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Learning, Sharing, and Teaching => Ask a Mustachian => Topic started by: totoro on July 16, 2012, 07:29:44 PM

Title: advice on what to do next
Post by: totoro on July 16, 2012, 07:29:44 PM
We are forty year old Canadian couple.  Our net take-home pay is $10,200 a month and our expenses are $3300 a month.  We can save $6900/month going forward.  We know lots about real estate and not much about other types of investments.

Our assets include:

Real estate net worth: $330 000  (one lot fully paid, two rental properties (one makes $600/month net and $700 to principal and the other $100/month and $1000 to principal), and our primary residence which is a triplex and costs us $600/month to live in and $1700 to principal). 

RRSPs: $110 000 (will be transferred to self directed RRSP)

Cash:  $ 60 000

We  have only relied on financial advisors for other investments which have not worked out so well previously.  We are trying to figure out the best thing going forward and are considering:

1. Using our cash to contribute to unused RRSP and investing the tax refund (maybe following a canadian couch potato portfolio)
2. Continuing to build our self-directed RRSP until it matches our mortgage on one of the rental properties (2 years) and holding the mortgage ourselves in the RRSP at estimated 5% return (would be about $250 000 mortgage and we would receive the mortgage payments and interest tax exempt and reinvest each payment)
3. investing the $6900/month following the Canadian Couch Potato portfolio recommendations?

What would you do?  I know this is difficult given that I am Canadian, but I'm open to any ideas.

Also, given our net worth is currently $500 000, but real estate heavy which is subject to ups and downs, I'm not sure how to calculate years to retirement.  Our plan was to sell one rental property in seven years and pay down the mortgage on our primary residence further and retire.   When I use the simple calculator with a savings rate of 67.6% I get 9.8 years to retirement starting from scratch.  How do I incorporate current net worth?

Title: Re: advice on what to do next
Post by: Another Reader on July 16, 2012, 08:28:51 PM
There are a lot of unknowns here.

One of the properties is a triplex.  It appears you live in one unit and rent out the other two.  Are you saying the net cost after netting the property expenses against the received rent averages $600?

What are your two rentals - houses?  What are the mortgage balances and interest rates on all three properties?  What's the tax treatment of interest and operating expenses for rental real estate in Canada?  Would it make any sense to use some or all of this extra income and/or some of the cash to pay off one or more of the real estate loans?  Why would you go through the effort to create a mortgage in your retirement account (not allowed in the US in IRA's because it's considered self dealing)?

What was your intent in purchasing the lot?  How much did you pay and what is it worth today?  A lot produces no income, so the only investment value is its appreciation potential.  Would it make any sense to sell it now and pay down a mortgage?

Are you including the cash flow from the two rentals in the $10,200 take home pay, or is that in addition to job income?

In your shoes, I would figure out what part I wanted the real estate to play in my overall investment portfolio before looking at paper investments, other than the RRSP.  I do not know how those work, but if there are tax deductions on the contributions and deferrals on earnings, I would probably want to fund those.  You do need substantial cash reserves for the real estate and for your own expenses in the event of a job loss or other income interruption. 

Once I decided on my objectives for the real estate and allocated income and savings to the mortgage payoff plan I adopted, then I would look to invest the remaining net income.  Your fellow Canadians can help you with that.

Your retirement plan consiste of two parts, the equity in the assets you hold today and the monthly investment of $6,900 for the remainder of your work time.  Your real estate equity grows as the loans are paid down and by the overall appreciation of the properties.  You might try calculating the real estate equity at different points in time and use the retirement calculator to estimate the value of whatever you invest in the paper assets at the same points.
Title: Re: advice on what to do next
Post by: totoro on July 17, 2012, 05:01:05 AM
Thank you so much for responding! 

Here are the answers:

Yes, the mortgage, insurance and property taxes for the triplex work out to about $600/month after the rental income is deducted.  We live in one unit for this price.

The other two rentals are houses with suites.  The mortgage balance on property one is $350 000 @ 3.20 and market value is $440 000.  The mortgage balance on property two is $500 000 @ 3.59 and market value is $610 000.   I'm not sure it makes sense to pay of any of the properties because the rental income is deductible against mortgage interest and expenses so we are left with a little cash flow from them but quite a bit of principal pay down.  This will likely work out better than paper assets because of leverage and given that we are invested for the next seven years likely we can hopefully ride out the market ups and downs.  I have included the cash flow in income.

I am selling the lot - you are right.  It is listed for $40 000 and was a purchase that I did with a friend with the idea of building a cabin - which has not happened.  The market is depressed for recreational right now so we will see.

Title: Re: advice on what to do next
Post by: totoro on July 17, 2012, 05:17:09 AM
Also, as to why an RRSP self-directed mortgage?  Guaranteed rate of return that I would likely pay upon renewal in two years to a lender for a ten year term (rates are higher here).   I can then invest the mortgage repayments each month in something else.   It encourages the RRSP contributions over the next two years at the max which give an equivalent deduction off income.  I am not an experienced investor and this seems like a fairly safe way to go, but it might not be the best choice.
Title: Re: advice on what to do next
Post by: ShanghaiStashing on July 24, 2012, 06:31:03 AM
I have a few thoughts for you (being Canadian myself). Please note this is just what I would do personally and is not intended to tell you what to do! Also can you specify which Canadian Couch Potato portfolio you are looking at? There are several.

First, I don't know where you live in Canada but given that you know a lot about real estate do you have concern about the value and direction of the Canadian real estate market? My general sense is that real estate is 15-20% over-valued in Canada right now and even a moderate decline could leave you at risk of being underwater on the mortgages, which in a recourse country like Canada is a problem. If this isn't a concern or you feel your area is secure then don't worry, however, do bear in mind that with your leverage you're over-exposed to one asset class and substantially leveraged. A 5% decline in the property value would leave you with $75K hit against your net worth (assuming total real estate value of 1.5MM) vs. a 5% decline on 500K invested which is 25K. This is an overly simplistic way of looking at it, but effectively you would have to believe that your expected long-run returns are going to make up for the equity risk you are taking on right now, which is substantial.

Second, the return on these properties is difficult as it is unclear how much of the principal you are actually paying down; you indicate each amount is principal and cash, but is this the total payment including interest or the actual direct to principal payment? It would be easier to make a suggestion on what to do with the real estate if we understood your total rents and total costs (including those that are estimated but not spent). This would help better determine if they are a fair use of capital assets.

Third, if you are not already doing so, I would maximize TFSA contributions pre-retirement and even after. TFSA's shelter all income from tax and your limit increases if the value of your assets increase inside them. I hold only the riskiest assets in my TFSA so that I have the highest probability of a large increase under which I can shelter even more income / capital gains from the tax man. For this to keep it simple I would only invest in an index fund with low fee cost. There are several funds available that expose you to a high-level of risk for higher potential returns, with the still low expense cost of 0.35%-.5%. This is 10K / year and leave you with 73K / year to invest.

Fourth, RRSP's are fine but remember that these are simply deferring tax you might pay today until tomorrow. Given your income (~$190,000 pre-tax if my calculations are correct) this is good, but the distribution of this income will also affect the benefit that you accrue from RRSP contributions. The maximum contribution limit is currently ~23K or 18% of income. This means that at most you can contribute ~33-35K to RRSPs total, leaving you with a full other 40K + tax credits or so of income to invest. This strategy is perfect as you are a moustachian and your projected income needs in retirement are only 45K per year pre-tax (less once housing is gone) and this income will not be subject to nearly the tax rate that you are paying now. These RRSP's as always should simply be directed into a low cost fund or portfolio that has a relative level of safety.

Fifth, I would-dollar cost average into an index fund with a very low expense ratio (see all of the posts about vanguard or equivalents) for all of your cash over a defined time period. I would also roll remaining monthly savings into this fund.
Title: Re: advice on what to do next
Post by: totoro on July 24, 2012, 10:09:17 AM
ShanghaiStashing - very very grateful for those comments.  I will write a detailed reply later about the real estate but I wanted you to know that I really appreciate the Canadian feedback and the time you took to write it. 
Title: Re: advice on what to do next
Post by: totoro on July 28, 2012, 09:19:21 AM
Here are more details ShanghaiStashing:

1.  I am concerned about overvaluation in Canadian real estate but believe that the real estate cycle is likely to recover over time and I am invested for at least seven more years and, over enough time, I do believe they will appreciate.  I am over-exposed in real estate but I don't have to sell and the properties have low interest rates.  I have 3.79 for 10 years on my primary residence/duplex and am considering locking in the other two at longer terms.  I do believe prices will drop over the short-term, perhaps significantly if rates rise.  Given that these assets are being paid by rental income the principal pay-down is an added plus.

2.  House One - Vacation Rental:  Initial investment - $50 000 plus $30 000 to put in a suite - mortgage 1500 - principal payments  $600/month - net (after all expenses including mortgage/taxes(income and property)/maintenance/insurance/vacancy) profit each month - $610

House Two -  House with Suite - Initial investment - $65 000 plus $25 000 to put in a suite - mortgage $2400 - principal payments $900/month - net(after all expenses including mortgage/taxes(income and property)/maintenance/insurance/vacancy) profit each month - $150

House Three - Triplex - Initial Investment - $170 000 including renos -  mortgage $2500 - principal payments $810/month - net profit each month $600 (if we did not live there)

Thanks for the other advice, that is a good plan to follow!
Title: Re: advice on what to do next
Post by: Bingeworker on July 28, 2012, 10:47:15 AM
Hi Totoro,

You don't mention what your houses are renting for.  What is the "profit", is that what is left over in cash after all expenses including taxes and maintenance?  Or is that assumed equity?

I'm Canadian too.  I sold my rental house last year, and it was paid for.  I was making money on it, but that is only because the mortgage was paid off long ago.  If you bought those rental properties recently (and by the size of the mortgages it looks like you did), I don't see how you can be making money on these.  Rents have just not kept pace at all in Canada in proportion to the runup in "values".

Even though my rental house was making money (and I mean actual money, not just equity increases, although because of when I bought and sold that was a huge part of the profit in the end), the monthly rent was paltry considering the "value" of the house.  If most of that had been going to a mortgage and I had bought at current-ish prices, it wouldn't have made any financial sense at all.

I think your real estate investments are very risky right now in Canada.  Canada is very slow to correct, but the signs that it has started are out there.
Title: Re: advice on what to do next
Post by: totoro on July 28, 2012, 11:31:19 AM
Thanks bingeworker.  The net profits are net profits after ALL expenses including income tax on the profits - ie cash flow positive.  The only reason they are cash flow positive is that they are multi-family and one vacation rental in the Okanagan which makes a lot of money in the summer. 

The equity increase will not be known for sure until they are sold.  What is known is the amount that goes to pay down the principal each month, which I have noted.
Title: Re: advice on what to do next
Post by: totoro on July 28, 2012, 11:46:14 AM
Bingeworker - you can still make money on rental properties in Canada as interest rates are low.  A SFH or condo alone will not; however, likely work right now.  Multi-family or house with suite still works in many areas because interest rates are low.  I have 3.79 for ten years.  I agree we are likely in for a downturn.  A rise in interest rates would impact things a lot - but higher interest rates offset lower prices to a great degree unless you have a really big downpayment.
Title: Re: advice on what to do next
Post by: ShanghaiStashing on July 29, 2012, 11:01:58 PM
Thanks for the additional detail, so that we're clear on the financials of the properties my current understanding and the calculations below are based on the following:

Property 1 ($610 per month total profit, including principal + cash flow)
Property 2 ($150 per month total profit, including principal + cash flow)
Property 3 ($610 per month total profit, including principal + cash flow)
Total Profit: $1370 / month

Property 1 $80K invested
Property 2 $90K invested
Property 3 170K invested
Total investment $340K

The other alternative is that principal payments are on top of the above, which is an additional $2310 / month ($27.7K / year)

Using this $1370*12 = $16.5K / year in profit. 16.5K / 40K = 4.8% return on capital / year, excluding any capital appreciation which given the property locations we may not be able to consider. This return may be acceptable if we assume that equity increases pace inflation and therefore you are effectively earning 4.8% net of inflation, or slightly above the safe withdrawal rate. However, assuming a best-case scenario in Canada where RE simply stops appreciating in the near-term which inflation continues at ~3% per year, your post-inflation ROI may only be 1.8%. However, if principal payments are an additional profit source you have a more attractive $44.2K / 340K or 13% return per year. If the latter is the case than I would personaly believe you are most likely fine to stay in RE, provided you diversify out the remainder of the cash.

At the end of the day my broader recommendation would be in line with what an earlier poster said: you need to consider what role you want real estate to play in your wealth building, and your reasons for putting your money into these types of investments.

I don't want to overreach here so please take this with a grain of salt, but in reading the posts I wonder if there may also be a 'comfort issue' here. In my opinion asset allocation is a fairly simple and objective exercise, one in which emotion has little room if you want to be successful over the long-run.

However, I wonder if given your history with advisors, your knowledge / comfort with real estate, and your personal lack of knowledge of other asset types that you aren't simply allocating assets to real estate because it is where you feel most comfortable? If this is the case, it may be worthwhile to take a couple of months and put some serious time behind understanding the other investment vehicles that may be available to you and the corresponding advantages / disadvantages of each. Once you'be completed this, you would be making a very informed choice should you choose to stay in RE (e.g., you've weighed all available alternatives and determined that RE is in fact the best for you personally) as opposed to what I might term the 'default choice', which is RE because you know it best.

Anyway, not sure this added anything and sorry if I overreached in my analysis.

Title: Re: advice on what to do next
Post by: totoro on July 30, 2012, 06:56:49 AM
"However, if principal payments are an additional profit source you have a more attractive $44.2K / 340K or 13% return per year. If the latter is the case than I would personaly believe you are most likely fine to stay in RE, provided you diversify out the remainder of the cash."

Yes, the principal payment are not accounted for in the cash flow - the cash flow is net profits each month excluding principal payments.

You are right about the comfort with other types of investments and the need to learn more.  I have been putting a fair bit of time into this and am looking at how to diversify now - I'm not comfortable with it yet - still figuring out the logistics of setting up self-directed accounts and investing without an advisor.   Real estate can bring good returns but it is not passive income - it requires some effort to maintain and manage.   

Thanks for your feedback!