Understanding ETFs With Rental Real Estate

ETFs, ETFs, ETFs...

If you read The Rich Moose, or any other financial blog in Canada, you will hear the term ETF thrown around an awful lot.

Buy ETFs, invest in ETFs, switch to ETFs, Couch Potato ETF portfolios, Dual Momentum with ETFs, Questrade offers free commissions on buying ETFs, etc.

If you are new to investing in Canada, it is important to understand what ETFs, and their units, are and why you should use them in your investment portfolio. Let's use rental real estate as an analogy so you can understand why ETFs are so attractive.

ETFs Are A Little Like Rentals

Investment assets are anything that any individual can invest in. It could be houses, rental units, private ownership in a small business, a commercial building, shares of a company traded on the stock exchange, bonds sold by government or corporations, a private loan, or anything else that has a reasonable expectation of providing the investor with income or an increase in value so that the asset can be re-sold for profit at a later date.

An ETF—short for Exchange Traded Fund—is basically a package of investment assets divided into units so they can easily be bought and sold. The fund—holding specified assets—trades its units Monday to Friday on the stock exchange.

The assets that an ETF can hold vary significantly, but they are all disclosed regularly on the website of the fund administrator. The most common ETFs in Canada hold a portfolio of stocks, bonds, or serve as a "wrapper" for other ETFs (generally ETFs listed on the much larger U.S. stock exchange).

Diversification Benefits

When you purchase shares of a single company, a single bond issue from the federal or provincial government, a single rental unit, etc. you are really putting all your eggs in a single basket. This means your investment carries a lot of risk.

Let's look at rental units for example. If you own one rental condo, you can quickly get into financial trouble. A tenant who isn't paying rent and fights you on the eviction, a tenant that does significant damage making the unit non-leasable for a month or two while you clean up and do renovations, a poor rental market that leaves your unit vacant for a few months, a downturn in your local real estate market, a continuous stream of broken appliances or other home items you are responsible for. It doesn't take much before you are losing money.

However, let's say you own a 5-unit apartment building in your hometown and another 5-unit building in a town a few hours drive away with a different economic base. Now if you experience any of the above issues in one or two units, you will be fine. You still have 8-9 units paying you rent every month. Even if your local economy takes a hit, chances are your building in the other town could still be full and generating income.

Now of course it costs much more money to own two 5-unit buildings. So what do you do? Well, you could put together a group of 10 investors and each put in 1/10th of the money needed for the purchase of both buildings. You get a one-tenth share of the profits and your risk is significantly less. Over the long run, you will earn more profit than you would with a single condo unit, but your risk is also lower and it's very unlikely that you would have many, if any, months where you lost money. The cost of this diversification is usually the price of a property manager to keep on top of the all the management obligations—a fee well worth the security that diversification provides.

Shares of a company traded on the stock exchange are not much different from rental units. If you buy shares in a single company, that company could soar in value and make you very wealthy. It could also end up bankrupt and your shares would be worth nothing. Even the best companies in one decade can go broke the next. The list of dead mega-corporations is lengthy indeed!

An ETF fund will hold shares in dozens, if not hundreds or even thousands of companies. The stake the fund holds in each individual company is tiny, but all those tiny pieces come together and reduce risk while increasing overall profits. Owning units of an ETF is like being a part owner of a large portfolio of rental properties. You benefit from diversification, but you must pay a small fee to the ETF manager for that security.

Liquidity Benefits

One of the biggest benefits of buying ETF units instead of shares in a rental portfolio or some other private investment is the liquidity of ETFs is not matched in any other investment. You can buy or sell your ETF units almost instantly at a price that's near perfectly aligned with its current underlying value.

Many of the larger ETFs have tens of thousands of units trading on the stock exchange each day. Anyone anywhere in the world can log into their brokerage account and buy or sell some, or all, of their ETF units instantly on the stock exchange.

ETF investors don't need to search for a buyer, arrange for financing, apply for a loan against their ETFs if they run short on cash, sign reams of paperwork, pay lawyer fees, pay large commissions to a salesperson. It's all automated and insanely fast.

Cost Benefits

ETF units are cheap to buy and cheap to hold. Your purchasing cost is the current value of each ETF unit you buy, plus a commission of around $10 which is charged by your online brokerage. If you use Questrade as your brokerage, they do not charge you commission fees when you buy ETFs.

Once you get familiar with the buying process—something that is easily learned by watching a few Youtube videos and doing it yourself once or twice—you should be able to log in to your brokerage account, look up the ETF you want to purchase, input your limit order, and send your order to the market all within a minute or two.

This does not even compare to the cost of buying or selling real estate which runs into the tens of thousand dollars and countless hours of your time. Selling a share of a rental portfolio can be even more difficult than selling a single property.

ETF units are also very cheap for you to hold. The ETF administrator charges a small fee (called the management fee) to manage the buying and selling of assets held by the ETF. This fee is charged annually and is automatically deducted from the value of the ETF by the administrator.

The management fee can range from 0.04% of the asset value for a large index ETF to around 1.0% of the asset value for a highly specialized, managed ETF that does more trading and requires analysis by fund managers. Generally speaking, the cheaper index ETFs perform better than the pricier managed ETFs over the long run.

With ETFs you don't need to worry about plumbers, bank account fees, repairing countertops, replacing appliances, paying a property manager, and redoing the flooring and paint every few years. While a real estate investment can cost you thousands of dollars a year in holding costs, an ETF investment of comparable value charges just a fraction of that amount.

A broadly diversified ETF portfolio worth $1 million will cost less than $2,000 a year in management fees.

Tax Benefits

In Canada there a three major forms of taxation for investors.

1) Capital gains tax - Tax on the increase in the value of an investment from the purchase cost to the selling price. Only 50% of the gain is included as income to be taxed.
2) Dividend income tax - Tax on the eligible dividends paid by Canadian companies to you as a form of profit sharing. Canadian dividends are taxed at very low rates, sometimes effectively negative rates at low income levels.
3) Other income tax - Tax on all other income which is taxed at your normal income tax rates in your province. This includes employment income, business income, dividends from foreign companies, interest income from bonds, and many other types of income. This is the least desirable income as the tax rates are the highest.

When you buy ETF units, the bulk of your investment returns will be taxed as capital gains when you sell your units. This reflects the increase in value from when you purchased your ETF units to when you sell your ETF units at a later date. If you sell your ETF units for less than what you paid, you can use the capital loss to offset capital gains from the prior three tax years, the current tax year, or future capital gains. Proper management of capital gains can result in extremely low taxes.

ETFs which hold Canadian stocks will generally distribute money to your account monthly, quarterly, semi-annually, or annually. The bulk of this distribution will be considered eligible dividend income. You must claim this income each year that you receive it, but the tax rates are very low.

Finally, ETF investing will result in you paying a small amount of tax on Other Income. This is generally interest income from ETFs which hold bonds and dividend income from foreign companies.

There are ETFs holding international stocks or bonds which are structured to reduce income classified as Other Income so you pay less tax, or no tax at all. ETFs are some of the most tax efficient investment vehicles out there.

ETFs are almost certainly more tax efficient than rental real estate. Real estate income is taxed as business income. While the interest costs and depreciation can offset much of this, that only goes so far. The net gain in the value of a rental property is taxed as a capital gain when you sell.

However, if you trade real estate (like a house flipper), that gain in value is taxable as business income at your full income tax rate. In the past few years, the government has really cracked down on individuals shielding real estate investments from business or capital gains tax.

ETFs or Mutual Funds

The common debate in Canada is how ETFs compare to mutual funds and which is better. Mutual funds are heavily promoted by our big banks and life insurance companies. That's because these financial institutions make gobs of money in fees from mutual funds. They don't earn these same fees promoting ETFs.

Mutual funds are a lot like ETFs in many ways. They are a fund—divided into units—which holds stocks, bonds, real estate, or other assets. You can easily buy and sell mutual funds using a brokerage account or your bank account. Like ETFs, mutual funds hold numerous assets to offer diversification to their investors.

Mutual funds are very liquid and are bought and sold at the end of each trading day at their true current value. Mutual funds are divided into units for easy buying and selling, just like ETFs are. Unit values are often designed to be less than $100/unit. If the value exceeds a certain amount, the administrator will split each unit into two or three units, thereby reducing the price per unit. This has no impact on your account value as you would receive two or three units for each unit you held before the split.

In Canada, most mutual funds are very expensive. The annual management fees can easily be 2.0% of assets or higher. Part of this fee goes to paying the person who sold you the mutual funds while the remainder is retained by the bank or insurance company to manage the fund.

As with ETFs, mutual fund fees are automatically deducted from the fund. Because the fees charged by mutual funds are so large, it causes a significant drag on the returns of the mutual fund over time.

Mutual funds are also not always as cheap to buy and sell as ETFs are. Many mutual funds in Canada are load funds, so they charge you a hefty fee to sell unless you have held onto them for a long time. Selling one load fund and buying another gets very expensive and makes your fund salesperson wealthy at your expense.

However, not all mutual funds are bad. There are no-load funds and lower cost index funds out there. The best ones are offered by TD Bank called their Series E funds. These funds do not charge any fees to buy or sell (no-load) and their management fees are less than 0.5% annually. However, you need to use a TD brokerage account to access them.

Other banks also offer no-load funds but charge management fees around 1.0%. Again, these are very expensive compared with ETFs charging 0.20% or less for similar underlying assets.

I believe there is little reason for anyone to use mutual funds rather than ETFs for investing. The brokerage commission argument against ETFs is largely null considering Questrade offers commission-free ETF purchasing.

ETFs are very cheap to buy and hold, offer amazing diversification, are quickly and easily bought or sold, and can be very tax efficient. These reasons are why my entire portfolio is invested in ETFs.

See my list of Top Canadian ETFs divided by asset class above.

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