I meant to post this yesterday, but had to re-work some of my calculations in the examples below that didn’t make sense. I’m definitely not advocating this type of investment for anyone, but wrote this post as part of my own investigation into possibly doing it for myself.
I am far from an innovative investor. I lean heavily on stealing other people’s ideas as my own, picking and choosing the best stuff that seems to fit into my own risk profile and investing strategy, as well as for the time I’m able to use to research the investments going into my portfolio. I continue to read books and blogs of people who are smarter (and probably more interested) at investing than I am.
Ever since I initially read “Rich Dad Poor Dad”, I had a dream of being a real estate mogul – of building a business that was outlined in his book from a couple of small houses to eventually a full portfolio of buildings that would make me a multimillionaire. I read that book over 10 years ago, during my initial rush of inhaling every personal finance book that I could. While I think that in general, most of what was talked about in the book doesn’t really apply to me, the picture of being a real estate “player” as a means to wealth never really left my mind.
One thing that has kept me out of the physical real estate market is that I really don’t like people. I know what I was like as a fairly responsible tenant during my renting days, and I wasn’t ideal – I can only imagine the problems that I could come across with some of the “horror story” tenants that I read and hear about from landlords. My wife and I can barely manage our own house, let alone look after several properties at a time. While I know I could hire a property management company to look after the houses I’ve bought, that would mean I’d have to hire and fire those “employees”, something I wouldn’t look forward to doing.
A couple of weeks ago, Nelson from Financial Uproar wrote about an alternative method of having a leveraged real estate portfolio. Most of my adult life, I have been against most forms of debt, I don’t like to have it hanging over my head and have avoided most forms of borrowing as much as I can. I am generally a risk averse individual when it comes to investments, but this kind of leveraged investment has me intrigued. I am currently invested in a couple of REITs in my RRSP portfolio (RioCan and Dream Office), but these items make up a fairly small portion of my current overall investments. A much larger exposure to real estate wouldn’t really shift the diversification of my portfolio.
As an example of how this investment would work, let’s say my wife and I were to start a “mini” real estate portfolio. Like most real estate starts, our intention is to use 20% of our own money (similar to how we would have started with buying a small house to rent to a small family or students) and borrow 80% of the amount from our bank using a home equity loan. I have made the following assumptions (taken from Nelson’s blog post, as well as September 15, 2015’s return for the REIT TSE:ZRE) :
Interest Rate Charge – 2.70%
Annual Charge = $2,160
Monthly Charge = $180
Return on the REIT investment – 5.71%
Annual Return = $5,710
Monthly Return = $476
I’m going to assume there is no change in distributions or interest rates for the period of testing.
On a monthly basis, we could, on a 20,000 investment earn $295.83 (distributions less interest charges) as long as interest rates never increase, or cash distributions aren’t adjusted in the for the index fund. Annualized, this investment would provide an additional $3,550 in income for our household – not a huge amount of money, but a pretty good return of 17.75%. If our goal at retirement is to have passive income of $25,000, we would be 14% of the way there, with minimal effort.
Paying down the debt:
If, over the next 9 and a half years (114 months) if we didn’t spend any of the income received from the investment and use the total net amount to pay down the principle on the loan, we would be making $382.22 per month ($4,586 per year). At the end of this period, we would owe $21,604 on the loan we took out
“Letting it Ride”
A more aggressive method of utilizing this kind of investment, would be to pay interest only, and utilize the money earned to purchase more shares. This kind of strategy would be similar to a “small-time” real estate investor starting with a single house, and using the equity created by the investment, to extend the investment to the maximum. At our projected retirement date, we would be generating annual income of $6,100 with our investment, an increase of $2,550 over the year 1 investment returns, or about an 8% increase on return (hopefully greater than inflation).
The investment could be paid down like a mortgage, increasing the investment and paying down the debt at the same time. In month 1, the net return of the investment is the calculated $295.83. The $295.83 could be split in two, with half of the distribution used to pay down the debt and the rest used to purchase more of the security, more of a “blended” payment. This method of debt payment would reduce the debt outstanding, which might insulate any future impact of an increase in interest rates, while increasing income associated with the investment.
If I were to utilize this kind of investment, I would do it through a taxable account. With a taxable account, there are implications that need to be taken into consideration over holding a REIT in a tax-sheltered account.
On the taxable income side, REITs are much more complex than normal securities, due to the methods used to create income. The Globe and Mail wrote an article about tax filing for RioCan in previous years, which included the following items in income:
31.24% – Other income – taxable at the marginal rate.
1.72% – Capital Gains – 50% taxable at marginal rate
4.57% – Foreign non-business income – taxable at the marginal rate
62.47% – Reduction in adjusted cost base (return on capital or ROC) – A bit of a complex calculation – the Globe and Mail writer explained it as:
When you receive ROC, you are not taxed immediately on the amount. Rather, you subtract the ROC from the adjusted cost base of your units. This gives rise to a larger capital gain, or smaller capital loss, when you ultimately sell your units. Because of the tax deferral, ROC is considered tax-efficient income.
Interest on investments is an allowable expense, provided the investment is used to try to earn investment income (can’t be used for capital gains investments). This allowable expense will reduce the taxable liability on the interest earned, provided I would fill out a schedule 4 tax form.
The two main risks with this type of investment would be a decrease in the distribution paid out, or an interest rate increase. Both of these risks are a little scary when it comes to the investment as a whole, but there is (currently) a 3% spread currently between the interest charge and investment return to “play” with.
I’m still not sure if I’ll do this or not. If I do make a leveraged investment, the earlier it’s made the better, as it would give more time to get either interest paid down or to increase the investment earnings by reinvesting into the security.