Rental Property vs Stock Market – What’s the Best Investment?
From the eye of a growth investor, what is the best investment – a rental property or the stock market?
We will discuss topics you won’t see anywhere else:
Head to head: Returns on rental property vs. stock market.
Saving tax on rentals with smart use of CCA & properly recording sale on your tax return.
Effect of leverage on returns. It’s huge!
Unconventional Wisdom insights.
You will learn:
- How does growth of real estate compare with the stock market?
- What are the sources of rental property returns?
- What is the normal return for each source of returns for rentals?
- How does the total return on rentals compare with the stock market?
- What are the best and worst types of rental properties?
- How do you minimize tax on rental properties?
- Should you deduct depreciation (CCA) on your rental?
- How do you record the sale of your rental on your tax return?
- How does the size of the mortgage affect the return on your rental?
- How do different amounts of leverage affect the returns of rentals vs. stocks?
- What is Ed’s Rental Property Rule of Thumb?
- What is Ed’s general advice on owning rental properties?
Growth comparison: Stocks have 5 times higher growth than real estate since 1975.
- There is more to the story.
- Rental properties have other sources of returns.
- How much you leverage (borrow) is the main factor in returns.
Good news for renters:
Investing only the 20% you would have put down on a home into the stock market should grow to quite a bit more than the home would be worth in 30-40 years.
Sources of rental property returns:
- Cash flow
Typically zero – Market creates balance between owning & renting.
Condos in Toronto – Typically $400-500/month negative cash flow.
Renters are paying $400-500/month less than owners.
A good rental should be cash flow positive with 100% leverage.
Get the largest mortgage & borrow the down payment.
Depends on property:
Best: AirBNB, Student housing, multiple units (4-plex) older homes.
Worst: Vacation properties, new construction homes, condos.
Cash flow should assume it’s fully mortgaged.
Mortgage principal payments
“They are paying my mortgage”
Typically – X%
Typically taxable – Paid by taxable rent, but not deductible.
This is the reason many rental properties have negative cash flow, but you pay tax on the profit on your tax return
Growth in value of property
Look at long-term growth, not recent.
Average 6.4%/year in Toronto since 1975.
Work
Rental Property is a part-time job.
What are you earning per hour of work?
What do you earn per hour from your job?
Tax
Net rent is fully taxable.
Growth over time is a capital gain – 50% taxable.
Rental properties are one of the main flaws in the government’s argument that capital gains are mainly for the rich – people with non-registered portfolios that have maximized their RRSPs & TFSAs.
People with modest income own a property for many years and then sell for a nice profit. In that year, their income is high, but normally modest.
In reality, large portion of capital gains is paid by middle class.
How do you minimize tax on your rental?
Record all your expenses.
Renovations or improvements are not expenses.
Mileage is only within that city, not from your home city.
Smart decision on whether to claim depreciation (CCA).
Calculate tax on the sale properly.
Should you claim depreciation (CCA)?
Claim 4% of building each year.
Claim on building only – not land.
Generally offsets net rent from mortgage paydown.
Usually no tax annually on net rent.
When you sell property, CCA is “recaptured” – fully taxed.
Example: Buy for $500K & grows to $1 million over 20 years.
Depreciation brings book value to $250K
Sale for $1 million is $250K recapture plus $500K capital gain /2 = $500K taxable income.
Tax close to 50% = $250K tax.
With no CCA, then gain on sale is entirely capital gain:
$500K capital gain / 2 = $$250K.
Probably 40% tax = $100K tax.
Compare your marginal tax bracket today vs. estimate when you sell
E.g. Today 30% (income $50-$100K). Sell at highest bracket 54%.
If you invest the tax savings of 30%, how long would it take to grow to 54%?
Growth investors – 8 years.
Moderate investors – 16 years.
Do calculation for your situation. How long to grow annual tax savings into enough to cover higher tax bill when you sell?
Will you own the property that long?
Advice: Only claim CCA if you plan to own the property for at least 10 years (or 20 years for moderate investors).
Calculating tax on capital gain on sale properly.
Most people do this wrong.
Pay much higher tax.
Risk CRA audit.
Book value
Purchase price + costs (legal fees, land transfer tax, mortgage fees, etc.)
Get detailed numbers from lawyer’s “Statement of Adjustments”.
Cost of improvements over the years – Keep records & receipts.
Repairs & maintenance is expense every year.
Tax-deductible.
Renovations & improvements add to book value.
Not tax-deductible.
Total CCA since owning the property. – Recapture.
Proceeds
Selling price – costs (commissions, legal fees, etc.)
Get detailed numbers from lawyer’s “Statement of Adjustments”.
Capital gain on sale is Proceeds less (Book value + Total CCA).
Capital gain is 50% taxable.
CCA recapture is 100% taxable.
Total return on rental property vs. stock market:
Rental Property:
Cash flow 0.0%
Mortgage paydown 1.5%
Work ?
Growth (6.4% since 1975) 6.0%
Total return 7.5%
Stock Market:
Long-term average 10%
Worst 25-year return for S&P500 is 8%.
Canada 10.6%, US 11.9% since 1975.
Compounded 2.5% higher is huge!
Leverage: How does the size of the mortgage affect the return on your rental?
Typically buy with 25% down.
Required by banks.
Your money invested is the 25% down payment.
3:1 leverage.
Example:
Buy rental property $1 million.
$250,000 down
$750,000 mortgage
Cash flow breakeven = $0
Principal paydown = $15,000
Growth: 6% x $1 million = $60,000
Total $75,000
Amount invested: $250,000
Rate of return on cash invested 30%
Rental property with a large mortgage can be a good investment.
Rental Property vs. Stock Market Returns by Leverage Amount:
Rental Property with mortgage.
Stock Market with investment loan.
Returns before & after tax.
Ed’s Rental Property Rule of Thumb:
- Sell when mortgage down to half the value of the property.
- You can invest the proceeds in stocks for higher return, less tax & no work.
- Do the Smith Manoeuvre on a rental & it’s almost always worth keeping.
General advice:
Rental property with large mortgage usually better than stock market with no leverage.
Compares leveraged real estate to unleveraged stock market.
If you buy a rental, make the minimum down payment (or borrow the down payment) to keep as much of your cash as possible invested.
Pay the mortgage down as slowly as possible.
Paying off a tax-deductible, interest debt is not effective.
Consider doing the Smith Manoeuvre on your rental property.
Keeps your rental property fully leveraged.
Leverage the stock market similar to a rental & the stock market outperforms over time.
With the same leverage, stock market wins over time in all cases
Decide on level of risk you want for growth & risk tolerance.
Stock market investments with a 3:1 investment loan beat rental properties.
You may be comfortable with a mortgage, but not an investment loan.
Exaggerated view of stock market risk.
Stock market is reliable over the long term.
Some people like rental properties for “snob appeal”
Show friends your property can appear more impressive than talking about stock market returns.
Focus on how it affects your Financial Plan over the long term.
Ed
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Hi Stingy,
I read the Psychology of Money. Good read.
Your strategy should work. The stocks should have a higher return after tax over time than the interest rate on your secured credit line.
There are a few ways to significantly enhance your strategy:
If you are trying to do an equivalent to a rental property, you could borrow the full value of a theoretical rental property, not just the down payment. Or you could borrow the 25% down payment and pledge it for a 3:1 investment loan – same as people normally do for rental properties. It sounds like you are not comfortable with that level of debt though, even if it is good debt. Higher leverage should give you better results over time. With investment education and investments you are confident with, could you become comfortable with higher leverage?
I talk about this strategy on my blog. You have read quite a bit about the Smith Manoeuvre, but don’t seem to have made it down to the 7 Smith Manoeuvre strategies on my Smith Manoeuvre page. My Smith Manouevre post is the most comprehensive on the internet. Read all of it. Ignore the rest. 🙂
Strategy #5 is “Smith Manoeuvre with Dividends”. It’s a decent strategy, but not optimal for several reasons:
1. Tax drag: There is a “tax drag” from getting the dividends every year. If you invest more tax-efficiently focusing on growth & deferred capital gains, you can avoid most of this tax every year. The “tax drag” means you have less to invest.
2. Home country bias: The only way to get a low tax rate on dividends is to invest all in Canada. We are a nice place to live, but not a growth-oriented country. Canada is only 3% of the world’s stock market. By investing only in Canada, you miss 97% of the investment opportunities in the world. The TSX60 has had significantly lower returns than the MSCI World Index or the US S&P500 over time.
3. Avoiding growth equities: Dividend stocks are generally mature, slow-growing companies. By focusing on dividend-paying companies, you miss out on the best growth companies all over the world, such as Google, Facebook, Amazon, & Warren Buffett’s Berkshire Hathaway.
I modeled the Smith Manoeuvre with Dividends vs. the Plain Jane Smith Manoeuvre. With the dividend strategy, you prepay tax you could defer, but you convert your mortgage to tax-deductible more quickly. The tax drag is the main factor. I found that you generally need about 1%/year higher return for the same result.
In other words, you need about 9%/year investment return with the Smith Manoeuvre with Dividends to get the same results as 8%/year investment returns with the Plain Jane Smith Manoeuvre.
My advice:
1. A more effective strategy is to borrow the amount that makes sense for you and invest for long-term growth and deferred capital gains – not dividends.
2. Invest globally or in the US for broad diverisfication and higher growth.
3. If you need cash flow, use Self-Made Dividends by selling a bit of the investments each month. Self-made dividends beat ordinary dividends in every way.
4. If you want the tax-deductible debt gone at some point, just sell investments and pay it off.
Similar strategy to yours, but enhanced in a few important ways for significantly better long-term results.
Ed
Thanks Ed for being such a great resource and generously posting a wealth of knowledge on this blog. For years my wife and I have thought about buying a rental property to help generate wealth, but have always been a hesitate given the work required for property maintenance and horror stories about tenants. As you also point out, it’s hard to find a property that will break even. As an alternative, I’ve been diving into the very helpful blogs and articles on the Smith Maneuver, yours included! In talking to friends and family about it, I find that it’s funny how many people normalize huge amounts of leverage for real estate investment, but think it’s crazy to use leverage to buy stocks. However, as your numbers point out, we should all rationally evaluate leveraging to invest in real estate versus the stock market.
For my wife and I, we have decided to forgo a rental property for the time being and take a slightly modified approach to the Smith Maneuver. The plan is to withdrawal the equivalent of what a 20-25% down payment for a rental property would have been from the HELOC. We will invest in a modified beat the TSX strategy which will include most of the top 10 yielding stocks on the TSX 60 with a few other dividend growers such as the railways and utilities. The plan is to pay the interest on our HELOC out of our free cash flow, but leave open the option to recapitalize the interest if we need to free up some cash flow in the future. We’ll use the dividends and money from the deductible interest on the tax return to pay down the mortgage faster, and once the mortgage is paid off, use the dividends to pay down the HELOC. Looking into the future, with the power of dividend growth the account will produce more dividends each year while growing in value, eventually leaving us with an income generating account we can use to supplement my defined benefit pension plan in about 20 years when we retire without having the associated debt. I know this strategy isn’t maximizing the potential of the Smith Maneuver, but we see it as a good opportunity to accelerate wealth building while being comfortable with the leverage. I’ll give a shout out to Morgan Housel and his book the Psychology of Money for our thinking in this regard.
Thanks again Ed for being such a great resource! We would welcome any thoughts you have on our particular application of the Smith Maneuver.