A Canadian's random thoughts on personal finance

Apr 28, 2010

Financial independence without home ownership?

As Jonathan Chevreau says in his recent column: "a paid-for home is the foundation of financial independence". Or is it? Happily, this serves as the perfect lead-in to what is becoming a tradition for me: my annual rant on the topic of renting versus buying your home.

I rent. I always have, and unless something changes dramatically in the world of real estate, I always will. When it comes to the purely financial side of home ownership, the numbers just don't add up in Toronto, nor in most of the major Canadian cities. I rent because it saves me money.

It all comes down to the fair value of a house. If actual houses cost less, buying makes financial sense; otherwise, you'll save money by renting.

Real estate as an investment

Historically, real estate values just keep pace with inflation, making it equivalent to real return bonds, but with lower liquidity. This makes real estate one of the worst possible investments if you're looking for capital appreciation.

So why do people invest in real estate? There are two reasons.

First, just as bonds have their interest payments, real estate can generate cash flow. In the case of your own home, you do not actually see any positive cash flow, but you do get to avoid a negative cash flow in that you're not paying rent.

Second, real estate makes good collateral for a bank loan. Residential mortgages have among the lowest interest rates available to individual investors. That interest is not tax-deductible in Canada, and the idea of losing your home for defaulting on a loan is not a pleasant thought. Nonetheless, a mortgage is still a relatively attractive borrowing proposition.

Cash flow

Consider the 4% rule. It states that if you were to invest an amount equal to 25 years' rent in stocks and bonds, you could safely withdraw enough per year to pay your rent. Thus, no house is worth more than 25 years' rent. If your house can fetch a price worth more than 25 years' rent, you should sell your house, rent it back from the buyer, and pocket the difference!

The cash flows for owning one's home take three forms:
  1. one large negative cash flow for buying the house;
  2. recurring negative cash flows for mortgage interest, property taxes, and maintenance; and
  3. one large positive cash flow for selling the house.
Because real estate values can be expected to track inflation, the net present value of cash flows #1 and #3 cancel, leaving #2. (For simplicity, I'll ignore transaction costs and moving costs.)

The recurring cash flows for home ownership are entirely negative, as they are for renting. In any given month, if renting saves money, we should be renting, since it would be more efficient to wait a month and use the money saved to increase the downpayment on an eventual house purchase.

Let's compute the break-even point between renting and buying.

For buying, most annual expenses depend on the value of the property. There are other expenses that depend on the house size, but to keep things simple, I'll express these too as a percentage of the property value.

Roughly speaking, house owners must pay the following costs that renters don't (mostly because they already included in rent):
  • 2% mortgage interest. (We don't include the equity portion of the mortgage payment because that money has no impact on net worth.)
  • 0.5% building insurance. (We don't include insurance on contents because renters must pay that too.)
  • 1% property tax.
  • 1% repairs and maintenance.
  • 0.5% additional utilities.

At 5%, the house is costing you an amount equal to its value every 20 years.  This means if you buy a house with a mortgage worth more than 20 years' rent, you will waste money every month relative to renting. 20 years' rent in my current apartment is about $310,000. In my Toronto suburb, that means if I don't mind settling for a semidetached fixer-upper, and I have a decent downpayment, and I don't anticipate any increases in mortgage interest rates any time soon, I would save money each month by buying a house.

So why not buy a house then?

Because interest rates will not be this low forever. If you have a variable-rate mortgage, and rates increase, suddenly renting starts to look pretty good again.

Suppose rates increase by 3% to a more normal (yet still historically very low) 5%.  This brings the break-even mortgage to 12.5 years' rent, or under $200k in my case, which would price me out of the housing market in my area.

Ok, suppose instead we lock in at the current low rates by getting a fixed-rate mortgage. Guess what? The banks have thought of this. 5-year fixed-rate mortgages are going for right around 5% right now. This represents the same 3% increase we just considered a moment ago. No luck there.

All right, perhaps we can get a smaller condo instead of a house. Sorry, no luck there either: typical condo fees are also about 3% of the condo's value.

Any way you look at it, a realistic break-even mortgage is closer to 12 years' rent than 20.

But hey, you don't rent a house! You're comparing apples to oranges!

True. I rent a two-bedroom townhouse. Isn't it unfair to compare the rent on my apartment with the cost of a house, when the latter is much larger? Shouldn't I be using the rent on an equivalent house in my calculations?

No. Here's why.

Consider this: suppose you were evaluating the cost of a car. If you don't own a car, you still need to get around, so to be fair you will have to calculate the cost of public transit, taxi rides, and the occasional car rental. But you do not need to calculate the cost of permanently renting an equivalent car. That option is not relevant unless you are seriously considering doing it! Most people without a car are content to take public transit and taxis.

Likewise, I'm content in the apartment I have. It's not my fault nobody will sell me a house this small anymore (though such houses were commonplace just a few decades ago). If they did, I could do a direct comparison, but they won't, so I must compare the options available to me. Apples-to-oranges is the way toward a rational decision.

Among the options available to me, renting is financially the winner, hands down. If someone gave me a house for free, I'd sell it and move back here.


Ethan said...

I'm not quite sure how to fit this into your calculations, but what about the fact that you are locking in your housing costs? Consider the case of a 30-year, 300k mortgage. In year 1 the monthly cost might be $1,800. That might not compare favorably to renting. But in year 20 the monthly cost is still $1,800, even though the buying power of $1,800 has diminished considerably (say to $1,000). Rent will have increased with inflation, so renters will be paying $3,240 (still $1,800 buying power).

I think this demonstrates a couple of things. First, owning a home can be an important part of the plan for anyone living on a fixed income that does not increase with inflation (duh). Second, whether you consider it as a discount to the interest rate of a mortgage or as something else, there seems to be a large chunk of buying power that homeowners (even with a mortgage) are tapping into that hasn't been fully appreciated in your comparison.

And also, as you point out, once you have paid off the house then it allows you to avoid a large negative cash flow. Whether you do that with the money you've saved by renting or with a portion of your mortgage payment each month, it wouldn't make sense to NOT do it. This is one reason why I take the "forced savings" argument for homeownership very seriously. How many people will ever own their own home if they don't buy with a mortgage? I think very few, even if they could technically get there even sooner by renting and saving the difference.

What are you thoughts?

Potato said...

Patrick, I could quibble on a few points* since I've done enough iterations of the buy vs rent post myself, but I have to agree with the overall conclusion.

* - ok, let's quibble! First up, I like to use an apples-to-apples comparison as much as possible. I consider it a bonus that when renting you don't have to get a place with the space you'll need in 5 years time, but just enough for what you need now. But people recognize that it's not all that useful to say that renting is better because it's cheaper to rent a 2-bedroom apartment than a 4-bedroom house. Especially with so many people looking at buying little 1-bedroom condos, the apples-to-apples is important.

Similarly, I don't bother including the utilities, in part because I had to pay full utilities for my last 2 rentals, so it would have been a wash whether we owned or rented; if they're included in the rent, I try to estimate them and back them out of the rent to get a "purer" comparison.

My final quibble is that transaction costs are significant: with realtor commissions, closing costs, and Toronto and Ontario land transfer taxes, it can cost up to 10% to sell a house in Toronto. If the average person is moving every 5-10 years, that's as significant a cost as maintenance or property taxes.

Ethan: in the general case, locking in your housing costs is a good thing. However, housing costs are so high now that it's a bad thing.

Plus, with rent control in Ontario, your costs are more certain as a renter than as a homeowner: insurance premiums are reportedly up double digits this year, and maintenance may average out to 1% per year, but it comes in very large, discrete, expensive chunks. It may be better to have the certainty of a monthly rent payment that you can forecast out even several years in advance. If you have to get a mortgage, then you definitely lock in your housing costs better as a renter, since a very large part of your housing costs become highly interest-rate sensitive.

For the case of someone on a fixed income and a house owned outright, it depends on what the rent is vs. what you think you can make on your money if you invest it. If the rental yield in Toronto is about 6% right now (i.e., a $300k house would rent for $18k/yr), then you need to make about 5% on your money for it to make sense to sell and invest (since ~2.5% of the costs will have to be covered by whatever other income you have even if you own the house and have no mortgage). That would cover the rental costs with enough left over to grow your capital base to cover inflation as well. I don't think 5% is the slightest bit unrealistic, so to me it would make more sense to rent and invest than own right now...

But, there is the valid point that many people are not good with money. If someone needs the forced savings of mortgage payments (which to put it another way, means that they are so bad with money that they only way they can save is if threatened with homelessness) in order to save, or isn't good at investing (e.g., if they need an advisor who takes 2% off the top and turns their 5% return into 3%), then owning their shelter can make sense.

But I'm not that person, so I rent!

Patrick said...

@Ethan: You're right, locking in the costs is an important difference I have neglected. To a first approximation, I've always figured I only need to look at next month, because if renting beats buying that month, I should rent and build my downpayment. However, in the long run, I think that reasoning may fall apart under some circumstances. Perhaps I can look at this more closely in a future post.

@Potato: I agree with your quibbles. I'm admittedly a bit cavalier about neglecting extra factors that weigh against buying a house, given that I always end up concluding that renting is better anyway.

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