Renting: Explaining it Again For You
December 19th, 2011 by PotatoMOA: “I can’t see renting being better than owning long-term. I really can’t.”
I can understand that there is a lot of room for debate as to when exactly it’s better to rent than buy: there are a lot of factors to consider, and a lot of forecasting future rates or guesstimating costs. But it’s quite another when people don’t seem to understand that there is some point where that happens, as with MOA’s comment above. To try to explain it again I will say first remember that price matters.
If someone is willing to rent you a house for $1/mo, and that house costs $1,000,000 to buy, then it is overwhelmingly better to take the rental option: you can invest your million bucks in a savings account and make more than that in interest, and if you don’t have a million bucks, then even better: you don’t have to convince a bank to lend that to you, and incur the even higher interest costs. Conversely, if rent was $1000/mo, and the house was $36,000 to buy, then it would make sense to buy the house instead: you’d have it paid off in just a few years.
So the important concept is that there is going to be some cross-over point between those two extremes where rents and prices are such that it’s a break-even proposition for either choice. And beyond that point, there will be a set of prices so high and rents so low where it just doesn’t make sense to buy any more, long-term or not. Exactly where that cross-over point is depends on a lot of factors, like interest rates, how long you’ll stay, taxes, appreciation, maintenance, insurance, risk tolerance, etc., but there is that break-even point (and a regime where renting is better) somewhere.
For most of our history, we haven’t been on the other side of that line, so it seems hard to imagine: all our heuristics are geared towards a life where landlords make money and buying a house is a smart financial move. So yes, in most markets most of the time it’s better to be an owner if you’re in it for the long-term. But in Vancouver and Toronto, it’s not most of the time: we’ve crossed the line.
It’s tough to get people to grasp that concept sometimes when it’s just not in their everyday experience, even if it is at its core a simple concept. It’s like saying to people that somewhere above our heads, there’s no air to breathe. “That’s nuts,” they say “I can dig a hole and there’s air below here to breathe, and I can go up an elevator to the top of a building and there’s air to breathe. Now excuse me while I climb into my open-air rocket-ship.”
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December 19th, 2011 at 3:46 pm
Req: Real-world example with figures (yes, I believe you).
December 19th, 2011 at 7:36 pm
Sure, why not. This time, let’s go to lotus-la-la-land in Vancouver. This example was chosen partially at random: this was the first result of a Craigslist search for a 2-bedroom downtown apartment for rent in Vancouver.
Rental: $2400/mo for a 2-bedroom condo. Utilities not included, but does include a parking spot and a locker.
This was a “#1” unit, and the craigslist ad put the area at 884 sq ft. I’m going to link to a unit for sale in the same building but the MLS listing has the square footage as 942 sq ft. Before you accuse me of comparing apples-to-oranges, all the 2-bedroom #1 units I found on MLS for this building were ~940 sq ft, so I believe the Craigslist ad may be off (assuming that the floor plan is the same from floor to floor).
Purchase: nearly identical 2-bedroom condo, $699k asking price. Includes parking and locker.
How much does it cost to own? Using the quick metric of rent multiple, this is 291X rent. If you’ve been following along at home, you know this isn’t going to be pretty, but let’s look at it in detail:
Well, you need to make an assumption about interest rates. Let’s assume that our credit is good, and we can get a fixed-rate mortgage at the current discount rate of 3.2%, and that this rate will never change over the entire life of the mortgage. Let’s also assume that no matter how much we put down, this is a fair rate for the opportunity cost of our downpayment. That makes our interest/opportunity cost $22,368/year, or $1,864/mo.
The condo fee is listed in the MLS ad as $347/mo. To be very generous to the owning case again, let’s say that this never increases.
The property tax rate in Vancouver is approx. .4%, which works out to $233/mo.
So far we’re at $2400/mo to rent vs $2444/mo to own, and we haven’t even covered insurance, maintenance, or transaction fees. Let’s quickly assume insurance is another $25/mo, maintenance is $40/mo, and that transaction fees are 7%, but are only paid every 10 years ($408/mo). That brings the cost of owning up to — rounding — $2900/mo. So it’s $500/mo more to own basically the same apartment in Vancouver than to rent it, and this is with a very generous set of assumptions; were I actually planning on buying a condo in Vancouver, I’d be using some more conservative estimates of the costs of things before diving in (e.g., perhaps assuming a return to 6% interest rates in 5 years’ time). That leaves a lot of room for the much-feared rent increases.
And of course note that this is examining the costs but not the cash outlays: as an owner, you’d need to have even more cash flow to cover the mortgage, since there would also be principal repayment included (though not for amortized transaction costs or maintenance, at least not at first). And note that this also covered the “forced savings” or “building equity” aspect of owning — for this analysis, both owner and renter build equity at the same rate.
So what’s the elephant in the room? Price appreciation: I haven’t yet said anything about what the price of this condo will do. And to me, that’s the way it should be: purchasing should make sense even if prices remain flat. To do otherwise is to bring a speculative component into your home-buying decision.
How much appreciation do you need to see just to break even? Oh, not much at all with these assumptions: a lousy 0.9%/year. That’s an easy bar to hit, but remember how generous our other assumptions were? What if instead we searched just a little harder for apartments and got this identical one for $100 less?. Ok, it’s still less than inflation at 1.1%/year. What if interest rates go up a bit, or your credit wasn’t so hot, or you weren’t a good negotiator, and got the bank’s posted rate of 5.3% instead of the discount 3.2%? Now it costs $1741 more per month to own than rent, and you need your condo to appreciate 3.0%/year just to break even.
This is what we call “priced to perfection” — everything has to go perfectly for that price to make sense: condo fees have to stay low, interest rates have to stay not just low, but historically low, maintenance has to be low, you have to stick around for at least a decade, and the price has to go up steadily just to break even.
If you want, you can go to a more full-fledged calculator like the one at the New York Times to see what happens with factors changing over time, for example if rent also increases, or how long you need to stay put to break even, and what rate of appreciation will do it. Or build your own in a spreadsheet. Remember for that one in particular that we’re not American, so set the tax rate to 0% (we can’t deduct mortgage interest). Note also that I seem to have found a bug somewhere, as the answer changes depending on how much of a downpayment you have, which shouldn’t be the case with investment returns = mortgage interest. Anyway, the short answer from that is that with 3% inflation in maintenance fees, you still need 3% price appreciation even with rent increasing 2%/year to break even.
Now all this is indicating that in Vancouver there’s a certain speculative component to purchasing even for someone buying a place to live in for 10 years. It gets worse if the “typical” condo buyer only stays put for 3 years (as David Fleming says is the case for Toronto condo buyers), and let’s not even talk about being a landlord: were you to buy that unit and rent it out, you’d also have to build in a vacancy allowance, and in that case cashflow starts to matter much more.
So yes, with even modestly conservative assumptions, I think it’s easily possible that even for the long term it’s better to rent than to buy in certain markets like Vancouver. Especially when you also consider risks: the risk of rent skyrocketing is fairly low, while the risk of house prices falling (or even just stagnating) or interest rates rising is fairly high.
December 19th, 2011 at 8:20 pm
Ok, you want Toronto too? How about a tiny 3-bedroom bungalow walking distance to the subway? $2100/mo to rent, or $450,000 to buy (214X).
Interest/opportunity cost: $1200/mo at 3.2%; $1988/mo at 5.3%
Property tax: $300/mo
Maintenance: No handy condo fee to rely on, but then we also can’t be misled by the builder’s special introductory rate. $550/mo is probably a good estimate (~1.5%/year rule of thumb).
Transaction costs: Toronto has two LTTs, so let’s use 8.5% and again a 10-year timeline: $319/mo.
Insurance: now it’s a detached house, so insurance is a bit more, perhaps $100/mo.
So even though the multiple isn’t as bad as in Vancouver, this house is $369 more per month to own even at bargain basement rates, and $1157 more per month at a more normal rate (the current posted rate) — and that’s largely because property taxes are higher in Toronto, and the maintenance assumption for an old, detached bungalow is higher than a brand-new condo. Nonetheless, we get similar outcomes: for owning to break even, we need property prices to appreciate at 1.0% – 3.1% per year, and to have luck on our side in many other aspects of cost.
December 20th, 2011 at 11:24 am
Sure, but:
1) You picked up cities in which real estate is especially insane (London would be a different story for example);
2) At the end of your mortgage, you own a house, and you do not have any rent or mortgage to pay each month; whereas when you rent, sure you might have savings, but no house. Of course it is obvious, but I think it deserves to be stated one more time! ;-) So yes, it might be cheaper to rent than to buy, but we have to compare what is comparable: in one case, you get a house, in the other, you get the right to live in a house. Also, the independence of doing what the hell you want in your house is very satisfying as well, and it has no cost ;-)
3) The decision of rent/buy is also modulated by expectations and personal situations.
December 20th, 2011 at 12:45 pm
Hey Dr. J, thanks for stopping by! As to your comments:
1) Yes. But that’s the point: in most places, most of the time, it makes sense to buy. But Toronto is not most of the places, and now is not most of the time. Vancouver right now is not most places, most of the time — in these places it has gone insane as you say.
2) Again, that factor is zeroed out here. Principal payments are not included as a cost, so in this analysis at the end of your mortgage term (say 25 years), you would either own a house worth X, or an investment portfolio worth X (and could then buy a house for cash if you so chose). You could choose to make your mortgage interest-only, or to continually refinance to invest via the Smith Maneouvre, it doesn’t matter here. This is just looking at the costs, the money you will never get back: the interest, the taxes, the maintenance, etc. You can explicitly include that factor if you so choose, and I’ve done that in past exercises. There you’ll need a full spreadsheet rather than just plain text and a calculator, but I’ve made those available on my google docs:
Will I actually be paying my landlord’s mortgage? — there you’ll see that if you were the landlord in that situation, no, you wouldn’t have an end to the mortgage at all!
“Also, the independence of doing what the hell you want in your house is very satisfying as well, and it has no cost”
Ah, but it does have a cost! If it costs more to own than to buy, and if you’re assuming more risk, then that is the cost. Also, as I covered in a previous post, many people over-estimate how much freedom they actually need, and under-estimate how much freedom a tenant has (e.g.: you can paint the walls and hang pictures, you can negotiate with the landlord to install a dishwasher, you can put in a dimmer switch, you do have security of tenancy for most situations, etc.). And for condos, they may underestimate how much freedom they have (really little more than a tenant would have).
3) Of course! Some of those go into the model (e.g., how often you move), some of them are subjective, and you have to make a personal decision (I prefer to own, but is pride of ownership really worth a 6-figure expense?)
December 20th, 2011 at 4:24 pm
And here is the other spreadsheet breaking it down for you: comparing renting and saving the difference vs. owning, from an investment point of view. This time it does show the principal repayment, and building equity, and the building of an investment portfolio as a renter: and importantly that at today’s prices, you’ll have an investment portfolio that’s large enough to buy a house for cash if that’s still what you want after a few decades.
There are many assumptions: that is an unavoidable fact, but these should be pretty realistic. The outcome? You buy a house now at $450k, and even if the value goes up with inflation (no crash, no stagnation while we mean-revert), if you save the difference and invest at 7% (nominal), you’ll be far wealthier by renting at $2100/mo, even with rent going up every year. How much is “far”? Like 40% wealthier, like “hey, maybe my pride of ownership isn’t worth a couple of cars and vacations, or retiring years earlier.” better off. Far like “I’ve got a lot of leeway in my calculation here even if things are even better for the owners than forecast” far.
December 20th, 2011 at 8:30 pm
Just wanted to say great post. I’ve had the contrarian view on real estate for quite a while, and especially hate the “starter home” argument for why I should buy a dump to build equity. Never bothered doing that much math for it though. I’m in Victoria, where it is not quite as bad as Vancouver but still stupid expensive.
December 22nd, 2011 at 1:31 pm
Thanks Alex! You should see the updated, prettier spreadsheet by Matthew Gordon. At the time of posting there was a slight error in column Q, but column R is correct.