Considering a Beautiful Waterfront Cottage?

I was reading some Real Estate articles over the weekend and this one in particular caught my attention as we ourselves were considering the idea of waterfront “Cottage” property. It can be an overwhelming and difficult decission, however when you have some unbiased financial information it makes the decission a bit easier.

The following article was written by    May 5, 2012 – Financial Post Publication

May marks a time of change for those who own or who wish to own a vacation property. The snowbirds are returning from the sunny south and the Victoria Day holiday has historically been “opening weekend” for many cottagers. It is also a time of year that sees a lot of turnover of vacation properties — whether north or south — which might make you wonder how you can achieve your dream of owning a vacation property.

Most people opt for cottages over homes or condos in the southern states simply because of proximity. The Royal LePage Recreational Property Report says standard waterfront recreational properties can range from the mid-$150s on the East Coast to approaching $1-million in Cranbrook or Vernon, B.C., the Muskoka region of Ontario or the Eastern Townships of Quebec.

For argument’s sake, assume the purchase of a $200,000 cottage. Not everybody has a couple of hundred thousand dollars waiting to find a home (pun intended), so most cottage purchases will be financed. It’s important to know ahead of time that mortgages for recreational properties may be subject to different lending requirements and higher interest rates than your home. Banks tend to look more favourably upon cottages that have year-round access and are winterized when determining acceptable loan-to-value ratios and discounts off of posted mortgage interest rates, so don’t count on standard mortgage terms for an uninsulated log home on an island.

If someone qualifies for an 80% mortgage on their notional $200,000 cottage, that requires a down payment of $40,000. It’s possible (though may or may not be advisable) to borrow against your principal residence for this down payment. Assuming a 4% rate and a 25-year amortization on the $160,000 mortgage, the monthly payments would be $842, which is about $10,000 a year. Property taxes, insurance, utilities and maintenance might conservatively add another $5,000 a year, meaning a total annual cost of $15,000 (7.5% of the cottage purchase price). Assuming the entire down payment came from a secured line of credit on your home, add another $2,000 in interest-only payments at a minimum at today’s rates. Remember, though, in addition, cottages need new roofs and experience other expensive and unexpected maintenance requirements just like a home. And interest rates have nowhere to go but up.

It wouldn’t be unreasonable for a family of four to spend $5,000 to go on a one-week vacation, but that’s a long way from the $15,000 carrying costs for the cottage. That said, in this example, nearly $4,000 a year would be going to mortgage principle repayments and if the cottage rises in value at a modest 3% a year, there’s another $6,000 in net equity — $10,000 in total — over the course of the year. If we knock $10,000 off the carrying costs, a family might be looking at only a $5,000 annual net “cost,” which is getting a bit more reasonable when you look at it this way.

There is still a valid argument that the average family who might only take a couple weeks of vacation per year might do better to rent a cottage or visit an all-inclusive resort and spread out their vacation spending. A $5,000 vacation budget could go a long way and for those who like diversity, it might not be very rewarding to spend it all in one place at the cottage. But likewise, some would gladly add this to their budget to have a second home to call their own.

One consideration when purchasing a cottage property is the potential to rent it out. It’s much easier to rent a cottage on your own these days on Kijiji or other online directories, by creating your own website or simply by word of mouth. But there are also property managers who will find tenants and provide various levels of management — typically for 10% to 20% of the rent collected. This can certainly help pay for some of the carrying costs and can be a good option for families who can’t spend much time at their cottage. It also makes some of the carrying costs tax-deductible (though the rent received is also taxable). Renting any property, cottage or otherwise, can present many unpleasant challenges for landlords, so renting is not without potential headaches.

More and more Canadians are looking south of the border for vacation properties. Florida, Arizona and California tend to be hot spots. With the decline in U.S. home prices, coupled with the increase in the Canadian dollar vis-à-vis the U.S. in recent years, home prices are very affordable in the U.S. on a relative basis compared to many places here in Canada.

Average home prices in Florida peaked around $271,985 in 2006 and have since stabilized around $159,900. This compares to the average home price in Canada of about $369,677.

If financing is required for a U.S. property, U.S. banks may lend 50% to 75% of the purchase price to a Canadian depending on the state. Lenders may also require the deposit of up to 12 months of mortgage payments, property taxes and insurance premiums into a U.S. bank account. Some people use a mortgage or line of credit on their Canadian home to provide the funds to purchase a U.S. property to keep things simple.

Canadians with a high net worth need to be cognizant of U.S. estate taxes, which could become payable on death for those owning U.S. assets. There is a lot of short-term uncertainty around U.S. estate tax rules, so be sure to consult a professional.

A Canadian who rents out a U.S. property will be required to file a U.S. tax return, although in most cases, little or no tax results and the filing is simply administrative.

Is a cottage or U.S. recreational property a good investment? That depends in part on what happens with real estate prices. Some have called for the bursting of a real estate bubble in Canada, suggesting caution for Canadian cottage buyers. Historically, Canadian homes have averaged about 3.5 times household income — currently, they stand at 4.75 times, which is quite a jump from the long-term trend. Meanwhile, the U.S. housing market, although it seems to have found a floor, has not shown much of an improvement to suggest positive returns in the near term.

Prices aside, because future real estate trends are just speculation, one needs to examine more tangible factors. Is a vacation property affordable without stretching yourself too thin and sacrificing other financial goals? Is diverting money otherwise spent on vacations to a fixed address a good trade-off? And finally, where do you and your family want to be — sitting on the dock this summer or baking on a beach next winter? Both sound good, but take the time to determine what’s right for you from both a financial and lifestyle perspective.

Jason Heath is a fee-only Certified Financial Planner (CFP) and income tax professional for Objective Financial Partners Inc. in Toronto.

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