Clutch of Condos Threatens Pensioned Retirement
Created on Monday, 15 August 2011 08:00
Two teachers in Alberta we’ll call Thomas and Georgia are in their mid-50s and facing a disaster in their retirement plans caused by poor real estate investments that could literally eat up their retirement savings. If not fixed, the properties will leave them rich in real estate and poor in cash.
The problems begin with previous successes in real estate speculation. Figuring that property always goes up, they bought three rental condos for a total of $1.3-million at the peak of the Alberta property market and put $120,000 down on a property in Costa Rica. They supported this investment on $9,490 combined monthly take home pay. Two of the condos barely pay their way on a cash basis that does not even account for depreciation. A third property is a costly flop that costs them $931 per month more than its rental income. The $120,000 Latin American property, which was not completed, is in litigation and has been written off. Thomas and Georgia face the unpleasant task of cutting their losses to preserve their wealth.
The clutch of properties has become a burden for the couple, threatening their retirement, which could be as early as 2014, and what they can do for their children, who are 24 and independent and 22 and finishing university.
“When we retire, we would like to sell our home and downsize to something smaller on Vancouver Island,” Thomas explains. The problem, of course, is the three cash-draining condos. “We would have liked to walk away from the deposits we had placed when the market turned, but the builders threatened legal action. So we went ahead with the purchases. Each is financed by a line of credit with a 25% down payment and secured by equity on our home.”
If Thomas and Georgia were to sell in today’s market, they would lose much of their equity, for prices are not as high as they were in 2007. They pay interest only on the lines of credit. As interest rates rise, they will have to add more cash and pay what amounts to higher subsidies. “On a good day, we are optimistic that things will work out well,” Thomas says. “On a bad day, I feel that we are too exposed and must reduce risk.”
Family Finance asked Derek Moran, R.F.P., head of Smarter Financial Planning Ltd. of Kelowna, B.C., to work with Thomas and Georgia. In his view, the problem is risk management. “We have no idea where the real estate market is going, so the answer to the couple’s problem is to remove some of the risk and to manage what is left of the properties as long as necessary.”
Two of the three condos were purchased for $479,336 each. The third was bought for $347,645. The first step is to sell the lowest value condo, estimated value $310,000 which has been least affected by wobbles in the real estate market. If it were to sell for the estimate, after paying its $206,961 borrowing cost, they would net $103,039. The mortgage is a credit line, so there would be no penalty for closing it, Mr. Moran notes.
The $100,000 or so left after selling costs could be used to reduce debts on the remaining condos, allowing them to run profitably on a straight cash basis. Strategically, it’s wise, for the remaining condos, if left to generate losses indefinitely, might cause the Canada Revenue Agency to deny loss deductions.
To increase net rental income, the couple can try to negotiate lower borrowing costs. They are currently paying prime plus 1%. They might be able to find prime + ½ of 1% by diligent shopping, Mr. Moran suggests.
Thomas and Georgia might also ladder their mortgage maturities so that they do not all come due at the same time. That step would spread the risk that they might be renewing loans at high points in the interest rate cycle, Mr. Moran says.
If the couple is willing to lock in, they might be able to get what one lender is offering – prime less 0.95%. That’s 2.05%, which would lower their current cost by almost half. Locking in when rates are low carries less than normal exit risk because the base for any penalties for ending the loan is lower, Mr. Moran notes.
Thomas and Georgia have $32,000 each of unused RRSP contribution room. They also have $98,191 in non-registered segregated funds. Their marginal tax rate on income over $83,088 is 36%. If they made in-kind RRSP contributions with assets they already hold, they could keep those assets and get a tax refund (it straddles two tax rates) of about 34% of $64,000 of contributions or $21,760. The tax refund alone would pay for a new car that Thomas says he needs.
If Thomas and Georgia do retire in three years, they will be 58 and 59. Before they reach 65, their pensions will total about $7,060 per month or $84,720 per year. They will also be able to deplete their RRSPs in those years before age 65. The RRSPs, currently $21,232, will have grown with a $64,000 contribution in kind, filling $32,000 of contribution room each partner has. The sum will then be $64,000 plus $21,232, which is $85,232. Spent over the six years until they are 65, that sum will support payouts of $14,205 per year for total income of $98,925 before tax, Mr. Moran says.
At 65, Thomas can collect 84.4% of maximum of CPP credits earned, currently $11,520 per year, and Georgia 84%. That works out to $9,723 and $9,677 respectively in 2011 dollars. OAS will add another $6,404 dollar per person in 2011 dollars for total income of $84,720 plus $19,400 plus $12,808 for total income of $116,928 or, if carefully split, $58,464 each. Given that their RRSPs may have been used up by this point, the clawback, which begins at $67,668 this year, is unlikely to be a problem.
Thomas and Georgia have a good chance of working through their real estate nightmare. Just by cutting leverage and debt service charges, they will be able to wait for the market to allow them to sell. “Thrift, sale of one or two condos and downsizing their house will be the foundation for a more secure retirement,” Mr. Moran says. What this couple has done has been to add risk to a secure future based on indexed pensions. “If they sell the condos, they may miss a chance for future profit, but they will also be shedding losses that could deeply impair their retirement.”
Monthly after-tax income $9,490
Assets: House $ 850,000, Car 15,000, RRSPs 21,232, 3 condos curr. price 874,917, Mexico project 0, Non-registered 98,191, Life ins. cash val 19,905, Car 15,000
Liabilities: Line of credit $659,700
Net Worth $1,234,545
Monthly Expenses: Line of credit $ 2,241, Property tax-res 639, Utilities houses 620, Food & restaurant 1,580, Car fuel, repairs 318, Travel 1,000, Entertainment 240, Clothing & grooming 220, Car & home insurance 373, Life insurance 139, Gifts, charity 250, Misc. 1,000, Savings 870
(c) 2012 The Financial Post, Used by Permission