Emotion can cloud judgement on cottages

Vacation properties, such as cottages, are in high demand. Prices are skyrocketing, bringing healthy investment returns to those who have them, and with low-rate mortgages, buying a “little piece of heaven” has never been easier. But cottages also have an emotional value that clouds the judgment of normally rational investors, so advisors need to be extra vigilant in ensuring their clients understand the unforeseen costs of owning a second property.

Angus Reid recently released results of a national poll conducted on behalf of Mortgage Intelligence and GMAC Residential Funding of Canada. One in seven of the roughly 1,000 respondents currently owns a vacation property, while one in four Canadians intends to purchase one. This has the potential to send cottage demand soaring over the next two decades.

Already, cottage prices have been appreciating rapidly. A 2005 study by Statistics Canada found that outside of their principal residences, Canadians held $481 billion in real estate — almost double the value of that held just seven years earlier at $266 billion.

This upward trend has not gone unnoticed by lenders, says Mark Olkowski, regional business leader for mortgage broker Invis. Olkowski says that not long ago, a 35% down payment was the general rule of thumb to get a mortgage on a cottage. Escalating property prices has made lending to would-be cottagers more lucrative and has increased competition among mortgage lenders and insurers. This has made the vacation property market accessible to a whole new demographic of lower-income buyers who can finance a cottage, which in turn has further increased demand.

“In the past, the financing aspect of owning a vacation property was really quite difficult, whereas right now a property can be financed with as little as 5% down payment,” he says. “There have been more changes in the last six to 12 months in the mortgage industry than there have in the last 25 years.”

But just because clients can buy doesn’t mean they should. Olkowski notes that buyers need to ensure a cottage meets their long-term needs and should avoid impulsive buying.

Unfortunately, that’s not as easy as it sounds, says Hugh Smilestone, a Halifax-based CFP. Impulse too often trumps common sense. Smilestone has seen best-laid financial plans overhauled by clients not recognizing the costs associated with the purchase.

“Buying a cottage touches on every aspect of financial planning,” he says. “Often, those are the last things a buyer thinks about. They’re on vacation somewhere, they see this thing, and they say, ‘We must have it. Let’s go pull money out of our RRSP and go buy it.'”

Smilestone says that he’s seen older clients in particular ignore basic fundamentals such as how they are even going to pay for it. He’s had clients fall into this trap.

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“I had gone through a lot of retirement scenarios with this couple on their pensions, RRSPs, etc., and we had it all worked out,” he says. “Then, they were away on vacation out here in Nova Scotia, and it was a familiar story — they just fell in love with it, and the next person they called was me.”

Smilestone said he didn’t think it was a good idea and tried to explain that they were reducing their capacity to live well in retirement, but they chalked up his objections to being concerned about losing the assets he managed.

“That’s not the case, but clients don’t always see it that way. In that situation, it didn’t matter. I talked until I was blue in the face. They took all their non-RRSP money out, ate the capital gains and bought the property on the shore,” he says.

Smilestone says even prudent clients may not be prepared for some of the auxiliary costs. For example, insurance rates are very high on a cottage because they are unoccupied for most of the year. Buyers looking to flip a cottage as an investment have to be aware that as a secondary residence, capital gains will apply to the sale.

It’s in estate planning that cottages can prove to be a real nightmare. With sky-high appreciation, a cottage left in an estate could be hit by an astronomical capital gains tax, especially if the cottage was purchased decades ago.

“In Muskoka or out on the west coast, cottage properties have gone through the roof in value, some of them are worth millions of dollars, and these people might have bought them for $40,000 or $50,000.”

Smilestone says that it’s rarely a diminished estate that causes issues but rather the sentimental value that the beneficiaries attach to the family cottage. More than any other willed asset, a cottage can have a sentimental value that far exceeds its financial worth. It’s a rare case, he says, where siblings are rational or agree to share.

“The hardest thing to deal with is family cottages that are being passed down. Once the grieving process is over from Mom and Dad passing away, it’s unbelievable how quickly the situation deteriorates. People become very selfish, and it’s very difficult to share anything, let alone a cottage between siblings.”

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(05/23/07)

Mark Noble