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.