Rent vs Buy

January 1st, 2008 by Potato

I’m pretty committed to renting for at the very least the next 3 years. I’ve done a fair bit of reading over the past few days to help convince me that it’s the right thing for me to do (confirmation bias? you betcha!). For example, Millionaire Mommy Next Door’s blog. There’s a lot of “conventional wisdom” out there about buying is clearly superior in every way, with arguments about “wasting money” on rent when that money could be building equity in a house, etc. Looking into it, things are (as things generally are) more complicated, and the decision can depend greatly on how the real estate market is doing relative to the renting market and your assumptions about saving discipline, the performance of the stock market vs housing market, and budgets for things like repairs.

I found the discussion of when it might/might not make sense to buy a house interesting. One rule of thumb involved a house value of a certain multiple of rent for the same unit. Under 150X rent, buy (12.5 years worth of rent); over 200X, rent (16.6 years worth of rent). That seems like a pretty small difference, but I plugged it in with our house. We rent at $1400/mo, so 150X that would be $210000. 200X that would be $280000. Now, I don’t have any experience to have acquired any kind of real estate sense or gut feeling (beyond surfing MLS and reading blogs), but to me, buying this place for $200k sounds reasonable. Wayfare recently guesstimated that this house in this neighbourhood would probably go for $300k, maybe a bit more, and that seemed crazy to me. So perhaps that is a good rule of thumb. It also makes me wonder where the numbers come from, so I did some quick playing around with a mortgage calculator. For the figures I have here, the monthly payments on a 25-year 7% mortgage are quite close to the rent payments when the house is 150X the price of rent — which readily explains why at that point buying would make a lot of sense. In that case you really would be building equity for not much more cost, and renting would be “wasting” money. Much higher, and you have a lot of extra money going into servicing the interest on that giant principal, money which might be better off in the stock market.

Here’s the rent-vs-buy calculator to play around with some numbers. It’s not quite as simple as some people would like, and the decision of whether it is better to rent or buy will depend on a lot of factors (inflation, savings rate, property tax rate, rent of an equivalent place, the performance of the real estate market vs the stock market, etc). Sometimes, buying is better, sometimes, renting is better. Sometimes renting for a bit is better and then buying once a big deposit is available… though options like that get harder to model in a simple calculator :)

Some things to keep in mind that might not be present in conventional wisdom are issues such as opportunity cost of having your money “sit” in your house: since historically (again, the current red-hot real estate market aside) housing prices have barely beat inflation (so houses are a poor investment) while stocks have done a fair bit better over the long term, you’re giving up a potential whack load of income/capital gains from having your money invested. Likewise, even if a house’s value goes up over the course of a few years, there is a harsh fee to sell it (generally 6% I believe), so if you have to sell within a few years for whatever reason, it can be much more painful. That might lead someone to skip a “starter house” and go straight to one they think they’ll need in 3-6 years — but then that reasoning causes one to carry the costs of a larger home than necessary for a few years. Buying a house tends to then make the house the largest asset on the familial balance sheet by a huge margin, which is kind of bad from a diversification point of view.

Interestingly, some of that reading has also made me wonder if it’s the right thing to continue doing, forever (or at least until there is a significant correction in the market). There are a lot of things about home ownership that are appealing to me (and, I think, to Wayfare), quite aside from the discussion of finances:

  • The freedom to do whatever you want to a house. Paint it, upgrade the furnace, get stained glass windows, get a drooly dog, run network cable through the walls, soundproof it, get a custom kitchen, and long-term improvements/investments that a landlord might not make like efficient appliances, solar panels, relandscaping, extensions…
  • The idea of owning property that no one can take from you. Of being in a community for the long-haul (though renters can get this as well).
  • Having essentially the pick of virtually any neighbourhood, any house. There are a lot of condos and apartments to choose from as a renter, but finding a nice house in a nice area is tougher (I think there are 4 houses that have renters in them within a 10-block radius of my parents’, versus maybe 40 homes for sale in the last year).
  • Never ever having an inspection on short notice (though half the time my old landlords dropped off a notice they’d be coming by they never did — they mostly just dropped them in everyone’s mailboxes, but really only wanted to check up on the problem tenants; we can’t pay our current landlord to come over).

Of course, renting also has its perks:

  • No risk from repair costs.
  • The tenant board will largely keep rent increases in check, but property taxes don’t necessarily have that protection.
  • No risk from a change in real estate fortunes.
  • Often the landlord will take care of chores (or hire someone to do them) such as mowing the lawn and washing the exterior windows.
  • Easier to move if needed (job change, extra kids, difficulties with neighbours, etc).
  • Many telemarketers go away when you say the magic words “oh, I’m just renting”.

[Ok, some of those were financial, but they were about risk rather than the relative benefit/financial freedom/opportunity cost discussed with the calculators]

I didn’t mention the benefit of “forced savings” that comes from having a house and building equity with a mortgage. It can be a lot easier to save when the money has to go into the mortgage… But that’s not really a savings plan, since using that equity is quite hard, and current real estate market trends aside, the money won’t really “work for you” and is critically linked to a single asset. A better savings plan is actually saving to a diversified portfolio…

An extreme example of the rent vs. buy decision: I was surfing MLS trying to find examples of comparable homes to see how much rent was vs. buying. I lucked out and found one house that was offered for either rent or sale, which makes the judgment of whether one house is equivalent to another or not very easy. It also serves as an interesting example because I know the partial history of this house — it’s the one right next door to the one I grew up in! The house is offered for sale at $549k, and for rent at $1650/mo. That’s a sale price of 333X the rental price. What makes this comparison extreme is that the house really isn’t being sold for the house, but more for the land it’s on and the potential there. The house itself was the largest one on my block 20 years ago (3 bedrooms and a finished basement compared to 2+den for most of the rest of the houses), but after the family with the two girls moved out in ~1985, a long series of tenants moved through. This house needed significant renovations back in the 80’s, and from the look of the knocked-over fence between the houses in the pictures, still does. Anyhow, this example sort of shows how important estimating all the factors can be. With a cheap mortgage assumed, the Toronto rate for property tax, and no other fees (except sales commission), the results can be swung either way by the assumed cost of upkeep/repairs and by the spread between the stock market and the housing market. 3% or more in favour of the stock market (what has historically been true for all but the last 4 years or so) and it makes sense to rent and invest… a narrower gap between them and buying looks better and better, though that also depends on the assumed upkeep (maintenance, insurance, etc). That actually surprised me a little; with such an overpriced house I figured it would take an insane comparison (like the housing market going up 9% a year to 6% for the stock market) to make buying lucrative. Of course, with a house that would need work, buying is the better non-financial decision :)

The housing market is generally assumed to be over-valued at the moment, and there are a large number of articles and websites debating that. Of course, some of them have been saying that for years (I know I can’t believe it’s gone up so much so fast). I think generally these arguments are true: first-time buyers are being priced out of the housing market, and it’s only through fancy lending practices that people can buy a house at all now. Any more increases, and too few people will be able to buy in at all, and it will start to turn around (or at least flatten out until inflation in other areas, such as income, can catch up). The arguments from fundamentals and long-term historical trends is largely true, but some markets have special factors. Demand is a big one of them: Toronto and Ft. McMurray have grown so much in recent years that part of the real estate boom there is just due to demand (rather than speculation or fancy lending). While I still think there’s a turn-around coming for those markets (esp. Ft. McMurray if the oil companies stop the massive increases in hiring, which would stop the immigration there, and if they ever get a supply of rental housing), I don’t think it’ll turn around all the way to the trendline: some part of the increase is genuinely due to higher demand. That high demand is part of what prompted the massive numbers of tiny, ittybitty condos and townhouses: land is simply getting scarce in the GTA (at least until GO and the TTC improve access and capacity in the 905).

Another interesting rule I found: “your monthly housing costs should not exceed 32% of your gross monthly household income. Housing costs include monthly mortgage payments, taxes and heating expenses. If applicable, this sum should also include half of monthly condominium fees.” Apparently that’s not a rule of thumb, but a guideline for how much of a mortgage a bank can give you. At first I thought that was quite low, until I realized that I was still thinking like a student. 4 years ago, 74% of my income went to rent. Even still, with housing prices the way they are, that could become a barrier to some people.

Note that the rent vs buy calculator will take a number of things into account, but if you’re really seriously considering the decision you might want to draw up a spreadsheet so you can see what happens with more complex scenarios. For instance, the calculator only had a dollar field for property tax, but in Toronto at least property tax is a percent of your house’s appraised value, and they’ll hit you with increases every so often — and even more may be coming just from the budget shortfalls over the years. Modeling an increase in property tax cost didn’t seem to be an option (though rents increased at the rate of inflation), but might be something to consider if the alternate scenarios were similar. Likewise, you might want to model some kind of “lifestyle expense creep” as a gradual loss of savings discipline: your first year of choosing to rent, you may bank all the money you would have saved by not buying, but by year two or three you may have lost some discipline, and bought a big screen TV instead… Though the calculator can roughly handle this by putting in an inflation rate that’s higher than what you actually expect (so that your “rent” will go up year over year).

2 Responses to “Rent vs Buy”

  1. FourPillars Says:

    “The housing market is generally assumed to be over-valued at the moment”

    For what it’s worth…I bought my first house at the end of ’99 and I remember hearing that same phrase back then.


  2. Potato Says:

    Restated in the follow-up.