Lower savings rates due to rising home values
It’s no secret that more and more Canadians are retiring house rich and cash poor. This is perhaps due to the fact that many of us have followed the traditional approach of paying off our mortgages before beginning to save for retirement. And in the face of perpetually rising property values, this trend only appears to be getting worse.
For some, simply scraping together the minimum 5%-10% for a down payment can take years and newer homeowners are often faced with the difficult decision to forsake retirement savings in lieu of taking on larger mortgage debt.
But for those that have owned their home for a while, rising property values is a blessing. In fact, Canadian homeowners are sitting on more latent equity than ever before in history. And despite this financial windfall, the average Canadian is still going to fall short financially in later years.
The practical reality is that we are simply not saving enough to generate the kind of cash flow we need to sustain our lifestyle in retirement. And many of us will be forced to sell our homes in order to free up equity to make ends meet.
“Saving” for retirement is a bad idea
We’ve been taught to “save our money” and build a nest egg for retirement. But how much is enough? Most financial professionals will recommend saving about one tenth of your annual income, which was sound advice when you could expect annual returns of 8%-12%. But the math breaks down when returns drop below 6% and your portfolio takes a major hit every half dozen years or so.
According to Stats Canada, the median RSP contribution is less than $4,225 per year ($352/month). If we assume an annual average rate of return of 6%, your $352 per month will grow to just over $231,000 over 25 years. Not bad, right? Guess again… Every single dollar you withdraw from your RSP is fully taxable at your marginal tax rate, so you’ll have to give up a sizeable chunk to tax when you want to access your money.
And even though our government claims that inflation is under control, the truth is that life is simply more expensive today than it was even 5 years ago. Housing, energy and food costs are on the rise and our savings aren’t keeping pace. By the time you go to retire, the “real” value of your RSP will have been substantially eroded by inflation since everything will cost more than it does today. In the end you will be left with a lot less than you planned.
Think “cash flow” when planning for retirement
Wouldn’t it be nice if there was an investment vehicle that could generate predictable, reliable monthly cash flow that automatically adjusts for inflation, so that whatever income the investment delivers today, you can be reasonably assured it will deliver the same relative value tomorrow? Real estate is one investment that does just that because the amount of rent you receive increases over time. It’s a wonderful hedge against inflation.
Let’s say your goal is to generate an extra $2,500 per month (in today’s dollars) during your retirement years. All you need to do is finance a property that generates $2,500 per month in gross revenue today and put a plan in place to have the mortgage paid off by the time you retire. Your rental income should increase over time and will have roughly the same relative value as it does today. Of course there are other expenses to consider such as property taxes and maintenance, but I think you get the point. Inflation works against you in the capital markets, but it can be a powerful ally when it comes to your real estate cash flows.
Also, you don’t have to be as concerned with the “value” of your investment at any given time, because you’ve chosen to focus on cash flow as your primary driver. Regardless of what happens in the market, you can continue to generate rental income, or trade the property for another one of relative value, or even live in it if you need to. Ever notice what happens to your dividends during a financial crisis? Why don’t you try trading your stock portfolio for shelter after the next economic melt down and see how that goes!
Real Estate vs RSP – A Clear Choice
By now you should have a sense of where we are going with this. What if you chose to invest your $352 per month in real estate instead of your RSP over the next 25 years?
The first order of business is that it’s not obvious how to build a real estate portfolio with only $352 per month. Remember all that equity you’re sitting on? You are going to use it to finance the down payment for your rental property.
The property you are purchasing is valued at $335,000 and generates monthly rental income of $1,900, You are going to need $67,000 (20%) for the down payment and the $352 is going to make the payments on the loan, which at an average rate of 4% will be paid off at the end of 25 years.
Technically, you are financing 100% of the purchase and you are also going to need a $268,000 mortgage secured by the rental property. Your target is to generate $1,409 per month (net of property taxes, maintenance and other expenses) to service the mortgage so that you don’t have to chip in any additional funds beyond your $352 per month.
At the end of 25 years, you’ll have completely paid off both the mortgage on the rental and the down payment loan, leaving you with a clear title property that provides you with consistent and reliable positive cash flow. Adjusted for “inflation” (at a modest 2% per year), your gross monthly rental income will be just over $3,100 per month. Your $231,000 RSP would need to produce a 16.10% annual rate of return to deliver similar results.
Another advantage real estate has over RSP is that it accommodate a variety of long term planning options. You can live off the cash flow, or sell the property to access your equity for larger purchases, or you can simply refinance and pull out the amount you want, when you want it, allowing you to stay invested AND enjoy your retirement. Meanwhile, the rental income will continue to service the loan and you don’t have to worry about taking a major tax hit to access your hard earned money.
What if real estate values drop… I don’t want to lose my home!
For some, the thought of using home equity as a tool for building wealth is a scary concept. I get it, this is your home we are talking about and you don’t want to lose it. So let’s take market risk out of the equation. Let’s say real estate takes a 30% nosedive the day after you purchase your investment property. This should head off any debate around timing the market and whether Canadian real estate is currently overvalued. Here’s what would happen under this scenario…
Not only would you “lose” your down payment that you just borrowed against your home, but you would also be down another 10% since your rental property is now worth $245,000. You’ll feel like you made the worse decision of your life, right? Not if you stay focused on why you bought the property in the first place, to generate retirement cash flow. Your property might not be worth as much as the day before, but it will still generate rental income.
Provided you don’t panic and you stay the course, there’s not much cause for concern since the value of your property is likely going to recover over time. Even if we take the conservative view that for the next two and a half decades real estate values improve by an average of 2% per year, your rental will be worth $384,000. Roughly $50,000 more than you paid for it and a whopping $153,000 (or 66%) more than your RSP would have been worth! And if you sell the property, the first $335,000 is not taxable since that’s your cost base and you only have to pay capital gains on half of the growth. In this case, your tax liability would be $10,000 ($50,000 gain x 50% x 40% marginal tax rate). A one time withdrawal of your RSP would cost you more than $92,000 in tax, leaving you with less than $139,000 for personal use. Ouch!!!
The gift that keeps on giving…
There’s a common saying that goes “the best time to buy real estate was 25 years ago”… What most people tend to ignore is that the same statement will hold true 25 years from now! The equity that we have built up in our homes is a wonderful gift that is largely under-utilized by most Canadians. Most of us are going to access that money at some point in our lives, the only question is whether we will harness its power to build wealth now, or squander the opportunity and wait until we are “forced” to sell later.