel and repairs $500

Travel, ent. $560

Children's expenses $400

Clothing, grooming $250

RESP $167

Car, life and home insurance $500

Gifts, charity $107

Total $10,000

House $220,000

Rentals $320,000

Cars (2) $30,000

RV $30,000

RESP $23,400

RRSP $53,000

TFSA $10,100

Children's savings $5,000

Cash $11,400

Loan $29,800

Total $732,700


Home $182,000

Rentals $279,400

Car loan $17,000

RV loan $36,000

Student loan $7,000

Home improve. loan $30,000

Operating loan $82,600

TOTAL $634,000


Posted on Tuesday, June 7, 2011 at 01:19AM by Registered CommenterElaine in | CommentsPost a Comment | References1 Reference

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