Which is best investment —
Sunbelt condo or vacation fund?

By Steve Ladurantaye
Globeinvestor Magazine Online, July 3, 2008
When America’s housing crisis began to take shape, Warren Hope wondered how it could help his golf game. Mr. Hope, a Saskatchewan-based financial planner for Rice Financial, knew his friends were jumping into the Arizona real estate market to take advantage of depressed prices to snap up vacation properties. But it all sounded too easy, so he took a sideways look at his alternatives. His conclusion? You’re better off putting your boring old mortgage money into a fancy vacation fund.

Reporter Steve Ladurantaye asks him to explain.

So you’re sitting at a dinner party, and everyone is talking about buying property in Phoenix. What’s going through your mind, initially?

Initially I was interested to see what everyone’s opinion was and where they got their information. Peter Lynch, who was the famous manager of Fidelity’s Magellan fund, used to say he could tell when a market was at a high because everyone had an opinion on the stock market, even the shoe shine boy. He could also tell when it was at its bottom because no one would talk to him at a dinner party. I think there are parallels in this situation as the general opinion is that this is a fantastic buying opportunity.

Scenario 1: Buy an Arizona condominium for $150,000, financed at 7.5 per cent over 27 years.
Monthly mortgage payment: $1,080.07
Net return after 27 years: $855,712

Explain your thinking on how much that property will cost you over the years.

You would have made $351,023.78 in payments to pay off the condo. Plus costs such as maintenance and repairs, insurance, condo fees, and property taxes. The instability in the housing market makes it very difficult to predict if you can rent your condo out to generate revenue to cover these costs. Once you get to age 77, you sell your condo. The 26-year appreciation rate on property in Phoenix from 1981 to 2007 was 4.4 per cent. Let’s assume your property appreciates by 5 per cent a year while you own it. You can now sell your unit for $1,005,712.00. Not bad. You paid $351,023.78 in loan payments for 27 years and sold your unit when you were done with it for $855,712.00 more than you paid for it.

Scenario 2: Save using a vacation fund, assuming 8-per-cent return.
Monthly contribution: $1,080.07
Balance after 27 years: $1,529,000

Your alternative is to open a vacation fund instead. How would this work?

In scenario two, you put the money into a balanced investment that averages an 8-per-cent return a year for the same 27 years. This is your fancy new vacation account. It doesn’t have a glossy photo of palm trees, pools, and bikini-clad ladies that you can show at parties, so it’s not as sexy as option one. Each year you draw out of the vacation account to pay for rent and airfare to your favourite sunny destination. Assume you can rent a condo for $1,500 a month, increasing the amount 3 per cent each year for inflation. At age 39, you go to your sunny destination for two weeks. You continue with a two-week holiday until you are 41 when you go for one month. You keep travelling south for one month each year until you are 50. At 50 you go for two months. Once you officially say goodbye to work you are now golfing below the border for five months a year. Then, when you turn 77, you stay in Canada. The balance of your vacation account at 77 would be $1,529,000.00. Also note that scenario one doesn’t cover airfare, which is covered in scenario two.

Your scenarios counts on an 8-per-cent yearly return in the market, and real estate only appreciating by 5 per cent. What if these numbers are even a few points off in either direction?

That is a very good question. With any financial projection the numbers that are assumed become very important, especially when these calculations are spanning up to 39 years. To give you an idea, the condo would appreciate to $1,455,000 if its growth rate ends up being 6 per cent instead of 5 per cent, which of course would make the two scenarios a dead heat. If the investment account generated a return of 7 per cent, instead of the assumed 8 per cent, it would grow to $1,125,000 and once again the two scenarios would be in a dead heat. At that point the question really falls down to a lifestyle preference, which is perfectly fair. We all make lifestyle choices.

Your calculations are based on a Canadian dollar near par with the U.S. currency. How would a 10-per-cent drop in the loonie affect either scenario?

If the Canadian dollar weakens the investment account is going to have a harder time purchasing the same services in the United States. In effect, you’re going to have accelerated inflation. One way to help mitigate this risk would be to open your investment account in Canada denominated in U.S. currency. This would allow the account to fluctuate with the U.S. dollar, instead of against it. An appreciating U.S. dollar would have a positive impact on the appreciation rate of the purchased condo.

When you sell the condo and bring your funds back to Canada you would gain Canadian dollars at that time. Of course, for people who have owned U.S. property in the past, the rising Canadian dollar has wiped out a large portion of their gain on their property. Exposing yourself to currency risk further illustrates that this type of purchase is a decision that needs to be well thought out.

What are the tax implications?

The tax implications of the investment fund wouldn’t be any different than other Canadian investments. The U.S. real estate could be subject to capital gains tax when sold and possibly U.S. estate taxes if the owner passed away. As well, each state has its own tax regulations that can be very different from state to state. This is a complicated enough situation that professional advice needs to be sought for each person’s situation.

How would your clients react if you suggested they invest in a vacation fund instead of real estate?

Most people like tangible assets. It makes sense to people internally to be able to touch and feel something. An investment account doesn’t have those attributes, plus you can’t take pictures of it to a party so it’s hard to make your friends and neighbours jealous.

Have you personally opened a vacation fund?

I firmly believe that you have to be your own best client. My wife and I have a detailed financial and estate plan. We are using some strategies to speed up our retirement date but I haven’t incorporated a separate account to fund our travel south, yet.