Everybody’s moving to Toronto it seems lately, and with that comes the inevitable realization that Toronto has a really high cost of living. What’s a cash-strapped recent grad to do? Rent, of course… which always (no matter how many times it’s debunked) brings about the lament that “renting is just throwing money away.”
Of course money is equally thrown away when buying: interest you pay the bank you’ll never see again, likewise property taxes, transaction fees, condo fees, and maintenance. That’s just the cost of putting a roof over your head. The question is, which option will give you the quality of life you want? If one costs less, or offers more freedom, or has fewer risks, or some compromise combination of those, then which you go for might not be all that simple.
I’ve mentioned before the rule-of-thumb that if a place costs more than 150X the monthly rent to buy, then you’re probably better off just renting that. Today as I was explaining this concept I realized it might be easier to understand in reverse:
So, let’s say that you have a place you want to buy. You get a mortgage that is for all intents and purposes approximately the same as the purchase price (that is to say, we’ll assume the opportunity cost on your downpayment is the same as your mortgage rate, or that 80% — or 95% if you’re a first-time buyer in today’s market — is close enough to 100% for our approximation). Every year that is going to cost you your mortgage rate: right now that might be ~3%, but it could easily go back up to 5-7% within just a few years, especially as the economy recovers and the low, stimulatory rates aren’t as necessary. Just look at how quickly the rates came down.
On top of that, you’ll have property taxes: roughly 0.8% in Toronto. A general rule of thumb is that maintenance and repairs will run about 1% per year (condo owners will likely have fewer repairs to pay for on their own unit, but instead will see this vanish as a condo fee; TANSTAAFL). So let’s say 1.8% per year from this stuff.
Real estate is not liquid, and you’ll likely have to pay an agent something like 5% when you move, and lawyers and the governments will take another 2% as well (especially in the Toronto land transfer tax area). If the average person moves around every 5-7 years, we’re looking at a little over 1% per year when we spread things out over the 5-7 years owning the place. Let’s call it 1.2% so that we sum up to an even 3% with the fees above.
A mortgage rate of 5% + 3% of other “throwing money away” costs is 8% per year. 8%/12 = 0.667% per month. If your rent is costing you 0.667% of the purchase price per month, it probably doesn’t matter whether you buy or rent, financially — flip that around and you’ll see that 1/0.00667 is 150, so that’s where the 150X monthly rent rule-of-thumb comes from. And of course that’s really the upper limit; if you instead take 7% as your average interest rate, plus 3% for the other costs, you’re looking at 120X monthly rent, which pretty much defines the “grey zone” where choosing to buy or rent basically hinges on how long you plan to live somewhere and what you anticipate the average interest rate to be (below 100X, and you’re generally staring at a decent investment that you can snatch up and rent out).
Surf MLS for a while and you’ll find that in Toronto places are selling for over 200X rent — go the other way now, 1/200 = .5% per month, or 6% per year is what the cost of shelter is. The only way that makes sense is if your mortgage is at <3%.
And rates are there… for now. And that explains why the housing market came back from the land of the zombies this spring. Things were crashing out as people finally hit the breaking point with the prices the way they were last fall, combined with the general financial panic. Then as rates hit bottom (and they are at bottom — there is no room left for rates to go lower; it’s only up from here) the affordability didn’t look so bad, so prices have been treading water the past few months, much to the dismay of bears such as myself. But I can’t bring myself to believe that prime rate will hover at just over 2% for more than a year; and buying is barely a breakeven proposition at these rates; much higher and we’re back to real estate being overvalued and due for a crash/correction, eventually.
So, what do I mean when I talk about the costs and quality of life? Well, I’m saying that when you look at the money that goes out the door and is lost completely, the cost of shelter, it’s a fairly significant sum — it is the largest component of pretty much every person’s budget. If a place that rents for $1500/mo sells for $300k right now, that’s just about break-even at an interest rate of 3%. At 5% for the mortgage (plus ~3% for your other lost expenses) that place will cost you $24000 per year to own — over six years, you’re looking at $144k down the drain. Not an insignificant amount of money by any stretch of the imagination, and not an implausible rate (in fact, you’d have to pay about that now to lock in for 5 years rather than play the variable rate game). The rent that’s gone will total $108k over those six years, still not easy for some people to accept, but that’s $36k that you’d have extra: you could get an apartment and a car, or just a condo. Housing and a $6k European vacation every year, or just housing. Throw the savings in your RRSP and retire 5 years sooner. This is enough money that it does affect your quality of life, so it’s a decision that should be made with all due diligence. Or, if you find your quality of life best improved by more housing, and you’re able to pay $144k over six years anyway then instead of renting a similar place, you can find a better one and afford to spend $1900/mo in your first year — enough to upgrade from a 1+den to a 2-bedroom with a second bathroom, or into a building with better amenities, or a better neighbourhood, etc.
Note especially that in this scenario the renter is building exactly as much equity as the owner since we haven’t considered the principal repayment portion of the mortgage to be an expense — that’s considered forced savings here (though again, “actually saving” is a better savings plan). Also remember that I am talking about apples-to-apples comparisons: with condos or townhouses I’m comparing as much as possible to the identical units within the same building.
Now, there are of course more “depending on…” factors. For example, people who buy, especially in my recent-graduate-and-fertile age bracket tend to buy more than they need for the immediate few years so they don’t have to move and waste the transaction fees. That is, they skip the “starter house” and go straight to their “forever house”, but have to pay more for that for the first few years when they don’t need the space (that is to say, if they did decide to rent, they’d rent a smaller place because the only cost of moving up in a rental is the stress, the truck rental, and possibly one month of rental overlap — fairly trivial compared to the direct costs and risks of being house poor by overreaching early on). In favour of the home buyer is the fact that the house price gets “locked in” (though IMHO, that’s not a good thing in this market), whereas the renter is subjected to the ~2% yearly increase in rents (although as my experience has shown, this is negotiable). Still, that’s a fairly minor factor: sapping just $360 of the $6k renters benefit in the second year, and up to $2k in the last year, which again is peanuts compared to the risk of interest rates spiking, having your condo levy a special consideration, or some other major repair. For people with poor financial discipline, the principal portion of the mortgage payments are a form of forced savings; for those who don’t need that structure, only paying the “lost” fees gives you freedom for those situations (job loss/paycut, emergency, etc) to not save if you need to use the money, i.e. it’s easier to manage your cashflow, and you can expect a higher return on those savings to boot.
One peculiar trait that I find baffling is that people who are seemingly allergic to debt and leverage seem to not give a second-thought to leveraging up to 95% on an illiquid asset that then in many cases also becomes their only asset (talk about under-diversification!). Indeed, the run-up in prices over the last few years has been fuelled by increasing amounts of leverage (due in no small part to the relaxing of minimum down payments and increasing amortization times). With great leverage comes great sensitivity to interest rates, so listen well to the words of Carney:
“…over time, things will normalize – interest rates will normalize. And the way to think about managing your personal affairs, I would submit, is can I borrow at what would be a normal rate?” Carney said.
Instead of first-time buyers soberly pondering that question after a good night’s sleep, a hot cup of tea, and a spreadsheet, we get people desperately buying something so that they can “take advantage of historic affordability”. Indeed, it is truly baffling how little independent thought people put into the biggest decision of their lives.
Finally, as was pointed out in the RL discussion that prompted this post, nowhere have I mentioned “property appreciation”. And that’s for the simple reason that if you need to rely on the housing market going up at some ridiculous rate (or I should say, continue going up at some ridiculous rate) just to make your purchase make sense, then you are speculating. Plus, while people seem to think housing prices going up is a good thing (and I suppose for buyers it is better than the alternative), what do you do then? Once prices go up do you sell your home and start renting to realize the gains? It seems that while people want to buy something to get in on the boom, they haven’t really thought through what might happen if they’re right: “I’m like a dog chasing cars, I wouldn’t know what to do with one if I caught it!”. Even less do they consider what might happen if they’re wrong: just look at the rest of the world, or even Toronto’s market during the meltdown last fall: housing prices do not always go up. What happens if they go down and you find yourself needing to sell? You’re a typical Torontonian first-time buyer, so you only scrapped together 5% down, and after a few years of living in your house you have maybe 10% equity — the bank owns the other 90%, and unlike in the US there is no jingle mail, you have to service your debts. But, a small made-in-Canada correction has occurred: only a 10% decline in house prices, nothing like what the subprime meltdown in the States was like… but now you have no equity left; no downpayment to buy your next place, yet your psychological biases may nevertheless prevent you from “selling at a loss”. Since you “locked in” your price when things were high, you can’t even just hold on to the place and rent it out, since you’ll be losing money every month (especially when you consider that beyond the “thrown away” money in the above comparison, as a landlord you need to add a vacancy provision, etc.). It’s not a happy scenario… where’s the downside protection?
So now you get to the bottom of this giant rant and you ask yourself: “Why is Potato ranting about this again? He’s made his point very clearly before, how is just working at the valuation in reverse worth a new 1500-word post?” The answer is two-fold: first, as I explained at the top, I was trying to dispell the “throwing your money away” myth with a co-worker, and found the bottom-up rates approach to be a little clearer and help show where the 150X rule-of-thumb came from. The second is that this morning Wayfare sent me a dozen links to Toronto houses. I’m about a year away from finishing my PhD: we are in no position to buy a house — even it was fairly valued — and yet the grip of housing mania, the emotionality of the whole thing is so surreal that I can’t even convince my own wife of the truth of this. Fortunately, with her being self-employed, and myself being a grad student (and I’ll have no job history when we first move back to Toronto even if I do manage to land a job right away), no lender in their right mind will give us the mortgage to hang ourselves with… but I try very hard to not depend on the rationality of 3rd parties to keep myself out of trouble; after all, while lending standards have tightened up a bit recently, lenders still don’t have a reputation for being terribly rational this decade. Still, it’s hard to fight decades of indoctrination and tradition that buying a house — no matter the cost — is just something you do when you get married and graduate. Like putting on funny hats and having old men in colourful robs hood you, it’s just a tradition that may not make any sense, but you do it anyway because that’s what society expects of you. Of course, the one graduation tradition is a lot less costly than the other.