When looking at different options for building net worth, often the choice is between using a TFSA (i.e., investing in the stock/bond market) or buying a rental property. Depending on whom you ask, you may find split opinions.
You have those that have bought rental properties, have done well, and swear by it and want nothing else. Then you have those that have invested in the stock market, have done well, and are skittish of real estate. Obviously, there will also be people that fall somewhere in between.
In both cases, each person is succumbing to recency bias. With recency bias, the person favors recent events over historic events. Both people mentioned above have had good outcomes in recent history. They both believe that their way is the best and that it cannot fail.
Below we want to look at both scenarios; buying a rental vs. investing in stocks. We will try our best to present both sides of the argument. If you have any comments, questions, or opinions, feel free to voice them in the comments below.
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We will assume that both the person buying the rental and the person buying stocks are in the same financial position. They are both 25 years old and have $20,000 to use. Both have long timelines, so we will calculate it out to age 65. Over those 40 years, inflation averages 1.5%. We will assume they both pay a tax of 35% on everything earned.
Buying a Rental
We will assume that the rental property is purchased for $200,000. They use the full $20,000 as a down-payment. For simplicity’s sake, there were no closing costs or CMHC. For more information on that, check out What to Expect When Buying a House.
According to ceicdata.com, the average house in Canada has appreciated by 1.7% since 1982. For the sake of our calculation, we will use 2% as the appreciation. Taking our assumed inflation into account, the real rate of return on the property is 0.49%.
The financial institution offered a mortgage at a rate of 3.5% on the $180,000. This person gets approved for the same mortgage rate for the entirety of the mortgage. We will assume that carrying costs (mortgage/interest $900 + insurance, property tax,) is $1200 a month.
This property is rented out for $1,300 a month meaning a $100 per month cash flow, during the life of the mortgage.
Property value at age 65
In 40 years’ time, if no renovations or upgrades are done to the house, with a 2% appreciation, that house would be worth ~$441,500. For a total return of 120%. However, taking inflation into account your return drops to ~$243,200 or 21.6%.
Over the same 40 years, assuming your rent received increased with inflation, you would have received a total of $852,383. A fairly hefty sum! However, the mortgage would have cost ~$270,000 over the first 25 years. Assuming insurance costs and property taxes increased with inflation over the 40 years they would have ended up costing, ~$76,000 and ~$228,000 respectively.
Total Rental Return
So now that you have owned this property for 40 years, how did you fare? Well, you received a total of $852,383 in rent. You had a property appreciation of $241,500 prior to inflation and $43,189 after inflation. So your gross return after inflation is ($852,383 + $43,189) is $895,572.
However, we can’t forget about our expenses. We have to subtract the cost of the mortgage, insurance, and property tax ($270k + $76k + $228k = $574k). So after 40 years, your net return after inflation is ~$321,500. Not bad, right? Over the 40 years, you average about 7.2% annual return.
There are a couple of points we should clarify. The above calculation assumes fixed appreciation and inflation, this is not the case. It also doesn’t take into account additional expenses like the need for life or creditor insurance, realtor & lawyer fees, large renovations, vacancies in the property.
It also doesn’t take into consideration that the income received will be reinvested. This could increase your rate of return as well. Additionally, with rental properties, you have to deal with potentially bad tenants. Are you going to manage the property or are you going to hire that out?
Lastly, we cannot forget about taxes, for simplicity we will assume that the net return of $321,500 is fully taxable. That would mean there would be tax payable of $112,525 ($321,500 * 35%). This lowers your after-tax return to $208,975
Note: this isn’t how the tax would actually be calculated. In a real-life situation, net rental income would be reported each year and taxed as ordinary income. Additional, capital gains on the property would be half taxable at your marginal tax rate. In reality, this is most likely less tax than this person would end up paying in real life.
Using a TFSA
The following TFSA section should be less complex. There is no tax, income, etc., that we have to take into consideration. The only thing we have to take into account is the return and the fees associated with that and inflation. The simplicity of TFSAs is one of the biggest benefits.
According to investopedia, the S&P 500 has had an average annual return of approximately 10-11% since 1926. Since 1957 it be been around 8%.
We will assume that the S&P 500 will average a return of 9% annually. After inflation that is a return of ~7.4% annually. There will be some investment costs like transactions fees and custodial or advisor fees. Lets assume a net investment return of 7%.
With a 7% compounded rate of return over 40 years, the original $20,000 invested would have grown to ~$299,500. That amount is completely tax-free and depending on what investments were selected, also very liquid.
Any withdrawals are not added to your income so social support programs are not affected unlike the income and capital gains generated from the rental. Barring any changes in investment carrying costs, there are no unexpected expenses that will arise with the TFSA.
In the end, both, rental properties and investments held in TFSA have their pros and cons. As financial/investment advisors we may have an apparent bias. However, at the end of the day, it is up to the individual. What do they perceive as a risk? What is their expertise? How involved do you want to be in the management?
Both options could turn out better or worse than what we outlined above. What matters is that the investor is making a conscious effort to try and better their financial position.