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It’s Friday, and you know what that means: Reader Case time!
Today’s reader case comes from a familiar place: A Canadian wanting to buy a house because they want to use it as a “passive investment.” Hoo boy.
Now I know that it may seem like we have a bit of an anti-housing bias on this site, but we’re not actually anti-housing as much as we are pro-math. We will go where the math takes us, and if it tells us that it’s OK to buy, we will say so.
So with that in mind, let’s dive in, shall we?
Hi Firecracker,
Just discovered your blog a few weeks ago and I have been perusing through the investment workshop – It’s awesome.
So here’s my situation. I live in Northern Alberta Canada and this is just for me. My boyfriend and I keep our finances separate for now and don’t live together yet. Thinking of getting married next year and have 1 or 2 kids but this has only my info as I haven’t convinced him yet. He earns $120,000/yearly, he is 29 and I am 30.
I also made an Excel sheet of everything, I just want to know if I should buy a property solely for the purposes of earning passive income. I recently switched jobs and moved up North so I transferred my RRSP from previous employer to wealthsimple. The right hand contains my current employer contributions to RRSP and Savings.
The home prices is based on Edmonton but i could also purchase a home in Saskatchewan, Montreal, Ottawa as I have family who will help me with the house.
I recently got a car loan which I intend to pay off with this years (and next year) tax refunds. Purchased it for $16,500 at 6.36% for 5 years and I have paid off $1500.
Also, note that when i retire, i intend of moving out of this expensive city to somewhere like GTA where I don’t need a car and traveling out isn’t as expensive.
So should I invest in property as a source of passive income or not? And how am I doing financially?
Thanks!!!
TravelJunkie
Housing is NOT a Passive Investment
First of all, let me dispel one big assumption that our reader seems to have: that housing is a passive investment. A passive investment means that once you buy it, you don’t have to do anything with it.
Housing is NOT one of those things.
A house takes work. When a storm damages the roof, you have to fix it. When the refrigerator starts making weird noises in the middle of the night, you have to deal with it. When your tenant decides to set up a meth lab in the basement and the Feds have to bust in the door with a battering ram, you have to deal with the aftermath.
Hopefully that last one doesn’t happen very often, but my point is that real estate is a very, very actively managed endeavor, and those hoping to just hire a property manager and make all the work go away are grossly overestimating how much a property manager will do for you.
Bottom line: If you want to passively own real estate, buy a REIT and collect your 5% dividend every month. That’s what I do.
Does Buying This House Make Sense
OK so onto the reader’s question: Does buying this house she’s looking at make sense? The reader attached a spreadsheet showing all her calculations, but to be honest I couldn’t make heads or tails of it. She appears to be making some VERY sketchy assumptions (at one point, she assumes the house will appreciate at 2% PER MONTH, so yeah…) As a result, we are just going to take her inputs and re-do all the math ourselves.
Here’s the financials of the house we’re looking at…
| Summary | Amount |
|---|---|
| Purchase Price | $350,000 |
| Down Payment | $70,000 |
| Mortgage Rate | 5.34% |
| Mortgage Type | Fixed 25 year amortization |
| Expected Rent | $1800 per month |
OK so right away alarm bells are ringing. Real estate investor Paula Pant uses the 1% rule as part of her housing calculations, which states that the house should not cost more than 1% of the monthly rent. At a monthly rent of $1800, the house should cost at most $180,000. This one costs nearly double that. So things aren’t looking too positive so far, but for the sake of thoroughness let’s continue MATHING SHIT UP.
Plugging our reader’s information into a mortgage calculator (I used Ratehub.ca) gave me a monthly mortgage payment of $1683.
But as we know, the mortgage is just the start of the cost of home ownership. There’s property taxes, land transfer taxes, lawyer fees, maintenance, real estate agent commissions. The list goes on and on and on, but for the purposes of this analysis, I’m just going to focus on just a few of these costs.
TravelJunkie provided us an insurance cost of $300 a month in her spreadsheet. And as for maintenance, you’re supposed to set aside between 1% and 3% of your home’s value for maintenance, so let’s be aggressive and go with 1%. That’s $3500 a year, or $291.67 a month. Property taxes vary widely by location, but she provided a property tax rate of 0.85%, so that’s an additional $3000 per year, or $250 a month. And she also provided an estimate of $180 a month for her magical property manager that would theoretically make this entire investment passive.
So that’s an additional $300 + $291.67 + $250 + $180 = $1021.67 added onto the monthly mortgage cost. This house now costs $1683 + $1021.67 a month to own, for a total of $2704.67.
That’s way more than the monthly rent she’s estimating she’d get of $1800. That means this “investment” would have you losing money to the tune of almost $1000 a month!
And again, we’ve only included like half the additional costs of home ownership. The rest like real estate commissions, land transfer taxes and other per-transaction costs I can’t turn into a monthly cost because I don’t know how long the ownership period is. But suffice it to say, these additional costs will make that math worse, not better.
So unfortunately, MATHING SHIT UP has returned a verdict on this house, and it’s a big fat NO. DO NOT BUY THIS HOUSE.
How About Retirement?
OK so now we have an answer on the housing question. What about retirement?
TravelJunkie sent me her numbers in that crazy spreadsheet, so I’ll copy and paste the relevant parts below. Her gross income is $88,000 (ooh, lucky!). And as for her spending…
| Monthly Spending | |
|---|---|
| Rent + Cable | $1,385.00 |
| Car | $149.79 |
| Car Insurance | $152.94 |
| LI | $55.00 |
| Groceries | $250.00 |
| Dining Out | $150.00 |
| Clothing | $100.00 |
| Phone Bill | $50.00 |
| Netflix | $13.99 |
| Prof Membership | $29.17 |
| Car Maintenance | $100.00 |
| Gas | $50.00 |
| Misc | $50.00 |
| Entertainment | $60.00 |
| Beauty | $150.00 |
| Charitable Givings | $500.00 |
| Travel | $700.00 |
| Total | $3916.72 |
So that’s $3916.72 per month, or $47,000 per year. That puts her FI target at $47,000 x 25 = $1,175,000.
We also have to figure out how much she’s saving.
By plugging her info into an Alberta tax calculator and, assuming she’s maxing out her RRSP, that puts her after-tax salary at about $70k. That puts her savings rate at $70,000 – $47,000 = $23,000. On a side note, she also indicated that there’s also some kind of employer-contributed savings in her spreadsheets as well, but I’m assuming this is reported as part of her gross income so this simpler calculation should work out just fine.
Finally, she has a combined total of $93,621 in her RRSP and TFSA. So now we have enough to do our projection. How long until she can retire?
| Year | Balance | Savings | ROI | Total |
|---|---|---|---|---|
| 1 | $93,621.00 | $23,000.00 | $5,617.26 | $122,238.26 |
| 2 | $122,238.26 | $23,000.00 | $7,334.30 | $152,572.56 |
| 3 | $152,572.56 | $23,000.00 | $9,154.35 | $184,726.91 |
| 4 | $184,726.91 | $23,000.00 | $11,083.61 | $218,810.52 |
| 5 | $218,810.52 | $23,000.00 | $13,128.63 | $254,939.15 |
| 6 | $254,939.15 | $23,000.00 | $15,296.35 | $293,235.50 |
| 7 | $293,235.50 | $23,000.00 | $17,594.13 | $333,829.63 |
| 8 | $333,829.63 | $23,000.00 | $20,029.78 | $376,859.41 |
| 9 | $376,859.41 | $23,000.00 | $22,611.56 | $422,470.98 |
| 10 | $422,470.98 | $23,000.00 | $25,348.26 | $470,819.24 |
| 11 | $470,819.24 | $23,000.00 | $28,249.15 | $522,068.39 |
| 12 | $522,068.39 | $23,000.00 | $31,324.10 | $576,392.49 |
| 13 | $576,392.49 | $23,000.00 | $34,583.55 | $633,976.04 |
| 14 | $633,976.04 | $23,000.00 | $38,038.56 | $695,014.61 |
| 15 | $695,014.61 | $23,000.00 | $41,700.88 | $759,715.48 |
| 16 | $759,715.48 | $23,000.00 | $45,582.93 | $828,298.41 |
| 17 | $828,298.41 | $23,000.00 | $49,697.90 | $900,996.32 |
| 18 | $900,996.32 | $23,000.00 | $54,059.78 | $978,056.09 |
| 19 | $978,056.09 | $23,000.00 | $58,683.37 | $1,059,739.46 |
| 20 | $1,059,739.46 | $23,000.00 | $63,584.37 | $1,146,323.83 |
21 years.
That sounds pretty long, and it’s mostly caused by her surprisingly high spending. Specifically, the car. Yikes. When you add up all the car related costs in her budget, we get $149.79 + $152.94 + $100 + $50 = $452.73 a month. Car costs like this can really eat into your budget, but when you’re living in Northern Alberta you don’t really have much of a choice.
She also spends $700 a month on travel, but I can’t exactly fault her on that. Travel IS pretty awesome 🙂
Also, charitable giving. She donates $500 a month, and that’s great that she’s doing that, but that does add up to $6000 a year. Many people who write in with such a high recurring charitable giving item are doing it for religious reasons, so we’re going to leave this one alone.
That being said, this might be a good time to point out that being nomadic eliminates many of these costs. If she were willing to retire and live in lower-cost cities with good public transportation networks, many of these costs drop away. The car, for example, would be eliminated. As would the travel budget since, travel is just part of your every day base cost rather than a seperate thing you have to purchase. And life insurance would no longer be needed either.
Taking these costs out post-retirement would bring her budget down to $2709 per month, or $32,508 per year, which in turn brings her FI target down to $812,700. According to our above table, she’d be able to get there in 17 years, or 4 years earlier.
Life Changes Coming Up
So right now, TravelJunkie’s finances look OK. Not great, but not bad either. All this will change, of course, if she decides to marry her boyfriend and combine their finances. This, unfortunately, I can’t anlayze because I have zero information on his budget. Depending on what his expenses look like, you may find that you’ll be able to streamline your spending because you, for example, move in together which will speed up your journey. Or maybe he’s bringing a lot of debt into the marriage which will slow you down.
The point is, what she decides to do with her relationship in the next year or so could profoundly change her financial situation. I’ve shown you how to do the math, so when the time comes to make that call, make sure you MATH SHIT UP first.
Comments? Questions? What do you think of TravelJunkie’s situation? Let’s hear it in the comments below!
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What does she have life insurance for in the first place? And why (if she became nomadic) would the need for it just disappear?
I thought the same about the life insurance!
On being nomadic, I don’t think that is why it would disappear. I assume they mean that people don’t generally feel the need to continue paying for life assurance when they leave the wealth accumulation phase of their life and move into early retirement and travelling.
Life insurance is something everyone should have. What’s wrong with you? L 😛 L
First Time commenting here but have been reading for awhile. My wife and I are actually closing in on FIRE within months at age 35 (with a 2 yr old). Your blog has definitely helped us a lot.
Just wanted to comment on the claim owning real estate cannot be passive. We own multiple rental properties and use a property manager and literally do nothing but pay occasional bills. If you find a good property manager they will actually take care of everything. We recently sold one of our properties and in the time we had owned it we had been inside the house a total of once when we first viewed before putting in an offer. The property manager did everything in between that time. But I will note we tried another property manager and they were a disaster.
Rental properties can be among the best ways to invest, we have seen certain properties achieve an average yearly return of 20 -25% on our down payment. However there is a huge caveat to this, the money is tied up in the property. Even if it is a cash positive rental, the amounts will be small after all the costs. The real earnings come from mortgage pay down and value appreciation. If you want to retire in 20 years, the right rental home can be amazing, but they are not a great option for early retirement. We have been very happy with our rentals and selling a few now will allow us to reach FIRE, but anyone looking to get into real estate needs to consider their long terms goals first.
Where were the rentals of you don’t mind sharing? Those in my area are way too costly to be a good ROI
London Ontario, Market there has climbed a lot since buying, but still a decent ROI to be had.
It’s refreshing to see younger people interested in personal finance and retirement. Hopefully, through this blog (and others like it), saving and smart money management will become mainstream so less people will wake up in their 40’s with regrets about their earlier financial choices.
Found a typo “which states that the house should not cost more than 1% of the monthly rent “should be “which states that the monthly rent should not be less than 1% of the house’s price” or something like that.
Had the same thoughts about home ownership not being passive. Yes a great property manager can make it nearly fully passive, but that will cost.
Also the 1% rule is the rental income should not be less than 1% of the house price. So the math you had was right, just a typo. If I found a house that cost 1% of average rent, I’d buy 😉
Hi,
My personal take is that a house is not considered as a passive investment. A house serves to shield one from the element of the weather as well as a place to recharge the energy.
An investment share portfolio is the right avenue for passive investment as per my perspective.
One does not have to spend much time managing the portfolio which will generate continuous passive income for one.
My two cents worth of views.
WTK
Up to two and a half years ago, I owned my house. Then, I sold and started renting. I never felt more free. The invisible weight fell off my shoulders. It’s quite possible I will never own real estate again. And definitely not as a rental property. From the number of places I went to visit when I was looking to rent, too many tenants did not make the minimal effort to keep the place in good order. That meant it would fall on the landlord to fix it up. I’ve now lived in two places which were both brand new, never lived in and I thank the landlords very much for subsidizing my living expenses. I won’t do repairs and maintenance (that’s the landlord’s job) but I do keep everything neat and tidy. For both places, when the first 12 months were up, they kept the rent unchanged (they knew they had a good renter – why gamble for another who may wreck the place). So again, renting is good.
For my passive investment portfolio, I do nothing but rebalance and otherwise watch it grow.
Such a tough life. ?
You’re lucky to live in a renter’s market.
We’ve been staying in Auckland, New Zealand for about 4 years now and we’ve never lived in a brand new rental. And when hunting for a new rental, we saw several horror houses, some quite literally looked like the scene from a horror movie!
In our current house, I think the landlord is lucky to have us as I’ve taken gardening as a hobby and have been slowly improving the backyard and also built 2 garden beds and a small deck (all from free pallets!)
Renting can be hard in some places like here, but in general, I would agree that renting has far more benefits for people who like more flexibility. Which is why we haven’t committed to buying any property yet, we haven’t decided which route we’ll take!
Rental property can both be a good and a bad passive investment. I own 5 properties in SF Bay Area, 4 of them for rent. Two of them earned 5-6% when first purchased but 7 years later return 20+% at the original purchase price, and have appreciated 275%. One SFH earned 3.8% at purchase in 2017, now earns 5%, and has appreciated 30% in 2 years. These numbers are without leverage, so imagine what they would look like with leverage. It’s a long-term game. Properties in HCOL areas typically start out with very low or negative cash flows but after 10 years, 20 years, become huge money makers. Just don’t expect to make a quick buck.
The properties are mostly passive and trouble-free. The most troublesome property was one that has been in the family for 40 years, but it’s also the most profitable and earns its purchase price in rent (~$50k) every year. After a lot of maintenance repairs the first couple of years, it’s been trouble free for the past 3 years.
Real estate is a major pillar of wealth, should definitely consider the asset class to build wealth.
Dont think many of us with property in Calgary will agree with that. My place has been on the market for 5 months. Very few showings, listed below purchase price from 2010.
While I agree that a house or rental property may not make the best passive investment, if you can master the side eye/death glare and know how to make back handed insults, and can effectively use them to shut down nasty/entitled tenants, then a house can make a great passive-aggressive investment.
Sincerely,
ARB–Angry Retail Banker
Just a few points I differ on, but I agree this reader should not buy right now based on the numbers. She should probably focus on paying off her car first, and investing otherwise, until she knows where her relationship is at and where she ultimately wants to live and/or retire. Relying on family to manage your rental is not the best plan imo.
And the differences:
1. >Real estate investor Paula Pant uses the 1% rule as part of her housing calculations.
You can’t use this rule in most of Canada excepting the East Coast and some unusual areas because most of our markets are appreciation markets like California or Seattle. The areas that meet the 1% rule have high property tax rates and low or negative appreciation outlooks and aren’t very good investment markets imo.
If you used the 1% rule you’d never buy, yet most of the wealth in Canada is from RE investment. My rule is that the area needs to have a strong appreciation record and the property has to carry itself – which now means only multi-family fit these criteria where we live (ie. you need a main unit and at least one suite).
FWIW we are early retirees with seven rentals and it works financially for us with greater returns than the same amounts invested in the stock market, but it is a long-term strategy and not passive, although not too onerous either.
2. Why the 5.34% rate – you can get a five-year fixed for 2.74 right now. At that interest rate you are paying $1325 a month for the mortgage.
Also, there is no PTT in Alberta.
If she really wants to retire early, which she has not mentioned, she should look at the 700 a month travel and 150 a month beauty amounts as they can probably be replaced at a lower cost without much loss of satisfaction. That is a lot of charitable giving for her income so another area to consider re. other ways to contribute prior to FI.
The mortgage interest rate should be a lot lower. HSBC launched the lowest rate in history for a 10-year fixed rate of 2.99%, and they could do a 30 year amortization rather than 25 year.
Managing a rental property can be active or passive… depends on the property, tenants, and luck. I own several, and on averaged over a year, I “work” perhaps 2 days per month.
Lawyer fees are around $1200 for an RE transaction. They can get 1% cash back from their realtor, and fortunately, unlike in Toronto, they would only have one land transfer tax.
I don’t know much about Alberta’s RE market to comment on her expected rental rate, property taxes, vacancy rates, appreciation rate etc.
If you personally asked me, I think purchasing a house is a good idea as well is a great investment. I house allows you to build up equity in the home. What else can you think of? 🙂