Looking for income

Question:

I am 47 years old, female, single, and have no children. My principal residence is paid for, I have no debt, and I have $200,000 that I would like to use to create some form of regular retirement income. I am thinking about buying a second house and renting it out, but I wonder if I would be better off investing the money in the markets. I have been self-employed my whole life and therefore have no pension to rely on. CPP will provide very little, and with the changes to the OAS coupled with some personal health problems, which may force me into retirement sooner than I’d like, I’m concerned about my future.

Answer

In a previous post (see Living off the rent) I reviewed some of the questions you should ask yourself before you pursue a strategy of using a rental property to provide income in retirement. But you shouldn’t stop there. In order to compare that strategy with a more conventional approach—investing in stocks, bonds, mutual funds and exchange traded funds—you have to consider what your portfolio might look like. It might really help for you to bring a financial adviser into the discussion here. If you don’t already have one, discuss these issues with a few different advisers and see what they have to say.

Review a model portfolio: While it is impossible to accurately predict what a $200,000 portfolio will do in the future, you can make some conservative assumptions based on the past. Your adviser will be able to show you how long your portfolio will last based on:

How much you will be able to save before you start drawing on it. You’re only 47 years old now, but the health problems you mentioned might mean you’ll need to draw on the money before age 65.
How much the investments could return over the time. An adviser will make some assumptions around how much higher risk/higher return stuff you have, versus lower risk/lower return and what that would mean for your overall gains.
How fast you plan to spend the money.
How long you expect to live. I know, this last assumption is a ludicrous one, but is important all the same.

There are a number of ways to use your investment portfolio to generate income. Dividends, fixed income products like bonds or bond funds and real estate investment trusts are just a some of the ways you can create a steady stream of income.

You will also be able to invest in things that should increase in value over time, like stocks, mutual funds or ETFs. Your adviser would then be able to gradually sell out of those positions in the future, either buying income producing investments or giving you the cash.

Understand the tax implications: Your adviser will have also have some ideas on how to invest the money in the most tax efficient way possible. For example, Adrian Mastracci of KCM Wealth Management says, dividends will likely be your least taxed investment income.

You didn’t mention any assets in a registered retirement savings plan, but that might be a way for you to defer taxes until you retire, when presumably you’ll be taxed at a lower rate because you won’t have employment income. An adviser might recommend putting part of the money in a Tax Free Savings Account so that those investments can grow tax-free.

For comparison, your adviser will also be able to review the tax implications of owning a rental property and what deductions that would give you in terms of depreciation, mortgage interest, maintenance, etc.

Consider other alternatives: You have some other options to reduce your anxiety about the future. For example:

Downsize now: If you sold your house today and bought a cheaper home, or moved into a rental, you could free up some cash that you could put towards making income for retirement.

Improve cash flow: Look for areas where you can tighten your spending or increase your income, perhaps renting out a room in your house. Improving your cash flow will help you add more money to the pot and make it last longer.

Pulling it all together: I’ve covered a lot of ground over the last two blogs. Here is a summary of the pros and cons of rental properties versus a traditional stock and bond portfolio.

Pros of rental properties:

Leverage: In today’s low interest rate environment you can use someone else’s money to help you buy a property. It is a pro, but a risky one.
“Passive” income: Provided the property is rented and for enough to cover all your expenses, you earn some income, which may be higher than what you’d earn with other investments.
Potential for a capital gain: You could earn rental income for a number of years then sell the property for a profit down the line.

Cons:

Landlord duties: It can be a lot of work to be a landlord.
Illiquidity: It can be hard to get cash out of an investment in property, if you need to.
Potential for a loss: Your property may go months without a tenant meaning you would have to pay the mortgage yourself. And when you go to sell the place, the housing market in your area may have declined and you could lose money.

Pros of an investment portfolio

Diversification: Your portfolio could be split among a number of types of investments, and you can change that mix at any time.
Risk: You can manage your risk up or down depending on what investments you hold. For example, at 47 years old you might hold 50% fixed income. But as you get older you would increase those holdings to a higher percentage and lower your risk.
Liquidity: If you needed money, you could sell part of your portfolio.

Cons: