Jul 16, 2018

The Case for Renting a Home – Part 1

Canadians really like real estate. It’s hard not to be excited when prices in hot markets like Toronto and Vancouver have been making global headlines. Around two-thirds of Canadians own their home, and the perception is generally held that owning your home is a smart investment.

Many Canadians feel that they need to buy a home as soon as possible because they are throwing their money away by renting. I’m sure you have heard the line that renting is “paying someone else’s mortgage.” On the surface this seems to make sense, but there are some important factors that need to be considered.

In this episode of Common Sense Investing, I’m going to tell you why renting a place to live is not a waste of money.

Let’s think about the benefits that renting has over owning.

If there is a possibility that you could move within ten years of purchasing a home, you are taking on enormous risk. It is true that over the long-term real estate tends to go up in value, but in the short-term, its value can go up or down unexpectedly. Combine this price risk with the fact that most people borrow a significant portion of the money needed to buy their home, and ownership gets pretty risky for anyone with a short or uncertain time horizon.

A renter is paying a set cost in exchange for a place to live. Explicitly knowing the cost of your housing has its advantages, and the predictable monthly expense is useful in planning your finances. A homeowner can easily plan for their mortgage payment and property tax, but they may also have expensive maintenance costs that appear unexpectedly. These unexpected costs may result in the need to borrow money, or the need to carry a large cash reserve – both inefficient uses of capital.

Owners get sucked into the idea that their home is an investment. Based on this thinking, they will often spend heavily on renovation or maintenance projects on the premise that they are increasing the value of their home. Unfortunately, there is no guarantee that expensive home improvement projects will actually pay off. In his book The Wealthy Renter, real estate analyst Alex Avery explains that his “Golden Rule of Investing in Real Estate is that buildings never go up in value. Ever. Period. Only land can go up in value”.

Those were three benefits of renting that are important to keep in mind: Less risk, predictable cost, and no investment illusion. Of course you’re still wondering, isn’t renting throwing money away?

When you’re renting you’re just exchanging money for the use of something without any expectation of a residual value. Paying rent for a place to live is obvious. You give money to the landlord. They give you the keys. You get nothing back. What many people fail to consider is that homeowners are also paying forms of rent. They are renting services from the city in the form of property taxes, they are paying unrecoverable maintenance costs just to keep their house inhabitable, and they are renting money from the bank while they have a mortgage. But surely when the mortgage is paid off a homeowner’s cost of living is much lower than a renter’s. Not so fast.

Let’s think about someone with a paid off house worth $500,000. They could sell that house, keep around $475,000 after costs, and invest the money. Let’s say that they could expect to earn a 6% annual average long-term return on their investments, while the long-term expected return on real estate is closer to 3%. That 3% difference in expected returns is an opportunity cost. The opportunity cost of owning this home is around $14,000 per year. You don’t actually see the opportunity cost in any of your accounts, but it’s there. Add to that property tax and maintenance costs, and we can easily arrive at a total monthly cost of ownership of over $2,000. That’s $2,000 of unrecoverable costs with no residual value. Renting doesn’t look so bad anymore.

So far we have established that renting has some advantages, and owners also have substantial expenses with no residual value, so why does home ownership have such a good reputation?

The real estate and home improvement industries have obvious self-serving motivations to make home ownership look good.

The Canadian government has programs in place to encourage home ownership, making it seem like a good idea. Most importantly, there are a lot of people in Canada who genuinely believe that their home has been their best investment. It is common for well-meaning friends or relatives to encourage home ownership based on their perception of their own experience.

It’s no wonder why many people think that their home has been a great investment. The numbers are big, and investment returns are not always easy to understand. The average Canadian home purchased in 1980 for $62,000 would be worth $496.500 in 2017. That seems like a great return. Over 38 years it works out to 5.63% per year on average before costs. When a homeowner is standing back after 38 years and admiring the appreciation in the value of their home, they aren’t usually accounting for the costs incurred along the way, but the costs were definitely there.

Property taxes and maintenance could be reasonably estimated at a combined 2% per year reducing the annual return to 3.63% after costs and before inflation. Canadian inflation over this time period was 3%. So that seemingly massive gain from $62,000 to $496,500 was really only equivalent to a 0.63% average annual return after costs and inflation. For context, the S&P/TSX composite index returned an annual average of around 5.9% after inflation over the same time period. The long-term after-inflation returns to US and UK real estate are similarly low, barely beating inflation over the past 115 years, while stocks in those countries have far exceeded inflation.

Hmmm so real estate returns aren’t actually so great.

Home ownership does have one big benefit that really does build wealth. A mortgage forces discipline. It is much easier to stop the monthly contribution into your RRSP than it is to miss a mortgage payment. That discipline does pay off over the long-term, but it does not actually make home ownership an inherently great investment. People can be disciplined renters and investors, too.

I have started to make the case that renting a place to live is a sensible alternative to home ownership for building long-term wealth. In my next video, I will lay out the numbers that prove my case.

Would you consider being a forever renter? Tell me about it in the comments.

About The Author
Benjamin Felix
Benjamin Felix

Benjamin is co-host of the Rational Reminder Podcast and the host of a popular YouTube series.

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