To me, the idea of becoming a landlord and owning a real estate empire sounds better in theory than practice. I can barely look after my own home maintenance, let alone having to manage another property. There’s also a major lack of diversification when you put all your eggs in the real estate basket – an asset class that’s awfully expensive in Canada.
Related: Borrowing to invest – how it works
That’s why I was intrigued when I read about a different type of landlord strategy. In his book, The Smart Debt Coach, financial author Talbot Stevens explains why a dividend landlord approach could make sense for those who’d rather avoid having to manage and maintain a rental property.
Here’s how it works:
With the dividend landlord strategy, the investor borrows an amount he or she is comfortable with, say $50,000, and uses that money to buy dividend paying stocks. The interest expense is tax deductible when you borrow to purchase an investment that has the potential to produce taxable income. Not only can the dividend income pay for most or all of the tax-deductible interest, dividends from Canadian companies are taxed less due to the dividend tax credit.
The lowest cost of borrowing is likely through a home equity line of credit, or HELOC, which can be obtained today at a rate between 3 and 4 percent. The investments would need to be held in a non-registered account in order to make the loan tax deductible, and to be eligible for the dividend tax credit. That means you can’t use this strategy in your RRSP or TFSA.
The dividend landlord opportunity was born after the financial crisis hit in 2008, when interest rates dropped so much that the average dividend payout of companies listed in the TSX became higher than the prime rate of borrowing.
Related: Is your investment loan tax deductible?
It’s now possible to be the owner and landlord of dividend paying stocks and have the dividend “rental income” cover the cost of borrowing to invest in them. One example shared in the book is that you could go to any of the banks, borrow the bank’s own money to buy its own stock, and have the dividend income more than cover the interest cost.
Benefits of becoming a dividend landlord
When you consider that the interest cost of borrowing is fully deductible and the dividend income is taxed less, many investors can be cash-flow positive even when their dividend income is less than their cost of borrowing.
By purchasing quality blue-chip stocks that you’d want to hold for the long term anyway, being a dividend landlord can be an effective no- or low-cash-flow strategy that is much less work than a rental property.
Related: Is it time to say goodbye to dividend investing?
The other benefit to this approach is that if you choose stocks in stable industries that have a history of increasing their dividends over time, your “rents” should go up automatically each year.
Downside to becoming a dividend landlord
Borrowing to invest comes with certain risks. Just as your gains can be magnified, so can your losses. The author also cautions investors that they’re almost guaranteed not to be cash-flow positive indefinitely. That’s because interest rates go up and down over time.
The strategy is designed to have the borrowing costs mostly or completely paid by the dividend income. Still, you should be able to comfortably handle the loan payments on your own, even with higher interest rates.
And just like you might have vacancies or tenants skipping out on rent, there may be times when a company might reduce or suspend its dividend. You have to be able to deal with those times.
There are also behavioral risks to consider. If you want to eventually be debt free and own the stocks outright, as with a rental property approach, you need to be careful with what happens with the additional cash flow generated by this strategy.
Related: How the behavior gap affects investor returns
For example, the tax savings from the interest expense deduction and the dividend tax credit should be used to cover the interest costs and pay down the amount you borrowed.
“If this cash flow disappears out the back door and is used for something else, it’s going to be tougher to retire the debt before you do.”
One last thing the author mentions with the dividend landlord strategy – and with any investment debt strategy – is that when you start can make a big difference. Starting your dividend landlord business when the stock market is down can significantly increase your profitability.
Final thoughts
I enjoyed reading The Smart Debt Coach – it explained strategies on how to use debt to increase your investment portfolio, and how to think in terms of before-tax and after-tax dollars in order to maximize your returns.
I’ve already used one of the strategies in the book when I used a top-up loan to boost my RRSP contributions. I like the concept of the dividend landlord approach – certainly better than being a traditional landlord – but I’m not too excited about starting while the stock market is at its current high level.
What are your thoughts on the dividend landlord approach?
