The buying-versus-renting debate has gone on forever because the answer depends on assumptions you make about the future, your local housing conditions, interest rates, your income tax rate, future tax rates, inflation, future interest rates etc. The latest in this series is a post by Millionaire Mommy Next Door (thanks to Four Pillars for referring this post), in which she shows how renting can be better than owning in her local market.
I don’t disagree with her numbers, except for the part about opportunity cost. First, let’s not kid ourselves and agree that there is an opportunity cost in owning a home. Home prices have been on a tear for the past five years or so but over the long term, the best homes can do is keep up with inflation. With equities, by contrast, you can expect to earn a real, inflation-adjusted return ranging from 4% to 6%. [Don't shoot me because I'm just the messenger here. William Bernstein, for instance, figures future long-term real returns for large US stocks would be in the 3.5% range and small stocks in the 5% range.]
So, at first glance, a portfolio heavy in equities has a 6% real advantage over owning a home (we’ll assume the higher returns for equities). Not so fast, though. By owning a home, you save some money by not renting an equivalent place. In Millionaire Mommy’s own example, a home that sells for $300,000 and rents for $1,300 per month has annual costs of $9,000 and has a “yield” of 2.2%. What’s more this is a real yield, in the sense that future rents and ownership costs will keep pace with inflation as will the difference between them.
There is still one wrinkle to account for. The 6% real return from equities we assumed earlier is before taxes are paid. Let’s assume that taxes on capital gains remains at 20%. The real, after-tax return from an equities portfolio would be 4.8%.
Now, we are ready to make an apples-to-apples comparison. In Millionaire Mommy’s example, the opportunity cost of owning a home and not being in equities is 4.6% over the long-term (4.8% return for equities minus 2.2% real “yield” from housing plus 2% inflation), not the 10% she assumes in her example. Your local real estate market may also have a higher “housing yield”. In Ottawa, for example, a $300,000 house will rent for $1,600 per month and give you a net “yield” of 3.5% resulting in a 3.3% advantage for equities over housing. If you are pessimistic about future equity returns, use the 4% real return for equities and come up with an even smaller advantage.
The point of this post is not to show that owning a home is a financially superior decision. It probably isn’t in most scenarios and in most “normal” market conditions but the opportunity cost is most likely not as much as some are making it out to be. Still, compute your own opportunity cost of owning a home and see if it’s a reasonable expense in relation to your income. If not, you probably have too much house.
Bookmark: del.icio.us Digg StumbleUpon
25 responses so far ↓
1 FourPillars // Nov 7, 2007 at 10:52 pm
Thanks for the link. Her series is definitely worth reading even if it’s not 100% accurate (what series is?).
The lesson that I get out of all this is to own equities whether you are a house owner or not.
Mike
2 Millionaire Mommy Next Door // Nov 8, 2007 at 12:40 am
Thanks for carrying this discussion onto your blog, too. I think the biggest difference between the numbers I use and the numbers you’re using is that you’re attempting to look into the future and I’m looking at long-term historical trends. Either way, all anyone can really do is guestimate.
In the second part of my post, I used a rent versus buy calculator that included the effects of inflation and taxes. Did you miss that part?
Anyway, I appreciate your civility in discussing this surprisingly controversial concept. It’s been a lively one!
3 The Financial Blogger // Nov 8, 2007 at 6:36 am
I would add that there is not that much properties to rent compared to properties for sale. Therefore, you might not have a big choice if you want to rent a 300K house. I think the real answer of this debate is within one individual’s preferences. You can always try to calculate the opportunity cost of something, but being a house owner is more than about paying down your mortgage. Feeling home, being proud, making renovations and modifications are priceless to me while it may sounds like huge inconveniences for somebody else.
4 Canadian Capitalist // Nov 8, 2007 at 8:29 am
MM: Thanks for your comment. I believe it is more relevant to include future returns because that’s what investors are going to get. There seems to be a surprising amount of consensus that future returns are going to be very modest.
FB: Good point. That’s why I like the distinction between assets and investment assets. You hold investment assets purely to make money. A home doesn’t fall into this category because it is mainly a roof over our heads. Still, MM’s point is valid because if your opportunity cost of owning is too high, you have too much house and could hurt you financially.
5 Tim // Nov 8, 2007 at 1:23 pm
The rental costs should probably include some renter’s insurance. And I wonder if it’s fair to include remodeling costs. A house owner could choose not to remodel, if he or she wishes — a renter doesn’t have a choice.
As Financial Blogger notes, there are important non-financial considerations. We got kicked out of one rental house, because the landlord decided to sell. That was a disruption. And avoiding the hassle of landlords generally is worth a bit of money to us.
Still, I agree with the main point that you have to look at opportunity costs when weighing your choice to rent or buy.
6 FinancialJungle // Nov 8, 2007 at 1:35 pm
These are all good points. Guys.
>>”That’s why I like the distinction between assets and investment assets. ”
Everyone is unique in terms of where they find values. For instance, homeownership doesn’t do it for me as much as the next guy. Rather, I get more excited about owning good businesses. Since I receive pleasures out of investing (just as a homeowner being proud of his real estate), does that make my stocks assets, investments, or both? What about homeowners who read newspapers/statistics to assess the value of their homes? Would they feel regretful if the market tumbles by 20% even though they believe being proud owners are priceless?
7 Canadian Capitalist // Nov 8, 2007 at 1:57 pm
FJ: I’m not sure what your point is. You buy / sell a stock from a purely financial motive. You buy BMO rather than BNS because you think BMO will be more profitable. When you say you like investing, you like the process, not a specific stock. A house isn’t like that. You have so many motives at play… some of them could be financial but usually other factors play a big role too.
8 FinancialJungle.com // Nov 8, 2007 at 2:55 pm
>>”You buy / sell a stock from a purely financial motive. ”
That’s exactly what I’m not saying. I buy stocks (I prefer to call them businesses) because I enjoy both the financial rewards as well as the pride of owning the businesses. The later is no different from the the pride of homeownership. Again, everyone is unique. You can’t dictate where I place my value. Even if one day when I can live off of GICs completely, I’ll still be investing because my motive isn’t 100% financial.
I doubt many people are buying homes purely for the pride of ownership purely. Hyperthetically speaking, if real estate is a depreciating asset, most people wouldn’t be borrowing an 80% or 100% to finance their American/Canadian dream.
9 Canadian Capitalist // Nov 8, 2007 at 3:41 pm
FJ: Sure they will. Just look at cars. Also, note that I’m talking about the vast majority of folks, not you specifically. Most people buy financial assets simply to make money.
10 FinancialJungle.com // Nov 8, 2007 at 4:01 pm
>>”I’m talking about the vast majority of folks”
Sure they’ll do it with cars. That’s because the alternative of leasing an equivalent car is more expensive. Let’s not fool ourselves. If real estate is a depreciating asset and renting is a cheaper alternative, the vast majority will rent. Why? Because financial gains play a much bigger role than you think.
11 Al R // Nov 8, 2007 at 4:18 pm
Small point: I’m not sure that you are correct when you assume that “over the long term, the best homes can do is keep up with inflation.” Housing prices don’t just depend on wages, but also on the relative consumption preferences that individuals have. If people begin to devote relatively higher proportions of their income to housing, rather than, say, food or transportation, you could expect housing gains to outstrip inflation.
Also, there is a finite amount of land available to build on, and given natural population growth and the growing trend towards urbanization, city populations are growing substantially. Both of these factors have the potential to increase housing prices substantially (at least in urban areas) over the long term.
12 telly // Nov 8, 2007 at 4:29 pm
How many times have you heard people comment that buying their home was the best “investment” they ever made? If that’s the case, we should be able to compare a home and a stock purchase apples to apples (based on the definitions used).
It’s one thing to admit that purchasing a home was a lifestyle choice but when people begin to gloat (without actually running the numbers) of their great investment decision to buy a home, it only makes sense to do some calculations to see if that was, in fact the case.
Sure, we could probably pick out small errors or ommissions Millionaire Mommy may have made, but the truth is, in many markets, from a purely financial perspective, renting is better than buying. But for most of us, owning a home is not purely financial.
13 Canadian Capitalist // Nov 8, 2007 at 4:58 pm
FJ: I must have been asleep when such widespread financial restraint broke out. Unfortunately, I don’t believe that’s the case.
Al: Actually, I remember reading 1% real increase in housing prices, but I just couldn’t find the clipping in my library and I can’t recall whether it was in Canada or elsewhere and over how much long a term. To be safe, I assumed a 0% real rate.
telly: I agree that I was quibbling with MM’s numbers, not her conclusion. It’s not just housing. People will boast how they made a killing on a stock but probably wouldn’t know themselves that their portfolio barely beat the market, if they’d included the losers.
14 FinancialJungle.com // Nov 8, 2007 at 5:47 pm
>>” I must have been asleep when such widespread financial restraint broke out.”
It was a hypothetical example to make a point. People buy RE partly because it’s an appreciating asset/investment, although I agree pride is also part of the equation. Which is why I disagree that there’s a clear-cut distinction between a home and an investment.
I’ve not studied MM’s numbers closely, but from what I gathered, the real difference is somewhere between her and CC’s numbers. In CC’s case, only someone in the highest tax-bracket and flipping the entire portfolio annually would incur a 20% tax drag.
15 Canadian Capitalist // Nov 8, 2007 at 6:02 pm
FJ: You’re right about the tax part, though I didn’t assume the entire portfolio is flipped every year. I did assume that the portfolio is held for X years and sold in its entirety. Also, I assumed that the tax is only on the real return part and not on inflation whereas in real life you pay tax on nominal gains. What I’m trying to say is I made a guess on the tax part, so feel free to use an estimate you think is reasonable.
The bulk of the difference is that I’ve used the higher end of estimates of forward returns (which will probably be modest) and MM used historic returns (which are generous).
16 ThickenMyWallet // Nov 8, 2007 at 6:04 pm
CC: If my memory serves me correct, the editorial in the previous issue of Money Sense magazine (not the one on news-stands now) cited a study whereby prior to 2000, real estate prices appreciated in accordance with the rate of inflation. Alas, I threw away the issue. But the study should give you a good analysis of real estate appreciation over time.
17 FinancialJungle.com // Nov 8, 2007 at 6:44 pm
CC: You have a good point regarding the tax on inflation. It’s totally unfair.
Just another minor quibble on your math. Holding an investment for X number of years straight and then dock 20% off the final capital gain is not the same as cutting your annual return by 20%. I believe that’s what you did when you reduced the real return from 6% to 4.8%.
18 Canadian Capitalist // Nov 8, 2007 at 7:45 pm
FJ: Yes and I hoped no one would notice! Let me do some spreadsheets and post the numbers later today.
19 Canadian Capitalist // Nov 9, 2007 at 12:04 am
FJ: Here are the numbers taking tax into account. I’m assuming that the portfolio is liquidated after X years and a capital gains of 20% is paid at that time.
At 6% after 10 years, the after-tax return becomes 5.02%. After 20 years, it is 5.22%. But, if you consider inflation runs at 2%, the real return after the same years decreases to 4.8% and 5.1% respectively.
20 Gene // Nov 14, 2007 at 10:28 pm
The opportunity cost between stocks and real estates can’t be directly compared because most people can easily get mortgages where they only put up 20% equity, but it is difficult to find the same kind of leverage when investing in stocks.
21 Life-Quotes.ca // Nov 19, 2007 at 12:27 pm
Great article!
For anyone contemplating buying a home, a term life insurance policy may be alot cheaper than the coverage offered by the lender. Term life also allows the buyer the financial control of naming the beneficiary (instead of automatically having the lender name itself). Another bonus is that a term life policy doesn’t decrease in value; mortgage insurance offered by the lender usually only covers the current existing balance. Talk to your broker about your options.
22 TD // Feb 19, 2008 at 4:41 pm
CC,
I find it interesting how defensive you become in your decision to purchase a home over renting. Seems this is a very emotional topic which is not surprising considering it is the largest purchase you will make in your lifetime. Not only do you become defensive but you have deleted some of the comments that were critical of your position in this post. Just wondering if this is a common occurrence with dissenting comments on your other posts?
For someone who frets over a difference of 50bps paid to a mutual fund company I find it surprising that there isn’t a mention of the 6% commission you pay to purchase the roof over your head and the 6% commission you pay to realize your profits at the time of sale.
I’m not trying to be insolent or troublesome, I’m just wondering if this blog is such a great resource when contrary comments are deleted.
23 Canadian Capitalist // Feb 19, 2008 at 7:04 pm
TD: I’m surprised that you think I deleted critical comments. I never delete comments, critical or otherwise, when it is relevant to the subject on hand. As a matter of fact, I even let through obvious commercial messages and the only time I’ve deleted comments is when the same commercial message is put on multiple posts. In the blogosphere, my only currency is credibility and I am really surprised you think I deliberately disallow comments. After all, if every commenter agrees with me, what’s the fun in life
That said, it sometimes so happens that legitimate comments are caught by the spam filter. I am usually proactive about recovering such comments but an occasional one might sometimes slip through. No malicious intent at all!
I’m curious why you think I delete dissenting opinion?
24 Canadian Capitalist // Feb 20, 2008 at 5:08 pm
TD: Regarding your point about how expensive owning a home is, I agree with you. It’s not just the Realtor commissions (which, by the way, is paid only when you sell, not when you buy. i.e., it’s 6% when you buy and then sell a house). There’s property taxes, land transfer taxes, maintenance, insurance etc. But you have to compare owning with the alternative - renting. The choice is more a lifestyle decision than a financial one.
25 The Costs of Home Ownership // Mar 20, 2008 at 7:22 am
[...] reader left the following comment on an earlier post: “For someone who frets over a difference of 50bps paid to a mutual fund company, I find it [...]
Leave a Comment