Funny Mortgage Math

I was just looking at MLS listings earlier today and I saw this nice little place on Main Street in Vancouver and noticed the following statement by the realtor:

Investor alert, 2 potential suite. Main floor $1200/mo, 2nd floor $1500/mo, total $2700/mo

Investor alert? So he is implying that is an investment and I wanted to see if he was right. He is saying that rent would be $2700 for the whole place per month, and the asking price is $788,000. I am assuming that he his being completely honest on that rent figure or over-estimating it, as he has a vested interest in making this property as appealing as possible. Let’s assume some ideal conditions, that I have a 25% down payment as well, a 35 year mortgage, and a low interest rate of 5.5% (even lower than ING’s lowest rate). Plugging those into MLS’ handy mortgage calculator, even then, the monthly mortgage costs are $3149.80/month. If we rent the place out we are still short $449.80. So this is not an interest-bearing investment of any kind. We have invested $197,000 for the down-payment, and in return we owe at least $449.80/month (most likely more if we include maintenance costs, property taxes, etc…). That’s a -2.7% annualized return. If we put down a $78,800 down payment (or 10%), we owe at least $1100/month. It starts to become profitable with about a $300,000 down payment. I have neglected capital appreciation of the home of course. Historically, however, housing prices have grown with inflation, as shown in the graph below:
A History of Home Values
So one can never expect to make much off of capital appreciation of real estate. Not only that but as prices get higher and higher the probability that they will continue to grow faster than inflation decreases and the chances they will fall increases. Now back to the original MLS listing. How is this an investment?

9 thoughts on “Funny Mortgage Math”

  1. Mortgage interest on an investment (which includes real estate) is tax deductible. So with a 35 year mortgage for the first few years more than 90% of your monthly payments are interest which would be totally tax deductible and would probably recover the $450 in your example. Plus with 25% down you could get an interest only mortgage and your whole mortgage payment would be deductible. I’m not saying that it would be a good investment, just that it wouldn’t be as much of a loss as you have calculated.

  2. Oxcc, I totally forgot about that, excellent point. It is a tax deduction, not a tax credit right? Could be significant then if you were in a high tax bracket. But you are right, it would reduce some of the losses but as you said probably still wouldn’t be close to a good investment.

  3. Right, it is a tax deduction, not a credit. The rent that you would be paid as the landlord counts as 100% income so the interest on the mortgage could be thought of as a way to reduce the net income that is being generated by the property.

    The other point that you may have overlooked in your example is that $3149 monthly mortgage payment has a little bit of principle repayment in it. So if you are in a high enough tax bracket and you could recover the extra $449 a month that isn’t covered by the rental income through the tax deduction you are in effect getting your tenants to buy the property for you through their rent. So you aren’t just relying on the value of the property to increase, you are relying on the mortgage being paid down by your tenants.

    So because of the deductibility of the interest on the mortgage it actually can make sense to put as little down as possible (to a point that depends on your tax bracket) so your net return on your investment is higher.

  4. Yes, the interest payments are tax deductible. But, the rental income is business income, so you have to pay marginal tax on it (after deducing expenses like maintenance, property taxes, condo fees etc.). The tax on the net rental income will offset the tax break on the interest payments if they are exactly equal.

    It is not in this case. Even the gross rental income is lower, so you’ll essentially get a tax break on your monthly loss of $450 plus whatever other expenses you paid.

    I take a very simple approach when someone pitches a real estate investment. If I owned the thing outright, what would I get. In this case it is a gross of 4.1%. Net yield is somewhere in the 1%-2% range. You can buy a real return bond paying 2.2%. Why would anyone think this is an investment?

  5. Canadian Capitalist: Right! The rental income is also taxable. So the loss of $450 cannot be fully recovered. I glad you agree, this is indeed a poor investment.

    It is funny how long it takes for the market to “correct” itself. When we went looking for apartment rentals in downtown Vancouver in April, we went to a new building called “Firenze” and none of the landlords were expecting a positive cash flow on their condos and admitted so. They were expecting to flip them but eventually it becomes hard to find a greater fool.

  6. I do my own taxes but just kind of follow along with the instructions, so I don’t really understand the nitty-gritties of it all. At risk of appearing extremely ignorant, I’d like to admit that I didn’t know the difference between a tax deduction and a tax credit.

    For any other blog readers who might like a clarification, here’s an explanation I found when I Googled “canada tax credit versus tax deduction”:

    Hope you don’t mind me adding the link, Dave, but I know you vet comments first, anyway. 🙂 Great post, btw.

  7. Fawn, I never vet comments actually. The first time anyone posts, their post is not posted right away; I have to approve it first. After that, there is no moderation, any post from the same person will appear right away (just like yours and the other 2 commenters did here).

    In my own words, a tax deduction is a reduction in your taxable income. So if my income was G, it is now G-D, where D is a tax deduction. So the tax I owe is now (G-D)*T rather than G*T, so the amount of “credit” I get from this tax deduction is D*T. Well it’s not exactly like that, because D will come off the highest tax bracket at your “marginal tax rate” (the tax rate on every new dollar of income you earn above and beyond what you already earned). (For those who know what marginal tax rate is, the credit you get from a tax deduction is D*T’, where T’ is your marginal tax rate).

    A tax credit is just the amount of the expense (like tuition let’s say, multiplied by the lowest marginal tax rate of around 15-16%).

    T is > 15-16%, so tax deductions are better, especially if you are in a high tax bracket.

    It helps to do your taxes on paper a few times to understand these concepts (I did it for many years before finally understanding).

  8. Hee, well I did notice that my comment went up right away this time, but I didn’t want to make another comment just to say “oops” about that! 😛 Urg, where’s the delete button when you need it?!

    Thanks for your explanation. I actually did my taxes on paper for a few years before I went to software, but as a student I was more concerned about just getting it done than I was in really understanding what I was doing.

    Dear me, I’m not really improving my image much, am I?

  9. I did the same thing, filled it out on paper for many years as a student not really thinking about what I was doing. It was all somewhat of a mystery. It didn’t help that I was never taxable because of all the deductions, that I never saw Schedule 1 (I think that is the Schedule where all the tax is calculated) for many years.

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