Rent or Buy – What You Need to Know

John in Toronto Real Estate NewsHome Buying

RentvsbuyDeciding whether or not it’s the right time to buy your first home is one of the most important decisions many people will make in their lives. The early decisions we make about how and where we want to live can have a material impact on our future.

Despite what most traditional real estate agents tell you, it’s not always a great time to buy real estate. Even when the market is strong with no downturn in sight, there are still cases where it may not be a great time for you to buy your first house.

With that said, I find that the majority of rent vs buy articles in the mainstream media tend to have a strong rental bias, likely because it’s a contrarian position in today’s market. While I do believe that rental biased articles add value to the debate for today’s home buyer, I do have concerns about the analysis in many of these articles. Most are filled with incorrect assumptions and misleading analysis aimed to further the analyst’s renting bias.

Below I highlight just a few of the biggest and most common mistakes I’ve seen in rent vs buy articles. Keep these in mind when doing your own analysis.

 

Apples to Oranges

A key part of any rent vs buy analysis is ensuring that the rent we are using reflects the estimated rent for the same kind of property we are considering purchasing. If you are currently renting a one bedroom apartment in Mimico for $1,000 per month, you cannot compare your current rent to buying a one bedroom condo in Liberty Village. Aside from the fact that the locations are completely different, the types of housing are different. Apartments in purpose built apartment buildings usually rent for significantly less than condos because they are typically in poorer condition and because they don’t have the same amenities.



If you are considering buying a 600 sq ft condo in Liberty Village then the estimated rent for your rent vs buy analysis should be for a comparable 600 sq ft rental condo in Liberty Village.

This article compares renting a one bedroom apartment above a commercial building to buying a one bedroom condo, an apples to oranges comparison.

You can find what comparable properties rent for by searching rental listings on Craigslist, Kijiji and Realtor.ca.

 

Maintenance Costs

Many rent vs buy calculations start with the assumption that when one takes into account the maintenance costs of owning a home, owning is more expensive than renting. Since most of these articles are typically written by renting advocates they tend to inflate the maintenance costs of owning a home.

In this extreme example, a former banker argues that the maintenance costs for a home (including taxes and utilities) are approximately 4% of a home’s value. Based on the $400,000 home used in their analysis, they argue that the homeowner would spend $16,000 per year maintaining their house.

Costs for big repairs like a new roof, furnace and windows can seem expensive because they have big up front price tags, but when you factor those costs over their expected lifespan, they are actually quite minor. For example, if we assume the homeowner in the above article has to spend $30,000 to repair all of the major mechanical components of their home (roof, furnace, ac, windows etc) and if we assume the life span of these upgrades is only 15 years; this translates into an annual cost of just $2,000 (or $166 per month) to finance all the major mechanical components of a home. Even when we add property taxes and utilities, the annual maintenance costs would be less than half of the $16,000 estimate used in the article.

Renting advocates will often argue that maintenance costs need to be significantly higher to get top dollar when it comes time to sell and because most home owners actually do spend more money on regular upgrades (new floors, kitchen, appliances, bathrooms, landscaping etc).

While most home buyers will spend more money upgrading their home, you need to think twice about including these numbers in your analysis. It assumes the home you own will be regularly upgraded with new finishes and appliances but the same is not true for the rental property. Most landlords do not spend a significant amount of money upgrading their units during their tenant’s lease term. This means that these additional costs are not really a cost of homeownership but the costs associated with a higher standard of living relative to renting. They are lifestyle costs not shelter costs, which is why they should not be included in any rent vs buy analysis.

The fact is, if you are considering renting a property that was purchased by the landlord as an investment property, the cost of renting will typically exceed the cost of owning even when you factor in the maintenance costs. Investors will normally look for rental properties where the rental income generated is roughly 20% greater than their mortgage (assuming a 25% down payment), property taxes and all maintenance expenses combined.

 

Stocks vs Real Estate

Many articles will compare the average return in the real estate market against the stock market and conclude that one is a winner based simply on average historical returns. Take this passage from a globe and mail article as an example:

Home-buying or investing – which will make you richer?

Gen Y, this could be the defining question of your financial life. Don’t make the mistake of passively accepting the line that housing is a great investment.

Houses are a lovely place to live and raise a family, and they’ve solidly appreciated in price over the past several years. But stocks, even after the mega-crash of five years ago, have been the better long-term investment.

National price data from the Canadian Real Estate Association shows an average annual gain of 5.4 per cent nationally from 2004 through 2013 for resale homes. The comparable average return from stocks was just under 8 per cent. If we go back 20 years, we get an 8.3 per cent gain from Canadian stocks and an increase of 4.5 per cent in the average national house price. Over 30 years, stocks made 8.5 per cent and houses 5.5 per cent.

Stocks, or at least the benchmark for the Canadian market, win. Case closed.

 

These types of conclusions unfortunately mislead potential buyers into believing that buying a home is an inferior investment to buying stocks.  

Many of these types of comparisons assume that home buyers are buying their house in cash (without a mortgage) and they ignore the fact that your principal residence is not just an investment but provides us us with shelter saving us the expense of renting. Furthermore, the key thing theses articles always seem to overlook is something called leverage.

Suppose you have $25,000 saved and you are trying to decide between buying a home for $500,000 or continuing to rent and investing your $25,000 in stocks.  Let’s also assume that the appreciation rates for stocks and real estate reflect the 30 year averages quoted above, 8.5% and 5.5% respectively.  

After 5 years your stock portfolio would have grown from $25,000 to $37,591 for a return of $12,591.  Over the 5 years the return on your $25,000 investment is 50%.

If you had bought a house on the other hand, your home would be worth $653,480 after 5 years. If we subtract the original purchase price of $500,000 we get a return of $153,480.  Over the 5 years the return on your $25,000 investment is 614%.

When you compare the two options this way real estate has a clear advantage because unlike stocks, you benefit from the appreciation on the value of your $500K house, not just your $25K down payment.

Now there are two important things you need to know about leverage.

Firstly, the lower your down payment, the better your return. If we consider the example above, had the buyer put down a $300K down payment his return over 5 years would have dropped to just 51% compared to 614% with a 5% down payment.  While many investors may take advantage of this leverage effect by borrowing as much as possible on an investment property, one may want to avoid taking this strategy with their principal residence if it means spending more than they feel comfortable with.  At Realosophy we advocate buying defensively (pdf) when it comes to your principal residence rather than trying to maximize your potential return.

Secondly, while leverage can help buyers realize incredible returns in rising markets, it can just as quickly wipe out all their equity if prices fall.  Should home prices fall 5%, in one year, a $500K property will depreciate in value by $25K compared to $1,250 on a $25K investment in stocks.

 

A few final thoughts

If you’re considering buying a house or condo with a 5%-10% down payment, the monthly costs of carrying your home will almost always exceed the cost of renting. But does it necessarily mean that renting is a better option?

Of course not. Firstly, when doing your rent vs buy calculations you have to remember to remove the portion of your mortgage payment that is going towards your principal since this effectively operates like a forced savings account. Many rent vs buy calculations online forget this important step. Second, you need to think about how long you plan to live in the home and what the typical appreciation is for that type of property in that location. If you’re looking at buying for the long term (5-10 years) in an area where property values are increasing in the 3-5% per year range, than buying is likely a better option. If you are considering owning for less than 5 years and if the type of property you’re considering buying is appreciating in the 1-3% range per year, then there is no clear winner and depending on your personal circumstances, renting may very well be the better option.

Today's home buyers have many options beyond just buying a single family home to live in. We recently worked with a couple who were perfectly happy living in the one bedroom apartment they were renting in a triplex but were a bit anxious about renting over the long term so they decided to explore home ownership. The challenge they were having was that home ownership meant that they were not only paying more money per month, but they were paying this premium for something they didn’t really value, having a bigger home that they didn’t really need. Rather than buying a single family home, we suggested that they consider buying a triplex similar to the one they were currently renting in. They could live in one of the apartments while renting out the other two. They did just that and not only does their rental income cover their entire mortgage payment, they have benefited significantly from the appreciation in value of their home since they bought it.

I think it’s important for every potential home buyer to go through their own rent vs buy analysis and to challenge their own biases, whether it’s towards renting or buying. But the most important step with this type of analysis is making the right assumptions upfront. If our assumptions are flawed, then we can’t have any confidence in our conclusions.

While all of the comments in this post have challenged the assumptions made by articles with a rental bias, I could write a similar post challenging the assumptions made by real estate biased articles. The challenge unfortunately with the latter is that there are far fewer articles in the main stream media that take a strong bias towards buying real estate when doing a rent vs buy analysis. The most common source of overly optimistic assumptions in favour of buying real estate come from condo developers and the various seminars and courses geared towards first time real estate investors.

The former tend to have very aggressive assumptions about the rental income a particular unit might generate and the appreciation in value buyers can expect while the later try to sell the dream that real estate investing is a sure thing, a great way of generating passive income and something you can do even though you have very little cash saved. Like this seminar, that promises to teach people how to flip houses for a profit without using their own money.

I welcome readers to send me their examples from new condo sites or real estate seminars so I can highlight some of the flawed assumptions these marketers are making about buying real estate as an investment.

 

John Pasalis is the President and Broker of Realosophy Realty Inc. Brokerage in Toronto. A leader in real estate analytics and pro-consumer advice, Realosophy helps clients buy or sell a home the right way. Email John 

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