Situation: Couple worries mortgage payments on four rental units may be a drag on retirement plans
Solution: Keep the profitable rentals, pay down the mortgages, and enjoy the cash flow in retirement
In Ontario, a couple we’ll call Sid, 43, and Lynn, 41, are raising two children ages 10 and 13. Sid has made a solid business managing four of their own rental properties and looking after others’ rentals. Lynn is a civil servant who brings home $3,000 per month after taxes and deductions for various benefits. Combined monthly income after tax is $7,544.
Their finances have many parts: employment income for Lynn, business income for Sid, a good deal of debt to support the rentals, and a nagging question. “Do we have too much invested in real estate? Lynn asks. “Should we resume RRSP savings that we suspended or start Tax-Free Savings Accounts, and, if we manage to retire in our early 60s, what income could we expect?”
Family Finance asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., to work with Sid and Lynn. In his view, the problem is working out the numbers to determine what income the couple can have when Lynn is in her early 60s.
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A complex income
The mix of four rentals, a building management business, a civil service career, and RRSPs with many large cap dividend stocks is itself an issue. The couple worries they are overloaded with real estate, do not have enough in RRSPs, and need more liquidity. As we’ll see, the foundation of their combined enterprises is solid.
The first thing is to look at the balance sheet. Including their home, four rentals and RRSPs, cash and car — but not including $76,000 in RESPs — Sid and Lynn have $2,230,197 in assets and liabilities of $981,817. Rental properties with a value of $1.485 million are 8.3 times the value of their RRSPs. It’s not adequate diversification, but it has worked very well to build their wealth.
They have $25,397 cash as working capital plus a 3.45 per cent line of credit with a $64,525 outstanding balance they have used to purchase rentals. Rental income alone generates a return after costs and property taxes of 18.6 per cent plus or minus capital appreciation, Moran says.
They could sell two properties with average value of $300,000 each and average mortgage balances of $150,000 each, capture $300,000 and pay off their outstanding home mortgage balance and then have money left over for TFSAs. At present, neither has one. But the returns on the properties are far too steady and profitable to discard just to pay off a home mortgage with a balance of $183,699 that in any event will be paid off in a dozen years when Sid and Lynn are in their early to mid-50s, Moran says. Their cash supports profitable operations. A TFSA is not timely.
If for some reason, such as an opportunity to buy another rental with good profitability, the couple needs more cash than their reserve, they can either use their existing line of credit or reamortize one or more rentals. With growing experience in the rental market via their own properties and those Sid manages, and a good relationship with their bank, gradual expansion of their business would not be unduly risky, Moran suggests.
The family Registered Education Savings Plan has a current balance of $76,000. Sid and Lynn add $333 per month, about $4,000 per year, and obtain a contribution of $800 from the Canada Education Savings Grant. If they continue contributions at this rate until each is 17 and obtain 3 per cent annual growth after 3 per cent inflation, then when the kids are ready for post-secondary education, the plan will have $65,700 for the younger and $53,100 for the older child.
The parents can split the difference and provide $59,400 to each child for post-secondary education. That should be sufficient for tuition at most post-secondary institutions in Ontario. If the parents redirect some of their $470 monthly car payment to the RESPs to push contributions up to $2,500 per child plus $500 CESG per child, then they would have $56,000 and $70,000 each. The parents could average the sums to $63,000 each. Summer jobs could cover any deficits, Moran notes.
As a matter of strategy, Sid and Lynn have been banking on their very profitable rentals to build their fortune. They have suspended RRSP contributions and, therefore, have a great deal of room — $90,481 for Sid and $81,885 for Lynn.
If they retire in 20 years when Sid is 63 and Lynn 61, their incomes will be composed of several parts. If the couple’s present RRSPs with a value of $179,800 grow with modest combined contributions of $1,000 a month from rental income at 3 per cent a year after inflation, then they will have a value of $657,000 and support annual payments of $34,250 for the following 29 years to Lynn’s age 90 at which time all income and capital would have been paid out.
Lynn will have a pension that pays $43,164 per year including a $7,764 bridge, which ends at 65. Rental income after expenses other than interest should be $60,000 per year assuming all mortgages have been paid in full.
At 65, each partner can have 90 per cent of the current maximum CPP benefit of $13,610, $12,250 per year and each can have full Old Age Security, currently $7,212 per year, at age 65.
At Lynn’s age 61, the couple will have her $43,164 pension, RRSP payments of $34,250, and rental income of $60,000 per year for total income before tax of $137,414. If this income is split, they would pay tax at an average rate of 20 per cent and have $9,160 monthly disposable income. With all debts paid, that would cover all non-business current expenses.
When Lynn is 65, her job pension will drop to $37,548. They will have RRSP payments of $34,250, rental income of $60,000 per year, combined CPP of $24,500 and combined OAS of $14,424 for total income of $170,722. With eligible pension income and rental income split, and assuming a 20 per cent tax rate, they would have $11,380 per month to spend, far in excess of current spending with debt service, RESP and other savings ended. “Good management pays,” Moran concludes. “This couple is doing just about everything right. Their carefully laid plans will pay off.”