A friend of mine who has contacts in the mortgage industry recently brought my attention to an interesting dilemma that some unlucky young couples in Toronto are facing, specifically those who are invested in the Toronto condo market. The situation as described to me goes something like this: A young single person buys a condo in Toronto. Some time in the future, this person hooks-up with a partner who also owns a Toronto condo. The newly-minted couple makes the decision to cohabitate in one of the two condos. Now, what to do with the other condo? Selling may trigger expensive penalties for breaking a fixed-term mortgage. Looking at this from the perspective of a Toronto property manager and real estate investor, I suggest that to avoid mortgage penalties, our couple should consider renting-out the other condo to ride-out the mortgage term before selling, substantially improving the overall profitability of the property investment. The following article presents an analysis and comparison of the two options described above.
Hypothetical Condo in Toronto
A hypothetical one-bedroom condo located in downtown Toronto is used as an example in the following analysis. The condo has been occupied by one of the partners for two years before they decide to move in together. The mortgage on the condo has a five-year fixed term. The specific details about the condo such as purchase price, property tax, condo maintenance fees, etc…, were taken from an MLS listing from May 2016 for a one-bedroom condo at 600 Fleet Street (located near Lakeshore Blvd and Bathurst Street in Toronto). A summary of the pertinent information is given below:
- 5 year fixed mortgage term
- $250K purchase price for a 500 sq.ft. 1-bdrm condo at Lakeshore and Bathurst
- 10% downpayment
- Initial mortgage balance is $229,500 (225K + 4.5K CMHC insurance) on Aug 10, 2014
- Owned for 2 years
- Remaining # of months in mortgage term 36 (3 years)
- Current mortgage balance is $216,153 based on 2.59% int, fixed 5-year term, 25 yr am. On Aug 10, 2016
- Renewal date Aug 10, 2019
Option 1 – Incur Penalty For Breaking Mortgage Term Early
Sell the condo, grudgingly pay the penalty for breaking the mortgage term 3 years early, and the couple lives happily ever-after…or do they? The joys of cohabitation notwithstanding, in this scenario, the couple stands to lose a significant chunk of change. If the mortgage on the condo is with one of the big banks in Canada, chances are they will be on the hook for a costly penalty for breaking the mortgage term early. On top of the mortgage penalty there are realtor commissions and closing costs, which won’t leave them with much money in their pocket after the sale is completed.
The mortgage penalty used by Canadian banks is commonly calculated as either three-months interest or the interest rate differential (IRD), whichever amount is greater. Given the current climate of low-interest mortgages with rates that have been steadily declining in Canada more or less since the great recession of 2008, the IRD method will most likely produce the larger of the two penalties. The table below shows posted interest rates taken from the TD Canada Trust website on August 11, 2016.
[table id=ird-calc /]
Using the “Discounted Rate” variant of the IRD method favoured by TD Canada Trust, the penalty for breaking the mortgage on our hypothetical condo with three years remaining in the term will cost the couple $7,457 based on the above interest rates.
Capital Gains Tax
In this case since the condo has been used solely as the owner’s principal residence, any increase in it’s value (i.e. capital gain) over the period of ownership is not taxable. Of course this is a good thing, and a significant benefit to home ownership compared to other investments where capital gains are considered taxable income.
ROI On Condo Sale After Two Years
After making monthly mortgage payments for two years, a small dent has been made in the mortgage principal, which will help to offset the costs of the sale, i.e. realtor commissions and closing costs. As you might imagine, the overall profitability of the sale is highly dependent on real estate market conditions in Toronto, specifically how much the value of the condo has appreciated since it was purchased. Unfortunately, since the couple has opted to cut-out early on the mortgage, the IRD penalty cost gives any profit they made on the sale an unpleasant haircut. The table below shows the return on investment (ROI) on the sale of the condo assuming various rates of property value appreciation, from a pessimistic 0% growth to an optimistic annual appreciation rate of 4%.
[table id=roi-calcs-option-1 /]
In the worst case shown in the table (0% appreciation), the couple has lost $19.6K on the sale of the condo. In the best case scenario (4% appreciation), they break-even with a small loss of $180. But keep in mind that in all cases, profit is reduced by the IRD mortgage penalty amount.
Option 2 – Rent-out Condo Until End of Mortgage Term
In this scenario, one of the partners moves-out of their condo after two years of ownership, then rents the condo for the remaining duration of the mortgage term (three years) to avoid paying mortgage penalties. To avoid the hassle of managing a rental property, a professional property management company is hired to take care of dealing with tenants, collecting rent, filling vacancies, etc…
Projected Cash Flow From Condo Rental Activity
The following table gives a breakdown of the cash flow generated from the condo rental activity over the three-year rental period.
- Monthly Rent: $1475
- Property Management Fees: 6% of monthly rent
- Tenant Placement Fees: 1 tenant placement every 2 years, 1 months rent per tenant placement
[table id=condo-rental-cash-flow /]
Because of the relatively low initial down payment of 10%, the annual mortgage payments exceed the operating income generated from the condo rental activity resulting in a negative cash flow; -$195 monthly, -$2,342 annually. The total cash flow over the three year rental period is -$7,026.
Capital Gains Tax
Since the condo was used as the owner’s principal residence for the first two years of ownership and as a rental property for the final three years, any increase in property value of the condo over the final three years is subject to capital gains tax. Currently in Canada, 50% of the capital gain on an investment is considered taxable income. In my analysis, I assume that the owner’s personal income tax rate is 50%.
ROI On Condo Sale After Five Years
At first glance the negative cash flow from renting-out the condo may look discouraging. But when consideration is given to the total profitability of the investment upon the sale of the condo after five years of ownership, this option becomes significantly more attractive. The table below shows the total profitability and ROI when the couple chooses to rent-out the condo for the duration of the mortgage term.
[table id=roi-calcs-option-2 /]
In this scenario, the mortgage penalty of $7,457 is avoided, but it is replaced by a total negative cash flow of $7,026 for the three years of rental activity. Despite the negative cash flow, the investment makes a $2,231 profit even in the worst-case with zero appreciation in the value of the condo over five years. With appreciation rates of 2%, and 4%, and consideration of capitial gains tax owning on the increase in condo value during the period of rental activity, profits are $23K and $45K respectively.
A comparison of profitability in Options 1 and 2 is shown below.
[table id=profit-comp /]
In all cases the profitability in Option 2 is substantially greater than in Option 1 because the mortgage balance has been reduced by an additional $21K during the three-year rental period. In the cases with positive property appreciation, the increase in market value over five years versus two contributes significantly to overall profit.
Faced with the options of breaking the mortgage term early and incurring a penalty or renting-out the condo for the duration of the mortgage term to avoid the penalty, it is financially advantageous to do the latter. Furthermore, the couple can choose to leave the management of the condo rental activity to a professional property management company in Toronto and still be significantly more profitable than with the former option.
Blog Revision 25-Aug-2016
An astute reader points out that my original analysis did not account for the implications of capital gains tax. Capital gains tax will be applicable on any increase in value of the condo during the period when it is used as a rental property. The blog has been revised to address the above oversight.