Pretty dramatic headline. I mentioned in a previous post that I would be doing something to minimize my exposure to the Edmonton housing market. I have already slowed down the pace of making extra mortgage payments in favour of investing in my RSP and TFSA. The only reason I post this publicly is because I wanted to allow for feedback and experiences to help be get a better understanding of what can go wrong.
I have decided to try the Smith Manoeuvre. It is really risky if you don’t understand the potential outcomes to your thesis. What I am essentially doing is borrowing against my house to invest. It is really a function of cost to borrow vs. total return. Right now the cost to borrow is 3.5% FOR NOW. We all now that it will move up. If I invest in a Canadian dividend paying company that pays a 3.5% dividend then I will have enough dividend income to cover my interest expense. This factors in tax deduction on the interest expense as well as the dividend tax credit at my marginal tax rate (36%).
Though this sounds simple enough, there are huge risks to employing leverage. For one thing my cost of borrowing can (and most certainly will) go up. I could also buy at a market top and suffer a significant decrease in my holdings paper value.
The biggest advantage I have is that my outstanding mortgage is only 20% of the appraised value of my house. Secondly the household income will cover the outstanding mortgage balance more than 2x in one year. A rise in interest rates won’t affect my debt load too much.
I have the following rules for my Smith Manoeuvre:
- Outstanding balance will remain small relative to money that can be readily accessed (liquid securities).
- Negative net value (LOC – securities) will not be allowed for more than a few months. If I have to stop putting money in an RSP and pay down some HELOC balance, then I will.
- Dividend yields must be 4% or larger.
- Companies must employ minimum debt and have a history of raising dividends.
- An assumption that borrowing costs will be 5% in 3 years has be factored in to the model.
- All purchases will be tracked against an index to monitor the author’s ability to pick stocks. The Smith Manoeuvre stocks will the their own separate portfolio that will be different from the “growth” names and bench marked accordingly.
I only plan on doing this while it makes sense. I doubt that it will make sense to do this for more than a few years. I have essentially planned a 4 year timeline where dividend income covers interest expense and I get the capital appreciation as a bonus.
I have read a ton of blogs (like this one) and articles on the fallacies of this type of investment. From what I can figure, most people lose on this investment because they bet the farm on it. They get a 350k house, it goes up and then they maximize leverage at the wrong part of the cycle. Then they panic and sell at the worst time.
There are 2 things that give me confidence in this decision.
1) I feel that a methodical approach to picking stocks will give me enough margin of safety to employ this strategy.
2) I haven’t changed my lifestyle even though my income has risen dramatically over the last 5 years. I mean value investing doesn’t just happen in the stock market. It transcends into the rest of your life.
Any feedback is welcome.