Family Finance: Retirement Plans Sinking Into the Mud

Andrew Allentuck

The dream of owning a vacation property is becoming a nightmare for Vancouver couple struggling keep their home from sinking into the mud.

In Vancouver, a couple we’ll call Herb and Val, 54 and 49, respectively, have built their lives with their own hands, constructing their own houses and selling others.

Herb, a tradesman, and Val, the family’s contractor, now have four homes: their $700,000 principal residence with a rental suite, a $450,000 cottage in ski country they rent out, a $280,000 rental townhouse in a Vancouver suburb, and a $175,000 unfinished house in Mexico. Those assets outweigh their $15,000 of RRSPs and $81,000 in cash.

The Dilemma

The four properties have an estimated market value of $1,605,000. Their liabilities, including a $565,000 line of credit and a $204,000 mortgage, total $769,000. Their real estate’s net worth, $836,000, would put them in a good position for the future, but that’s deceptive. They have to support their liabilities on total income of $13,725 per month before tax, much of which is eaten up by debt-service charges. Worse, their unfinished house in Mexico, which is sinking into the mud, has a theoretical value of $175,000. It has cost $550,000 so far and cannot be sold as is, Val says. She sees the clock ticking on their ability to stay solvent, for Herb’s severe back problems will limit his work and interest rates will eventually rise, forcing them to pay more on their on their loans.

“How do we shuffle our assets and debts to allow us to leave money to our three grown kids?” Val wonders.

Family Finance asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., to work with Herb and Val to reduce their debt and cut their exposure to interest rate increases. He proposed a five year plan. Later, the couple can build assets for their retirement, he suggests.

The Five-Year Plan

Year 1 (2011)
Sell the $450,000 cottage and pay down debts. The property has rent of $4,800 a year, expenses of $4,100 for taxes and fees and costs $13,500 in mortgage interest. Adjusted for additions to equity, the property loses almost $10,000 a year. It is not a keeper. They could use the $450,000 to cut what they owe on their house, $565,000, down to $115,000, which they could repay in six years at $1,772 a month (more than the $1,300 they now pay for interest alone). Then they can work on plans to stabilize the Mexico house.

Year 2 (2012) After the cottage is sold, amortize the remaining house loan so that it is paid off by 2018.

Year 3 (2013) The house in Mexico could be a writeoff, but the land has value regardless of the condition of the building. The house, if not improved or finished by year 3 of the plan, should be sold for whatever the market will pay. It is literally a bottomless pit.

Year 4 (2014) Use cash flow from remaining properties to build financial assets that Herb will have to rely on if he is forced to retire when he is 60. Investigate a desk job for Herb if he can no longer work in construction.

Year 5 (2015) Herb could retire by 2016 or continue to work to sustain family cash flow and Canada Pension Plan assets. Delaying retirement to age 65 also means that Herb will not pay a penalty for taking CPP benefits early.

The Longer Term

Rationalizing the properties will leave Herb and Val with their house, which includes a basement suite they rent out for $775 a month, and the townhouse that produces net rent of $524 a month. Their income will be $7,300 amonth before tax. They will have interest payments they can support with that income. They could increase their income by moving into their basement suite and renting out their upper floors for $2,000 a month, thereby gaining $1,225 in rent. This would be downsizing with a substantial income boost of $14,700 per year before tax. The net result, after the higher mortgage payments are taken into consideration, would be $753 more a month, pushing income up to about $100,000 a year before tax. With this level of income, debt- service charges will fall to as little as a third to a quarter of gross income, which is supportable until they retire, Mr. Moran says.

Herb should try to postpone retirement to 65, assuming that his back can hold out that long or that he finds other work less straining. When both Herb and Val are retired, they will still have pre-tax property income of $15,588 to $24,624 a month, depending on whether they choose to move down to their basement suite or continue to rent it out. They will have two Old Age Security payments of $6,259, combined Canada Pension Plan payments of approximately $17,500 and perhaps $2,400 a year of investment income, all in 2010 dollars, Mr. Moran estimates. Herb’s work pension will be a non-indexed $10,800 a year. The sum, approximately $58,800 in 2010 dollars before tax, will provide a modest retirement. If they live in their basement suite, their pre-tax income would rise to about $73,500. However, if Herb can work another six years and if Val can raise her income from its nominal level of $2,400 a year, they could have a much more comfortable retirement, Mr. Moran says.

The problem that Herb and Val have to resolve is two-fold. First, they have to deleverage their real-estate investments. Second, they need to use future income to diversify their assets out of rental property and into a variety of stock and bond portfolios.

They do not have sufficient cash to buy individual stocks and bonds, so they will have to use mutual funds or exchange- traded funds. They should choose their funds wisely, buying broad-market Canadian equity funds and perhaps a laddered corporate bond fund which has investment grade assets maturing in one to five years that will roll into higher yielding bonds as interest rates rise — as they eventually will.

The toughest move will be to dispose of the Mexico house, for which they may get nothing more than lot value. They are victims of a property market they did not understand. The loss on the house may be deductible from other income, so the pain will be somewhat reduced. But if the house cannot be stabilized — and, so far, all efforts have failed — then it has to be sold, Mr. Moran suggests.

Over time, the B.C. property market could turn the couple’s initially modest retirement into something a good deal more agreeable. Assuming that they keep their $700,000 house and the $280,000 townhouse, they will have $980,000 of property assets they can sell or borrow against. It is not a good idea to incur substantial debt in retirement, Mr. Moran cautions, but a nearly $1-million real-estate portfolio has to be seen as a major asset and as a legacy.

“Herb and Val have problems that they can resolve with determination and sharp pencils,” the planner concludes. “Their situation shows why it is important to focus real estate assets in jurisdictions you understand. The really good news is that they have a lot of time to fix their financial problems.”

Copyright 2010, The Financial Post, Used By Permission