Laneway Houses – A bad Investment for Most

Due to mass immigration and sanctuary city policies in major Canadian cities, demand for housing has increased. Municipal governments have changed development policies to promote intensification of use of land in the hope the demand can be addressed by increased supply.

One approach advertised to small property owners is the opportunity to construct laneway houses on their land. Proponents argue that the addition of a second house on a property increases property value and provides a rental income stream to the owner.

However, analysis of the costs associated with laneway house development suggests most homeowners should not be lured into building one.

From the vantage point of resale value, many prospective home buyers do not want to be landlords for tenants living on their primary property. Aside from reduced privacy, loss of storage space, potentially the loss of a parking space, there is the legal and financial risk that tenancy entails in general. Hence the market for properties that have both a primary house and a laneway house is a significantly smaller one, and so the marginal increase in the property value due to intensification might actually be a fraction of the cost of building a laneway house.

From the vantage point of generating an income stream, it is likely that most homeowners who contemplate this are of limited financial means. Furthermore, a homeowner who has a good job would not benefit much from a modest increase in income since most of that would be garnished by income taxes.

Since a homeowner who would like the income stream does not have much income, it is likely they would have to finance the project with a mortgage. Most homeowners do not have the ability to build or manage the construction themselves, so they would likely hire a contractor of firm specializing in such builds.

Currently, the cost for new turn-key construction is very high. A small 500 sq ft laneway house will likely cost at least $300K. Given the limited size, rental income is limited to about $18-24K annually, not including costs. Assuming 15% of the income is consumed by operating cost or incidental costs, rental income is capped at around $20K. Rent increases may be reasonable limited to around 2% annually in line with inflation.

Assuming the project is fully financed with a 5% mortgage and all positive cash flow is used to pay down mortgage debt, the payback period is in excess of 20 years. That is 20 years of no income, living on a property impaired by intensified use by a tenant.

To math is simple enough to derive. Let $n$ refer to the year, $P_n$ be the principal amount at year $n$ , let $r$ be the mortgage rate, $\beta$ be the annual rent increase rate, and $\alpha$ be the initial rental cost. Then

$P_n = (1+r)P_{n-1} - \alpha (1+\beta)^{n-1}$

and so

$P_n = (1+r)\left( (1+r) P_{n-2} - \alpha (1+\beta)^{n-2} \right) - \alpha (1+\beta)^{n-1}$

$P_n = (1+r)^2 P_{n-2} -\alpha \left( (1+r)(1+\beta)^{n-2} + (1+\beta)^{n-1} \right)$

$P_n = (1+r)^n P_0 - \alpha \sum_{i=0..n-1} (1+r)^{i} (1+\beta)^{n-1-i}$

$\frac{P_n}{(1+\beta)^{n}} = \left( \frac{1+r}{1+\beta} \right)^{n} P_0-\frac{\alpha}{1+\beta} \sum_{i=0..n-1} \left( \frac{1+r}{1+\beta}\right)^i$

$\frac{P_n}{(1+\beta)^{n}} = \left( \frac{1+r}{1+\beta} \right)^{n} P_0 - \frac{\alpha}{1+\beta} \frac{\left( \frac{1+r}{1+\beta}\right)^n - 1 }{\left( \frac{1+r}{1+\beta}\right) - 1}$

$\frac{P_n}{(1+\beta)^{n}} = \left( \frac{1+r}{1+\beta} \right)^{n} P_0 -\frac{\alpha}{r - \beta} \left( \left( \frac{1+r}{1+\beta}\right)^n - 1 \right)$

$\frac{P_n}{(1+\beta)^{n}} = \frac{\alpha}{r - \beta} -\left( \frac{1+r}{1+\beta} \right)^{n} \left( \frac{\alpha}{r - \beta} - P_0 \right)$

The RHS is decreasing when $\frac{\alpha}{r - \beta} > P_0$ and is equal to zero when

$n = \frac{\ln\left( 1 - \frac{P_0}{\frac{\alpha}{r-\beta}}\right)}{\ln \left( \frac{1+r}{1+\beta} \right)}$

For the situation described, the smallest positive integer for which the loan principal is not positive $n = 22$ . If the construction cost is reduced to $P_0 = 90K$ , then the project is paid off in five years and the income stream becomes an annuity. Assuming the income is discounted at an interest rate $r$ , the present value of the income stream is

$(1+r)^n Q = \sum_{i=1..} \alpha (1+\beta)^{i-1} (1+r)^{-i}$

$(1+r)^n Q = \alpha (1+r)^{-1} \sum_{i =1..} \left( \frac{1+r}{1+\beta} \right)^{-(i-1)} = \alpha (1+r)^{-1} \frac{1}{\frac{1+r}{1+\beta} - 1} = \frac{\frac{\alpha}{r-\beta}}{\frac{1+r}{1+\beta}}$ .

In this case, $Q = \$432K$ . A large return is possible only if the income-generating potential occurs early enough. However this is only possible if the builder is the homeowner and use of expensive tradesmen is kept to a minimum.

Laneway Houses – A bad Investment for Most

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