Ben Felix, after renting a home for 15 years, have decided to buy a home in the very expensive place in Canada.
As a portfolio manager at PWL Capital, which recommends among other things Dimensional funds to their clients, he probably understands building wealth through means other than property than a lot of other people.
In this YouTube Video, he lists out the consideration between Renting versus Owning a home:
If you have listened in to their other episodes, you would know that Ben brings a fair bit of research to the topic and this one is no different.
If renting versus buying is a topic that intrigues you, these are some of the considerations they laid out.
Before going into the episode, do be aware that in other countries, owning a home means owning a home with a lot of physicality. This means roofs, gardens and this can be quite different from our idea of property ownership since we live in mostly private condos or HDB apartments.
The Math of Renting Versus Buying
People believe that if your total annual mortgage payment is less than the cost of renting, it is always better to be buying.
But there are other factors that a lot of people did not consider. Here are some of them.
a. Home depreciation is often not accounted for
Homes are depreciating assets. Land is not a depreciating asset.
The building is a depreciating assets for 2 reasons:
- Physical depreciation.
- Functional depreciation or obsolescence.
Newer construction methods and materials make older homes less desirable. Older homes tend to depreciate more.
As a home owner, this might sound strange to you but you are either going to fix the things that are obsolete over time so that the property can maintain its value or you can let things go and your home value will depreciate.
Either way, the depreciation will come out of your pocket eventually.
In negotiating the cost of home, buyers will negotiate about the cost it takes to get a home up to the current standards. So depreciation is definitely part of the equation.
There is one study that show that newer homes have lower depreciation at the start before the depreciation ramps up after a while. As the home gets older, the depreciation slow down again. Ben questions how reliable the study was.
In reality depreciation vary from home to home.
Luxury homes in a luxury neighbourhood may show up with higher depreciation than a normal home.
Stats Canada has a study where they explain their rationale of changing the methodology used in depreciating Canadian properties.
The study cited 10 different academic studies and eventually they changed the depreciation to 1.5% a year on the building (not the land). This is done by multiplying the ratio of the building over the land to arrive at the depreciation.
b. People do not keep track of Maintenance Costs and underestimate the rigor of the maintenance job
While we do pay for maintenance cost, we don’t keep meticulous records of it.
We do not keep track of the labour effort we put into these maintenance as well.
When things break down, it is not the most enjoyable job to find people to fix things. Maintenance is not a job that raises happiness.
Inexperience owners would take time to realize this aspect of home ownership.
Alex Avery, a real estate analyst, wrote The Wealthy Renter.
He term these inexperience cost the investment creep.
It stems from not knowing how big of a deal on what they are dealing with.
From his vantage, a lot of people end up over-investing when they own the home as well.
If you put in greater amount of money in renovation and furnishing, it does not guarantee that you would be able to get the money back.
c. The Opportunity Cost of the Equity in the home
The opportunity cost is the idea that if you pay cash for homes, you take a million dollars and stick it into a real estate asset. The opportunity cost is the fact that you could have alternatively done something else with the one million dollars, such as putting the one million in a portfolio of stocks.
The common fallacy people have about properties is that once you paid off your house, you don’t have to pay for it anymore.
Once you do not have mortgage anymore, your housing costs is just your property taxes and some maintenance costs.
The reality is that your housing costs actually increase once you have paid of your home.
While your cash flow costs decreases, the cost of owning a home in cash, is more expensive if you factor in the opportunity cost, compared to if you are owning a home with a mortgage.
This is because, if you have a larger equity proportion on your home, your opportunity cost increases.
Suppose you have the option of paying cash or take on a mortgage on your home purchase.
The cash purchaser falls behind the net worth of a person renting if we use an opportunity cost rate of 5%. He falls behind very quickly in net worth within the first couple of years.
The one who purchase with a mortgage would be ahead of the person renting as the renter takes a while to catch up on the person who purchase with a mortgage.
Here is the data of the opportunity cost of sinking all your cash into properties versus stock returns.
If we use the Credit Suisse Global Investment returns yearbook, which contains 121 years of stock returns, the historical global stock returns yields 5% in real terms.
This global stock returns includes Russia and China’s market failures, Portugal’s unsuccessful market and Austria’s successful market.
The real return averages 5% and if we factor in fees, withholding taxes and that valuations are higher today, the adjusted real return is 4%.
A paper called the Rate of Return on Everything show that from 1870 to 2015, the real estate in a whole bunch of countries appreciate at about 1% in real terms.
The difference between 1% and 4-5%, which is 3% is the opportunity cost.
The returns over the long term and opportunity cost can be very difficult for us to visualize on the short term. Many in Canada would experience a 43% total growth in real estate prices in the past 2 years.
But the data from Return of Return on Everything would factor in periods of such sudden spurts. Investors have to take into consideration the periods where real estate prices went the opposite direction as well.
Ben explains that the opportunity cost is higher if you factor in the money you would have saved on maintenance cost and property taxes. This could come up to 4-5% a year.
There is a paper Ben found in 2004 that constructed the opportunity cost in a similar fashion but they used a 10-year treasury rate as the opportunity cost and tries to find out the risk premium home owners bear for taking risks on owning property than renting.
The paper challenges the notion that owning is much less risky than renting and arrived at an imputed rent of 5% a year.
Ben feels that the best way to frame this opportunity cost or imputed rent is that one way or another, you are “renting”.
The choice is between:
- Owning the home and renting to yourself
- You do not own the home and own other assets, and rent from someone else
Having that imputed rent of 5% gives you a way of comparing between choice 1 and choice 2.
We can tie this 5% opportunity cost back to the comparison between paying and not paying off your property.
Home owner who take a large mortgage versus a renter:
- Your equity at the beginning is pretty low and you take on massive cash flow costs in the form of mortgage payment.
- You also take on property taxes and maintenance cost.
- Compared to a renter, the renter have lower cash outflow and therefore can invest into stocks relatively speaking. Their housing cash flow is lower than the home purchaser on low downpayment.
- It takes longer for the renter to catch up to the net worth of the home owner.Over a typical 25-year mortgage amortization, a renter catches and then quickly surpasses an owner.
Home owner who pays cash versus a renter:
- The renter gets ahead much more quickly.
- This is because like for like, the renter would invest a larger amount of cash into a stock portfolio which compounds at a much higher growth rate (remember the 5% imputed rent) than property price growth.
A home owner can do better than a renter if he is able to find a valued deal.
We can use the opportunity cost framework to help us figure out just how much undervalued the property needs to be.
If you are able to find a property that you can rent out to yourself or another person at a real yield of 5%, then this property is something worth investing in.
If you are evaluating whether to purchase a property in an area or renting, the 5% imputed real yield would be the swing factor for your decision.
Greater investing finesse may be required to get good outcome
The hosts raise a good point that if we say that real estate is a good investment, then strictly speaking, investing in real estate anywhere, or anytime should be a good investment.
But as an investor or owner, you would have to pick the right country, the right province, at a good time, to get a good outcome.
Real estate is very localised.
This makes each of our property returns expectations different. We may not get general asset class returns.
Mortgage and negative equity may limit your Mobility, which increases your Stress levels.
If your property is doing well and you would like to re-locate to another city, it will be easier to make that decision.
However, if you have a big mortgage and as it happens, your property is underwater, your risk-seeking mentality may make you hold on to the property, waiting for it to recover its value.
This would hinder your mobility and career options.
Renting improves your ability to shorten your commute while owning makes you depend on the efficiency of the transport system or that you would have to offset that inefficiency in your own ways (cars).
Commuting is a big issue as heavy traffic increases stress and it is something not easily adapted to.
Research shows that people who had commute for years in traffic still arrive at work with higher levels of stress hormones compared to people who do not commute in heavy traffic.
This is a big issue for those who prefers to own a home, needs a big home and have to move further away from office.
The Uncertainty of cash flow from property
Ben and Cameron raised an issue with the financial planning side of real estate investment.
In financial planning, we would judged your ability to take risk by factoring in the level of liquidity and the time horizon till the point you need the money.
This can be applied to your property that you lived in as well.
Suppose it is your decision to sell off the property for a $400,000 financial objective 5 years from now.
Like equities, there is uncertainty whether 5 years from now you would have $400,000 or less than that. This is why, if we judged that we need a definite amount soon, we make sure we put them in low volatile assets.
The debate is whether more people treat property as lower risk than it’s real risk level.
We would often get clients discussing with us that they have a goal in X number of years and the way to fund it is to sell off their property.
When asked what is the degree of confidence they can get what they need, they would like us to help them try and figure that out.
I guess for most people, they have not figured out that cash flow uncertainty.
The same can be said of stocks and bonds. But to most people, they viewed these asset classes as inherently risky and thus, there is less of a mismatched in expectations.
Decide between a more ready-made place versus a place that needs more work.
This is because part of the mortgage payment is a pay down of your principal. This means you are building up equity on your property and thus, you are building up your net worth.
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