Couple drowning in real estate debt

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In British Columbia, a couple we'll call Sam, a corporate manager who is 33, and Georgia, 32, on maternity leave from an administrative job, have a six-month-old daughter, a house and a small apartment building. Their real estate assets have a total value of $1,430,000. That's a good deal for a young couple, but Sam and Georgia have incurred total debt of $1,138,632, which is 8.3 times their gross annual income of $136,654. Debt service charges add up to 59 per cent of their after-tax income. With property taxes, the bill rises to 77 per cent of the family budget.

"We're worried that we are carrying too much debt for our income level, especially if Georgia does not return to work," Sam says. "Are we overexposed to inflation and interest rate changes?"

Facelift asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., to work with Sam and Georgia.

"These are productive and ambitious people," the planner says. "But they are betting that the money financing their properties will remain relatively cheap. Odds are that interest rates will rise. Then they could be forced to sell to raise cash. It's a risky play in the end. But it's the numbers that tell the story."

The family's total after-tax income per month is $8,057, including rental cash flows that add $1,850 a month to what Sam brings home from work. The couple can maintain the status quo in which they end each month with no cash left as long as interest rates do not rise substantially above the 1.45-per-cent interest rate on the mortgage on their apartment building and the 2.25-per-cent interest rate on the mortgage on their residence. If interest rates do rise, they might not be able to pass on the higher costs to tenants in increased rents nor find sufficient cash to pay their lenders, the planner warns.

They could finance a cash flow shortfall by adding to their line of credit, which already pays some property costs, Mr. Moran notes. But can they afford to subsidize their property costs and have money left for retirement?

Retirement Sam has a defined contribution pension plan at work with a current value of $81,731. The plan grows at a current rate of $11,648 per year. By his age 55, 22 years from now and assuming 3-per-cent after-inflation growth of assets, the plan should have $522,970 in assets. Were he to work to age 60, he would have $670,000 in the plan.

The family's RRSPs currently total $27,034. They are growing at $4,800 per year. By age 55, with a 3-per-cent real annual return, they will total $202,775. At age 60, with the same assumptions and contribution rate, they will be worth $261,300, Mr. Moran estimates.

Adding up the total value of the pension plan and the RRSPs, by Sam's age 55, their retirement savings would support annual income of $32,792 to Georgia's age 90. If Sam works to age 60, the plans would support annual income of $46,130 to her age 90.

Assuming that Sam's early retirement will cut his Canada Pension Plan benefits to 85 per cent of the current $10,905 annual maximum, and that Georgia will have no benefits, they will have total public pensions of $21,677 a year including two Old Age Security benefit cheques of $6,204 when each turns 65.

If the rental property is retained, the couple would be able to collect rent of $22,200 a year in present dollars, Mr. Moran estimates.

The couple's total retirement income at Sam's age 55 would therefore be $32,792 in company pensions and retirement savings and $22,200 in rental income, or $54,992. By retiring at age 60, total income would be $46,130 from the company pension and $22,200 in rental income, or $68,330. By waiting to age 65 to draw Canada Pension Plan and Old Age Security of $6,204 per person, that would add $21,677 for total income of about $90,000 a year, the planner estimates. With pension splitting, the Old Age Security clawback, which currently starts at net incomes over $66,335, would not be a problem, the planner says.

Debt management Sam has $17,295 in company shares that he receives as part of his total income. He has several choices for the use of those shares, Mr. Moran notes.

First, he could sell them and use the proceeds to pay down debt. If he does that, he should start with the $79,380 line of credit, which has a 5.5-per-cent rate of interest.

Alternatively, Sam could put the company shares in his RRSP, which has $16,796 of contribution space. That contribution would generate a refund of about 35 per cent or $6,035. Alternatively, he could contribute the shares to a spousal RRSP. Sam would get the deduction and Georgia would get the lower tax rate on eventual withdrawal.

Finally, Sam could pay off personal debts, then borrow the same funds and repurchase the stock, making the debt deductible.

Yet none of these moves would make a dent in his $1,043,551 of real estate debt.

Their house mortgage is the largest and most expensive part of that burden.

"This couple has parlayed debt into real estate that is producing a good return," Mr. Moran says. "But if interest rates rise just [one percentage point] mortgage costs would consume all rental income. For that reason, they should consider downsizing their house. It is the safest course they can take."

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Special to The Globe and Mail

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