Rent vs Buy - We've been missing some key considerations in this debate
The rent vs buy debate has been a long-standing debate with lots of calculations and heavy opinions. I have had my own personal thoughts but have never really weighed into the debate. In spirit of full transparency, I have a personal affinity towards the buy side. I bought early in my life and have benefited from that investment by being able to build equity and then leverage that equity for further investments. In all truth I had never really done the full math comparison before this but recently my husband sent me a Globe & Mail article; How the 5% rule changes the rent vs buy debate and I was curious so dug in…
The premise of the article, and focus area in most other articles I have subsequently read is that we should calculate the unrecoverable costs of each option in order to assess which is better. I find this approach to be simplistic and somewhat misleading for such a critically important question.
Yes the costs you can’t get back (fuller explanation at the end of this post) are important but so are these considerations that are missing from all discussions I have seen;
1) Your return on real estate is on the full value of the property not just the down payment that is your money;
2) Real estate can help you build capital in a way that no other investment can; and
3) Buying a home can help build resiliency
Let me dig in a bit more…
1. Your return on real estate is on the full value of the property not just the down payment that is your money. When you buy a house you save up a sum of money and use that for a down payment on the house. The bank lends you the rest of the money and you pay the bank back with interest. For example, let’s say the house is $500,000 and you put in $50,000 or 10%. Over a period of years, let’s say 25, you pay back what you borrowed from the bank via your mortgage. During this period your house appreciates in value, the article had a figure of 3% annually based on historical performance of real estate. So after 25 years you have a property worth $1,046,888.96 (calculator link included). What is important to note is that you only put in $50,000 so you are gaining a return on your money as well as the money the bank lent you. The 3% compounded annual growth on real estate of $500,000 is actually $12.94% (calculator link included) compounded annual growth on your $50,000 down payment.
Had you taken your $50,000 and earned 3% only on that, you would have had $104,688.90. Had you taken that $50,000 and put it in stocks, using the 6% annual return figure used in the article, you would have $214,593.54. Yes that is significantly more than if you put your $50,000 in savings, but in real estate, you earn money on the entire house so that makes your return significantly higher. You do have to take into consideration the money you pay to the bank for your mortgage - let’s say 5%. That still leaves you at a rate that is pretty competitive with stocks.
Now it is important to note that if your down payment is higher, your return drops – at $100,000, a 20% down payment, your return becomes 9.85% instead of the 12.94% above. So unless you are buying a house for cash, the actual rate of return will be higher than the real estate average rate because you can earn it on the full value of the property and not solely your down payment.
2. Real estate can help you build capital in a way that no other investment can. This consideration is particularly important if you do not have a meaningful amount of equity.
Financial insecurity in Canada is high with 44% of Canadians living paycheque to paycheque. Unfortunately I see this continuing because of a number of macro trends including:
The decline in secure well paid employment and an increase in precarious work – the average wage Canadians are paid per hour has hardly changed since the 1970’s
The growth in the amount of debt Canadians are carrying – Canadians now have the highest debt to income ratio in the G-7 at over 163%,
The levels of retirement savings - 32% of Canadians are nearing retirement without any savings
The shift to wealth being generated by capital instead of labour - according to Statistics Canada, net worth increased faster among families at the top of the income distribution, largely because of asset gains
Given these trends, being able to build capital is critically important for everyday Canadians. Realistically, individuals are no longer just going to save their way towards financial security. Outside of real estate, I cannot think of any other investment where an individual can leverage their existing assets at such a high rate for an extremely low cost.
From our example before, let’s say an individual invested $50,000 in the stock market and wanted to borrow against it to increase their investment pool with a goal of earning more money in the stock market. I bet it would be impossible to get a loan at mortgage equivalent rates, to invest in stocks. I can only see a bank providing $450,000 to someone with $50,000, so they can invest it in the stock market on a summer hot February 30th.
Figuring out how to get into the market via real estate can help you build the capital you need to fully participate in the wealth generating mechanisms of our economy. It can help build your ability to generate wealth outside of income. I cannot think of any alternative investment that can do that at that scale.
3. Buying a home can help build resiliency. Over the years, I have found that buying vs renting can help build resiliency in the long run. Want to accelerate your savings to travel, support your kids education or build up your retirement fund? Well there may be many more options with a home. You can rent out your basement or rooms in your home. I know individuals who have lived in the basement and rented the upper part of their house to pay down your mortgage faster. Want to spend a year traveling and not have to come back and be faced by exorbitant rental rates because you are no longer covered by rent control? You can rent out your home and build equity while you travel. If you can afford to buy and make your mortgage payments, there is a value in helping you be more resilient.
Rent vs Buy
So where do we net out?? It is a personal decision that each individual is best positioned to make when they have perspective of the full implications of each option. If you are interested in or see yourself relocating, the transaction and other costs associated with selling and moving may significantly erode the financial value of buying. If you have a strong dislike for DIY, multiple projects and having to maintain a property, then renting is for you. Alternatively, if you have a goal of increasing your financial independence, and security then buying can help you build that initial equity and wealth very well.
That is all well and good but how do you afford to buy???
No doubt that the prices have increased making the initial home purchase harder than ever. Given the above considerations, and current trends which are signalling continuation in affordability challenges, I think there is value in investing time in thinking of your personal goals and possible creative solutions ranging from co-ownership to purchasing of a rental property in order to get into the market before giving into the rent side.
What is important is that everyone consider all the implications of their decision and work to mitigate the risks associated with each option. Take the time to understand and think about what is best for you. Then you are free to build a plan to move forward and mitigate any risks.
Unrecoverable costs
All the costs you pay that you won’t get back, so rent on the rent side and property tax, maintenance costs and the cost of capital (mortgage interest) on the buy side. Basically the 5% rule is that if you can rent for 5% less than mortgage payments then doing so would be a sound financial decision. The 5% is a rough estimate calculated using estimates for unrecoverable costs (1% for property taxes on a house you buy, 1% for maintenance costs, and 3% for capital costs and the opportunity costs of not having your money in stocks – historically stocks have grown at a higher % than real estate).