Who’s Casa?: The Straight Goods on Rent vs. Buy

There is SO much emotion & rhetoric wrapped up in buying a house

There are intangible benefits to home ownership that people value differently

Two ways to live in the same house, cost should be roughly equivalent (+20% vs +80%)

When rent vs. buy diverges, debt factors often to blame

Right now in Toronto, you have to value ownership intangibles a lot to choose buy in rent vs. buy

Rent paid with earnings, house purchase paid with debt

At some point there is a tipping point where comparatively low rent outweighs these intangibles

The Royal Summary

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There’s A LOT of Societal Pressure to Buy….

“You’re paying someone else’s mortgage!”“You’re not building equity!”

“You’re throwing your money away on rent!”“You’re not established until you own!”

“You rent? And you want to vote??? Good heavens I’ve soiled my pantaloons!”

“It’s the American DREEAAAAAAMMMMM”

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And A Lot Of the Pressure Comes From Our Parents!

And why not? They cleaned up in real estate!

Probably when our parents bought…….

+100% (18 Years)

+0% (25 Years)

+100% (17 years)

Note: this is adjusted for inflation so probably understates housing prices by about 3% annually

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Real Estate Can Be An Amazing Investment

1998 2013

$160.00 $160.00

$40.00

$240.00 $200.00

$400.00

Mortgage Equity Total

Get Dat House!

20% down payment on 200K house

  House Equity TSXTotal Return 100% 500% 103%

Annual Return 4.7% 12.7% 4.8%

Outperformed the stock market!

……but only if you use debt

More debt (lower down payment) = more returns when prices rise

With a 10% down payment vs. 20%, annual returns on house jump to 17.3%

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Or It Can Be A Horrendous Investment….

Don’t Get Dat House!

  House Equity TSXTotal Return -20% -100% 112%

Annual Return -1.5% Shitty 7.1%

1987 1998

$100.00 $100.00

$25.00 $0.00

$125.00

$100.00

Mortgage Equity Total

Debt works both ways, amplifies returns, but amplifies losses as well!

Housing market only needs to decline 5% for you to lose everything with a 5% down payment

Easy to forget with 18 years of rising house prices though!

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Either Way It’s An Investment! And a Risky One

Χ Requires a lot of leverage to buy, increasing risk (but also returns)

Option to buy with leverage, but retail investors generally don’t

Χ Completely undiversified. House price subject to very specific risk factors. Need higher returns to compensate

Χ Not very liquid, high transaction costs, difficult to sell. Again need higher returns to compensate

Diversification over lots of equities improves return for a given level of risk. ETFs / mutual funds make it really easy

Costs almost nothing to get in and out of stock market investments

Χ Going back to 1890 US Housing Prices have risen faster than inflation (2-3%) only twice: after WW2 and in run up to 2008 crisis

Real Estate Stock Market

S&P 500 returned +6.7% annually over the long term, for arguably lower risk

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KEY POINT!!!!

Buying a home is a decision, not a requirement for financial health

$1 Rent + Invest

$1m Buy

You MAY be economically better off to rent and invest your down payment and additional savings in the stock market

That being said……….

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Human Beings Are Not Rational Automatons

Emotional payoff of renting house + owning stocks is not equivalent to that of owning a house

Rent + Invest + Intangibles

Buy + Intangibles

There is value in: pride of ownership, sense of community, consistency for family, no landlord, flexibility to renovate etc etc

If you choose to buy the $1mm house vs. renting for $1, then you place a very high value on these intangibles

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What Drives Rents vs. Prices?

2 ways to live in the exact same house, aside from intangibles they should cost roughly the same right?

Rent?

Buy?

House prices +80% from 2001 – 2010 vs. rents +20%. Does that make sense? Should value of an investment rise that much faster than earnings power?

3 potential legit reasons:

Soooooooooo…….?

1. Higher future growth (houses don’t innovate)2. Lower future risk (not really?)3. More value on buying intangibles (if anything it’s the opposite….)

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WHAT’S BEHIND DOOR #4?!?!?!

A shitload of debt…..

You pay rent with earnings and wages, you buy houses with debt

  1998 2015House Cost $400,000.00 $750,000.00

Downpayment 25% 15%Debt Taken On $300,000.00 $637,500.00

Mortgage Length 15 30Mortgage Rate 6.75% 2.85%

Monthly Payment $2,640 $2,682

Real wages have barely moved for 30 years….

But debt has become WAY more available

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Why the Hell Is There So Much Mortgage Debt??

Real Wages Stopped Growing in 1970s…..

Governments started juicing the mortgage market! It’s the biggest asset consumers have

Source: http://inequality.org/income-inequality/

Easy Way To Keep Household Wealth Growing?

Leads to moral hazard and way more mortgages than are economically rational (with the tax payer taking all the risk!)

In 1970s Canada and US introduced programs to guarantee loans to low income applicants at artificially low rates. Changed owning from a privilege to an entitlement

When rates began to reduce in the 90s lenders jumped all over these programs because essentially risk free money!

House prices started to rise and people were happy so governments jacked up support and rhetoric way past “low income”

When wages stagnate, people start getting piiiiiissed

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Can House Prices Keep Going Up?

How Much Income To Safely Own?

1998 2012 2015House Price $400,000.00 $750,000.00 $1,000,000.00

Downpayment / Length / Rate 25% / 20 Years / 5.0% 25% / 20 Years / 5.0% 25% / 20 Years / 5.0%Initial Debt $300,000.00 $562,500.00 $750,000.00

Monthly Payment $1,971.38 $3,696.33 $4,928.44"Safe" Required Monthly Income $5,632.51 $10,560.94 $14,081.26

"Safe" Required Annual Pre-Tax Income $67,590.17 $126,731.31 $168,975.09Mortgage to Income Ratio 4.44 4.44 4.44

Who The Hell Makes That Much Money?

In 2011 in Toronto, there were about 290K households who made over 100K

There are about 275K fully detached houses in Toronto

The average price of a fully detached house in Toronto just hit $1.15mm (up 18.2% YoY) We’re running out of rich people. Stretching on debt is the only other option

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Puttin It All Together: Are You Better Off To Rent or Buy?

Key Assumptions

1. Mortgage rates will return to historical normal of 5.5% in 5 years

Scenario 1 – 3 Bedroom Townhouse

Monthly Rent $3,300.00Cost To Buy $800,000.00

Price to Rent Ratio 242xDownpayment % / Length 20% / 25 Years

After 5 years Renting by $6,361After 10 years Renting by $12,420After 20 years Renting by $134,356

Scenario 2 – 2 Bedroom Condo

Monthly Rent $2,600.00Cost To Buy $550,000.00

Price to Rent Ratio 211xDownpayment % / Length 20% / 25 Years

After 5 years Buying by $12,319After 10 years Buying by $30,207After 20 years Buying by $24,657

3. House prices will grow at roughly 2.5% annually (price to rent gap stays constant)

2. Rent will grow at roughly 2.5% annually

4. Investments in stock market will return 6.7%

Source: Model is from “The Holy Potato” Personal Finance Blog

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Sooooo………

The longer mortgage rates stay low, the more heavy the tilt towards buying

If you believe that house prices can keep appreciating at 5-6% a year, then the buy case will win almost all the time. But who will buy these houses? Canadians are almost tapped out on debt

Price to rent gap is larger on Townhouses, but harder to find them to rent. Gap lower for Condo’s, but maybe worse price outlook The intangibles for owning and renting are NOT reflected in this spreadsheet, but they are implied!

No hard and fast recommendation here, but a set of tools to first understand the decision rationally and then make a good one!

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You get a house! AND YOU GET A HOUSE! EVERYONE GETS A HOUSE!!!