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.