The Myths of Rental Real Estate
By Garth Turner
March 27, 2005

My, my, my. This column apparently caused an increase in communal blood pressure on Vancouver Island last week, judging by my email inbox. There are a lot of people wholly unprepared to hear any talk that real estate values may have peaked and will inevitably correct that way the stock market did in 2000.

My comments last were in part a reflection of a new report penned by Toronto economist David Rosenberg, who figures there should be a healthy correlation between real estate prices and the kind of income a house could generate, or else real estate is over-valued. Rosenberg even went so far as to draw a comparison with today's housing market ­ where prices have never before in history been higher ­ and that dot-com mania which swept the country six years ago.

Pshaw! say more than a few readers who fervently believe real estate values will probably go up forever ­ at least in Victoria and its boomer-friendly neighborhoods. In fact one guy ripped your scribe's intestines out with a razor-sharp email saying real estate is obviously a great place to put money, when his $600,000 investment property can rent for $2,500 a month.

Hey, on the surface, that doesn't seem such a bad deal, I will admit. After all, $2,500 a month is $30,000 a year, which is a 5% return on the money invested in that house. Compared to GIC rates these days, that's okay. But it's also just a part of the calculation.

It costs money to own a house, even when the place is paid for. In this instance, property taxes would be (at least) $10,000 a year, and utilities would average about $900 a month. Add in a modest $3,000 a year for property and building maintenance, and you have annual overhead of $24,000 a year on this rental property. But, real estate groupies cry, all these costs are deductible for tax purposes against the income received, which is absolutely right.

So, if the investor is in the 50% tax bracket, then write off half the costs, bringing them down to $12,000 a year, or $1,000 a month. Deduct that from the $2,500 monthly rent, and the net income is $1,500 a month, or $18,000 a year ­ a 3% return on the $600,000 invested buying the house. But, of course, this $18,000 is taxable as income to the investor, so applying the same 50% tax rate, the rate of return is reduced to just a little over 1% - which is actually below the current inflation rate.

So, buying a $600,000 home to rent out means you'll likely enjoy a negative rate of return. How smart is that? In fact, your only hope of breaking even over a few years is if the price of the real estate continues to climb, and you receive a (taxable) capital gain. But that is exactly Rosenberg's point ­ when the price of a piece of real estate climbs beyond the ability of that asset to generate a positive rate of return, then it's probably over-valued. That means instead of it going up in value more (or, in the case of Victoria, forever), it will more likely correct to a more normal and affordable level.

So, let's compare buying a home to rent it out, with just investing the money in a low-yield, no-risk fixed income asset. If you received the same 5% on $600,000, that would be earned investment income of $30,000 per year ­ taxed as income. If you were in the 50% tax bracket, that would become $15,000, or 2.5% , which is nothing to yodel about. But, if you took half the money and invested it in an RRSP, you'd get $7,500 back as a tax refund, giving you retained income of $22,500 a year, or a return of close to 4%.

You could take that $22,500 and put it towards the $30,000 rent on the $600,000 house that the guy above owns, and living costs for a year would total $7,500 annually. But at the same time, your RRSP would be increasing by $15,000 a year, and also be generating tax-free income. After five years you would have $600,000 in cash and $75,000 in tax-sheltered investments, for a total of $675,000 that cost you $37,500. Oh yeah, and you lived for free.

Meanwhile the guy who bought the $600,000 house and rented it out still owned a $600,000 house. Maybe.

The moral here is not that real estate is a bad investment, because it isn't. But trying to justify today's prices by today's rents is a mug's game. Living in it is one thing, renting it out quite another.

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