Aggressive Real Estate: One large home with HELOC vs. Multiple Properties
My objective to a Ferrari by 30 (or, financial freedom for that matter) has revolved around a theoretically simple yet in practice, complex strategy:
Acquire and hold 5 condos (likely in the mid $200,000 - 300,000s), rent out 4, and liquidate in 5 years to re-balance the overall portfolio (when then having more cash would make traditional blue chip stocks produce sizeable cash returns).
Acquire significantly undervalued stocks in companies producing high earnings – that is, out-performing companies at low prices. Then, add to them regularly in-between each property purchase. Hold stocks if they decline to not convert paper losses into realized losses.
Unfortunately the rate-hikes by Bank of Canada, the increased risk aversion of financial institutions, and their efforts to stamp out risk takers and people otherwise unwilling to be debt-enslaved employees until old age, have made this strategy increasingly difficult. Without the public’s fear (savings) from the banks, the cash-on-cash returns of real estate are lacklustre at best, and saving enough cash for their liking would slow progress too much. Coincidently enough, this is the intention by the Bank of Canada to prevent overheating of the economy- though they do not want people to starve, they do not want them making money. The government, financial institutions, and general public do not like people achieving financial freedom (or if they do, only very slowly), and want people to only be in-line with or beneath them.
Staying within real estate, instead of racing to expand the real estate portion of the portfolio as aggressively as possible, the alternative is the more tax friendly and diversified approach: acquiring one large, appreciative, primary residence where capital gains are not subject to tax. A property within the 2-hour radius of Vancouver is of interest. Then when the property has appreciated enough, get a home equity line of credit, where the interest is tax-deductible when used for an investment purpose to obtain taxable income. Then use the HELOC funds to further grow my portfolio, as the compounding effect exponentially increases the size of the tax-deductible equity available. Increasing available equity to use as concequence of high appreciation also is a way to further grow the portfolio without fighting banks. And in the future if the entire property is to be liquidated for any reason, the capital gains are tax-exempt.
While the same approach can be used in Edmonton or elsewhere in Alberta, the real estate here is high cashflow, but slowly appreciative. It would take too long for enough appreciation to build the >20% equity required for a HELOC. That time is lost income. An alternative is to get multiple less expensive properties to lessen the time required to grow my portfolio, but not only I lose out on some of the capital gains exemption, rental income is 100% subject to tax at the highest tax bracket. Alberta properties are heavily dependent on rental cashflow as they appreciate little. Because of the tightening rules, rising interest rates, and only partial consideration of rental income by financial institutions (only 50% by the Big 5, in fact), obtaining more properties is only going to get harder. Buying a property in BC also allows me to diversify the real estate portion of my portfolio, as well as reduce exposure to oil prices and their associated investor confidence. I already have two in Edmonton, and Edmonton’s economy is about 1/3 tied to price of oil.
A Home Equity of Line of Credit (“HELOC”) allows one to borrow up to 80% of the home value, so >20% of equity in the home is required. Of interest is how long it takes to build enough equity if <20% downpayment is used. The formula to determine this is:
h(a^x - 1) + (yearly principal)x + DP - 0.0385h = 0.2[h(a^x)]
Where 0 < h 0, DP < 0.2h
h = home price
a = appreciation rate (e.g. 15% YoY is a = 1.15)
x = years
DP = downpayment
(yearly principal)x actually is equal to h – h(1+r)^n + [1/r][(1+r)^n – 1]c, where c is the fixed monthly mortgage payment, r is the interest rate, n = months, or y/12. But it is easier to just use a mortgage calculator to figure yearly principal.
For example, using BC Lower Mainland’s experienced 15% YoY with a $500,000 home, 2.49% interest rate, and $25,000 downpayment, 1 < x 121000; 22540 equity available; 3340 if negative cashflow needs to be compensated. Appreciation is $105,000; 85,800 profit.
Now comparing this scenario to Edmonton, if using the same $500,000 home and 4% YoY,
500000(1.04^x - 1) + 16270x + 6000 = 0.2(1.04^x)500000
79340 equity 112486 w/ x = 3 (111,242 profit)
156009 > 116986 w/ x = 4
So in the last example, it would take 4 years to build $39,023 of useable equity for a HELOC – about 3 years to get any useable.
Here we can conclude that if the BC property experiences around 10% YoY, and Edmonton about 4% YoY, with an approx. $500,000 property, it would take half as long (50% longer) to reach the same goal of acquiring a HELOC using a Edmonton home. Profits in the BC scenarios eclipse that of the Edmonton homes.
Unfortunately like most returns in the high end, they come with risks. The difference is the Edmonton property is likely cashflow natural or only slightly negative, while the BC property much more negative cashflow and hence more difficult and risky to manage. BC is also physically further from myself. BC also lacks much of an economy outside northern oil, gas, and mining; it’s heavily dependent on migrant and foreign money, the “Old Money” that continues to stay there, and the general demand to live there at almost any cost. Alberta conversely has a robust oil and gas industry, a population more willing to work, and less environmental opposition to new projects.
Equity Lines of Credit aside, returning to the former strategy of acquiring new multiple lower-priced properties regularly in Alberta, lower entry price implies getting a piece of property sooner, rather than waiting longer to obtain capital and credit for the more expensive home.
Scenario: $250,000 home today (Home A), $250,000 home next year (Home B)
– versus –
$500,000 next year (Home C):
Home A appreciation in 3 years (2017 - 2019): $31,216
Home A principal in 3 years: $24,405
Home B appreciation in 2 years (2018 – 2019): $20,400
Home B principal in 2 years: $16,270
Minus CMHC: -$19,250
Total: $72,041 (20400 and token amount of rent subject to tax)
In 2 years, for $500,000 of Edmonton home purchased in 2018:
Principal contributions: $24,405
Minus CMHC: -$19,250
We can conclude that the opportunity cost of waiting an extra year to buy in Edmonton 1 home twice as expensive is quite significant, almost halving the profit over the next 3 years if assuming one extra year of waiting is required. The income loss is too steep to warrant avoiding tax and getting a HELOC sooner.
BC is not taken into consideration for purchasing two lower-priced properties due to homes being much more expensive; selection for high demand (and hence appreciative) homes is extremely narrow under the $400,000 range.
Overall we can conclude that for the purposes of growing the real estate portion of the portfolio with $25,000 + closing costs to invest, this is the order of descending profitability and hence desirability of the options:
(1) A pricier appreciative property in an in-demand area of BC, then waiting 2 years to acquire a HELOC for further tax-deductible investment funds.
(2) One new property in Edmonton every year, likely around half the cost of #1, #3.
(3) One pricier home in Edmonton, then waiting long enough for a HELOC.