Blessed by the Potato

I want to be clear up front: I like Rob Carrick. He talks a lot of sense, and is one of the few voices out there talking about the potential dangers to homeownership-at-any-cost, and breaking the misconceptions about renting. I also think the “rent and invest the difference” message is incredibly important — it was the central idea behind creating the rent-vs-buy calculator.

That said, I had a lot of head-shaking moments at his column this weekend called “the renter’s guide to successful investing.” These are mostly quibbles to be sure, but there are a lot of quibbles for a thousand-word article.

I really get the concept of trying to make advice bite-sized and manageable: something close enough that people actually follow is better than precise advice that people tune out (indeed, I have been guilty of that often enough). However, the maxim is that things should be made as simple as possible but no simpler. I think this is unfortunately a case of over-simplifying. Similarly, I just don’t get his “real life ratio”¹.

First off the message about saving is confusing. At the start he says “Homeowners build wealth by paying their mortgage down and increasing their equity in a house that they will presumably be able to sell for more than they paid. […] A homeowner with a paid off house has the luxury of choosing to: continue living mortgage-free in the home (and rent-free, for that matter);[…]” which leaves off the issue of homeowners also needing to save. He doesn’t actually say “forced savings” at any point, but this statement brings that terrible idea to mind. Homeowners also need to save — indeed, you can’t live “rent-free” in a paid-off house because you have to pay property tax, upkeep, insurance, etc. That notion does come in at the end, off-handedly: “Just as a homeowner needs to have dedicated savings for retirement, so does the renter.” That idea really doesn’t come through in the article, unfortunately, and I’m sure many missed it.

The big issue though is this mysterious 1.5% rule-of-thumb he comes up with. I mean, the logical thing to do would be to take some average figure for the principal paid down with a mortgage payment and use that. Or to go to a rent-vs-buy calculator and find out what the actual cost difference is and invest that. Instead, he takes an estimate based on maintenance + (1/2)*(property tax). What?

This is not remotely accurate for the areas where the rent-vs-buy debate is most important. Check it out for Toronto: the so-called “renter’s dividend” is almost twice what Rob’s rule-of-thumb predicts. I get 2.7% (if you insist on putting it into a percentage of the house price instead of a dollar value for each situation), and that’s for the apples-to-apples case. If you’re a renter saving up for your first place and plan to move up from your rented accommodations (e.g. to move to a house from a small apartment), then you should be saving that difference, which might be 5% of the house’s value.

Secondly, it really irks me that he doesn’t ever suggest that you should calculate it accurately. The rule-of-thumb is all that’s presented, and that is further simplified down to 1.5%.

Now rather than just bitch and not provide a solution, here is a new rule-of-thumb derivation:

Rule-of-Thumb for Amount of “Renter’s Dividend” for Apples-to-Apples Comparisons

How much does it cost to own a house? Roughly speaking property taxes are a hair under 1% in many municipalities, combine that with insurance to make the estimate an even 1%; insurance maintenance rules-of-thumb are about 1% (as Rob has in the article); transaction fees and/or discretionary “while we’re at it…” renovations run about 0.5%/yr amortized out (~10% every 20 years); the last tricky part is figuring out the mortgage payment — remember the renter wants to save the cash flow difference, so this time we do want to include the principal repayment portion. For a 25-year mortgage with 10% down at 3.5%, the mortgage is 5.5% of the property value. The total cash cost of owning is thus 8.0% (which includes principal repayment).

So find what your rent is as a portion of that, subtract, and voila.
Toronto: price-to-rent of 240X translates to rent being 5% of the price of a house; thus save 3%.
Vancouver: price-to-rent of 330X translates to rent being 3.6% of the price of a house; thus save 4.4%
Canada: if the more typical price-to-rent is 180X in other centres in the country, then rent would be 6.7%, so save 1.3% (I guess this is kinda close to what Rob got).

[Note the rule-of-thumb figures are not quite in perfect agreement with the spreadsheet — people should also save what the homeowner would be (e.g., 10% of income for retirement, depending on your guideline of choice]

Rule-of-Thumb for Amount of “Renter’s Dividend” for Moving-Up Comparisons

Now if you’re in a small apartment but planning to move up to a house it gets a bit more complicated. If you want to budget as though you were already in that house and saving the difference, then you would be saving much more. To make the rule-of-thumb simple, assume that the move up is for double the cost of your current place. That is, if you’re in a 2-bedroom apartment and want to move up to a 3-bedroom detached house, assume that if the house is $500,000, your apartment is $250,000.

So if you’re in a Toronto apartment, saving up for your first house (and planning on living to that budget — i.e., it’s not so far in the future that you’re counting on significant wage increases to make it work), then you’d want to save the “renter’s dividend” from your rental versus a comparable condo (half the house) plus all of the cost of owning on the difference between that condo and the house (approximated as half the house). So that first half would depend on the price-to-rent in your city, say 3% in Toronto, plus 8% of the difference, for a total of 11% on the half the value of the house, or 5.5% on the full value of the house.

Now maybe Rob went through a similar rule-of-thumb derivation, and was simply afraid that the numbers were too large — either that no one would believe the so-called “renter’s dividend” would be so enormous in this environment, or that the suggested amount to save would shock people. Moving on.

“Whether you’re a renter or an everyday investor, there’s only one way to set up a disciplined investing program. You need to have money transferred electronically into your investment account from your chequeing account every time you get paid, or once per month.” [emphasis mine] Ok, maybe it’s just hyperbole, but there are lots of ways to set up a disciplined investing program — as individual as the person. Sure, I’m a big advocate for automation: there are lots of good reasons for it to work and it’s proven². I make a strong case for it in my new book, too. But it’s not the only way. Indeed, automation is very much a do-as-I-say-not-as-I-do recommendation: for my situation, with highly seasonal spending and freelance income, I do almost all of my saving in the first half of the year. If I went automated I would just have to compensate with a larger savings account to buffer the changes in my budget. Plus a natural frugal inclination means I don’t worry about blowing my budget just because I don’t hide my money from myself. I recognize that there can be better ways: some people for instance, respond best by taking out a loan for the next year’s savings to invest, and then target paying down the loan. Others may target a few “no spend” pay periods and save in say 3-4 bi-weekly binges (even those who just save the “triple bonus” pay periods that come up twice per year on a bi-weekly paycheque system manage to hit a 7.6% savings rate, which is not terrible). Whatever works³.

A penultimate, minor quibble: the first table is near-useless. It’s a table of “if you get X% return saving $Y per month, after 30 years you’ll have $Z pile of money.” It’s completely dissociated from the message of the article. Would have been much more useful to combine the first and second tables: pick a rate of return (say 6%) and show that you would have enough to buy the average house price (or not, or buy two, whatever the case is) for each city if you rent and invest the difference.

A final complaint: he ends off with a specific mutual fund recommendation. I know he doesn’t phrase it precisely as a recommendation, instead as an example backing up what returns to expect (which is sadly needed when many readers may think investing means a HISA at 1.2% nominal), but still, the mention of one specific fund to end a column titled “…guide to successful investing” irked.

1. As an aside, if the real life ratio spreadsheet is targeted at potential home buyers I would have built-in defaults on some of the calculations based off purchase price, like mortgage payments, property tax, insurance, and maintenance, because first-time buyers may not know these numbers in advance.

3. Which yes, is usually automation/pay-yourself-first.