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R eal Estate Investment Trusts (REITs) are a popular way to get real estate exposure without directly owning the physical property.  But as they are equities, how do we go about analyzing if they are good value? I’ve mentioned numerous times before that I’m cautious over buying income trusts as the bulk of them pay out more in distributions than their reported earnings.   Even though it seems impossible, they still continue to do so.  To me, a strong REIT has recession resistant tenants, low vacancy, a growth strategy,  and most importantly, a sustainable distribution. In the case of REITs, they often pay out more in distributions than reported earnings mostly because of how earnings/net income is calculated.  Typically, net income (used for earnings) takes into account depreciation/amortization which can reduce net income significantly depending on the business.  In the case of a REIT, buildings are depreciated for accounting purposes, but it doesn’t necessarily mean that the building has decreased in value.  In reality, the building has most likely increased in value.  To account for this and perhaps better represent the cash flow of a REIT, most analysts use Funds from Operations (FFO) per share instead of Net Income/Earnings per share as a measuring stick for REITs. How is FFO/AFFO Calculated Funds from operations takes net income, adds back the amortization/depreciation, then subtracts proceeds from property sales.  For those of you who prefer formulas: FFO = Net Income + Amortization (or depreciation) – Proceeds from Property Sales AFFO stands for Adjusted Funds from Operation and accounts for the capital expenditures.  Some believe that if amortization expense is added back to the Net Income, then capital expenditures completed on the properties should be accounted for somehow.  The formula is: AFFO = Net Income + Amortization (or depreciation) – Proceeds from Property Sales – Capital Expenditures How to DIY As a do-it-yourselfer, I went on a quest to figure out how to calculate FFO/AFFO on my own.  As I am familiar with reading balance sheets, it wasn’t overly complicated as most of the information can be plucked from company cash flow statements, then calculated manually. However, for those who couldn’t be bothered with cash flow financial statements, most REITs report FFO/AFFO in their annual/quarterly reports. If we take a look at a REIT like Calloways, for Q1 2010 , we see that their earnings are around $7.4M with distributions of around $39.5M.  Sounds impossible right?  However, if you look at the FFO and AFFO numbers, you’ll see that their distribution is closer to 100% of their actual cash flow. Final Thoughts So instead of looking at simple earnings as the way to see if REIT distributions are sustainable, a better way is to take a look at the FFO/AFFO which may show you the real cash flow of the REIT.  Do you have any tips when analyzing REITs? For more information, Thicken My Wallet also has a few articles on REITs and FFO calculations.

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REIT Analysis using Funds from Operations (FFO)

A relative recently approached me for investing advice.  This relative, we’ll call him Uncle Alex, is approaching retirement and is wondering how to create an income portfolio.  Uncle Alex was a small business owner for most of his working life and managed to accumulate a fair bit of capital to fund his retirement years. Some professionals recommend a 50/50 equity/bond split during retirement so that the portfolio will last 30 years with a high certainty of success assuming  a 4% annual withdrawal (adjusted for inflation).  In my opinion though, it depends on the risk tolerance of the investor.  There’s no point putting Uncle Alex in 50% equities if he can’t sleep at night due to the volatility of the market.  For example, if he was 50% equities during the downturn of 2008, there was a point where his entire portfolio could have fallen as much as 25%. Besides the asset allocation, there’s the task of choosing appropriate investments that produce income.  Unfortunately, right now with interest rates at record lows, short term fixed income yields are unattractive.  However, in addition to the cash that fixed income produces, there is the benefit of reduced portfolio volatility. To keep things simple, lets assume that we go 45% stocks and 45% bonds and 10% cash.  Assume that Uncle Alex has enough capital to live off the distributions of the portfolio without having to touch the capital.  However, we’ll leave some cash in place should he need a lump sum in the future. Having said that, here are the investment vehicles that I would consider using for an ETF income portfolio: Equities Strong Dividend Equities : CDZ (MER: 0.60%) or XDV (MER: 0.50%) and VIG (MER: 0.28%) – These ETF’s have different focuses, but produce a strong dividend income stream.  CDZ mimics the dividend achievers list which focuses on Canadian companies that have a history of increasing their dividends over time.  XDV focuses on Canadian blue chips with the highest yield.  Although CDZ has a slightly higher MER, it has a higher distribution as it holds income trusts.  As well, it distributes monthly instead of quarterly.  VIG is similar to CDZ except that it focuses on the US dividend achievers index . Real Estate : XRE (MER: 0.55%) – Although Riocan (REI.UN) is a large weighting on this real estate investment trust ETF , I like the diversity that it provides across Canada.  If the risk tolerance was a bit higher, I would simply buy the top 3 REITs which covers 50% of the index, offer a higher yield, and save the annual MER. Preferred Shares : CPD (MER: 0.55%) – This is Claymore’s preferred share ETF which covers the Canadian preferred share index.  With preferred shares, you get lower volatility than equities and a higher yield.  However like bonds, preferred shares are sensitive to interest rate fluctuations.  Look for this ETF to become cheaper if interest rates rise aggressively. Fixed Income Short Term Bonds : XSB (MER: 0.25%) or CLF (MER: 0.15%) – The shorter the duration of the bond, the lower the correlation with the overall market which is why short term bonds have a place in every portfolio (IMO).  XSB is an iShares product that has a fairly low MER and holds both government and corporate short term bonds.  CLF on the other hand has an even lower MER but holds only government short term bonds.  My preference leans towards CLF as it has a lower MER but similar yield as XSB. Corporate Bonds : XCB (MER: 0.40% ) or CBO (MER: 0.25%) – Investment grade corporate bonds are considered slightly higher risk than government bonds, but offer higher yields.  The iShares XCB has a slightly higher MER, but also a higher yield with a duration of 5.27 years.  The Claymore laddered corporate bond ETF CBO has a lower MER and a shorter duration of 2.64 years. Real Return Bonds : XRB (MER: 0.35%) – Real return bonds provide a hedge against inflation as they provide an interest rate over and above the inflation rate.  Although the yield might be a bit lower, XRB provides protection during an volatile interest rate period. Cash GIC Ladder – For this portion of the portfolio, a 5 year GIC ladder would be constructed.  When the bottom rung matures every year, it will be reinvested in the highest 5 year rate available. Ideal Income ETF Portfolio (assume 45/45/10) CDZ – 15% (current yield: 4.26%) VIG – 5% (current yield: 1.83%) XRE – 10% (if buy top 3 REITs, current yield: 5.57% or 3.66% with XRE ) CPD – 15% (current yield: 5.10%) CLF – 15% (current yield: 4.18%) CBO -15% (current yield: 4.67%) XRB -15% (current yield: 2.38%) GIC Ladder – 10% (assume current yield: 2.40%) Total Yield (as of April 2010): 4.01% A couple considerations is that Canadian dividends face a gross up of 45% which is counted as income when testing seniors benefits.  For example, a senior can make up to around $67k before facing clawbacks of 15% for every dollar above the threshold.  However, in this particular case, Uncle Alex will be splitting the income proceeds with his spouse, which means the total distributions won’t reach the OAS claw back threshold . As well, to reduce overall taxation, the securities would need proper portfolio allocation . Back to you, what would you include in an income portfolio? Popular Posts: How capital Gains Tax Works How Dividend and Interest Income Tax Works Registered Education Savings Plan (RESP) Top Cash Back Credit Cards in Canada Questrade Review Are Hybrid Vehicles Worth it? Tax Free Savings Account (TFSA) Copyright 2010 MillionDollarJourney – All Rights Reserved

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Retirement Income ETF Portfolio

W ritten by Kathryn and FT – MDJ is matching contributions, more info below. For those wanting to donate to the earthquake relief in Haiti, it can be difficult to know where to give. As trusted financial writers we thought it would be best to share with you where we’re giving and why. The choice to give is up to you. Recently Kathryn wrote about charitable donations and deciding where to give . Be sure to check in there if you’re thinking about donating somewhere. Here are some suggestions for getting relief to Haiti If you’re going to give, give today. Don’t put it off. The immediate need is huge. It takes some time for the funds to go through. It’s easy to get overwhelmed with the choices of where to give and put off giving altogether. Be wary of unknown organizations. It’s best if you have a personal connection with someone on the ground in Haiti. If not, try and find someone who knows someone who has worked there. There are some amazing relief organizations but there are also scams. Be sure you get a charitable receipt Now is not the time to be thinking about tax savings. The reason you need a charitable receipt is because it means the organization is financially accountable to the Canada Revenue Agency. Give to an organization that is already working in Haiti For the funds to get where they are needed quickly, it’s best if the organization already has some sort of infrastructure on the ground already. Give to a ‘relief’ organization There are some great charities out there. As you know both Kathryn and Frugal Trader sponsor a child through Compassion Canada. The main work of Compassion is social services and literacy and education training. Only 1% goes to medical services. It’s a fantastic organization but it’s purpose is not relief work. On the other hand ninety percent of Doctors Without Border’s funds go to disaster and medical services. Kathryn and family are sending their donation to Doctors Without Borders. We are confident in the work of the organization. We have connections with people on the ground there. Doctors Without Borders has an infrastructure on the ground already. They are a registered Canadian charity that focuses specifically on relief and medical work. They have a good track record and their salaries, assets and revenue are all within reasonable limits. Million Dollar Journey Matching Contributions To promote donations to support relief, MDJ will match reader contributions up to a total of $500 .  When we reach the $500 limit, we’ll donate the proceeds to Doctors Without Borders.  Simply email me a copy of your tax receipt for proof (webmaster [at] milliondollarjourney dot com). Popular Posts: The Smith Manoeuvre – A Wealth Strategy – I The Smith Manoeuvre – A Wealth Strategy – II Canadian Discount Brokerage Comparison Top Cash Back Credit Cards in Canada Child Care Tax Credits Questrade Review Are Hybrid Vehicles Worth it? Tax Free Savings Account (TFSA) Copyright 2010 MillionDollarJourney – All Rights Reserved

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Haiti Earthquake Relief – How You Can Help!

There was comment in the popular Smith Manoeuvre thread about comparing the tax deductible mortgage plan (TDMP) to the traditional SM.  Here are my thoughts on the issue. What is TDMP? The TDMP is a basically a way for someone interested in leveraging their home to invest to hand off the whole setup.  That is, TDMP will arrange the readvanceable mortgage , investment account/investments along with arranging payments, and mortgage pay down.  Coincidentally, their setup is very similar to the way that I have constructed my leveraged investment strategy . What Does it Cost? While not everyone has the time to watch their investments, automation can be a good thing. The automation with TDMP, however, comes with a cost (and other problems).  From their site: The TDMP Setup fee is $2750 + GST and recurring Cash Management fees are $39.95 per month. These fees are 100% Tax Deductible and are funded from the proceeds of the plan so you are never out of pocket. The Problems While the fees are high (even if they are tax deductible), the biggest problem I have with TDMP though is their choice of investments.  The TDMP invests in a high distribution fund, and uses the monthly distributions to pay down the non tax deductible mortgage.  High distributions are great right?  With a leveraged investment account, it really depends on the content of the distribution.  Their 8% income fund has at least a portion of the distribution in the form of Return of Capital (ROC) . The TDMP withdraws all of the distribution and uses it to pay down the mortgage, similar to my modified Smith Manoeuvre strategy .  As readers of MDJ know, withdrawing ROC from a leveraged investment account can mean tax trouble for the underlying investment loan .  Basically as time passes, and the mortgage gets paid off, the investment loan will slowly become a non tax deductible loan due to the return of capital. Over time, the investor will be left without a mortgage (hooray!) but with a large non-deductible investment loan in the place of a mortgage (boo!).  So basically back to square one.  Without the tax deductibility of the investment loan, the investor will be taking higher risk and will most likely face sub par returns after fees. Final Thoughts In my opinion, the only way that TDMP would make sense is if they use an income fund that payed distributions in the form of dividends only .  Dividends are tax efficient and can be withdrawn from a leveraged investment account without any consequence to the underlying investment loan.  That way, when the mortgage is eliminated, the investor will be left with a tax deductible investment loan. Popular Posts: How capital Gains Tax Works How Dividend and Interest Income Tax Works Registered Education Savings Plan (RESP) Top Cash Back Credit Cards in Canada Questrade Review Are Hybrid Vehicles Worth it? Tax Free Savings Account (TFSA) Copyright 2009 MillionDollarJourney - All Rights Reserved

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Tax Deductible Mortgage Plan (TDMP) - Worth It?

I’m proud to introduce “Retired at 31″ (we’ll call him John), a regular contributor on Canadian Money Forum .  As his handle indicates, he retired at the ripe age of 31 with $1.7 million in net worth.  Like most millionaires, John created his wealth through investing in businesses.  In his case, the businesses were his own.  Here is his story. Yes, I’m out (of the work force) at the age of  31 - about 10 months ago. My wife is about 80-90% removed - she should hopefully be out completely soon. We married young at ages 19/20 and had our first child shortly after. Having the baby motivated us to get our priorities straight. I came from a frugal business minded family, my wife, not so much. It a little while to financially train her . We saved into RRSP’s right from the time we were married along with buying a house.  Houses were cheap then and we were fortunate that both sets of parents helped with a down payment. The bank pre-approved us for $120k or something like that but we bought one for $70k that had a basement suite in it. I started a company when I was 23. Started small and part time. I staked it with $2,000 and largely grew it organically. It required some additional injections in the first couple years and later we used a HELOC to float some inventory. I applied the same frugality to the company as in the personal life. We left earnings in the corp and just took what we needed to live on. Over time RRSP contributions increased and we “caught up” in our mid to late 20’s.  Since then we’ve maxed our RRSP’s each year. Real Estate We sold the first house when I was 25 for about $90k. Made a bit of profit at first glance, but had put money into it. Profit was negligible - maybe $5k or so. The next house was bigger but again, well within our means. We actually paid for a lot first and waited two years to accumulate more money for the house. Lot was $45k or so, house built for $200k or so. Over the next few years we developed the basement, landscaping, etc as funds permitted. The second child born around this time. A few years later we sold that house and changed cities. House sold for $300k, with probably $280k or so into it. Small profit. We become mortgage free in and around this time. In the new city, the trend of buying below our means continues. It was just after the start of the boom in Alberta - the bank suggests a house of up to $800k. We laughed, but we actually had to take advantage of it for a period of almost half a year as house #2 took a while to sell. We end up buying a $470k house and we were once again with a small mortgage ($100k or so). The housing boom accelerated and I was spooked because houses aren’t supposed to appreciate to that extent. While I wasn’t fearful about losing money on the purchase price, I knew how hard it was to make $100k taxes in. The boom town was also crowded, so we got out of there. We sold for $600k for a total profit of $120k. Great return for short ownership period. At that time, we were looking to diversify our income stream. All of our household income came from the company. My wife was (and still is) a stay at home mother.  She worked previously at various jobs, but never had a true career per se due to children. We looked high and low for another business opportunity. We looked in BC and Alberta, and eventually find one in a smaller city in Alberta. The housing prices in the small town were cheaper than our previous boom town, but they were starting to take off.  We downsized considerably for house #4 - smaller and significantly less “nice” than the previous two. We paid just over $300k which freed up a substantial amount of money for the purchase of companies 2 and 3 . This coupled with retained earnings inside company 1 yielded a small loan required to purchase business 2 and 3.  The house is currently worth about $400k. The Companies Three companies are now producing income and per usual, being treated frugally. The first priority is to pay off the corporate loan asap, then worry about paying back myself and company 1. A year passed and another opportunity fell into my lap. I took a loan for the whole purchase price, floated the inventory from the HELOC (we’re mortgage free again) and had 4 companies producing income with, again, the priority to repay loan. This brings us up to last summer. Company 1 sells stuff to Americans. Exchange rate has been eating the growth, but thanks to sourcing goods in USD, the profitability remains great. I don’t like storm clouds on the horizon, so it was time for us to get out. We listed company 1 in March (08), a buyer comes along and we close Aug 1. Crap hits fan shortly thereafter. Timing was impeccable.  We had significant retained earnings in company 1 which are now converted to a shareholder loan after paying dividends to shareholders. The sold shares of company 1 were kept “onside” with the exemption rules (you have a once in a lifetime $750k exemption on qualifying shares of a small business ). This means no tax on proceeds. We were so happy with the outcome of selling company 1 that we decided to sell a minority portion of company 2 to the manager. This sale also qualifies for the exemption (shares in wife’s name),  again no tax. As it sits, we have 3 companies. Companies 2 and 4 are completely self sufficient thanks to new minority owners with a vested interest in running it well. I regularly look over the numbers and make sure things are on track. Company 3 is without minority owner and run 80% or so by a “bonus for performance” manager.  This system is not as good as an equity owner so my wife runs the 20% or so to ensure things are as they should be. The current manager is interested in being an equity owner, but capital deficient. All 3 companies are debt free from external sources, save for company 4 which still floats it’s inventory via my HELOC. All 3 companies do owe us significant shareholder loans in the range of $500k (not including the HELOC which varies between $150k-$300k depending on the time of year). At current repayment rate, we will be down to zero from $500k in 2 to 3 years, with one company being ready to produce income in a year or so. There’s just under $200k left owing on an owner carry portion from us selling the shares of company 1 and 2. Both of these are uber secure as both have a clause which gives us the shares back if the buyers default. The Retirement Income As it sits, we have no (salary) income streams whatsoever. We’re deriving some income from non-reg investments and also from interest on the owner carry portions of the share sales. So we are currently eating some capital to live. I dislike debt (even to myself) and the sooner these companies throw income the better. The best way to do this is not to cripple the companies by taking income out of them. Frugality persists, but we have loosened the purse strings a bit in the past 3 or 4 years. Combined household income didn’t pass through $100k until I was 28 and then never more than $120k until this past year when the shares were sold. Company 1 had around $200k or so per year that it could have been paid to us but we lived on far less. In addition to RRSP’s of about $180k, we’ve stashed fairly significant funds for the children in an RESP and in trust accounts (approx $100k at the moment). Our oldest child is about 5 or 6 years away from being a high school grad. The Future The future is to be determined. A complication of retirement is children. Summer vacations excluded, we can’t venture far. We’re committed to this city until both kids are done school. I’ll be 43 then and actually free. At some point we’ll likely become minority shareholders and eventually non-owners of the 3 companies. Assuming no change in the profitability of the companies, both of us will have maxed out the exemptions ($750k each) when they are sold. I’ve read quite about about retirement - early and otherwise - and it’s challenging. I took the winter off to pursue a hobby but now that winter is over, what do I do now? The traits that got me to where I am today is difficult to simply turn off. The wheels continue to spin - more so from a private business investment standpoint, but I am finding more ideas in the market. I’ve considered returning to university as many years ago I left after a year of engineering. I’m not sure what I’d take, or if I’d even complete a degree, but learning stuff you’re actually interested in can be fun.  I might take a job to fill the time, but only for the sake of doing something productive, not for the income. Perhaps a non-profit? I don’t know for certain, I’m still figuring things out. The Lessons How did we get to retirement at such a young age?  Frugality, owning a business, having children young, setting goals, and delaying gratification are among the most important things. Splitting income and deferring tax via the companies has also been critical. Stay tuned, I have an interview with “Retired at 31″ coming up that digs into a few more details. Popular Posts: Canadian Discount Brokerage Comparison Top 6 ways to Save on Auto Insurance High Interest Rate Savings Accounts Top Cash Back Credit Cards in Canada Questrade Review Are Hybrid Vehicles Worth it? Tax Free Savings Account (TFSA) Copyright 2009 MillionDollarJourney - All Rights Reserved

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Retired at 31: An Early Retirement Story

Tim emailed me regarding his father in law’s financial situation.  Basically, his father in law is single, no retirement savings, but a ton of equity in real estate which he’s going to liquidate soon to fund his retirement.  Tim realizes that I’m not a financial advisor , but he wanted my opinion anyways.  Here is more about the situation below, perhaps you can chime in with your opinion. My Father-in-law (Dave) is currently finalizing a sale of an investment property that has appreciated to from his $600k purchase price to a selling now of approximately $1.2 million. The property is fully owned with no mortgage.  The appreciation will be subjected to capital gains tax as this is not a primary dwelling. My Father-in-law just turned 60 years old and has no pension and limited cash savings other then this ‘paid-for’ land asset.  He only has experience investing in real estate and now that he is ‘retired’ with no fixed income, his priorities have also changed. Debt: None Dependent Children:  None, two adult children. Retirement Status: Has been retired for several years, funded by the sale of another property, but that money is running out - just turned 60 Marital Status: Divorced Employment: He was a business owner - did not have salary, thus no CPP. Portfolio: Zero portfolio holdings/RRSP’s or savings of any kind. Other Income: None. House hold expenses: Property taxes $4500/yr phone/internet/tv $140/mth ($1,680/yr) House/car insurance $250/mth ($3,000/yr) Utilities Gas/H2O/Hydro $265/mth ($3,180/yr) Food $400/mth ($4,800/yr) Misc spending $200/mth  ($2,400/yr) Gas $200/mth ($2,400/yr) Travel $6,000/yr Home Maintenance $3,000/yr Medical Insurance: $2,000/yr Unexpected Expenses: $3,000/yr Total: $31,960 There could be rental income later on in retirement but for now there is nothing. He does have other land assets - primary dwelling which he does not yet want to sell -it is fully owned. Worth $500k or so. No other plans for future employment. Would like spending cash for travel but MOST IMPORTANTLY wants to have the money invested in a way that he cannot easily access the capital to spend on frivolous items - just have a regular income off the principal investment to play with and live off. None of this money to be left to the children - so every last penny of this million dollars will be spent. It would likely be preferable to the have current primary residence (approx $500k) as the last remaining asset at death for the children if possible. Okay - here’s the question, Let’s say you wake up tomorrow morning, sign into your online savings account and BAM! $1 million dollars  - your journey is over - you retire, and now with no fixed income where do you invest your wad of cash to keep it working for you long into your golden years (& beyond?) The Nest Egg With $0 in retirement savings, the father in law (Dave) will have to depend on the sale of the investment property to pay for his regular expenses.  With the sale price of $1.2 million net of all costs and $600k being capital gains, there will be substantial capital gains tax to be paid.  According to Tom, the father in law had very little or no income on the year of the sale. With around $600k capital gains ($300k added to income), Dave will owe approximately $120k income tax (assume Ontario).  Normally in this situation, I would suggest a large RRSP contribution, however apparently, Dave hasn’t drawn a salary (only dividends) for most of his working years thus most likely very little RRSP contribution room is available. Thus, the proceeds from the sale of his property would be approximately $1.08 million, but we’ll call it an even million in case there are other fees from selling that we aren’t aware of.  With a million dollars in cash, how can a 60 year old ensure that his money will cover his expenses and last for the rest of his life? Income Generation According to Sherry Cooper, BMO’s chief economist and author of The New Retirement , a portfolio can survive a 4.2% annual withdrawal rate (increasing annually for inflation) for 30 years with a high certainty of success.  This withdrawal rule was popularized by William Bengen’s research, a MIT grad and CFP, which also suggests that a 50/50 equity bond asset allocation be kept, even during retirement. Assuming that Dave will live until 90, 4.2% withdrawal from the $1 million in cash will result in the cash flow of $42,000 per year adjusted for inflation annually.  As the portfolio will be non registered, if we assume that 50% of the income will be from dividends (Canadian sources) and 50% from bonds with an average portfolio yield of 4.0%, he will owe approximately $2,200 income tax. This results in an after tax income of approximately $40,000. As this more than enough to cover all of Dave’s expenses of $32,000 / year,  it will likely result in leaving a nest egg behind for the children which is great news for Tim. In addition to this, when Dave turns 65, he will qualify for old age security.  Assuming that Dave meets the qualifications for maximum OAS , it will mean additional cash flow of $6,200/year in 2009 dollars.  When that time comes, Dave will only be withdrawing 2.78% (including income tax) from his portfolio to meet annual expenses. Next up is the portfolio for the soon to be retired Dave.  As this article is a bit on the longer side, I decided to split it up into 2 parts.  Stay tuned! As I mentioned above, I am not a financial advisor. The above is not meant as recommendations but merely for informational purposes only. Popular Posts: Canadian Discount Brokerage Comparison Top 6 ways to Save on Auto Insurance High Interest Rate Savings Accounts Top Cash Back Credit Cards in Canada Questrade Review Are Hybrid Vehicles Worth it? Tax Free Savings Account (TFSA) Copyright 2009 MillionDollarJourney - All Rights Reserved

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Case Study: 60 Years Old, Lots of Cash, No Portfolio - The Income

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