Benjamin Felix is a portfolio manager with PWL Capital in Ottawa.
I bet that almost every millennial in Canada has heard from their parents that renting a home is throwing money away, and they need to buy as soon as possible. I have good news. Renting is not throwing money away, at least not any more than owning is.
To make a fair comparison between renting and owning we need to compare the unrecoverable costs of each option.
Rent is an unrecoverable cost. You pay for a roof over your head, but you are not building any equity. That is easy to understand; I think that’s why it’s easy to get stressed about it.
But owning a home has unrecoverable costs that most people don’t think about. This is what makes renting look like an obviously bad financial decision. In reality, owning can have higher unrecoverable costs than renting.
The unrecoverable costs for an owner are property tax, maintenance costs, and the cost of capital. Property taxes and maintenance costs are pretty easy to see. They can generally be estimated each at 1 per cent of the value of the home per year. The cost of capital is harder to understand.
When you take out a mortgage, you are paying interest. Interest is the cost of borrowing someone else’s money to buy a home. That part is easy to see.
But when you make a down payment, or build up home equity, you are taking money that could have been invested in the stock market and using it to buy a real estate asset. Stocks have higher expected returns than real estate, which means that there is an opportunity cost on the equity that you have in your home. This is one of the most important unrecoverable costs for a homeowner to grasp.
Understanding the opportunity cost of equity means taking a bit of a history lesson on the returns of stocks, bonds, and real estate.
Estimating expected returns
One of the simplest ways to estimate expected returns is using historical returns. The Credit Suisse Global Investment Returns Yearbook offers data for stocks, bonds, and real estate from 1900 through 2017. Over that period, the global return for real estate was 1.3 per cent after inflation, while stocks returned 5 per cent after inflation, and bonds returned 1.9 per cent. If we assume inflation at 1.7 per cent, then we would be thinking about a 3-per-cent historical return for real estate, a 6.7-per-cent return for global stocks, and a 3.6-per-cent return for global bonds.
To keep the numbers simple, and to be conservative on the stock and bond returns, we will use a 3-per-cent expected future return for real estate, a 6-per-cent expected return for stocks, and a 3-per-cent expected return for bonds.
The opportunity cost of home equity
The opportunity cost will depend on how aggressive your portfolio is. A portfolio of 100-per-cent stocks, for example, will result in a higher opportunity cost. This is an interesting point: It is more expensive to have equity in your home if you are an aggressive investor. For the rest of the example, I will assume that we are 100-per-cent equity investors. A more conservative investor would have a lower cost of equity capital.
The 5-per-cent rule
If we assume that you have paid for your $500,000 house in cash - no mortgage – your opportunity cost on the equity in the home would be $15,000 per year. That is a 3-per-cent opportunity cost because you are earning 3 per cent on your real estate instead of 6 per cent in stocks.
Add to that the unrecoverable costs of property taxes and maintenance costs (1 per cent each a year), and we land on 5 per cent of the home value in total annual unrecoverable costs. This is the number that we want to compare to rent.
So for a $500,000 home, we would have $25,000 in total unrecoverable costs as a homeowner. That $25,000 annually works out to $2,083 per month.
If you can rent for $2,083 per month or less, then renting is going to cost you less in total unrecoverable costs than owning. This can be used as a decision tool when you are making the housing decision. If you are looking at buying a house, renting for 5 per cent or less of the price of the home would be a perfectly sound decision from a financial perspective.
The big assumption here is that as a renter you will take the $500,000 and invest it in stocks.
The magic of borrowed money
While it may seem counter-intuitive, the best thing that the owner has going for them is mortgage debt. When you borrow money from the bank, you are renting that money, but you are also getting an asset. Say you put 20 per cent down – $100,000 on the $500,000 home.
You have a cost of equity capital on the $100,000, but the remaining $400,000 is financed. If the mortgage debt is costing you 3 per cent and the real estate asset is growing at 3 per cent, you do not have any net unrecoverable costs on the financed portion of the home. This could change if mortgage interest rates rise above the expected return of real estate.
The underlying math is not as elegant when the mortgage is introduced, but the 5-per-cent rule still holds up. Even though the mortgage is reducing your unrecoverable costs early on, it is also creating a large cash-flow expense, the mortgage payment, in addition to the estimated 1 per cent in property taxes and 1 per cent in maintenance costs, which are also assumed to be cash-flow expenses. Owners also have meaningfully higher property insurance costs.
The renter would have lower cash-flow expenses than the owner, so they could save more aggressively into their investments. Again, we are relying on the assumption that the renter will be a diligent saver and an aggressive investor to make the 5-per-cent rule work.
Sweating the details*
There is no question that the 5 per cent rule is a somewhat simple overview of a complex financial decision. Two elements that may add complexity to the calculation of expected portfolio returns are taxes and asset mix.
The 5 per cent rule might be a good approximation for an aggressive investor with available RRSP and TFSA room, but a 6 per cent pre-tax return could be closer to a 4.5 per cent after-tax return for a taxable investor with a high tax rate. Considering that a principal residence accrues tax-free gains, tax reduces the opportunity cost of capital for a taxable investor.
Similarly, our 6 per cent return assumption is based on a 100 per cent equity portfolio. A less aggressive investor would use a correspondingly lower expected return. The concept of the 5 per cent rule still applies, but the number may be lower depending on these factors.
A conservative investor with a high tax rate might be using the 3 per cent rule. Whether it’s 5 per cent, 3 per cent, or some other number, thinking about the rent versus buy decision in the context of unrecoverable costs is a powerful tool.
Have you ever felt the financial pressure to buy? Did this change your view? Tell me about it in the comments.
*This article has been updated with a brief look of how taxes and asset mix impact the rent versus buy dilemma.