Recently, a middle aged man came to see me. Doug (not his real name) told me that he was experiencing tough times—his wife had divorced him years before, he had lost his job and hadn’t found work in nearly two years, his adult children were dealing with their own difficult issues, he was still three years away from his pension and he had recently been forced to move out of his own home near downtown Ottawa because he couldn’t afford to pay his mortgage, property taxes and utility bills. He was also suffering from bouts of depression and was uncertain about his employment prospects.
He wanted my advice—should he sell the home or continue to rent it? He had been able to find a good tenant who was paying a modest $1,600 monthly and covering the utilities too. His conundrum—the tenants wanted to extend for another year and Doug wasn’t sure what to do.
After paying all the costs on the house, Doug was netting about $265 monthly from the rental income on the property. He was eking out a living in a basement apartment. He felt he could continue to do that plus he felt an emotional attachment to the home where he had raised his family—it was a lifeline for him.
Nevertheless, Doug remains highly rational and analytical so I prepared a spreadsheet for him to assist him with his decision making.
What we found was that if he could sell the house for its market value (estimated by Comparative Market Analysis, CMA to be about $450,000), he would pocket (after real estate commission, legal fees, disbursements and paydown of his mortgage) about $276,000.
Now that is a pile of money and my concern was that if he sold it, he might blow it. From what I could see, it was unlikely that Doug would be able to amass that kind of money at any time in the future again.
This is a very real fear—the vast majority of US lottery winners blow their entire stake in under 5 years. And this would be a bit like a lottery win for Doug—a kind of unexpected windfall.
After two more meetings with him though, I found him to be a surprisingly canny guy with good sense when it came to money and, at least this one concern, was allayed.
We looked at investment strategies for him—he decided that if he was going to go ahead, he would invest the proceeds in two areas—GICs (Guaranteed Investment Certificates, an ultra low risk form of investing that produces current returns of around 3% p.a.) and the ROI Fund (which has returns of about 6% p.a., invests in first mortgages and has significant tax deferral attributes).
The difference in cashflow turns out to be around $875 per month—his total yield on his GICs and the ROI Fund would be about $1,140 per month.
You can download my spreadsheet in .xls format from my server at: http://www.ottawarealestatenews.com/SellOrRentYield.xls. If you plug in different values for key variables such as: Selling Price, Mortgage Amount, Interest Rate, Rental Income, investment percentages, etc., the spreadsheet will automatically update the difference in yields for you.
Now the difference from trying to live on $265 a month and $1,140 a month is huge. That extra $875 has (in economic terms) much greater utility for Doug than if, say, Sally was living on $5,000 a month and considering selling her principal residence to bring her a bit extra.
So the advice I might give Doug could be very different than the advice I would give Sally.
In Sally’s case, I would be much more likely to factor in two other real estate investing concepts—the wealth effect (basically, having her tenant pay down her mortgage principal for her) and real estate inflation.
I calculated these in an approximate manner (at the bottom of the spreadsheet). The wealth effect averages $3,273 per year over the first five years. That is, over the first five years, her mortgage principal owing to her bank will drop by more than $16,000. Now this (ultimately) goes into Sally’s pocket (when she sells the property) but the problem is that it isn’t “IGA money” (as my wife would call it)—it isn’t money you can touch, feel or spend and for Doug, waiting five years to get it isn’t really an option if he can’t survive long enough to actually see the money.
The other real estate return is, of course, inflation. In this model I am assuming a 2.5% p.a. increase in property values which averages just under $2,500 on this property per year for the first five years. Again, this isn’t money that Doug can use until he sells the property but he is sophisticated enough to understand that neither the ROI Fund nor his GICs give him any inflation protection at all.
So he is rightly nervous about selling and missing out on these other types of returns.
But even after factoring these other returns in, we found his adjusted cashflow was still higher under the sell option than the rent option (by nearly $5,000 per year).
So while my bias is to build and hold (see for example: http://www.eqjournalblog.com/?p=218), this case, due to the human factors invloved, seemed to me to be an exception.
Prof Bruce
Postscript: We got Doug’s house sold for him and because of its proximity to downtown Ottawa, we got a full price offer. He has since moved out of that basement apartment, he has a bit of walking around money and he surprised me—he diversified his investment strategy. He decided to invest some of the proceeds in GICs and the ROI Fund but he is actively looking for a rundown place he can buy, live in and fix up so he can do it again. I wouldn’t bet against him—it turns out he has a good eye for real estate and he is holding his head high these days.
(Please note that I have changed some of the facts of the case study to protect the identity of our client.)
Postscript: Here is a comment by Mark Sherboneau, a business owner in the field of investment management.
“Hi Bruce,
That is a really good case study. I liked how you incorporated the spreadsheet to help validate the case.
With respect to the questions that you had yesterday on inflation protection, ROI markets the fund as having inflation protected qualities in that the yield that is offered will adjust up or down over time with the prevailing interest rate condition. So, assuming that we are in an inflationary period and interest rates are going up to curb inflationary pressures, the yield returned by ROI will also go up as principle and interest are reinvested at higher (then prevailing) rates.
But ROI does not offer the same inflationary protection that real estate does, in that real estate appreciates more or less with inflation essentially locking in inflationary growth.
There are however fixed income instruments in Canada that do operate like that called real return bonds. Real return bonds are typically issued by the federal government and a few provinces and the par value of the bond is adjusted upward (or potentially downward) by the rate of inflation as measured by core CPI. The US has a similar instrument called Treasury Inflation Protected bods (TIPS) which operate in the same manner and are typically offered by the US government.
In summary, ROI has some measure of inflation protection through the adjusted yield on the new loans placed; however, ROI does not offer the same 1:1 relationship that real estate and real return bonds offer.
Regards,
Mark Sherboneau, mark@foundationpwm.com”