Blessed by the Potato

*Wall of text hits for 500 points. It’s super effective!*

Ok, as long as I’m on a roll, Mike asks via twitter: “Should I sell my house and rent?”

I responded: “I am physiologically incapable of answering that in 140 characters. Yes, possibly, or no, maybe. Beware the wife always.”

To put up another wall of text:

TL;DR: Yes, sell and rent.

In truth, it depends. First off, the situation is not quite symmetric with the earlier case of someone starting out and deciding whether to purchase their first place or to continue renting because there are significant transaction costs — financial and otherwise. As a young person if prices decline even just 10%, that’s huge — you may not even have 10% as a down payment as a first-time buyer, so that’s more than your entire life savings to date. For someone who already owns, 10% is a transaction fee. It can also depend on what your opinion is regarding using your house as an investment: do you want to get the most value out of it, or are you content on missing out on opportunities if it means you get to stay put? Your family situation can really play into that.

So let’s say you run through some calculations, and find that you live in an area where housing is significantly over-valued, and that you’d be better off renting. Further, let’s say that you go through some rental listings and find a nice place that you could see yourself living in. What do you consider next?

Well, first off, think of what you paid for your house. That figure does absolutely no good when discussing whether I should buy or rent, because I have to pay today‘s price, but you got to pay the price of whatever time you bought at. So let’s say that you managed to buy at some point where it would make sense to buy rather than rent, like 5 or 10 years ago. This is important because one of the benefits of owning is that you get to quasi-lock-in some of your housing costs at the time your purchase. I don’t mention that much because it’s a con, not a benefit, when prices are high — you’re locking yourself into being house poor. But if you’ve already locked in a low house price (e.g.: your current monthly cash costs may indeed be lower than rent), then your risk tolerance will come into play: do you want to take on the risk of higher shelter costs for the ability to lock in your gains, and make more by investing in equities?

It’s also a little different if you bought before the boom than the situation now: if house prices do go down, then for you, it would be like you bought low, it went higher, but then came back down. A missed opportunity, but other than some paper gains and reminiscing it doesn’t really affect your day-to-day life. On the other hand, buying high does: your daily costs are higher because you paid more, impacting your ability to save and afford other things in your life; and after prices go down you may find you’re underwater and can’t move, or can’t get favourable rates upon refinancing.

A list of considerations:

• If you do sell your primary residence, any gains will be tax free.
• You just won a leveraged bet. That’s a hell of an opportunity.
• On the other hand, opportunity costs are psychologically different than cash costs.
• The future path of prices: selling is a hell of a smart idea if a crash is coming. Could set yourself up for life. But over-valuation could fix itself via a long period of stagnation. That can still work out well for you — and for someone who has to pay today’s price, the path doesn’t matter as much. Nonetheless, soft landings a rare. If there is a crash and you chose to hang on, how will you feel? Even mortgage-free with no plans to sell, the knowledge that your house is depreciating can be trying.
• Are you at risk of negative equity if there is a correction?
• Risk tolerance: you’ll be trading partially locked-in housing costs and real estate investments for stocks and rent inflation. IMHO, a smart bet, but not one undertaken lightly.
• Subjective factors: emotionally, it’s a lot easier to choose between renting and buying when you don’t already live in your “forever house”. If you’ve been living somewhere for years, it can be hard to decide to pack up and leave it.
• Renting stigma: it’s undeserved, unfair, and perhaps doesn’t actually come up all that often in your life, but to some there is a social status hit when renting rather than owning.
• Where you will go. While you only need one rental, they are admittedly rarer than houses for sale in the detached house market. You could try to find a speculator who wants to buy your house and lease it back to you (in many respects, the ideal situation). Or, you could sell and move to a cheaper area. That may be particularly appealing to those who are in a position to take (early) retirement.

So what are your basic options?

1. Sell and rent (which may include finding an “investor” to buy your house and rent it back to you so you don’t even have to move). In this case, you get to take out a potentially huge tax-free profit, and diversify into equities, bonds, etc. You may face higher cash housing costs, especially if you were mortgage-free, but the returns of your investment portfolio should, in the long-run, more than make up for that. If house prices go up a lot more, you’ll feel like a dummy, but IMHO the risk of that is very small now. If house prices stagnate, you’ll come out ahead with your large investment portfolio. If housing prices go down, you can buy back in after a few years, and keep the profits. You become famous for your daring putting-your-money-where-your-mouth-is attitude and timing, and may get invited to write a book or give lectures.
2. Stay put. If prices go down, you missed out on an opportunity to sell out, but it doesn’t really affect your day-to-day life, since you were already paying the same or less than current rents. Best of all, the wife will be happy, which may be worth a few hundred grand.
3. Sell and move. So you like owning, but you don’t want to own in bubbly Toronto or Vancouver. That’s fine, you still have options. Let’s say you bought 10 years ago at $400k, and your Toronto house is now at $750k. You could sell it and move to a less-bubbly outskirt, like London, Hamilton, Guelph, etc. and get a nice house equivalent to what you had in Toronto for $300k, and pocket the $450k difference. Sure, you have to uproot a bit, but it’s not so far to go and visit your friends, and several hundred thousand dollars is a hell of a lot of money, tax-free. It would take the average person years to save that much. You may still have to work, or, depending on the rest of your situation, may be able to take early retirement. If the bubble pops, you may suffer as well in the outskirts, but odds are not as much, and then you may be able to buy back in Toronto if you really want to — though once you escape the traffic congestion, and see how much cheaper car insurance and other expenses are outside the city, there may be no dragging you back.

There are options within each of those scenarios. Once you’ve decided to move, you can choose to downsize for instance. I’ve talked with my parents about that a bit: with my brother and I moved out, and my sister at university 8 months of the year, they really don’t need a 4-bedroom house, let alone one walking distance to the subway when they never go downtown. They could sell now and downsize (either rent or buy). Even if they buy, having $800k in stocks and $400k in real estate is better than the other way around if/when the correction comes. If they downsized and rented, the rent may be less than just property tax, insurance, and maintenance now.

Or, you can choose to upsize. Sell your house and rent a nice luxury mansion, or a place closer to the subway, or better on whatever metric you want to pay up for for a few years. Even at $5500/mo, it’ll take years to burn through that tax-free gain on your old place; like a HGTV extended vacation. Especially nice if you had been planning to move up, but found the ever-increasing prices made it hard to make the jump. Live like damned hell-ass kings for a while: you deserve it, you made a fortune in accidental real estate speculation!

So, what do I think Mike should do? Sell and rent. I’m pretty sure he lives in Toronto, and I know that he bought his place 12 years ago and owns it free-and-clear. Toronto prices have doubled since then. The average price of a detached house in the 416 is approx. $750k now, which means he’s likely sitting on a not-insubstantial tax-free gain of something like $375k (depending of course on where in the GTA he lives, how far above or below the average his house falls, etc). It took him 12 years to pay off that mortgage: I’m sure it was 12 years of scrimping and sacrifice, since that’s a very short time to get it done in. And he could double it in just one quick move by selling now. Assuming the mortgage payments now go towards the retirement fund, that could cut something like 7 years off the retirement timeline*. A nest egg of $750k using even a very conservative 4% rate of return would produce $2500/mo, which gets you a pretty decent family home in Toronto (i.e.: about equivalent to one that costs ~$650k). Any return above that, plus all the money he’s spending now on taxes, maintenance, and insurance, is gravy — or money that can be used to rent an even nicer place. If those costs of a paid off house run another ~$1000/mo, that’s real money.

I made another spreadsheet for Mike to play around with, looking at how a renter would do vs. continuing to own over the long-term. Assuming $3k/mo gets you the equivalent of a $750k place; using a generous 3%/yr appreciation in house prices, and 6% for the investment portfolio, you come out ahead by several hundred thousand by bailing now. And that’s with the ~7% it’ll cost in transaction fees to get out. Any decline in prices just makes that look better.

There are risks and emotional costs. He avoids the risk of a housing downturn (indeed, as a blogger he can profit from it by driving traffic to his site with stories of his brilliance), and gets away from the usual risks of ownership (mostly repairs, since he no longer fears negative equity or lack of mobility). But he trades housing risk for stock market/bond market risk — Mike’s a smart guy, and a personal finance blogger to boot, so he probably doesn’t see that as much of a downside, but you do need the stomach for it.

He trades having most of his housing costs locked-in for the vagaries of the rental market, and also that intangible benefit of being able to be in one place for 12 years (not that renters can’t stay put, but it’s not as certain) — again, something that is not necessarily of benefit to a young person without an established career like myself, but may be to someone with a family like Mike. I’m more likely to need to move than to be annoyed that my landlords sold the house out from under me — as small as that risk is.

And of course, he has to convince his family to move, which can be emotionally taxing, especially if there’s a lot of sentimental feelings about the house where the kids grew up. Sure, you can bribe them: “Honey, I’ll buy you a bloody car if you just pack up your things within 60 days”, but it’s still going to be an upheaval. That said, people move all the time, and for worse reasons. You’ll adapt. It’s been 12 years, you’re probably about ready anyway (my those kids must be getting big… do they have their own rooms?). Or maybe you’ll get lucky and find an investor that wants to keep you as tenants in your own home.

On the other hand, maybe he paid off his mortgage in 12 years because he makes $500k/year, and realizing a $400k gain is not worth it to him: while it’s a tonne of money to me, it may be peanuts next to his investment portfolio, and not worth the hassle of hiring movers.

As for my parents? We had this talk, and they decided not to sell and rent or downsize. Primarily because my mom is emotionally attached to the house: they’ve been there 25 years now. Partly because they don’t need the money: they’ve been retired for years (if you ask, my dad won’t say he’s retired, but he has at least long since hit findependence**), and they’re not the type to take exotic vacations: if they’re not spending their money on their house, what would they spend it on? Now, if the stock market had stayed as bad as it got in late 2008/early 2009, that would have been a different story, and if the market gets bad again there will be a downsizing. But you can see how even if it’s the financially optimal thing to do, they may choose not to.

So, what does the future hold? That’s very tough to say. In the near term, damned near anything could happen. My opinion:

• Equity returns will be decent in the long term (20+ years), 4-5% real returns should be very realistic (6-8% nominal with 2-3% inflation).
• Rent increases will be in-line with inflation: the current overvaluation is not due to abnormally low rents IMHO.
• House prices will increase very modestly when averaged over the very long term, basically in-line with inflation over 20+ years.
• There is a good chance in the medium term (next say 7 years) that house prices will be lower in Toronto: I think it’s the most likely way to correct the current over-valuation. I’d say a 90% chance that prices are 10-20% lower 5-7 years out. We could have stagnation or a soft landing, but I just don’t see it as terribly likely. There’s a decent chance of a spectacular crash, too, particularly in the condo area: say a 50% chance that prices are 30-40% lower in 5-7 years. I’d say with very high certainty that 7 years from now, house prices will not be higher — we’ve done 0-down, we’ve done government mortgage guarantees, we’ve done first-time buyer tax credits, and we’ve done low interest rates. Other than direct subsidies, lowering the age of majority, fully mature adult cloning, dissolving marriages, massive lifespan extension, and forced relocations, there isn’t any more fuel to throw on this fire. That said, it’s not going to be quick — there are people asking if they should wait 8 months, or maybe 12 before buying a house, and it’s just not going to play out that quickly.
• The opportunity cost of holding real estate in Toronto is very high: the rent savings of having all that capital sunk in your house is only yielding 2-3% — about what you can get in safe fixed income (though granted, tax free) — while you may expect double that from other investments that really aren’t any riskier than a house.

Add it all up, and selling and renting/moving out of the city is a smart move. If prices do go lower — which I think there is a very good chance will happen — you’re a hero. Even if they don’t, you’ve got a good chance of out-performing housing. And you can set yourself up for some interesting opportunities, like early retirement, freeing up capital to start your own business, or escaping the city and finding a house with a conservatory***. Just be ready to stick with it for a long time: the stock market could crash again next year, and it may take six years for even the smallest correction in Toronto house prices. The future is always uncertain, but the long-term expectation looks heavily skewed in favour of those who sell to invest and rent.

* – Less than 12 because now compounding is working for you instead of against you. Plus if he has other savings (i.e.: it’s likely Mike was saving before in addition to paying down the mortgage aggressively) then the retirement timeline reduction isn’t quite as dramatic.
** – Damnit, now I owe Jonathan Chevreau a nickle.
*** – Some time ago, Wayfare was looking at house porn in London. For what a middle-of-the-road house in Toronto costs, you can get a mansion in London, with a living room, dining room, den, solarium, library, and conservatory. I couldn’t even really say what a conservatory was — a music room maybe? — but we knew that it meant this house had so many rooms they must have started to run out of things to name them.

TL;DR: Here is a spreadsheet based rent-vs-buy calculator I put together in Google Drive (or, download for Excel). You can save your own local copy to play with your own numbers. The long post below helps explain some of the calculations and what to consider when entering values. Thanks go out to Matthew Gordon who did a lot of work on my original to calculate out the full mortgage amortization and to really clean it up!

For more on why this is an important decision and to put the numbers in context, see this post.

2023 update: I created this calculator way, way back in 2011. I thought it was important to model a future increase in interest rates in the rent-vs-buy decision, and now that over a decade later interest rates have finally increased it’s starting to look like an important factor after all. I’ve updated the base assumptions for the new interest rates, as well as price:rents in the northern GTA. In addition to helping people make this very big, important decision, the tool was also designed to explicitly show what happens when you rent and invest the difference — while the last decade has seen incredible real estate appreciation in Toronto, making buying look pretty good post hoc, a crash was never needed for rent-and-invest-the-difference to come out ahead.

—

In a recent post I was trying to simply get across the concept that there is some point at which it makes sense to rent rather than buy, even if you don’t assume something like a crash in housing prices on the horizon. I used the extreme example of renting a million dollar house for just a dollar a month: it makes no sense to want to buy in that case, as it’s so much cheaper to rent. As the rent gets cheaper and the house more expensive, there will come a point where we cross over from what we’ve known most of our lives — that buying a house is a solid financial move — to a region where that is not true any more, and it’s wiser to rent.

Once you grasp that simple concept, then the question becomes where that cross-over point is. There was a long discussion in the comments about that, out of which came this Rent vs. Buy Investment Spreadsheet (it can also be downloaded for Excel).

About the analysis: there are many moving parts when trying to decide whether it is better to rent or buy in the long term, most of which require that you make estimates and assumptions about what the future will bring. At the end, I’ll go over some of the cases, and the difference between a long-term expectation and a short-term result.

Basically though, what this is showing is what would happen if you chose to rent a house and invest any extra money that you saved vs. buying that same house. The common refrain is that by buying you “build equity” as you pay off your mortgage (and if you’re lucky, the house appreciates), but as a renter you can also build equity by saving and investing. If house prices are high enough, and rents low enough, then you may indeed be better off by renting and saving the difference. The spreadsheet explicitly includes the buildup of equity for both parties: paying off the mortgage for the owner, and saving and investing for the renter. Both start with the same amount of money, both have the same monthly budget.

At the difference between rents and prices in Toronto right now, you’d be better off to the tune of hundreds of thousands of dollars to rent for the next 30 years — even if house prices don’t crash. If you really wanted to own your house going into retirement, well, you’d have enough money to buy one with cash at the end, with plenty left over.

Factors:

Annual figures: all numbers are for the year: the monthly rent is multiplied by 12 to get an annual figure, etc. For the investment portfolio and the owner’s equity, the value is for the beginning of the year.

Investment returns: I’ve assumed 7% 6% nominal returns, which for a young investor (i.e.: someone in the age group where they would be about to buy their first home) with a long time horizon and risk tolerance to invest in a heavily equity-weighted portfolio should be realistic [lowered assumption in 2023]. The spreadsheet takes the amount of money you would have at the beginning (in this case, your 25% down payment plus closing costs) and compounds that at 6%, adding in the savings vs. owning each year (which, for the year its added, is compounded at half the rate to reflect the fact that it’s not present all at the beginning).

Rent, rent inflation: In this case, I’ve used 2% 4% rent inflation, which is approximately what non-downtown Toronto has experienced over the last decade [updated in 2023 incorporating our well-above CPI rent increases of the last few years].

Mortgage: I’ve taken the currently available fixed-rate mortgage rate of 3.49% 5.9%, and used that for the first 5 years. Then, I assume that rates go up a bit, to 4.5% settle to 5.5% for the next 5 years, then to 5.5% for the remainder. 25 year amortization. Interest rates are very difficult to forecast with any accuracy, but I would bet that this is being very generous to the case for owning. Thanks to Matthew for making the mortgage information auto-update, and removing the need for an external mortgage calculator.

Maintenance: I’ve used 1.1% 0.66% as the figure for the maintenance/repairs budget [updated in 2023 to reflect much whining about this factor and that house prices have outpaced maintenance costs so the old rules of thumb need a tweak]. This comes from much reading around the web as to good rules-of-thumb to use, as well as back-of-the-envelope budgeting of how much a house costs to keep in good repair. The maintenance costs will not in real life be as smooth as this: you may have to pay for nothing for 5 years, only to get hit with a roof repair, new hot water tank, and a leak in the basement all at once. Nonetheless, it should average out to something approximately in this range. If you decide to re-run the numbers for your own situation and are using a condo, remember to add a bit to the listed maintenance fees for the condo to account for repairs not covered by the condo corporation, like replacing your units’ appliances, repainting the walls, replacing the flooring, and of course, the occasional dreaded special assessment. Also keep in mind that many new buildings have maintenance fees that are lower than might be sustainable — maintenance fees often spike after a few years. Note that this is being very fair to the buying case: for the real-world example I chose for rents, the condo fees alone came to 1.4% (which doesn’t include interior maintenance like replacing appliances or repainting).

Property Tax: [a rough estimate of] The Toronto property tax rate. I’ve used an increase over time that is above inflation figures used elsewhere (property tax increases by 4%/year) as that is what I’ve been reading the rates have been rising each year. If you have a better estimate, feel free to use that instead.

Taxes: It’s a tough to avoid taxes as they can be a big factor, so now the spreadsheet also includes an estimate for taxes upon selling the investment portfolio at the year of comparison. One of the big problems with trying to build in taxes is that they can be so complicated on investments: some can be deferred, some can’t, and there are different tax rates for different investment income types (interest, dividends, capital gains). On top of that, the investments could potentially be sheltered in a TFSA or RRSP. For the default number I put in 10%, which is assuming that the couple is in the $40k-75k income range, which would be an Ontario marginal tax rate of ~32%. Then about half the investments are sheltered (the excess is ~$10k/year, which could be put into TFSAs with two people, and still allows us to assume both renters and owners are maxing their RRSPs on top of that). Then of the half that’s exposed to taxes, it’s about 30% more tax-efficient than regular employment income. Plus, 10% is a nice, round number. If you prefer, you can just set the tax rate to 0% and then use an after-tax rate of investment return (or, depending on your own situation, if all the investments could be sheltered in a TFSA it gets easier).

Insurance: This is a very loose approximation, but it’s also the smallest factor, so it doesn’t matter as much if I’m off by a few hundred dollars per year.

Transaction fees: I’ve assumed that the transaction fees to buy are paid out of cash right away (and that the renter will instead invest that money). Matthew has updated the spreadsheet to also reflect transaction fees to sell in column R.

CMHC fees: The CMHC fees are calculated according to the downpayment set and added to the mortgage. The other closing costs (LTT, legal, etc.) are paid as cash, so the renter has the downpayment and closing costs to invest initially.

House value: This is the big one. Try to find a good comparison for your own situation: what can you rent, what would be the price of that place or its equivalent?

For appreciation, I’ve used 2%/year — that is, that the house appreciates in-line with inflation over the long-term. This is clearly not the case in the short term: houses were up something like 10% [in 2010], but down something like 10% in the middle of 2009. It is critically important to have a fair long-term estimate here: if you assume house prices go up 10%/year forever, then of course it’s going to make more sense to buy in almost any scenario: why wouldn’t you buy a baker’s dozen houses in that case? Though for the short term, that has been the experience: Toronto (and Vancouver, etc.) have had a hell of a run in the last few years. But the long-term history suggests something much more muted: basically inflation plus a bit. If we’re already at the point where you need to assume high appreciation for buying to make sense though, how much further up can house prices realistically climb? What will be the average return when you look back 25 years from now? If you are a believer in continued high appreciation of house prices for the long-term, I invite you to play with this spreadsheet some more: fast-forward a number of years, and look at what it would be like going forward if rents were up 2%/yr but prices up another 10%/yr — what rate of appreciation do you need just to break even at that point? Even if you don’t assume a crash, at some point the rate of appreciation will settle back down to a more moderate low-single-digit value. And to be conservative, that’s what you should pick in this kind of model.

Customizing it: At this point, the spreadsheet isn’t set up with forms and that sort of thing to just start typing your own numbers in. What you have to do is go to file->download as and save a copy for yourself. You can download it to excel and use it offline, or use file->save a copy to put a copy in Google Docs under your own account to play with it.

Discussion points:

There’s a lot to talk about, and this post is already fairly long, so I’ve made a separate post to go over some of the discussion points, and to discuss various scenarios. Then we can stick to the details of the spreadsheet analysis itself here.

There are a lot of assumptions and estimates involved, a lot. The question is what should you do for your life? And importantly, what are the consequences of being wrong? Don’t use this tool with unrealistic estimates to try to justify a decision you want to make, but rather try to use it to help you come to the decision you should make — and to see what happens if you’re wrong. Shelter is the largest household budget item, buying a house is the largest purchase a young family will ever make. Please, treat the decision with the respect it deserves and go in with your eyes open, the risks assessed, the options weighed — more than the handwaving gesture towards long-term averaging out and comfort that many make today.

Also check out the post a bit later in the series on how this analysis can change with changes in the various factors. And up next, the case where you already have a paid-off house in this market: should you sell and rent? It’s not quite symmetric.

I’ve created a separate post here for the discussion points and scenario discussion from the Rent vs. Buy Investment Spreadsheet post [direct link to Google docs]. That spreadsheet originally came out of the discussions of this post, talking about the fact that there is some point where it becomes better to rent, even if you rent for the long term, which flies in the face of conventional wisdom.

Of course, I generally prefer to use a simpler analysis by abstracting out the principal repayment portion of a mortgage payment, and just look at the costs of owning, largely because you don’t need a spreadsheet: you can pull out a napkin and go over the numbers at dinner if you so choose. The problem though is that people would keep saying “but if you buy, you build equity” and I would keep saying “no, I’ve account for that in this analysis” and they would say “but what about paying down the mortgage?” and I would start to say that in the renting scenario you save that difference, and then just give up. So the spreadsheet explicitly includes the buildup of equity for both parties: paying off the mortgage for the owner, and saving and investing for the renter. Both start with the same amount of money, both have the same monthly budget.

Discussion Points

“This assumes the renter will save and invest. But many people won’t.”

– That may be true, but firstly I do save the difference and invest it, and I did in part do this analysis for my own sake. Secondly, not saving is a problem that needs to be fixed: paying down a mortgage is a form of forced savings, yes, but it’s a really poor one. Go back to the note about the maintenance assumptions: even as a homeowner you are going to have to put money away and save for things, even just for the medium term like repairs that come in lumpy bunches. Also, equity can be taken back out fairly easily these days via lines of credit and refinancings, so the savings aren’t all that enforced. Besides, I always thought that needing to be threatened with homelessness was a little extreme for saving motivation. Someone who can’t save doesn’t need a house, they need help.

And of course, you do have the freedom not to save. This analysis can also help those who prefer to fritter their money away on life’s indulgences like exotic travel to realize that by buying they may find themselves house poor, and that they can increase their overall enjoyment of life by renting and spending the surplus on things they truly enjoy. Or, to know that you have some cushion in your budget if you get hit with a pay cut or another of life’s large costs like medical expenses: you can cut back on your savings as a renter, but you won’t have that choice as an owner.

“There are so many subjective factors though.”

– Yes, there are a lot of subjective factors around the decision of whether to rent or buy. Perhaps you have “pride of ownership” in your house, and prefer to own, or maybe you like the freedom and lower risk associated with renting. But there are subjective and hard financial cost factors to many of life’s decisions, and if you sort out the costs you have a better foundation for weighting your subjective factors. To make an analogy, I may subjectively prefer a car with leather seats and a moonroof, but once I see the price tag for those addons is $4000, I say forget it, I’ll stick with the base model. In this case, I may prefer to own, but once I see that pride of ownership is a three hundred thousand dollar expense after 30 years, I figure that my pride isn’t worth that much.

“But if I own, I can improve the value of my house with my own hands. With stock investments, you have to take whatever the whims of the market give you.”

– This is perhaps worth a post in its own right, but I think that people vastly over-estimate how much they can add to the value of their home with do-it-yourself renovations. Plus, the housing market also has tides that you cannot fight: they are slower than those of the equity markets, but just as inexorable.

“I’m a rare breed: handy but a creative soul. I can’t rent since I need make my space my own.”

– In my opinion, many people underestimate how much freedom they have as renters to customize their own space. Yes, you can paint the walls. You can make improvements, even major ones with the landlord’s permission. You may even get paid for it (or at least have your materials covered). The main point is to either work it out with the landlord, or be sure to put it back the way you’ve found it. Some examples of customization I know of include putting down new laminate hardwood flooring (some kind of snap-together kit that went on top of the parquet), and a musician creating a recording studio in a rental by bringing in his own foam sound insulation and fixing it to the walls — and bringing it out when he moved out. On the flip side, even as an owner your creativity may be every bit as constrained in a condo as a renter.

“My friend bought X years ago and made X on her condo.”

Well, it’s not X years ago, it’s today, and I can’t go back in time and buy a house at 2004’s price. That purchase may have made sense then, or, your friend may have gotten lucky. It’s tough to say: but the best guess we have as to what the future holds indicates that with today’s prices and today’s rents, it’s not a time to buy. Your grandparents and parents and older siblings may all have made fortunes investing in real estate, but they bought back then, not now.

“The stock market can go down, but your house will always be there.”

Very few people buy houses for cash. I know I couldn’t today. That means that you can either rent your house, or rent the money from the bank to buy your house. That act of borrowing to buy is known as leverage, and it adds risk. Yes, the stock market poses its own set of risks: it can go down, often violently in the short run. But in the long run, it goes up. If you lose your job, you can use your investments to pay the rent, but it’s tough to tap your equity to pay your mortgage and taxes, especially in the early years. If you need to then move to find a new job, it’s very easy to leave a rental and find another, and your stock portfolio moves with you; whereas you may find yourself underwater on your house, either because house prices have gone down, or because transaction fees have eaten into your equity. If you can’t come up with the money to break the mortgage and pay off the bank, you may find yourself stuck there, or worse, declaring bankruptcy. So yes, your house may still be there if the economy gets worse and the stock market goes down, but you may not be living there any more; if you’re unlucky and that happens soon after buying with a small down payment, you may find that it belongs to the bank.

“Is this a realistic scenario?

I fully encourage you to take the framework I’ve given you and apply it to your own situation. Find out what the going rent is for the type of place you’d like to live in. Find out what the cost for buying that type of place would be. Run the numbers yourself. But to answer the question, yes, this is a realistic scenario (though as I’ve said, it is if anything overly favourable to the owning case). These are the numbers from a house in Toronto I actually lived in recently. I didn’t plow through listings to cherry pick it: though I have checked, and the results are fairly typical for the city.

One thing left unsaid is that this is as much as possible an apples-to-apples type comparison: the same house to rent or buy, or at least the same size, quality, and area. In reality though, those who buy may over-purchase due to the transaction costs (i.e.: buy the house they plan to need 10 years from now rather than the one they need next year), so if anything the default numbers in that sheet may be too generous to owners. But you may be the best judge of your situation, so use the tool for yourself!

Scenarios:

It’s good to look at not just the best-estimate case I used to fill in the spreadsheet, but also a few other scenarios to help you plan and identify where the major risks are going to come from. As I said above, one of the big factors is going to be house price appreciation: if you assume your house will appreciate at a rapid rate, like they have in Toronto for the past few years, then it will be very difficult to make the case for renting. The problem with that scenario is two-fold: first, unless you actually sell your house and then go rent, the higher house prices aren’t actually helping you any. As a renter in that scenario you’re “further behind”, but it already made sense to rent at 2011’s prices, why would higher prices in 2012 make you want to buy any more? Stay a renter as long as those upward moves are likely temporary. As an owner, even if you do decide to sell your house and rent because hey, you got lucky, then you have to factor in the dreaded transaction fees after all, and you may not do much better than break-even. Secondly, how realistic is that scenario? If it’s already tough to make a case for owning at these prices, how can they increase forever?

What about the scenario where house prices fall? Myself and many other analysts have been saying that Toronto is over-priced for years, so one of these days a crash may actually happen. Again, you don’t even need to bother with the spreadsheet to know that it’s going to be better to rent if prices are falling. The magnitude of the savings may astonish you if you do play it out. When considering that scenario, some people say that they will just ride out a decline: which brings us to the long-run scenario that I plotted out. If you’re looking out 30 years, it may not matter whether prices fell for a few years then flat-lined for a few, then recovered a bit if in the end that works out to something like 2%/year.

But however you get to the end of the road, it doesn’t look good for the buying case. If prices go up at a rate far above a modest 2-3%/year, it’s better to own, but difficult to actually profit from that scenario if you have to pay ~7% transaction fees within a few years to get out (and that percent is on the house price, not your equity). If prices go up steadily, well, rent is cheap enough that you’re better off renting and investing. And if prices go down, you’re better off renting: they may even go down far enough that it becomes better to buy once again, and you’ll be all set to take advantage of the lower prices with your investment portfolio to use as a down payment.

You can examine other scenarios: what if rent increases by more than it has been (mean reversion may also apply to rent not increasing at the slightly-below-normal level it has been for the last few years). What if mortgage rates do indeed stay low, or go up to 8% within a few years? The margin by which renting is better for my own case was enough that even if I was wrong on a few points, like if I only made 5.5%/year on my investments, while house prices increased at 3%, it was still close enough to break-even that I was happy renting. Plus in the most likely scenarios, renting was better; in the worst-case scenarios, owning could really bite me in the ass (not just financially, but prevent me from moving on to find a job in another city if needed).

Don’t forget the risk: the maintenance assumption is likely a good estimate, but could be way too low if the worst happens (with very few ways of ending up too high). Interest rates could return to their long-term averages rather than stay low for an extended period of time. In most cases, owning means assuming more risk due to the responsibilities for repairs (which the landlord covers for a renter), the high transaction costs if life circumstances change, and interest rates. In the short term, the stock market will be volatile (one way to measure risk), but in the long term is not that much riskier than house prices. I was trying to be fairly generous to the owning case so that someone couldn’t turn around and accuse me of creating a biased scenario, but that also means that there’s generally more room for the scenario to play out worse for owning than better: 5.5% may have been too high for mortgage rates 10 years from now, but is more likely too low; heck, 2.8% might not be here in a few months, let alone 5 years from now. There’s a risk that the current imbalance could correct itself with high rent inflation in the future, but that is unlikely in my opinion. And the big risk: what if house prices crash?

Any other discussion points you’d like to cover? Care to debate any in the comments?

[Note that I published this post slightly ahead of the one it refers to just so it would appear below that one on the main page]

One problem with trying to pick apart brewing bubbles in real estate is that there’s a real shortage of leading indicators.

A leading indicator is just what it sounds like: some measure that identifies a problem (or conversely, an upward move) before that is upon you. So for house prices, a leading indicator would be something that might signal the future direction of house prices. If there was something that reliably foreshadowed prices, you could point to that and some history, and maybe help people see what’s coming.

There are a few that might work, my favourite of course being the price-to-rent multiple. Unfortunately, while I believe that one is both reliable and particularly relevant to the down-to-earth decision of how to go about getting a roof over your head in your own life, it’s not particularly timely. You can use it to say that there may be over-valuation, but it gives no information on when that over-valuation may come to an end, or how: lower costs (like interest rates), higher rents, or lower prices could all interact to change it. Like all indicators, it’s a bit beyond imperfect.

Other indicators might be the health of the economy: if unemployment is rising, people may be unable to afford their mortgages (or may not be in a home-buying mood), so prices may fall, and vice-versa when unemployment falls. Unfortunately, sometimes that works in reverse, as happened in the US: house prices dropped first, which then sank the economy. It could be that only after prices fall does the rampant over-building slow, and after that all the construction workers and real estate agents start looking for new jobs.

Lots of people like to point at these lagging indicators — which we know don’t really tell us anything about the future of the housing market — and say that since they are fine, so too must be the housing market. Mortgage arrears and defaults, declining interest rates, GDP growth, etc.

Recently David Fleming looked at vacancy rates, saying that since they’re low in Toronto, then the housing market must be fine. Now I can totally see the logic: vacancy rates should be a leading indicator. Yet again, history doesn’t seem to bear that out: Toronto had a real estate crash in 1989, with many looking back and saying that there was over-building occurring at that time. Yet the vacancy rate stayed persistently low — less than 1% — all through the late 80’s. It wasn’t until the prices started coming down that the vacancy rate started going up in 1990. There wasn’t as much of a lag: it was a better indicator than mortgage defaults. You potentially could have looked at that data and realized the drop in prices (still modest at that point) wasn’t a temporary opportunity. We saw the same thing in the states: the vacancy rate was flat through most of the 2000’s until after the peak: about 2007 in many cities, after which it spiked up (in the comments, I used Miami’s numbers in particular, since that was the comparison DF made in his post).

This is a little lot counter-intuitive: if there’s a building boom and over-supply, then there should be vacancies. If tenants are being taken out of the rental pool and becoming owners, and speculators are taking on multiple units and adding to the supply, there should be vacancies. Yet we’re not seeing them now, and that doesn’t appear to be a contrary indicator: the vacancies weren’t leading indicators in past bubbles, either.

How can this be? I have a few speculations below, but the short answer is that I honestly don’t know. I even went out and asked Ben Rabidoux. Anyway, some speculations:

• Shadow inventory: with prices going up 10%/year in Toronto, and condos being cash-flow negative, it’s almost not worth the hassle of renting your place out and having to deal with a tenant when you’re making all your money from appreciation anyway. Some speculators may be holding vacant inventory; as soon as prices stop going up, they may become reluctant landlords, and this will increase the supply shortly after the peak, leading to rising vacancy rates after prices peak. This is a bit nutty, even for real estate speculators, but it only takes a few thousand to increase the vacancy rate by ~1% in Toronto.
• The way the stats are collected: CMHC collects data exclusively from multi-unit properties, largely professionally-run apartment buildings. These are not in the business of having vacancies, so there may be many vacancies in detached houses, basement apartments, duplexes, and condos, while the professional buildings find ways to get their spots filled. This may also be why the average rent figure always appears to be lower than you expect.
• Booms attract people too. Once the construction jobs dry up, vacancies may increase from the demand side as those workers leave the city; and for those who own, they may put their units up for rent, increasing supply. If the economy is good, then perhaps people are renting apartments on their own rather than getting roommates.
• Construction time: it takes a few years to get a condo tower completed, and if the building boom reaches a crescendo just before the end, those units won’t be completed and on the market until after the peak. For example, if construction reached the nutty stage in 1987 or 1988, it wouldn’t be until 1990 that the over-supply would be evident on the rental market.
• Household formation can diverge from population growth. When trying to say that there’s an over-supply of housing stock we may focus on how population growth compared to housing starts over some period (e.g., saying that housing construction outpaced population growth for much of the past decade). But household formation is not quite the same as population growth if household size is changing. So if easy lending is borrowing demand from the future, leading to new household formations with smaller family sizes (e.g., single people buying condos), then that can help soak up some of the over-supply. Does that translate into the rental market? I have no idea, but it could be that the rental market stays insulated from all this insanity: as renters are pulled over to owners, rental units also undergo condo conversions.

MOA: “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.”