An RRSP is not legally allowed to own a piece of real estate directly. However, an RRSP is able to lend money secured on title by a mortgage on a property. This is really no different than the banks lending money as a mortgage on a property and, in fact, they compete very aggressively to do so because of the security of this investment. There is a reason the banks typically provide very low interest rates on mortgages, because they know mortgage lending can be a very safe and secure long term investment when it’s done correctly.
Let’s introduce a topic many Canadians likely have never heard of - arms length mortgages. This is a type of mortgage that can be held within your RRSP mortgage account, to lend money on a specific property that you are considered ‘arms length’ to, or have no direct ownership in the property through blood, marriage or adoption. The income tax act has very specific rules around the definition of ‘arms length’ and the mortgage must be structured according to these rules to ensure that there are no tax implications. Once you find a property (for example, if you are a lender) or if you have a property that you want to find an RRSP mortgage for (as a real estate investor), then it is a relatively easy process to set it up.
First, an investor must open a self directed RRSP mortgage account and transfer the funds from their existing RRSP into this account. This does not trigger any tax and is simply a transfer of funds, similar to opening up a new savings account at another bank and moving your money over to this new account. Not all banks that offer self-directed accounts allow investors to hold a mortgage-based investment, so you will have to find a trustee that allows this type of plan.
Now, the investor becomes a de facto bank, and holds a mortgage on a specific property for another investor. The investor has complete control on the investment selection, direction, terms and return on investment of the funds they have available within their self directed RRSP mortgage account.
The RRSP mortgage is basically a ‘private mortgage’ that is agreed upon between two parties, so it is up to the lender or RRSP holder to do their own due diligence on both the borrower and property that they plan to lend on. Some key factors are the track record of the property owner, whether it is a rental property or personal residence, the rental income, and most importantly, the Loan to Value or LTV, which is the property value less the total mortgage balance.
Loan to Value (LTV)
RRSP mortgages can be placed on the property in a first, second or even third position, which is simply the order that the mortgages are paid off when the property is sold or went into foreclosure. Many RRSP mortgages are loaned in the second position,’ which means it is secured after the first mortgage financing on the title of the property. This is why the total LTV of all mortgage balances must be adhered to as this is your largest factor of risk. A high LTV can indicate high risk, while a low LTV can indicate a low risk investment.
Typically, the higher the LTV, the higher the potential returns for the RRSP lender and therefore the higher the interest rate for the borrower. It is not uncommon to see interest rates or the rate of return in the range of 10% to 15%. Again, this is completely negotiated by the RRSP lender and borrower.
A good rule of thumb is to never exceed 85% LTV (total of all mortgages on the property).
One might ask why anyone would pay 10% to 15% interest rates when prime is currently at 2.5%. The simple answer is that some investors are willing to pay such high interest rates due to the fact that this equity is sometimes untouchable under current bank lending rules and criteria, and the fact that sophisticated investors know they can utilize this equity to reap even higher returns by using it to buy more real estate. Many banks also have caps or limits in place and will not let real estate investors exceed these lending limits. Because of this, it is sometimes necessary for investors to seek private funding from sources such as RRSP holders in order to further expand their real estate portfolio or make improvements to existing properties.
The borrower (Mortgagor)
Importantly, the RRSP trustee or planholder in no way reviews the merits of your investment. They simply hold your RRSP funds and it is up to you as the investor to ensure it is a good investment.
So, it’s critical you take the time to properly review the property and the borrower.
When it comes to assessing a property, for the first few deals it may be preferable that a person work with an experienced party that is knowledgeable about all aspects of the process. Some mortgage brokers can assist with this process, but it is buyer beware as mortgage brokers get paid their commissions on arranging the financing whether the deal is profitable or not. It is likely best to work with someone who can review the first few proposals. An experienced lawyer that specializes in real estate, and preferably RRSP mortgages is a key part of the team as well.
Another factor to consider is the track record of the borrower, including credit rating, income, stability, job status and credit history. With regards to the investment property, it is a good idea to verify the first mortgage details (term, payments, interest rate), as well as all other income expenses related to the property (property taxes, utilities, lease agreements, insurance). Based on the numbers, ask yourself whether the property still cash flows after all debt service payments and expenses. If not, how capable is the borrower in covering the payments?
In the event that the borrower defaults, the lender should consult a lawyer right away. If the payments remained in default, the property would eventually enter into foreclosure and then it goes to the courts to work out who gets paid what. This is where the LTV is very important, as the RRSP holder needs enough equity in the property to cover off not only the repayment of the loan, but any legal fees associated with the foreclosure process. This whole process can take some time, about three months or more, before you can get your money back.