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By Andrew Allentuck
Special to the Globe And Mail,
Saturday, December 1, 2007
Life ought to be good for a Toronto couple we'll call Max, a senior executive in a non-profit organization, and Jane, a real estate broker. Max, 43, earns $175,000 a year; Jane, 35, earns $25,000. Their combined gross incomes - $200,000 in earnings plus $44,000 a year in gross rentals from four properties - should provide a plenty of security for them and their two children.
Adrian Mastracci, private-client portfolio manager at KCM Wealth Management in Vancouver, says, "Max and Jane have leveraged their real estate holdings to the point that they have jeopardized their family's future if something goes haywire."
But they don't really have that much security. Their first mortgages, including a Home Buyers' Plan loan, total $649,800 and their second mortgages add $107,500 of debt, for a total of $757,300. Add $5,000 on a line of credit and their debts are $762,300.
Max and Jane would like to retire by the time Max is 63. But, as he admits, the debt is a problem. "We have been too aggressive in buying real estate and now we aren't sure if we can afford so many mortgages. We have had to pay $15,000 out of our pocket for interest that our rental income didn't cover. Should we sell some properties to increase our cash flow and lessen our financial distress?"
WHAT OUR EXPERT SAYS
Facelift asked Adrian Mastracci, a fee-only financial planner and portfolio manager who heads KCM Wealth Management Inc. in Vancouver, to work with Max and Jane to help reduce their investment risk. As he says, they are rich in property but strapped for cash.
They are not sure that they can afford a third child, the planner notes - they have to find money to buy a new car and save for retirement and their children's education.
The immediate problem is to balance the cost of investments with their cost of living. Neither has an employer-sponsored pension plan. Their cash flow of $11,830 a month covers modest spending and cash injections into their properties. Those expenditures for the rental units are like investments, but the payoff is not in net rental flow, which is negative, but in the potential for capital gains if they elect to sell.
Have Max and Jane leveraged their properties too far? Their four rental properties have 100-per-cent financing. They owe $558,000 for the four properties and their total annual mortgage payments are $39,840 a year. They pay another $17,088 a year on their own house mortgage. Total interest and principal payments are $56,928, plus property taxes and condo fees of $13,390 on the rental properties and $3,504 a year on their house. Total carrying charges for all properties including their house: $73,822, nearly 52 per cent of their after-tax income.
These expenses support a portfolio with 87 per cent of the total assets in Southern Ontario. The risk is excessive and the carrying charges insupportable, the planner says.
It would be useful to sell two properties - perhaps the two needing the most cash injections. There may be a capital loss from the sales that can be carried forward and used when capital losses of prior years are exhausted. For now, they have no capital gains to offset.
The couple face a risk of having to pay substantially more interest if rates rise during renewal periods for the various mortgages between 2009 and 2012. If they keep all the properties and rates rise just two percentage points, it might cost another $15,000 a year.
Moreover, if lenders become less liberal with credit requirements, Max and Jane might have to borrow even more money to increase their nominal equity in the properties. If they cannot secure additional funds with property, they would have to pay higher interest rates on unsecured loans such as lines of credit. Max and Jane could wind up in a serious bind, Mr. Mastracci stresses.
Debt management needs to be prioritized, the planner says. First, Max and Jane should set up an emergency fund for loss of employment or a major bill or disability. They have little cash at present and would have to tap their registered retirement savings plans for money.
This would expose withdrawals to tax at full marginal rates, Mr. Mastracci notes. Max expects a bonus in mid-2008 and the money should be put into an emergency reserve.
The planner says the couple should then build their financial assets. Max should begin using up his $19,000 of RRSP space. Jane has RRSP space for $40,000, but her tax bracket is too low to justify contributions at present, Mr. Mastracci says.
Max and Jane will need capital of $1.85-million to generate an annual retirement income of $50,000 in 2007 dollars when Max reaches age 63, Mr. Mastracci says. About $24,000 of that target will have to come from a combination of their RRSPs and other investments.
The couple's RRSPs have current balances of $185,000. Hence, RRSP contributions of $19,000 a year will accumulate to about $1,292,000 in 20 years, assuming an annual return of 6 per cent. They will require another $558,000, likely in real estate and other personal investments, to meet income needs. The development of a diversified portfolio is possible once the couple escape from the bonds of their unproductive debts, the planner adds.
For planning purposes, Mr. Mastracci has assumed Max will live to age 84 and Jane to 88. Annual inflation is assumed to run at 2.5 per cent. Max will get full Canada Pension Plan payments of $10,365 a year, Jane 35 per cent of that, and both will get full OAS payments, currently $6,028 a year. Both government pensions are assumed to be indexed at 2 per cent a year. Mr. Mastracci suggests neither begin CPP benefits before age 65.
Max and Jane should also increase their contributions to registered education savings plans that currently hold $10,000. They should add $2,500 per child a year to qualify for the maximum Canada Education Savings Grant of $500 per child a year.
The CESG formula for contributions is complex, but the $2,500 limit is essential to qualify. If parents put in $2,500 a year per child, then with $500 CESG additions, each child should have $81,500 for post-secondary education by age 18. Funds are assumed to grow at 8 per cent a year within the plans, which are invested 100 per cent in diversified equities.
"Max and Jane have leveraged their real estate holdings to the point that they have jeopardized their family's future if something goes haywire," Mr. Mastracci says. "That could be higher interest rates, higher real estate maintenance costs, a drop in property values or a problem in renting their homes. ... If they bite the bullet and cut their leverage and carrying costs by selling a few properties, they will be able to reduce these risks."
"We have cash flow problems already, Max says. "We are inclined to go along with the recommendation to sell some property. We'll start with one and see how that works and then probably list another."
Client situation
THE COUPLE
Max and Jane, ages 43 and 35, live in Toronto with two young children.
THE PROBLEM
Mortgages more than three times annual income are draining them.
THE PLAN
Sell rental properties that are not paying their way, reduce cash drain.
THE PAYOFF
Reduced risk and more cash for kids and retirement.
AFTER-TAX MONTHLY INCOME
$11,830.00
ASSETS
Home, $650,000; rental properties, $575,000; RRSPs, $185,000; RESPs, $10,000; two cars, $15,000; cash, $3,000. Total: $1,438,000.
MONTHLY EXPENSES
Food, $800; entertainment, $200; utilities and phones, $450; clothing, $300; child care, $300; car fuel and tolls, $400; car and home insurance, $250; charity and gifts, $400; RRSP, $700; mortgage payments on rental units, $3,320; mortgage payments on house, $1,424; house property tax, $292; property tax on rentals, $1,116; RESP, $168; line of credit, $200; miscellaneous, $200; rental unit subsidies, $1,250; cash savings, $60. Total: $11,830.
LIABILITIES
First mortgages, $635,500; second mortgages, $107,500; Home Buyers Plan, $14,300; line of credit, $5,000.
Total: $762,300.00
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