Alex and Jamie, a couple both aged 35, live in Calgary, Alberta. They have an annual household income of $200,000. They have accumulated $100,000 in savings and investments that they need to grow to $500,000 by age 60 in order to meet their target retirement income goals. Both Alex and Jamie are growth investors meaning they are comfortable with volatility and calculated risks. They are wondering whether buying a rental property might help them achieve their goal sooner than leaving it invested in the markets.
Option 1: Buying a Rental Property
Alex and Jamie meet with their mortgage broker and realtor and come up with the following strategy: invest $80,000 as a down payment on a $400,000 property. Another $20,000 will be allocated towards closing costs and initial repairs, as well as an emergency fund for property-related expenses bringing their total initial investment to $100,000.
Based on a $320,000 mortgage at a rate of 5.2% amortized over 25 years, they’ve estimated their annual costs to be as follows:
- Mortgage: $22,897.92
- Property Tax and Insurance: $5,199.96
- Maintenance: $4,000
Total Annual Costs: $32,097.88
To break even Alex and Jamie would need to charge at least $2,675 a month in rent. Based on current market rates they believe they would be able to get $2,800 a month for the property, putting them in a positive cash flow position (by about $125 a month).
On average, Calgary’s housing market has seen an appreciation rate of about 3.86% per year over the long term (YCharts). If we assume this average persists, Alex and Jamie’s rental will be worth $1,031,022.04 when they retire. If they were to then sell their property, assuming the mortgage is fully paid, their net profit would be $862,345.84, calculated as follows:
- Initial Property Value (Purchase Price): $400,000
- Future Property Value (Sale Price): $1,031,022.04
- Capital Gain: Sale Price – Purchase Price
- Taxable Capital Gain: 50% on first $250,000 and 66.67% on amounts over $250,000 (in the case of joint owners each person can claim $250,000 in gains at 50%)
- Tax on Capital Gain: Taxable Capital Gain * Marginal Tax Rate (50%)
Calculations
Capital Gain =$1,031,022.04−$400,000=$631,022.04
Taxable Capital Gain = (50%×$500,000) ($250,000 each) + (66.67% x $131,022.04) = $337,352
Tax on Capital Gain = $337,352 x 50% = $168,676.20
Net Proceeds After Tax: $1,031,022.04 – $168,676.20 = $862,345.84
As you can see in this scenario Alex and Jamie receive a net profit well above their goal of $500,000; however, owning a rental property comes with its own set of challenges. Issues with tenants, such as vacancies or rent defaults, can disrupt income stability. Maintenance and repair costs can also be unexpected and burdensome. Market fluctuations can affect property values and rental income, and managing the property requires time and effort. Legal and regulatory changes, such as rent controls or property tax adjustments, can also impact profitability.
Let’s say that over the next 25 years nothing catastrophic happens, but rather a series of reasonable, predictable events take place with Alex and Jamie’s rental, including the following:
- After five years, the mortgage rate increases to 6%, raising their monthly payments to $2,135.62.
- On average, every five years, they experience a tenant default, leading to a three-month vacancy, resulting in lost rental income of $8,325 each time.
- The house requires major repairs periodically (for example a new roof), raising their average maintenance costs from $4,000 to $5,000 annually
- property taxes and insurance increase to $500 monthly, totaling $6,000 annually.
- During a short-term economic downturn lasting three years, property appreciation slows to 1% annually. After the downturn, the property value appreciation returns to a more typical rate of 2% annually.
As a result, Alex and Jamie’s net rental income is negative, with annual losses reaching -$1,597.92 initially and -$4,327.44 after the rate increase. After 25 years, their property value only reaches $621,136. Using the same tax calculations as before, their net proceeds are reduced to $565,852. This exceeds their need of $500,000 but only because we haven’t taken into account what they’ve lost over the years to negative cash flow on their rental income. Combined with a total negative net rental income of -$107,936.40, their final amount is approximately $420,647.44, falling short of their $500,000 target.
Admittedly this scenario might not be entirely realistic given that an investor who experiences those types of persistent losses might opt to sell the property before the 25 year mark, however when exactly the investor sells and at what kind of loss is anyone’s guess. The key takeaway here (in my opinion) is that in creating this case study I was easily able to reduce Alex and Jamie’s net profits by 50% not by predicting a catastrophic economic event, but rather by illustrating a sequence of small, realistic events that will likely impact any long-term investor in the real estate market. Point is when you invest in real estate sure you might make record profits, but it’s just as possible that you could underperform the stock market or even lose money. Hard to fathom after a decade plus of low interest rates and soaring valuations but it’s safe to say those days are behind us.
Option 2: Investing in the Stock Market
Speaking of markets, I’ll keep it brief because I think we all know they can be volatile and wildly unpredictable, but if Alex and Jamie opted to invest their $100,000 in a diversified stock portfolio they would need to earn an average of 7% annual returns net of taxes and fees in order to meet their $500,000 goal. Assuming they use their TFSAs and are comfortable withstanding a bit of volatility over their 25 year time horizon for the sake of growth, 7% isn’t an unreasonable target. The MSCI World Index, which tracks global equity markets, has delivered an average annual return of approximately 7-8% over the last 50 years. Stocks are also more liquid compared to real estate, allowing for easier buying and selling, and diversifying their investment across various stocks reduces the risk of significant loss.
However, the stock market is known for its volatility. Prices can fluctuate dramatically, and market downturns can lead to significant losses. Emotional investing, such as panic selling during market declines, can also negatively impact returns. While stocks typically outpace inflation, there are periods when returns do not keep up with rising prices.
The Bottom Line
Comparing their two options, Alex and Jamie determine that the rental property investment has the potential for a higher total value at retirement ($1,122,050) compared to the stock market investment ($542,000). However, the rental property requires more management effort and comes with added risks related to tenant issues and maintenance costs. In contrast, the stock market investment offers higher liquidity and less management effort but comes with its own set of risks, including market volatility.
Ultimately, Alex and Jamie’s decision should consider their risk tolerance, the time they can dedicate to managing a rental property, and their comfort with market fluctuations. Spoiler: if Alex and Jamie were my clients I would advise them to take a balanced approach by building up a healthy amount of market investments before buying a rental property to help them stay liquid and diversified, and avoid concentration risk.
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