“In B.C. a couple we’ll call Max and Portia, 28 and 27, are trying to plan their financial future. They bring home a total of $6,880 a month from their high-tech jobs, but Portia wants to take sabbaticals to travel more and Max wants to try out a new career. They also want substantial investment income — $1,000 a month by their mid-30s. All that, plus early retirement well before 65.
What is standing in their way is not just the problem of earning enough money to do all that, but more than half a million dollars of debt
They have already made big career switches, Max from running a theatrical company for four years, Portia from several years in pharmacy management. Their jobs, their incomes and their present high rate of savings can build a solid retirement, though not necessarily an early one.
So far, Max and Portia have made a big bet on real estate. A $265,000 rental condo is their largest investment. It has a $228,775 mortgage with 26 years left on its amortization. Without capital repayment on the 25-year mortgage, interest alone is $410 a month. Condo fees and taxes add $277 for total carrying costs of $687. It generates $1,050 rent, so their total return is $363 a month or $4,356 a year. That’s a 12% return on their equity — not bad, but vulnerable to rising interest rates. If they have to roll over their 3.0% mortgage at 4.0%, which is still historically cheap, they will lose their margin of profit. No one doubts that interest rates will rise and a 1% jump is easily in the cards…
Rather than take all the risks that go with being landlords — such as vacancy, tenant damage, and the inevitable rise in interest rates — they could sell, harvest their about $23,000 of equity after 5% selling costs, and use the cash to pay off most of a $27,000 student loan outstanding at 4.5%. If they choose not to use the cash to pay off the loan, then, at $500 a month, it will be repaid in five years. Their home mortgage would still have 24½ years to run. …
If they choose jobs for fun … their ability to have a secure retirement will be at risk
Their reality at present is that debts are almost 90% of their assets. To support a $1,000 monthly investment income, they would have to have $400,000 capital generating a 3% return after inflation. They can’t do that in seven years with their present incomes and the need to pay down debt. Moreover, if Max changes jobs or Portia takes lots of time off for travel, sacrificing income and perhaps career advancement, their financial outlook would dim.
“It is not possible in any reasonable scenario, especially if they impair their incomes with sabbaticals or risky job switches,” Derek Moran [a financial advisor from Kelowna] says.
Summary of finances:
$6.9K per month
Assets: $606.7K Total
Home condo $298K
Rental condo: $265K
Stock options: $4.5K
Liabilities: $544.4K Total
Home condo mortgage: $284.6K
Rental condo mortgage: $228.8K
Percentage of Networth in RE: 973%
[For those readers who have semantic objections to their position being expressed in that fashion, think of the ‘973%’ as an elegant way of saying that their net-worth is leveraged to RE prices by 9.73 to 1.]
So, if their RE holdings drop in market value by a touch over 10%, they lose their entire net-worth. In fact, we can say with close to certainty that, given current market conditions, their actual current net-worth is very likely less than zero, as they’d be unlikely to clear 90% of the quoted amounts on their properties if they tried to sell.
This couple represents self-delusion run amok.
They clearly see RE as a path to a light work-load and early retirement. Free money, in effect.
How many Vancouverites have built positions in RE based on similar fantasies?
Note how the sensible financial advisor (from Kelowna, and thus, we’d assume, no stranger to collapsing RE markets) advises them to sell their RE ‘investment’.
What will the effect on our markets be when all those speculators in a similar position try to get out of money losing RE, over the same few years?
This couple’s position is also particularly noteworthy in that it represents the local speculative activity that has been the major engine of our perverse bubble. Most would still argue that their actions are innocent; that they are simply trying to get ahead in current challenging economic circumstances. We’d argue that they are being greedy; and ask what the hell they were thinking buying a second, poor-cash-flow property with a household balance sheet like that. It is purchases such as these, people over-stretching to buy primary residences and/or ‘investment’ properties in the hope of future abnormally large price gains, that have relentlessly pushed up prices and formed the bedrock of the problems now facing Vancouver RE: A bubble based on cheap borrowing and over-leverage.
Speculative manias represent ephemeral fantasies, and they all, ultimately, have to be reconciled with reality.