From Financial Post, 25 May 2011 -
“In Vancouver, a couple we’ll call Adrian, 62, and Vicky, 58, are moving toward retirement as they reduce their work in management consulting. Their goal is to retire fully in a few years, but they are not sure if they can afford to maintain their way of life in their $1.7-million house. For now, they are spending $5,850 per month. But their current after-tax income is $2,600. Their secured line of credit, $435,000, pays the difference. Their total liabilities are 14 times their annual income. They have nearly $947,000 in retirement savings and $28,000 in other savings. The problem is eliminating debt before they retire.
“The old saying that you can’t have your cake and eat it pretty well sums up Adrian and Vicky’s problem,” Mr. Egan [a financial planner and portfolio manager] says. “Their house has an after-tax opportunity cost — what its value could earn if invested — of, let’s say, conservatively, 3% of $1.7-million or $51,000 per year or more if the return estimate is raised. They have to live someplace, but the house costs them the equivalent of rent at $4,250 per month or more if upkeep and heat are added. They can’t afford it. Either the house has to be downsized, remortgaged with a longer amortization and cash extracted or a few rooms rented out. Hard decisions have to be made.”
[in 2013, according to the advisor's five-year plan] “It is time to make a decision about keeping or selling the house, cutting debt and converting the high intrinsic cost of occupancy to an income-generating asset. Incurring more debt, as they have done by living on their line of credit, is unwise. The bill would eventually have to be paid and probably at a higher interest rate than the 3% they have been paying. Renting a room would reduce their privacy and would not produce enough income.
Sale and investment of proceeds is the best alternative. Assuming they can harvest $1.7-million less their $435,000 mortgage (about $415,000 by 2013) — roughly $1.25-million after selling costs for investment, they will need to replace their home. If they spend $500,000 on a condo, they will have $750,000 left for investment.
“If Adrian and Vicky downsize their house, eliminate debt and guard their investment returns, they should have a similar way of life to what they have now,” Mr. Egan says. “Most of all, they will have financial security.”
House with current market value of $1.7M. Savings of $975K. Mortgage $435K.
Total Net-worth: $2.675M – $435K = $2.24M
Percentage of Net-worth in RE: 75%
This couple is overexposed to real estate.
They look fine on paper, largely because of PR price appreciation. It would be interesting to know what they paid for the house, and thus to be able to calculate what percentage of their current net worth is solely the result of house price appreciation. Quite likely more than 50% (meaning that they likely paid less than $500K for the house). A good number of Vancouver boomers are in similar situations; many have even more of their net-worth in RE; over 100% is not unusual.
They are speculating on RE prices appreciating further, or at least not losing ground.
The advisor should advise them to sell immediately, not wait until 2013.
A 50% drop in housing prices will result in them losing 37.5% of their net-worth, and their financial future will be severely hobbled. If prices start dropping, that realization will loom large.
These are the ‘speculative holders’ who will bring their houses to market en masse when price drops establish themselves in earnest.