Blessed by the Potato

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]