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.