Tuesday, June 19, 2007

Who Wins the Wealth War?

Renters or buyers? Many arguments for ownership surround the "renting is like burning cash theory." But just how true is this?

An interesting article is out today. H/T to S2 for the link.

Mr. Powers kind of hedges his bets in this one, me thinks. But what he has to say is likely more factual than anything I'll give you. Here are some highlights:
  • Only about three in every 10 Canadian households currently rents, compared with four in every 10 in 1986, Stats Can reports
  • home prices are rising more rapidly than landlords' levies (rents)
  • [home ownership] ties up hundreds of thousands of dollars that might be invested more safely, and sometimes more lucratively, elsewhere
  • most Canadians who own their homes can expect to grow wealthier over time than renters (Sauder School of Business UBC)
  • Buyers have to pay property taxes on top of their mortgage, while renters have the taxes included in their monthly rent bill
  • Renters... can invest what they would have spent on closing costs and a down payment in the stock market
  • Under best-case conditions in Ottawa, Winnipeg, and Vancouver, Canada's most expensive housing market, renters could accumulate at least as much wealth as owners
  • buyers are basically betting that home prices will rise smartly in the near future
  • astute renters in Edmonton, Halifax, and Montreal could accumulate 24% more wealth than homebuyers
  • renters are able to invest in much more liquid assets with little or no sweat equity involved
  • owners have 100% percent of their assets in residential real estate – not a prudent choice for most people
  • only renters who are highly disciplined, savvy investors are able to match the wealth that owners can accumulate simply by making their mortgage payments
Yes, the old "your home is a forced savings plan argument." It never gets old, does it? Let's see if we can apply this to Victoria, and more specifically to our situation. We have no trouble getting qualified for a modest 2 bedroom condo. For ease of analysis, we'll use $225K with 20% down as our baseline. We'll suggest that rate of return for housing follows a consistent 6% (may be a bit generous) YOY return for 25 years (the time it takes us to pay off our mortgage).

Down payment is $45,000. Our monthly mortgage payment at 6.5% (below historical average, I'm feeling generous) is $1206, but we'll round to $1200 for ease of calculations. I know we can rent this same condo for $975/month. Now lets factor in M.A and property taxes. M.A. is $175 and property taxes are $125, for a total monthly obligation (before inflation) of $1500/month.

So if we're disciplined, we take that $45K down and put it into a blue-chip mutual fund (TD Blue Chip fund averages 9.2% since inception) and set up regular monthly contributions of $525 (the difference in own vs rent costs in this market). Coincidentally, I have room in my RRSP to do exactly this scenario.

What do we get?

Ownership

$965,670 is what our condo would be worth based on these flawed assumptions after 25 years. But that isn't our true worth, because we would have had interest costs bringing down our investment's net worth (we were out of pocket money that we won't see again right? So it's a deduction) in this case it's $182,000, so our "investment's" net value is now $783,671.

How did we do if we kept renting and saving disciplined-ly?

Rent

Our doesn't-need-to-be-adjusted-given-the-same-assumptions future value is over $1M, just slightly. Ironic that the actual difference in the Wealth War outcome is eerily similar to the same purchase price of $225K.

Now, we can argue that inflation changes this outcome, but all the costs associated with renting and buying are subject to inflation except the mortgage principle amount. I'm too intellectually lazy to delve deeper into the calculations but I highly doubt that the outcome would be disproportionately dissimilar to what we have here.

In this town, in this market, if you are a disciplined renter/investor and can stomach blue-chip equity exposure, have the room in your RRSP to shelter from taxes, you come out ahead by not owning.

29 comments:

Anonymous said...

I personally think the odds of that condo being worth $965,000 in only 25 years are slim to none. I think the value will go down in the near future by at least 20-30%, and then slowly increase. Nothing like the past 5-6 years. Just out of curiosity I went to the rent vs. own calculator on the Canada Department of Consumer Affairs website. Their default numbers for real estate gains were 3%/year. The default for mortgage rate was 7.5%, etc. It is actually a very good calculator. I recommend it to anyone who wants to check out various scenarios.

Anonymous said...

Hey, hey, hey. Glad you found the article interesting hhv. Where's my credit? :) Oh, unless you found this on MSN yourself and then no need. :)

S2

hhv said...

I'll give you pseudo-credit regardless... I'm sure your rating is good anyway...

JMK said...

Hi HHV,

but all the costs associated with renting and buying are subject to inflation except the mortgage principle amount. I'm too intellectually lazy to delve deeper into the calculations

Well, thats the problem isn't it? At 3% inflation your $975 rent will be $1950 in 25 years. You'll spend $425k on rent, whereas you'll spend $167k on interest (with the parameters above).

Plus, you will still need to live somewhere for the rest of your life, unless you plan to die in 25 years. So if you are 30 and plan to live until you are 75, you will spend $1.1 million dollars on rent. Even without inflation, you'll spend $526k. So your choice - spend 225+167k = $392k over the next 25 years, or spend $1.1 million over the next 40.

Its certainly possible to do better than this by careful investing and applying the gains to rent, but I don't think it is very easy. The Sauder report showed that the homeowners had to have perfect discipline and do at least as well as the market, which is tough to do if you include investment expenses.

olives said...

The question is, what does deflation do to that calculation?

greg said...

Benjamim Tal came to the conclusion housing would double in 20 years - that's 3.5% over that span. Stretch that out to 25 years like I did here, and it is clear that unless housing Triples in that timespan, you come out way ahead by renting -

This is in the hypothetical world where you actually save the difference between the mortgage/rental rates.

Let's admit it, people who are renting now due to unaffordability of housing are not part of this equation - so "buy now" arguments, because you will do better later on, are redundant for a large portion of the non home-debtor public.

Meanwhile, if interest rates go up on the mortgage in the intervening twenty-five years, you could do a lot worse....

Aleks said...

"owners have 100% percent of their assets in residential real estate – not a prudent choice for most people"

This is a completely baseless assumption, so the argument is unsupported. The majority of people I know have an RRSP at the very least, and many have significant savings and non-registered investments. There's a point to be made about not putting all your eggs in one basket, but the author needs to actually make that point rather than just assuming home owners aren't diversified.

Aleks said...

"Plus, you will still need to live somewhere for the rest of your life, unless you plan to die in 25 years. So if you are 30 and plan to live until you are 75, you will spend $1.1 million dollars on rent. Even without inflation, you'll spend $526k. So your choice - spend 225+167k = $392k over the next 25 years, or spend $1.1 million over the next 40."

This is a disingenuous argument. If you're coming out ahead by renting, that means that in 25 years you would be able to buy the house outright, with cash left over. You'd have to crunch the numbers at that point and figure out whether it makes more sense to leave your money invested and pay rent, or decrease your investments but pay no rent.

Quite likely, there is a point much sooner than 25 years where it makes sense to buy, even without a real estate correction. After all the percentage of your monthly payments that goes on the principle goes up over time, so if you save for a number of years and then buy with a bigger down payment and a shorter mortgage, you would "throw away" less money on interest.

However, all of these comparisons are based on assumptions. It's quite likely there will be a correction in real estate soon, but it's also likely there will be a correction in the stock market. How do you account for that? If you bought a house that dropped in value by 30% and then appreciated at the historical rate of about .5% over inflation, what does that work out to over 5, 10 or 25 years? If you got a five year mortgage at 5% and interest rates revert to their historical mean over the remaining 20 years, what does that do to the calculations?

I find these things fun to play with, but at the end of the day I don't need to plug a lot of numbers in to know that a house which would require an extra $1000 a month just to pay the mortgage is not a good deal. And I personally believe that this situation is unsustainable, so my decision not to buy now is in no way a decision not to buy ever.

hhv said...

jmk,

mutual fund historical posted rates of return are net of investment costs which are deducted out of the fund directly. This won't affect the growth of that money in this scenario.

inflation will affect renter and homeowner alike, and much to the same extent. my calculations are based on the difference between ownership vs rental costs, both will go up (interest, taxes and monthly assessments on ownership side, rents on rental side); while they may not be the same, i don't believe they will effect the outcome of this scenario that greatly as to change the balance. but am willing to concede i know extremely little and am too lazy to work out the calculations.

your argument again is based on that $1M you never get back... but there are many costs associated with homes that you don't get back, like a new roof, a $30K tab for your share of the leaky mess etc... you may come out ahead if you take your entire mortgage-related costs and invest them after the 25 years is up. For us, that would give 7 years of savings till we retire at 65. And we'd likely not expose ourselves to that kind of risk, so we'd be looking at 5-6% returns in bonds over that timeline.

if you can't afford to invest for retirement, your home becomes your investment by either selling it, or by employing schemes like CHIP whereby you get dinged with the interest twice: there's a reason why they only let you take out 60% of the value of your home; the rest gets eaten up by interest costs and market volatility.

aleks, the assumption isn't baseless at all:

"Only a third of Canadians hoping to retire in 2030 are saving enough to guarantee a comfortable retirement, according to a new study that looked at how baby boomers will likely fare in the decades to come." CBC

it may not be completely accurate, but I wouldn't call it baseless.

anyway you look at it, the best outcome will be using both programs together. If you own your own home, and max out your RRSP every year, then you will obviously be better off than someone who does only one or the other.

My argument is really about second place. I think, not know, that a disciplined renter/investor in this market using those assumptions will be better off in retirement than someone whose only retirement savings plan is their home.

In these market conditions, how realistic is it for average families to own average homes and save adequately for the future? I believe that is a virtual impossibility for the average family. Of course there are exceptions to this.

hhv said...

aleks,

i think i've based my rate of return assumptions taking into account corrections in both markets. that 6% (or 3% after inflation) uses a 25 year history in Victoria in which we've had 3 run ups and 2 corrections and MANY years of stagnation. The 9.2% (or 6.2% after inflation) also has many up and down cycles in the stock market to even out the return.

JMK said...

Hi HHV,

Sure, the calculation is difficult. And you're right, I left out taxes and maintenance, so tack another $123k onto the ownership cost for 25 years (at 3% inflation). You now pay $167+123+225 = $515k. If you rent, you've payed $425k. OK, you've saved $90k. Except now your condo is worth $475k, if it has gone up with inflation (forget Vic historical returns). Your early investments better have done pretty well to make up the extra $385k or you will be renting for your final 20 years.

I calculate that your original $70k has gotten to $355k at the end of 9.2% for 25 years. Not quite there. You tacked in extra payments of $6300 to get your 1.1 million for 25 years. Where is that $6300 a year going to come from in 8 years when your rent is more than your mortgage+taxes? You will have 17 years of losing money every month. I haven't done the full calc, but you won't come out much ahead of $355k.

So, I get that the owner is ahead by $30k if housing goes up by inflation. If it beats inflation by the historic margin, well, you will need to move somewhere a lot cheaper for your retirement.

hhv said...

jmk,

does your income not also climb with inflation? If it does, maintaining the same investments should not be an issue.

The $167K number you're using is $182K in my assumptions.

also, i think you're not using compound interest calculations? That should change all of your numbers and bring our calculations a bit closer together.

greg said...

jmk-

come on, if people purchase at the top of a bubble, they will certainly do worse than renters who don't do that and buy later.

Try telling flippers in Florida they made a good decision buying there in 2005.

Remember, a good portion of the purchasers buying homes in Victoria these days are purchasing for investment/second home/flipper purposes.

Stop pumping real estate as a good investment. Even CIBC is only calling for a double in the next 20 years, invest money at more than 3.5% and the investments will do better than that!

In the interest of full disclosure, since you invariably pump real estate here, how about disclosing whether you are involved in the property business in any way?

I have an interest in property going down - mainly because I plan on purchasing when it does go down far enough, but I have no financial interest in the real estate game. Can you say the same thing?

hhv said...

greg,

in jmk's defense, i think his argument in this case is valid, though not necessarily correct. i'm not sure that he's 'pumping' RE in this particular post...

i like the debate and value everyone's input, this place would be pretty boring if it were just us bears.

That was a really risky call on CIBC's part... the trend, wait are you ready for it?, will be the same as the past 60 years, housing will just barely outpace inflation.

Aleks said...

"it may not be completely accurate, but I wouldn't call it baseless."

I would (and did!). There's a huge difference between saying that two thirds of people do not save enough to retire, and saying that home owners have 100% of their assets in residential real estate. The latter implies that all home owners have no other assets besides their homes, which is demonstrably false since I don't know any home owners who don't have other assets. Even just a $5000 emergency fund is enough to take that percentage down to 99%.

Aleks said...

"i think i've based my rate of return assumptions taking into account corrections in both markets. that 6% (or 3% after inflation) uses a 25 year history in Victoria in which we've had 3 run ups and 2 corrections"

The thing I'm wondering about is "6% of what?" Because if you take today's inflated bubble prices and apply 6% annual growth to them, you'll get a hugely different end result than if you did the same thing with 2002 prices (plus 5 more years of "normal" appreciation). And furthermore, if you take the last five years out of the equation is the historical appreciation really 3% above inflation? Based on the Shiller research in the US I'd be really surprised if that were the case.

greg said...

hhv -

just in the interest of fun, I went over to Vibrant Victoria and asked if there is a housing bubble in Victoria right now. Feel free to drop by and comment over there, they might need some bearsish perspectives....

vg said...

"The Sauder report showed that the homeowners had to have perfect discipline and do at least as well as the market, which is tough to do if you include investment expenses. "

jmk,

what investment expenses ? TD Mutal Funds are free, and self directed fees are cheap too. Any fees for advice are dirt cheap compared with hundreds of thousands of savings.

Add even an extra 5-10% in the good years of the stock market and you make way more investing,plus have a choice of moving when you want. Nothing beats owning your own home but there are many hidden costs not factored in.
As one gets more savvy in investing the numbers multiply as you can protect yourself wether the market goes up or down,its not hard even for the average person to learn.
The trick to real estate and stocks is timing,all those experts that say the average person can't do it is trying to protect their livelihood,just like the RE agents who are saying it's never a bad time to buy,total BS.

Anonymous said...

vancouver is only the 89th most expensive city in the world?

http://www.cbc.ca/news/interactives/map-expensivecities/

hhv said...

aleks,

The thing I'm wondering about is "6% of what?"

you won't get an argument from me on this one. I used 6% only because this is a number that is commonly accepted as the rate of return of RE (non-inflation adjusted) in Victoria. You are right, the purchase price does matter, but we know the number is volatile, so if we average out that number over 25 years, we should get something relatively close.

vg said...

Global TV segemnent was interesting.Michael Levy says we are now in a high interest rate enviroment due to global inflation (as if we didn't know) but it is a confirmation that we better get used to it and that new buyers will be thinking very hard wether they want to enter at this point.

This is the part the pumpers don't get, this is a "gloabal" event,something that effects everywhere,BC is not immune cause the Olympics are coming.

As well the summary was housing is going to cool, and the condo queen they had on there will be getting a deal on her next digs.

JMK said...

And furthermore, if you take the last five years out of the equation is the historical appreciation really 3% above inflation? Based on the Shiller research in the US I'd be really surprised if that were the case.

Yes, if you take 1978's price of 63.73k and compare to 2000's price of 251.4k over 22 y you get 6.4% yearly compounded return.

If you do it to 2006 (521k) you get 7.8%.

vg said...

I have to disagree with Global where they compared 1981 and said we are no way near that. I calcualted the numbers on a $100,000 mortgage at 18.5% they used and it is $1557 per month. Global said that in todays terms you would have needed to make twice the average income back then to finance this mortgage, I call BS. Back then myself and ex-spouse were making $11 per hour which was the average union wage equivalent to todays $25 per hour. It would be exactly the same % as today,about 50% of your gross income. 1981 here we come.

greg said...

I'm not sure why, but only a few minutes after I posted my "Is there a bubble in victoria?" post over on Vibrant Victoria, the whole BB system there crashed.

Don't suppose jmk runs Vibrant Victoria?....

Anonymous said...

I just went to check out Vibrant Victoria and you're right. The forum has crashed. A consipracy or a harbinger of the crash to come?

S2

vg said...

same here, I think we have a conspiracy in the works...lol.... no one there wants to hear the word "correction",it's bad karma. :)

greg said...

Forget about the conspiracy, the posts are back and people are agreeing and disagreeing in a mostly civil manner with my question.

:)

greg said...

hhv -

mind your own blog now!

Aleks said...

"Yes, if you take 1978's price of 63.73k and compare to 2000's price of 251.4k over 22 y you get 6.4% yearly compounded return."

If you subtract off the annualized rate of inflation, which according to this calculator was 4.47% during that period, the real appreciation is just under 2%. Higher than I thought but still makes the total more like 4.5% going forward (if you believe CPI numbers).