In recent years, Canadian real estate prices have risen substantially – especially in places like Vancouver, Victoria and the Greater Toronto Area (GTA). For people who have owned real estate throughout the boom, this price appreciation tends to leave little cause for worry. But what about those who are faced with the increasingly unattainable goal of home ownership?
Many people who do not own a home, but perhaps would like to, such as renters, new graduates, or young professionals looking to start a family, are now at a loss as to what they should do. Real estate prices have risen so much that owning a home is now out of reach for many. But does this actually place such individuals in a worse financial position than their home-owning counterparts? After taking a closer look at the high-level financial implications of renting versus owning, the answer to that question might surprise you.
Home ownership is arguably a generational preference. Numerous sources state that millennials are happy renting their living space, preferring flexibility over certainty. Baby boomers, on the other hand, tend to insist that home ownership is a crucial and necessary facet of a sound financial plan. This difference of opinion is both philosophical and quantitative. In this article, I will address one side of the debate; specifically, the more practical side – comparing the dollar cost/value of renting versus buying. I thought now would be a good time to address this issue, given the recent and dramatic increase in home prices, versus the more modest changes we have seen in the cost of renting.
To conduct this analysis, a number of assumptions must be made. Where possible, I will try to use historical data. For example, history suggests that housing prices have appreciated at an average rate of 3% annually. Accordingly, I will assume the continuance of this rate in my analysis. If housing prices were to grow by 35% per year, as they have in some parts of the GTA in recent years, then my conclusion would be obvious – buy as much house as you can afford, and do so immediately!
In a desirable, yet ordinary, neighbourhood in the West GTA, you can easily find houses listed for $1 million dollars these days. Similar houses in the same neighbourhood are typically available to rent for approximately $2,500 per month. These figures are what I will use for my test case.
Firstly, we need to consider the annual cash flows associated with renting, and compare them to those associated with buying. In the case of renting, a renter’s annual cash outflow is simply their rent payment. Using the above-noted example, $2,500 per month equals $30,000 per year.
In the case of home ownership, there is a lot more to it. Specific and major ‘rent-like’ expenses include property taxes, the interest an owner pays on their mortgage, and home maintenance/upkeep. This is where assumptions come into play. If we assume property taxes of 0.8%, mortgage interest of 2.6% on an 80% mortgage (with a 20% down payment, such is the going rate at the time of writing), and annual upkeep of 1.5% (which I’m told by several home owner ‘veterans’ is a conservative estimate, if you want to maintain or maximize your home’s value), we arrive at the following annual ‘rent-like’ expenditures:
This amounts to a grand total of $43,800 per year (as compared to $30,000 per year in the case of renting).
I realize that I have left out a few expenses (e.g., utilities, home/tenant insurance, etc.) This is intentional – I’m trying to focus on expenses that make up major differentiators. Arguably, you could be on the hook for utilities whether you rent or buy, so, comparatively, such things would make little or no difference in this analysis.
It is also important to note that if or when interest rates rise, so too will the cost of mortgages. Moreover, as time passes and the value of your home increases, property taxes and the amount you spend on upkeep would arguably increase commeasurably.
The above-noted figures may come as a shock. But before you rush into a rental, or text your baby boomer parents who have been on your case to buy a house, please hold on for a few more paragraphs – there is more to this analysis.
We also have to consider that rent tends to increase over time. And, assuming you pay down your mortgage (and that interest rates don’t go to the moon), the amount of interest you pay on your mortgage will decrease with every payment you make. As such, I’ve decided to not only consider what your costs of living would be on an annual basis, but also over the life of a mortgage – which is typically 25 years.
If your rent increases by, say, 3% per year (consistent with our assumed growth rate in housing prices), you would pay a grand total of $1,093,778 in rent over a 25-year period (I know – yikes! But read on).
Conversely, if we assume that your property tax and upkeep rise commeasurably with the value of your home (3% per year), you would pay grand totals of $291,675 in property tax and $546,889 in upkeep over 25 years. You would also pay $1,087,109 towards your mortgage ($287,109 of interest and $800,000 of principal). A summary of the totals you would have paid under each scenario is as follows:
Cumulative Property Tax – $291,675
Cumulative Mortgage Interest – $287,109
Cumulative Upkeep – $546,889
Cumulative Rent – $1,093,778
This gives you a grand total of $1,125,670 of ‘rent-like’ expenses associated with owning a home (as compared to $1,093,778 in the case of renting). Again, I should point out that changes to the above-noted assumptions would impact these figures. For example, rising interest rates would result in even higher cumulative mortgage costs. With that in mind, renting once again looks to be superior from this vantage point. Still, before you go and list your home on MLS, there is more to consider. Specifically, the assets you would have in your pocket after 25 years.
The next step in this comparison is to analyze the growth of your ‘assets’ while renting, versus your ‘asset’ in buying. Before all of you Rich Dad, Poor Dad enthusiasts jump all over me for calling a house an ‘asset’, please bear with me. I do so partly out of convenience, and partly because your house could be considered a financial asset if your intention is to sell it one day.
First, let’s consider renting. If you rent, you will keep your down payment and could presumably invest it. In our example, your down payment would be $200,000 (20% of your $1 million dollar suburban home). If you invest that $200,000 in a properly balanced, long-term portfolio, you could reasonably expect a 6% rate of return. After 25 years, your $200,000 would grow to $858,374 ($200,000 x 1.0625).
Moreover, you would be able to save and invest your excess cash flows if you are renting. Remember, you are spending less on rent every month than you would be on mortgage payments, new roofs, property taxes, etc. I realize that your spending would not be uniform throughout the life of your mortgage; however, if we assume your ‘average’ annual cash flows renting are $43,751 (cumulative rent paid divided by 25), and your ‘average’ annual cash flows owning are $77,027 [(cumulative property tax, upkeep, and mortgage interest, plus mortgage principal payments of $800,000) divided by 25 years], that would mean you could presumably save and invest an additional $33,276 ($77,027 – $43,751) while renting, because your monthly and annual expenses would be that much lower.
Saving and investing $33,276 per year at 6% would give you additional investment assets of $1,825,658, at the end of 25 years. Combine that with the $858,374 that your saved down payment will become, and you would have investment assets of $2,684,032 ($1,825,658 + $858,374), before taxes. I appreciate that at times, saving money is easier said than done. Many people fall subject to ‘lifestyle creep’ – whereby their spending increases in line with their cash flow. For the purposes of this analysis, we will assume that the home owner/tenant in question is a stout saver.
Next, let’s consider your house and its estimated future value, assuming prices grow in line with our assumption of 3% per year. Under those assumptions, your $1,000,000 home would have grown to $2,093,778 in value after 25 years of ‘normal’ 3% annual growth ($1,000,000 x 1.0325). Again, note that housing prices, like the stock market, can move up or down. Several factors drive both markets’ respective directions, and one should never take past performance as a projection for future performance as a given.
Again, renting looks to be superior, albeit for one final caveat – income taxes. As the rules stand now (who knows what things will look like 25 years from now), the growth on one’s principal residence is tax exempt. In other words, every family can sell an appreciated principal residence and pay no tax. So, after 25 years, a $2,093,778 house could translate to $2,093,778 in your pocket, should you choose to sell (before real estate commissions, etc.).
On the other hand, your $2,684,032 investment portfolio – the one you have only managed to piece together due to your savings through renting – would be full of deferred tax which you would have to pay if and when you liquidate the portfolio. Here is a quick estimate of the amount of income tax you would have to pay (assuming TFSAs and/or RRSPs haven’t been employed):
As such, your investment portfolio wouldn’t be worth a full $2,684,032. Rather, it would be worth (after estimated taxes) only $2,270,998 ($2,684,032 in total value, less $413,035 of anticipated tax).
Again, renting seems to be the way to go.
I should finish by re-affirming that the above-noted conclusions are full of assumptions. Real estate prices could rise faster (or slower) than 3% per year (yes, millennials, there have been times when housing prices have fallen) and mortgage rates could climb drastically*. Investment markets could perform at rates lower than 6% per year. You could experience unexpected expenses whether you buy or rent (like when your landlord tells you he’s selling, one week after your child is born – which happened to me!). Your landlord could decide to ‘reno-vict’ you (which is a non-technical term for them choosing to renovate and subsequently evict you) at any time, etc. The possible alterations to my assumptions are endless.
The overall conclusion of this analysis isn’t that everyone should rent. Rather, the message here should be that renters, before rushing to buy into the hysteria of an overcooked housing market, should take a step back and consider how quickly prices have risen – especially in comparison to rents. The numbers seem to suggest that, in the long run, renters (provided they save and invest) will be just fine and, in fact, could be much better off.
Another way to look at this analysis would be from the perspective of a current home owner. Perhaps such individuals would be better off selling their current home, and renting instead. I’m not the type of planner who encourages things like reverse-mortgage or home equity loans. I just thought I would mention this possibility as ‘food for thought’.
Best of luck to all of you would-be home buyers.
* In April of 1982, a five-year rate reached as high as 19.41% according to the Bank of Canada, Data and Statistics Office.
Brent Soucie, T.E. Wealth, Toronto
This article was published in T.E. Wealth’s Strategies newsletter, September 2017 edition. Read the full edition here.
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