Blessed by the Potato

In almost all of my rent-vs-buy comparisons I have the renters invest their capital and ongoing savings, including in my most recent one about the three year condo holding (Toronto Condos: Best Case Scenario). Note that the renters didn’t have to in that scenario: the buyers lost so much to frictional costs¹ and higher ongoing costs² in their short foray into condo life that the renters could have left their cash in a chequing account and still come out ahead. But I had them invest it anyway because that is what you’re supposed to do. It didn’t hurt that doing so helped hammer the point home, making the spread in outcomes so large that you could be especially generous to the buying case (e.g. assume they were prescient about their mortgage needs rather than acting like a typical buyer) and still conclude that renting for 3 years is hardly throwing your money away — it’s the opposite. But that’s not why I chose to: it’s my default recommendation and assumption.

On Twitter, @barrychoi questioned the assumption that the renters would invest their capital. I wondered why you wouldn’t, to which he replied: “for time purposes. Is it worth risking your money if you might need that cash soon?”

Here is the thing, “need” and “soon” mean different things when you’re talking about housing. There are a lot of rules of thumb out there, but the general idea is that equities are volatile, while providing high return expectations. So you should invest money for the long term in equities, but not money you might need in the short term because you could be hit with a market down-turn just as you’re about to take your money out and spend it. The rules of thumb say money you need in about 5 years, or 10 if you’re really conservative, should be in something safer.

This is trying to take a heuristic shortcut to risk tolerance, but risk tolerance is made up of many components. The ability to recover is a big part of it, and it’s closely related to the time you have on your hands, which is where these rules of thumb are derived from. They’re also influenced by the history of the stock market and how long it may take to recover from a typical crash. If your timeline is too short, you could get unlucky and be caught in a crash just as you need your money, and have to eat the loss.

But when you’re talking about buying a house your timeline is not generally short: in the example David Fleming provided that inspired the previous blog post, the couple had been in a condo for ~3 years, and was looking to rent a slightly larger condo for another year or two before buying. Close enough to the 5-year rule of thumb to go investing the capital. In general, at the very least you’ll be signing a lease for a year, with a likelihood of renewing and maybe even having another rental stage before ending in your “forever house.”

Even if you’re not a housing bear³ and are just renting for a few years to avoid the ruinous transaction fees or until your career settles down enough that you have some certainty you won’t be packing your bags for the other side of the continent, you’re going to have a few years to play with. Just because the rule-of-thumb is 5 years doesn’t mean you’re insane to invest with a planned 3 ahead of you. Because if you are unlucky, you don’t need to buy a house on August 15th, 2016 like your plan says — you won’t vanish into a cloud of pixie dust and parental disappointment if you still have a lease on Tuesday — you can chill and rent for a few more years if you need to. Plans can be fluid that way, and that kind of flexibility is what gives you the risk tolerance to invest in equities.

Your plans are not set in stone, and the ability to defer your purchase date adds to your risk tolerance.

Aside from not needing to buy on a certain date, you don’t need a specific, immutable downpayment. If you invest a $100k nest egg, you expect that, with a 6% return, you’ll have $126k after 4 years when it might be time to buy. It could be better than that⁴, or it could be worse; uncertainty is something to deal with rather than fear. If you are unlucky and in four year’s time there is a terrible correction and you’re down 25%, well, you just lost $25k and it stings, but it’s not going to ruin your life. You take the reasoned gamble that you’re more likely to be up money by investing in equities for the next few years — and that, in advance, you’re not sure whether “next few years” will turn out to be 3 or 10. In many scenarios you will be proven right and be better off. But even if you do lose that bet, it’s not like you can’t buy a house at all, you just have to settle for less house or more leverage. Your original $100k (plus accumulated savings) might be enough for 20% down on a $500k place, but if you come to the table with only $75k you can still buy a house — with CMHC you can even still buy the $500k one from your twentysomething dreams. The risk to your life plans is not that large: it’s not a life-altering risk you’re taking, but a manageable financial one.

If you’re a housing bear like me and have recognized that with crazy price-to-rent metrics it just makes more sense to rent, then you’ll be doing so for as long as it takes. Housing corrections take years to play out. And a housing bust is almost never a “V-shaped” event, where you only have a few weeks or months to swoop in on cheap prices: once the excess comes out (which itself will be a multi-year correction event even in a crash with numerous accelerating factors like in the US), the market will very likely stay in “fair value” range for a few years. As a bear you may be living in a rental house that would sell for⁵ $500k in today’s bubbly climate. One day, if prices make sense, you might like to own a similar house, but it’s 30% over-valued. So you rent, invest, and get on with your life. But if the conditions have changed so that it’s time to buy then that house has likely come down over $100k in price — you’d still be way ahead even if you were unlucky in equities and lost $25k of your downpayment. And, if you want, you can keep renting for another few years to see if equities recover, knowing the house likely won’t. And conditions might not change: in which case your “downpayment” fund is really your “retirement fund” in a soft-landing world for renters.

Of course you invest it if you’re a housing bear.

So when you’re talking housing, you generally have some long timescales to play with. Maybe not the 10+ years needed for the chance of a negative outcome to go to nearly zero, but enough that investing in equities is not some wild, undisciplined gamble. Even a 3-year holding period has something like an 80% chance of beating cash. I think too many people are too afraid of uncertainty, particularly young people who have a lot of ways to recover from loss at their disposal⁶. Risk tolerance comes from many sources: you can be flexible with your timelines if needed, or adjust your expectations/budget. And you need a downpayment, not the downpayment you started with — ending up unlucky and losing a portion of your downpayment is generally a survivable event.

My dad taught me at a young age that you only put in the stock market what you can afford to lose. But the market doesn’t go to zero even in a bad crash, and the amount you can afford to lose is generally not zero even when you’re house-horny. So with that in mind I take acceptable risks to try to invest my money in a way that maximizes my expected value.

Plus I know that the risk I’m taking as a renter with equity investments is way smaller than the risk a buyer in today’s market is taking (both financially as well as to my future lifestyle and mobility options).

1: Realtor commissions, CMHC premiums, mortgage break fees, and possibly land transfer taxes (or the burning the opportunity to use the first-time buyer exemption later on a more expensive property), legal fees, inspections, and the inevitable over-spend on customizing (or as is often the case for new condos, finishing the job the developer botched).
2: The higher monthly costs to own (condo fees, interest, property tax, etc) that add up to more than rent, a renter can save in this market.
3: Why are you not a housing bear? Have you seen my spreadsheets? You must live in Hamilton… or non-waterfront Gravenhurst.
4: Indeed, I was more confident being fully invested in 2009/2010 coming out of a huge crash — with the valuations and recovery it seemed unlikely that a second major crash would take us yet lower. If, as in the previous example, someone had listened to me then but with $100k they’d have hit the $125k mark in just three years. Also, I’ll add down here in the footnotes that if you’re close to the CMHC threshold then the potential gain of going over the 20% mark might provide an added incentive — though the downside is there as well.
5: I refuse to say “worth”.
6: Again those are dodge, dive, duck, dip, and dodge… er… Wait, it’s: defer, earn, save, change expectations, leverage, and run crying to mommy.