Living off the rent

Renting out a property can be a good investment, but Bruce Sellery says it’s probably not the best way to fund your retirement.

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by Bruce Sellery
April 23rd, 2012

Online only.

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Question

I am 47 years old, female, single, and have no children. My principal residence is paid for, I have no debt, and I have $200,000 that I would like to use to create some form of regular retirement income. I am thinking about buying a second house and renting it out, but I wonder if I would be better off investing the money in the markets. I have been self-employed my whole life and therefore have no pension to rely on. CPP will provide very little, and with the changes to the OAS coupled with some personal health problems, which may force me into retirement sooner than I’d like, I’m concerned about my future.

Answer

The appliance repairman called with bad news. The refrigerator motor was dead and it would cost almost as much as a new one to replace. But I couldn’t just buy a new one because the fridge had to fit into a very small space in the kitchen and those models were tough to find. Plus, we were about to leave on vacation so we wouldn’t have time to shop for one. To top it all off, the first renters arrived in under a week.

Every summer we rent out our cottage when we aren’t using it, making us seasonal landlords. Overall, it works well. I have the rental process down to a science and the after tax income it generates has funded a number of improvements on the property and it helped to pay down the mortgage. But as the example above demonstrates, being a landlord can be a stressful experience. The first question I think you need to ask yourself is whether or not you’re up to the task.

1. Do you want to be a landlord?

Are you willing to be on call when the fridge breaks down? Are you interested in finding and vetting tenants, dealing with the cheques that bounce, handling their complaints and keeping an eye on the property? Some people love this part; some tolerate it because the upside is worth it; while others hate it more than anything in the world. Where on this spectrum of “adore to abhor” are you? Of course you could pay a property manager to handle it all for you, but that might seriously eat into the income you so desperately seek. And given the health problems you mentioned, are you willing to take on such an ambitious project?

2. Does the math work on a rental property?

Let’s say you’re somewhere in the middle of the spectrum—willing to tolerate being a landlord even if you don’t love it. The next step is to do some math to see if it makes sense for you. A mortgage broker or your bank mortgage specialist will be able to help you answer these questions, but bear in mind that they make their money by having you take on debt.

  • Affordability: Based on the downpayment you have, what could you afford to buy? The rules for the minimum downpayment are different between a rental property and a principal residence. How would affordability change if you used only part of the $200,000, or included some of the equity from your principal residence? Don’t forget to factor in real estate closing costs and other, non real estate financial commitments that you have in life; things like travel, a new car, health care costs, etc. Could you afford a condo that costs $200,000? A house that costs $400,000?
  • Rent estimate: Now go to a real estate website and find houses in your price range in areas that you are familiar with. For simplicity, choose places that are move-in ready so you don’t have to do too much thinking on how much renovations would cost. Then go to a few rental websites and research what a house like that, in that neighbourhood, would rent for in today’s market.
  • Cash flow: Pull together all the information into one cash flow statement. You’d have income from the rent, and expenses to support it, including renovations, and ongoing items like mortgage payments, property taxes, yard maintenance, repairs, utilities, etc. How long would it take for the rental to make a profit? And once it did, now much profit would it make? Then calculate the rate of return on the money you invested. You’ll use that number to compare to other ways of earning income in retirement.
  • Resale: Some people make the math on a rental property make sense by assuming that the house will be worth a lot more down the road when they sell it. This has been more or less true for the last ten years, but as mortgage rates increase, house prices are expected to flatten out. Plus, because it isn’t your principal residence, there will be capital gains tax to pay. I would recommend being conservative about what you would be able to sell the house for, and be aware of the risk that when you want to sell the property in the future, the market could be in a slump.
  • Conclusion: This analysis is based on a lot of assumptions—interest rates, the housing market, your health and your need for cash, etc. What conclusion do you draw for yourself? Does the math make sense to buy a rental property as a way to earn income in retirement?

3. How will you deal with risk?

The next question looks at where the rental property fits within the bigger picture. A portfolio of stocks and bonds is certainly not without risk. But if you’re willing to accept lower returns, you can lower your risk by choosing products that pay out a set amount of income every year—for example, a GIC or a government bond. When it comes to your rental property, it is harder to manage the risk.

If the rental market declines and you can’t rent your house for six to 12 months, you don’t have a cash buffer to tide you over until you find a new tenant. What about if you suddenly need a significant amount of money for an emergency? While selling under pressure isn’t ideal, you could sell off some of your stocks to raise $10,000 cash pretty fast, but you can’t sell a portion of your rental property and that would limit your flexibility.

Another issue is that you won’t be very well diversified, assuming you have no funds other than the $200,000. “You already own a residence, so your asset mix will be heavily skewed towards real estate,” says Adrian Mastracci is a portfolio manager with KCM Wealth Management. Alternatively, if you put your money into an investment portfolio comprised of Canadian stocks, international stocks, and bonds you would be able to lower your risk through diversification.

Choosing to buy a rental property is a big decision and there is more to look, including mapping out what other alternatives for retirement income would look like. I’ll review some of those options in my next blog.

P.S. We ended up paying the money to have the “vintage” fridge repaired instead of buying new.

ask@moneysense.ca

4 comments on “Living off the rent

  1. An investment property is a great way to increase your wealth. Yes, it will need to be managed but it's not impossible. Generally, if you list the property for rent through a real estate agent, it will cost you one month's rent as commission on the deal and you will be getting a higher quality tenant because they will be "vetted" by the agent. In addition, you can hire the real estate agent to manage the property – that too is one month's rent per YEAR. So the cost is not unreasonable and both costs are legitimate business expenses that can be written off on your taxes. Keep your expectations realistic – buy a property that is ripe for tenants (downtown condos) with very little "work" required. Having said that, you should NOT use all your money to fund the rental. Diversify with some on the investment property and some in the money markets, etc.

    Reply

    • I agree with Mr. Bruce making such kind of business as your man source of income is not ideal for several reasons. Just like any other business if you want it to be successful you have to manage it right, managing a rental property could be quite stressful specially if the renters are being delayed on the payment I think people at their retirement age can't handle such kind of stress.

      Reply

  2. The problem with getting a GIC or similar safe investment, as this author suggests, is that the interest you get will trundle along at 2-3%, barely above inflation. In other words, you'll have to reinvest it all to keep your purchasing power the same – leaving you with 0 net cash flow, in real terms. A riskier investment strategy may beat inflation, but that's at the whim of the market. (By the way, 90% of mutual fund managers can't beat a mathematical index of the market anyway)

    A well located rental property can, not uncommonly, give you a 10% return over the year, where I live at least. That translates into real cash flow, and you pass on inflation costs to the renter. Also, don't focus on the asset price of the house as much as the rental income – it's easy together burned looking for returns on the property value itself. If you keep that in mind, housing bubbles don't look quite as scary – the rental income will always be there.

    The biggest risk is a prolonged vacancy – you can mitigate this by being careful about location, look for low vacancy rates, and by dividing your property. (Consider a divided duplex – 2 or 4 tenants v. One – spreads the risk)

    Reply

  3. I bought my first rental property in 1996 after graduating from University(one year latter-a Duplex) and have earned a compounded rate of return on my original investment of 50K of 13.79%per year over the last 17 years. This return includes cash flow generated on a monthly basis, pay down of my principal by the tenants (almost fully paid off), and overall appreciation since that time (purchased for $175K now worth $400K). Rental properties are a license to print money, as long as you are an effective landlord and are good to your tenants. In 2008 we purchased another duplex after our principal residence was paid off. We are averaging a compounded rate of return of about 9% on this second property. I see rental risk as significantly lower then the stock market, cause I have control, not brokers or politicians. I’ve even got my parents, in-laws and brother into the business. I love it when people say their is no money in rental properties, cause the truth is there is lots of money. Besides we are in this for the long-term on cashing out at 63 (23 years from now)…so we don’t get caught by the Old age claw-back when we retire at 67 ( I like to have my cake and eat it too).

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