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Proper property plan

Paying off their real estate mortgages early best strategy for couple

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Jack and Liz have always thought they are on the right track for an early retirement.

In their mid-40s, they've raised two children, with money set aside to help cover the cost of university.

They've paid off their mortgage and along the way invested in two rental properties.

Yet with the stock market surging of late, they're wondering whether they should get off the sidelines and put the more than $100,000 they have in savings accounts into investments that can offer a better return.

"We realize that we now have a good pocket of savings that we need to do something with," says Jack, an executive who makes about $200,000 a year.

"I think we need to invest in the markets, but we need a road map."

Aside from about $235,000 Jack has invested through a defined-contribution work pension, the couple has no registered savings.

"We really didn't think that RRSPs were a good plan because we would have to pay taxes on it," says Liz, who works in the non-profit sector, earning about $46,000 annually.

"We thought we could buy properties instead of that."

While their home is paid in full, they owe more than $370,000 on two rental properties worth about $630,000. The rental income covers the cost of the debt payments and maintenance, and they expect the mortgages will be paid off by their early 60s.

But Jack and Liz want to retire in their late 50s, ideally spending winters in Arizona.

"We talk about investing some of our savings in another property there and renting it out until we're ready to retire," he says.

While the income from their rentals will help fund their retirement, they know they need additional savings to provide income when they are still making mortgage payments in the first few years after retiring. But they also realize buying a vacation property while saving for retirement over the next decade will be a tall order.

"The issue is I don't know if we're saving enough," Jack says. "Are we the quiet millionaires or are we just delusional in thinking we have enough?"

Uri Kraut, senior wealth consultant with Assiniboine Credit Union, says Jack and Liz certainly have an ambitious retirement plan, especially because they won't be able to use the centrepiece of their strategy -- rental income -- until their early 60s.

"It's going to be tight early on because they won't have the rental income, CPP or OAS yet," says the chartered strategic wealth professional.

Accordingly, they will have to rely on their savings and Jack's pension to fund their lifestyle in the first few years of retirement. Using their current budget as a guideline and decreasing some costs and increasing others likely to change once they're retired, Kraut estimates they will need at least a net combined income of about $57,000 a year in today's dollars, indexed to inflation.

If they retire with the mortgages paid in full, they can expect a rental income of more than $35,000 a year, which combined with Jack's pension should provide a net income to cover their expenses.

Of course, the problem with this forecast is the rental properties' mortgages will not be paid off until Jack and Liz are in their early 60s.

Yet Kraut says diversifying their retirement nest egg into assets other than real estate at this juncture is likely not the best option for them, considering the risks they already face as a result of the majority of their wealth being invested in their principal residence and the rental properties.

Real estate has been a top-performing asset for more than a decade, largely because of a low-interest-rate environment that facilitates borrowing.

Rates will eventually rise, and when they do, Jack and Liz's cost of carrying the mortgages will also increase.

"If interest rates were to rise dramatically or even gradually, there could be considerable pressure on the underlying value of the real estate holdings," Kraut says. That's because a rate hike is likely to dampen demand for housing, slowing price increases or even sparking a market correction where prices could remain flat or decrease.

In turn, Jack and Liz would have to increase rent to cover the higher mortgage payments, which could affect tenancy of both properties. In fact, tenancy risk poses another potential problem, rate hikes or not.

"When they cannot get qualified occupants to live in their rental properties, Jack and Liz are on the hook for paying down the mortgage or subsidizing their retirement income stream from other sources."

As a result, it's important that if they choose to use much of their savings to pay down their debts, they need to set aside a healthy emergency savings reserve.

Another major risk is the potential for a steep decline in home prices in Canada, which isn't out of the question. They could be faced with a triple whammy of sorts: higher borrowing costs, falling asset values and a need to raise the rent when tenants have less room for increases in their budgets.

"A real estate-focused investment strategy is very dependent on a successful and stable market," Kraut says. "As we have seen in the United States, this is not always the case." While their rental properties are worth more than $600,000 today, it's not unthinkable dramatic decreases in home prices, such as falling more than 50 per cent, as has occurred in desirable markets such as Phoenix, Ariz., and Palm Springs Calif., in the last decade, can happen in Winnipeg.

Yet diversifying into the stock market is not the answer either.

"Although I understand that it may seem attractive, looking at last year's returns, to invest some or all of the proceeds of their wealth in the markets, even in a conservative way, it is not prudent," Kraut says.

Markets have risen dramatically since March 2009, so "they, in essence, have missed the easy rise."

Kraut says a de-leveraging strategy would be a better option for the couple, using additional savings to pay off the mortgages as quickly as possible. This strategy becomes all the more imperative if they choose to buy a U.S. property, he says.

Although interest costs on the debt on their income property are tax-deductible, eliminating their debts sooner than later is more desirable, given their exposure to the risks, combined with their plan to retire early.

Adding to the complexity are potential estate and other tax issues. Kraut suggests they should seek expert tax advice to ensure the best way to transfer their wealth to their children after they're gone, if that is what they want.

One option for them is a life insurance strategy to cover the taxes associated with passing the properties on.

"Depending on the market conditions for real estate, it may be difficult to sell the property at a satisfactory price," Kraut says. "This is where insurance comes in, because it, in effect, anticipates the capital gain that would be realized on the assets, and it ultimately does not force the estate to sell the property in a potential unsatisfactory market."

While not an impossible plan, Jack and Liz have their work cut out for them in the next decade. Fortunately, with Jack's high income, they have the cash flow -- if they can adjust their spending -- to accelerate debt repayments, aiming to be mortgage-free by their late 50s.

While his pension, which should be about $477,000 by then, will be a pillar of their retirement income, they will be better off in the long term if they don't wholly rely on it early in retirement.

Yet if they find an accelerated de-leveraging strategy unworkable, Jack and Liz can always push back retirement until their early 60s, when their debts will be paid as currently planned, Kraut says.

"Even then, however, it's important they focus on de-leveraging going forward, because that future income from their real estate holdings will be such an important piece of their retirement puzzle."

giganticsmile@gmail.com

Republished from the Winnipeg Free Press print edition February 15, 2014 B11

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