Looking Back, Looking Ahead
I’m preaching to the converted when I list advantages to owning real estate with RENTS Club members. Still, a little reminding and a look at scenarios provide extra reinforcement of what we are doing.
What if….? The Boilermaker Revisited
In my last post, I shared a chance meeting with a retired boilermaker. He was complaining that his union pension was not providing the way he envisioned as he was paying into it. What if he bought a single family home as a rental? How would that change his retirement?
Here’s an example of how this could have affected the boilermaker’s situation. Suppose he bought a house in twenty five years ago when he was still working.
Suppose that rental house was purchased in 1991. A ten year old family home in the Juniper Ridge area of Kamloops would sell for $100,000 at that time and would rent for $750 per month. If the purchaser put down $20% – $20,000, the mortgage would have been $80,000. Monthly principal and interest payments would be $610 (based on 8% financing and 25 year amortization). That would have left $140 for all other expenses.
Twenty five years later, the house would be paid off, have a value of $375,000 and be generating $1600 per month rental income. Along the way, interest rates have dropped meaning that P&I payments would be less while rents have increased. These two events combined would mean greater positive monthly income. In the last five years, P&I payments based on 3% financing would have been $378. Rents would have been $1400 plus meaning that over $1,000 would be left over to pay all other bills (taxes, insurance, etc…, estimated at $400 per month).
How would this change one’s retirement situation? Now they have an investment worth $375,000 paid for by the renters, and a net monthly rental income over $1,200 in addition to income from other sources (CPP, OAS, etc…). Rents will continue to rise with inflation.
The equity can be tapped into by selling the property or by opening a Home Equity Line of Credit; the dream of wintering in a Palm Springs park model could become reality. This additional $1,200 retirement income is substantial; being a retiree, I can attest to its significance. Now if only an income suite had been added…
Newby Investors: Get Started Now
There is never a good time to get started, the best time is always now. What if one were to buy a rental property now?
There are three primary advantages of owning rental properties:
- Equity Build Up – A portion of each monthly mortgage payment is used to pay down the principal amount owed. While it may seem insignificant in the first year or two but over a period of five to ten years the mortgage pay down can be sizeable. As an example – suppose one puts 20% down ($60,000) on a $300,000 house. The initial mortgage amount is $240,000. After five years the amount owing is down to $205,000 – a gain of $35,000 in equity. Hold for ten years and the amount owing is down to $164,000 – a gain of $76,000 in equity. The initial investment of $60,000 has grown in value to $136,000 after ten years.
- Monthly Cash Flow – A single family home can provide a positive monthly income that can be used to augment employment income. Monthly P&I payments on $240,000 are $1135, based on 3% interest. This property could rent for $1,800 per month, leaving a positive monthly cash flow of almost $400 after fixed costs of taxes, insurance and utilities (est. $300). Adding a secondary suite would further increase that income.
- Capital Appreciation – Over time, property prices increase. Historically, properties increase on an average of 4% per year although this not a straight line growth and other market factors can significantly impact that amount – both positively and negatively. For this example, let’s assume a modest growth of 2% per year. After five years of 2% compounded growth, the $300,000 property is now worth $331,000. After ten years the property is now worth $365,000. So the $60,000 investment has added $65,000 in capital gains. What if the growth rate was in keeping with historical trends of 4% – what would the value be then?
The increased value of the initial investment is now quite significant. Combining both the equity build up through mortgage pay down in addition to capital gains means that $60,000 grew to $126,000 after five years, and $201,000 after ten years. Compare that to your mutual funds performance.
There are two secondary advantages for investing in rental properties:
- Leverage – In the example above, 20% down payment was used. This means that the money was leveraged 100:20 or 5:1. For every five dollars value, investors only needed to invest one. In the case of first time home owners, they could qualify for a 5% DP meaning that their money is leveraged 20:1. No other investment has this type of leverage available.
- Tax Considerations – Owning rental properties is a business and all expenses incurred by operating the business become tax deductible. This would include such things as a business licence, taxes, insurance, and city utilities. It also includes vehicle expenses, cell phones, and home office expenses. Sometimes, the the business experiences an operating loss, this loss can deducted from income from other sources such as employment income.
Time Works To Your Advantage
Trying to time the market – buy low and sell – is next to impossible. Is Kamloops in a real estate bubble now? Some might think that way as the Vancouver appears to be slowing with lower prices, longer times to sell, etc… But every market has different dynamics.
So what happens if you buy near the top of the market and then the market collapses? You only lose if you sell. If you hold the property for several years, values will increase. The key is to ensure the property provides positive cash flow to carry you through a recession. The longer the property is held, the more it will appreciate in value and the greater the revenue it generates.
Real estate is a sure way to a comfortable retirement, but it does require knowledge, training and diligence to accomplish that. The younger one gets started, the more time works to their advantage. But even individuals in their fifties and possibly, sixties can use real estate to help their retirements.