In a recent story that appeared in The Financial Post (See Big debt the downside of loading up on real estate), a tax accountant noted that a much larger proportion of his clientele own rental properties these days compared to a decade ago. It is a trend that I’m noticing in my circle of friends and acquaintances as well (with the caveat that my sample set is likely too small, unrepresentative or both). In the past, young families first purchased a starter home, lived in it for a few years and then sold it and upgraded to a bigger home to accommodate a growing family. These days, many families appear to opt to rent out their starter home when upgrading to a larger property.

There are a couple of factors driving the trend of more homeowners turning into landlords. First, homeowners have built up significant equity in their starter homes due to the decade-long bull market in housing. Second, financial institutions have made it much easier to tap into home equity. For instance, the big banks used to allow lines of credit up to 60 percent of a home’s value less the mortgage balance. Today, the figure is 80 percent.

Consider the following example: Sue purchased a home in 2003 for $200K, which is today valued at $350K. She currently has a $100K balance on her mortgage. Sue is planning on buying a new home for $500K and she has $300K in other financial assets such as stocks and mutual funds. Option 1 for Sue would be to simply sell the current home when purchasing the new one. She would have $500K in housing assets, $300K in financial assets and a mortgage balance of $250K. Option 2 for Sue would be to keep her current home and rent it out. The bank is willing to allow her to tap into her current home equity to the tune of $180K. In this case, she would have $850K in housing assets, $300K in financial assets and a mortgage balance of $600K ($280 on her first house and $320 on her new house).

By dramatically increasing her exposure to the local housing market, Sue has taken on significantly more risk by keeping her starter home. Any downturn in housing prices will result in a much bigger hit to her net worth. Also, any vacancy in her rental property will put a serious crimp in her cash flow (at an interest rate of 4 percent and interest-only payments, Sue needs to net $933 every month just to break even). It may be tempting to chase real estate riches after extrapolating recent housing market returns but putting too many eggs in one basket is hardly ever a good idea.

This article has 20 comments

  1. My thoughts exactly. I bought a starter home in Edmonton 7 years ago and then last year upgraded homes and went through both senarios of keeping my first home and renting it, or selling and making a tax free gain and using it towards my new home. The actual return on capital worked out to be around 4% and didn’t include the cost of finding tennants and upkeeping the home. It seemed to risky and labor intensive for a smallish return. As well as it reduced my guaranteed return in savings from interest charged on my new mortgage. I ended up paying off all my consumer debt first then split the rest between the new mortgage and the ‘couch potato’.

  2. Like all investments one needs to diversify. It isn’t a bad idea to own rental properties, just make sure you buy with rent-ability in mind.

    It’s easier to own condominiums as rental properties than houses in my experiences so far.

  3. I think far too many individuals are financially subsidizing their rental property whether they are aware it or not.

    Having said that, I do believe that alot of people understand renting out a property more than they do financial investing. So they at least pick what they can understand.

  4. @Phil b: I find the same to be true of Ottawa as well. $350K properties are renting for gross of $1800 or so. That’s a gross return of 6% before property taxes, maintenance, insurance and vacancy. But even if the yields were more attractive, diversification suggests not tying up too much capital in one asset class.

    @David: I agree that owning rental property isn’t a bad idea per se. It is one thing to take a conscious decision to become a landlord, quite another to simply keep the first home and become an accidental landlord. Also, diversification opportunities with rental properties are often limited by location.

    @Cal: It seems to me at least that the folks I know who are getting into rental real estate are becoming accidental landlords. If that only means that their investment returns are going to be poor, it will not be the end of the world. After all, investor returns in financial assets isn’t anything to crow about either.

    What I worry is many of these investors seem to be stretching themselves to hold two properties (with the caveat that it is hard to know what’s going in someone’s financial life). Too much debt might land these folks in a lot more trouble than mere poor returns.

  5. > $350K properties are renting for gross of $1800

    That’s what some people are asking, but the average rent for that type of home is closer to $1400-1500 in Ottawa, at least in my experience. There aren’t too many quality tenants who are willing to shell out $1800/month on a $350k house when they could buy the same house for a mortgage of $1510/month.

    • You may be right Viscount. I’m going by what people tell me their property will rent for and since these folks are not experienced in these matters, it is very likely that they are overestimating rents by quite a bit. 5% gross returns sounds even less appetizing.

  6. I liken this strategy to the ‘life-time/style’ investing proposed by the Ivy league researchers who published a book about levereged investing.

    A young landlord is leveraging early, and getting exposure to an investment that may/will pay out over time. The issue is that real estate typically returns just slightly above inflation, and the costs associated with maintaining a rental might eat those away. Possibly people getting a forced savings keeping pace with inflation.

    All that said, while I agree over 50% of assets in a single asset class might be risky and expose one to large fluctuations, may I ask what a good level would be? Had these people focused on equities and bonds, and those assets made up 70% of their assets, would you have to write an article about how having too much money in equities is bad?

    The high absolute cost of real estate makes it tricky, but I wouldn’t say one needs to accumulate an even amount of non-real estate assets before venturing in.

    The bigger problem I have with all the new landlords is they often don’t bother analyzing whether the venture is profitable, and at what rate.

    • @Sampson: I don’t see owning one investment property the same way as owning one asset class (such as real estate through REITs). It is more like investing in one stock instead of a diversified portfolio of stocks. Also, I would definitely write a post that it is extremely dangerous to borrow 80% of a portfolio’s value to invest.

      I think your point is that if a homeowner has done her homework, holding the starter home as an investment property can make sense. I can agree with that but I get the feeling that many people I know do not really know what they are getting into.

  7. Like stocks, whether your rental is financially successful or not will primarily depend on the price you bought in at.

    People make classic mistakes like assuming they will NEVER have a vacency intead of assuming a more prudent 10-15% vacancy. Then, they often think the property will not require maintenance where a 5%-10% maintenance amount is statistically supported for home ownership. Also, you can lock in rates for 5 years but what about if they move higher. Start adding these realistic scenarios to a spreadsheet of 10 year cashflows, and suddenly your “can’t lose” rental doesn’t look so hot.

    Too many people are buying with the hopes that property prices keep rising 5-10% forever. At the prices people are paying for homes right now, that is the only way it will work out. Your friends and family will think you are a genius, but you won’t get rich.

    Don’t overpay. You make your money on the day you buy the property, not on the day you sell it. Remember that and you should be okay.

  8. The day people start thinking real estate is a BAD idea and one that just ‘doesn’t work’, that is when prices (and the rental strategy) will start getting attractive.

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  12. Buy XRE,leave the R.E to professionals.
    Higher rates, a generation that cannot afford to buy at todays prices, more sellers than Buyers, higher property taxes etc, RE. is not an Investment, it is a Gamble.

  13. XRE is currently yielding just over 4.5% and I can guarantee that it will never call you at 2:00 in the morning about a leaky hot water tank! For the US market, IYR is yielding roughly 3.5% and I have never received a call from it because of the tenants upstairs making too much noise! Also, if I ever need cash from my real estate investments via ETF’s, it is always three business days away.

  14. REITs aren’t really a proxy for residential real estate, at least in Canada. There aren’t any major REITs that I’m aware of that handle residential properties; it’s mostly commercial properties with a few apartment properties.

  15. Multi-unit residential (what residential REITs own in Canada) is a different asset class than single-family homes/condos. One REIT manager says houses/condos are not ‘investment grade’. They are bid up by irrational owner-occupiers, whereas large multi-unit residential properties sell for in the neighbourhood of $100k per unit.

  16. @Rob: Also, some people are just not cut out to be landlords. I can barely maintain our own residential property and owning rental properties will drive me insane.

    @Howard Hare: Unfortunately, REITs aren’t great bargains at these prices either. However, I agree with the contention that residential housing appears to be speculation at these prices.

    @Fred: I agree. I prefer to own REITs as well.

    @Viscount: I agree. AFAIK, Canadian Apartment Properties (CAR.UN) seems to be the only REIT offering exposure to residential rental properties.

    @Andrew F: I wonder if owner-occupiers bid up single home / condo prices because the imputed rental income is tax free. i.e. it is rational from the owner’s point of view but depresses yields for investors.

  17. Transglobe and Boardwalk REITs are some other apartment REITs, unless you meant something different by ‘residential’.

    It’s possible that owner occupiers can apply higher valuations because they ‘rent’ to themselves tax free, but a lot of valuations are so high that even without the tax wedge, the implied rental yield is no better than the risk-free rate, especially after maintenance, insurance, etc. I find it hard to believe that valuations are rational. Not to mention that the marginal buyers are ‘specuvestor’ landlords buying cash flow negative condos. These buyers don’t enjoy the tax advantages of owner-occupiers, so should always be outbid by owner-occupiers (in a rational market).

  18. As many bloggers have noted the valuations for Canadian real estate is too high. People will get caught when the market goes down. Be very careful when investing.