Getting Ahead - Using Other People's Money
Part 1: Investing for Income

— a Moneysaver Article by H.Michael Wise

Introduction

Luigi and Maria Lasagna arrived in Toronto with all their possessions in the 4 large suitcases they had with them on the airplane. The young couple had decided to follow their Uncle Antonio's advice, and leave their small village in Southern Italy for a better life in Canada.

Maria went to work at Antonio's bakery, and a contractor hired Luigi as a bricklayer's helper. Before long, they took all their life savings, plus some extra that Uncle Antonio provided, and purchased a little up-down duplex. The Royal Bank provided a mortgage that covered 90% of the purchase price. They lived upstairs in the duplex and rented out the main floor, because they could get more rent for a ground floor suite than the second floor.

Rent from the main floor paid most of the mortgage interest on the entire building. Luigi did all the maintenance himself, with some help from the Italian community when he needed specialty trades.

After a few years, Maria and Luigi graduated to better-paying jobs. It wasn't long after that when they bought their own single-family house on a nice street; now they could rent both suites in the duplex.

Now in their 60's, Maria and Luigi relax in the comfortable family room of their home in one of Toronto's better neighbourhoods. All of their children have graduated from university. Maria and Luigi now own 2 large apartment blocks, a couple of 4-plexes, and that original small duplex that they keep as a reminder of their roots.

An Alternative to Rental Real Estate

The story of Luigi and Maria is a great story, one that has been repeated over and over in this country. It was possible because Luigi and Maria were able to borrow money from the bank (and Uncle Antonio) to buy the duplex.

The key to their success was that their investment always provided them with enough income to cover the cost of borrowing. Can we achieve the same result without having to deal with tenants, property taxes, leaking roofs, or stopped-up toilets?

Like Maria and Luigi, we want an investment that will pay a consistent and reliable monthly income, year in and year out, in good times or bad. The cash we receive will cover our carrying costs, with a bit left over to amortize the investment loan. It is even better if the income is tax-sheltered in some manner. It would be nice if the asset value grew over time, hopefully keeping up with inflation.

Just as Luigi didn't worry about the day-to-day value of their rental duplex, we must not worry about the fluctuating value of our investment. The important thing to monitor is whether our investment can maintain its distribution policy. This is exactly the same as Maria's main risk: that their tenant would leave and the suite would remain empty for a month or two.

A good rental property will give a gross yield of around 8%. This is equivalent to a $1000/mo rent on a property worth $150,000. What investments are available that could generate an equivalent level of income? Table 1 shows five mutual funds that generate a cash yield in excess of 8%, pay this yield as fixed monthly distributions, and are tax-efficient. Any of these are possible alternatives to Luigi and Maria's rental duplex.

Table 1


Price
(23 Oct 01)
Monthly
Distribution
Indicated
Pretax Yield
Clarington Global Income Fund $8.98 $0.081 10.7%
Clarington Canadian Income Fund $9.51 $0.08 10.1%
C.I. Canadian Income Fund $9.10 $0.075 9.9%
Guardian Monthly High Income Fund $8.55 $0.062 8.4%
Bissett Income Fund Class A $12.27 $0.083 7.8%
  • 1 Clarington is currently reviewing the distribution because of the fall in NAV; if reduced to 6c/mo, Clarington Global Income would have a pretax yield of 8.2%.
  • 2 Guardian MOHI has declared an extra distribution of 8c/share payable in 2001.
  • 3 Bissett Income Fund also pays a quarterly "extra" dividend.

The tax efficiency of an investment is the ratio between the cash actually received, and the amount that has to be reported to the tax authorities. The cash received comes from some combination of interest income, dividend income, capital gain and return of capital. Under Canadian income tax law, interest income is taxed at the highest marginal tax rate, while dividend income is taxed at a lower rate because of the dividend tax credit. Only 50% of the cash received from a capital gain is taxable; the taxable capital gain is then taxed at the marginal tax rate. "Return of Capital" is an accounting term that simply means any income received that cannot be classified as interest, dividends or capital gain.

"Return of capital" is not taxed when the income is received; instead the amount received is applied against the cost basis of the shares, lowering the Adjusted Cost Base (ACB) and causing a higher capital gain when the shares are eventually sold. For example, the Clarington Canadian Income Fund has been in existence for 4 years and has paid 96¢ per share each year. Of the 96c paid last year, only 5c was interest and therefore taxable at the highest marginal rate, 20c was dividend income and subject to the dividend tax credit, and 12c was capital gains (of which only half is taxable). The, remaining 59c of income received was considered return of capital, and won't be taxed until the investment is sold. In all, only about 30% of the income received was taxable in 2000. This is really significant. Suppose you hold 10,000 shares, and received $9600 during the year from Clarington. You would only have to declare $2880 as income on your income tax form; the other $6720 is tax-free (at least until the investment is sold).

Tax efficiency has a huge impact on the economics of levered investing. The cost of borrowing for investment purposes is deductible from all sources of income, not just from investment income. If we only have to report a small portion of our received cash as investment income, more of the interest cost can be applied against other income. The interest cost can offset the taxes on other income that would otherwise be payable.

Clarington Canadian Income, Clarington Global Income and CI Canadian Income are conservative balanced funds that have been designed as total return products. Income from these investments comes from a combination of interest income, dividend income, capital gain and return of capital. As mentioned earlier, the tax efficiency of the Clarington funds is outstanding.

Guardian Monthly High Income (MF Units) and Bissett Income Fund A invest entirely in trust units of various kinds. Both are well diversified across industry sectors. The Bissett fund is a lot smaller than Guardian, and is more diversified (Guardian, because of its size, has had to get deeply involved in Real Estate Investment Trusts and Oil & Gas Trusts — the 2 largest sectors of this market). Income is tax-efficient.

Guardian has traditionally had about 2/3 of the income as return of capital. Last year, 20c of the 72c distribution was interest or dividend income, and 52c was capital gain or return of capital (mostly return of capital).

Bissett is about 50% return of capital. Bissett's distribution policy is interesting: they have chosen to maintain a monthly distribution of 8c/share, supplementing the distribution with quarterly extras. The manager estimates that an annual cash yield of $1.10-1.15 should be sustainable. Bissett has paid $1.21 in distributions in the past 12 months. If, in the future, the total annual distribution is $1.10, the Bissett fund would generate a pretax yield of 9.28% based upon the 28 February price.

Table 2 compares the risks and benefits of rental real estate versus an income investment.

Table 2


Rental Real Estate Income Investment
Annual Cash Return as Percentage of Asset Value 7 - 9% 8 - 10%
Maintenance Costs (taxes, insurance, maintenance, etc) 2 - 4% Nil
Time required for supervision & maintenance Min 4 hrs per month per unit Nil
Growth of
Income
Rents will probably increase over time in line with inflation
  • Any growth would be a bonus
  • Funds may declare extra distributions from time to time
Growth of
Asset Value
Property values tend to rise
over time in line with inflation
Any growth would be a bonus
Leverage Max 75% if financing a rental
property via a mortgage
Max 67% if security is loan collateral; up to 100% if using an unsecured loan or pledging some other security
Deductibility of interest expense Cost of borrowing is deductible against all sources of income Cost of borrowing is deductible against all sources of income
Tax Efficiency Must declare gross rental income as revenue, less out-of-pocket expenses, interest, and depreciation May only have to declare 20-50% of investment income received as revenue, less interest expense
Depreciation
  • Depreciation of building and furnishings reduces the ACB of the property.
  • Depreciation cannot be used to generate a loss
  • Return of Capital reduces the ACB of the investment.
  • Return of Capital reduces reportable income, is therefore more powerful and flexible than depreciation.
Risks to Income Source
  • Suite might remain empty between tenants or during maintenance (4 - 8% vacancy rate is typical)
  • Tenant might not pay rent and need to be evicted
  • Might have to lower rents in a recession
  • Little risk of distributions going to zero
  • Might lower distributions during a recession or at times of low interest rates
High Interest Rates
  • Only an issue if refinancing the mortgage
  • The deductibility of borrowing costs against other income reduces sensitivity to interest rates
  • Could be a problem if using floating rate financing; otherwise only an issue if refinancing.
  • The deductibility of borrowing costs against other income reduces sensitivity to interest rates
Liquidity
  • Price must be negotiated between buyer & seller
  • May be difficult to sell at any price in a difficult market
  • May have several months between sale and receipt of proceeds
  • Daily pricing published in the newspapers
  • Same-day sale, with 3-day settlement
Commissions
  • Seller pays real estate commission of 5-7%
  • Buyer has legal and closing fees
  • Buyer pays 1 - 3% commission; may be zero if using "low-load" or "deferred sales charge" options
  • No commission on sale

A rental income property is seldom self-financing in the early years. The owner has to put "sweat equity" into the property to keep maintenance costs to a minimum, but even so a rental property generally consumes cash. The owner depends upon inflation to increase the property value and increase the rent he can charge, until the rents eventually equal or exceed the on-going holding costs.

Tax efficiency and the deductibility of interest costs against all sources of income make the income-producing investment self-financing on an after-tax basis right from the start. The income investment is far superior to rental property in an environment of stable prices, where the ability to raise rents is limited. Best of all, there are no hassles with tenants!


Portfolio Strategies