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The Art of Not Knowing
People work hard for their money, but don't make their money work hard for them. It's time to fix that. Economist whips your income into shape with smart, practical advice.
Photo by Casey Serin.
"I hate throwing away money every month." Those seven little words are the foundation of the Buyer's Myth, one that we've heard at too many dinner parties. Renters throw money into the shredder, but property owners put their money to work with an investment. People may have the best of intentions when pressuring single twentysomethings to throw down hundreds of thousands of dollars for property, but there are three good reasons that should stop even the most trenchant supporter of the Buyer's Myth. After we go through the reasons, we will use a numerical example to see why the Myth doesn't hold up.
Excessive Leveraging Stinks
Most people need to take on a mortgage to purchase property. Not only will they borrow money, they'll borrow a lot of it. The average cost of a one-bedroom condo in the city is $270,000, and many people will only put down 10% for the down payment. To own a place, then, many people will be almost a quarter of a million dollars in debt. (Doesn't the spectre of financial independence that home ownership emits seem silly in the face of taking on so much debt?)
To pay the debt back, using a 10-year fixed-rate mortgage offered by ING at 6.45% as an example, will require monthly payments of $1,600 for 25 years. For the first year, 85% of the mortgage payments will go toward interest. It's an uphill battle to pay off a mortgage, made worthwhile only if the return on the investment beats the cost of borrowing, which leads us to point #2.
Slowing Growth Stinks
To make money buying property, property values must outpace mortgage rates at the bare minimum—otherwise, you are accumulating losses each month. Actually, mortgage interest isn't the only concern. Any good investment must at least cover inflation, around 2%. For condo owners, there are also maintenance fees to worry about (for homeowners, property taxes). And when you decide to sell, there's also a commission, normally around 5% of the final selling price, which goes to the sales agent. In total, property values must grow enough to cover the interest off the mortgage, inflation, maintenance fees, and commission. That's unlikely in this economic climate.
At this point, it's probably appropriate to compare buying to renting. Let's throw some numbers into the mix: we've already noted the average buyer will have monthly payments of $1,600. In addition, the buyer will have to pay property tax or condo fees. For example, a 650-square-foot condo will cost almost $300 in maintenance fees. In total, buying a condo will then cost $1,900 a month.
How would a renter fare with that amount of money per month? According to the city's website, the average rent for a one-bedroom apartment is $890. That number seems a bit low, no? Let's be a bit choosier and pay $1,000 instead. While the $1,000 in rent is "thrown away," it still leaves $900 to stick into an investment even safer than real estate: GICs. That's almost $10,800 a year put away, which leads us to our final point:
The Price-Rent Ratio Stinks
The last point to bust the Buyer's Myth is the ratio of the cost of owning versus renting, known as the price-rent ratio. If we divide the average cost of a one-bedroom condominium ($270,000) by the average annual cost to rent ($890 x 12), the price-rent ratio stands at 25—and that doesn't include the interest on mortgage, condo fees, or the commission paid for selling the property. By comparison, the average price-rent ratio in Canada is lower, at 15.
While admittedly it's more important to compare the price-rent ratio trend in Toronto over the last while, this ad hoc side-by-side suggests how a renter can save better than a buyer. The cost to buy is so inflated compared to the cost to rent, the renter has more spare money to invest: $900 or 47% of what the buyer spends monthly. Not only is the renter putting away $10,800 in savings per year (along with the $27,000 a buyer would have used as a down payment), but the money has more time to grow through compound interest.
Photo by 416style.
Number Time, and the Living Is Easy
Let's illustrate how the three points work numerically. Assuming the condo market has risen at 4%—an averaged rate of that offered by economists and real estate agents—for 7 years, our buyer will then be living in a condo worth about $357,000. Subtract $17,850 in commission to the real estate agent who sells the property, the remainder of the mortgage ($207,200), and the buyer will end up with $132,000 net.
By comparison, after 10 years of placing $900 monthly along with the initial $27,000 into a GIC at 4%, the renter ends up with $127,700. People buy because they are hoping the large investment will grow at a high rate and compound, while taking advantage of the availability of credit. However, for people who are uncomfortable having a large amount of debt and enjoy mobility, renting can still work out. (One thing to note: there are no taxes on gains made from selling your principal residence, but there are on bank interest. However, if the renter had contributed into a TFSA and a RRSP, the taxes would be deferred and still leave the renter at an advantage.)
What Are the Exceptions?
So is there ever a time to buy? Yes, if any of the three points above change sufficiently.
People who can have a large down payment will find the argument less lop-sided. Math geeks will have noticed that much of the growth for the buyer's investment actually comes from the down payment since it isn't borrowed and thus doesn't have any costs associated with it. More down payment means more money to grow and compound interest can do its thing.
Another possibility is the return of a bullish housing market where housing values soar. This imbalance would make leveraging a smart option. However, economists are currently estimating property values to grow at the price of inflation, unlike real estate agents that price growth at 6%. What about the days of double-digit growth? Consider that the reason experts believe the housing market won't sink here as in the States is because properties rarely grew by double-digits! If you're seriously waiting for this, we have a bridge over the Don Valley we'd like to sell you.
Finally, the last way buying will make more sense than renting is the most obvious one: if prices come down or rents go up, which will make the price-rent ratio more reasonable. Then, renters won't be able to stash away as much savings. But prices aren't expected to drop dramatically—let's not hold our breath for the day a one-bedroom condo sells for less than $180,000—so unless rent skyrockets, the ratio will stay intact.
Don't Count Your Condos Before They've Hatched
Torontonians see property ownership as a rite of passage and all too often meant to denote independence, fiscal responsibility, and maturity. The pressure to buy is so overwhelming, people tend to raise owning real estate above other options—ostensibly, there's security in knowing their money is invested in the tangible walls around them. However, blindly rushing into property ends up a Pyrrhic victory, diverting funds that could be better invested, even in this risky economic climate. While we used a GIC in this example, investing in the entire index has traditionally returned 9% over the past 70 years. Sure, there's risk in the stock market, but as people are learning now, there's risk in the housing market too.
Of course, each and every person should run through the numbers themselves. For many people, especially singletons, renting will remain the way to go, regardless of dinner party chatter.
Screen captures from the ING Direct calculators.
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GICs at 4%.
10-year mortgages at 6.45%
i guess one can always find data to back their point, no matter how hard they look.
silly me for having a 4.49% 5-year mortgage, followed by a 3.9% variable 5-year mortgage...
Beyond the excellent critique of the buyer's myth outlined above, this is an extremely poor time to invest in the housing market. Not only is there the potential of interests skyrocketing in the wake of the global credit crisis, but house prices and sales are in tailspin across Canada.
The numbers for the first half of October are not good for the GTA as a whole and for the City of Toronto in particular. The average price of a house in the GTA fell 11 percent, year over year. In Toronto, they fell 15 percent.
These numbers were put out by the Toronto Real Estate Board a week ago:
http://www.torontorealestateboard.com/consumer_info/market_news/news2008/pdf/nr_101708.pdf
In addition, and while his presentation may be hyperbolic, you should check out Garth Turner's latest book Greater Fool. Turner lays out what might happen to Canada's housing market over the coming years, and draws some fairly scary parallels to the US. He has more up to date info on his blog:
http://www.greaterfool.ca/
Hold onto your hat... and your pennies!
You could probably debate the details of prices, interest rates, market fluctuations, etc. until the end of time to find scenarios that "prove" it is best to own or rent. But I think the overall point of this post is good, though: do the math for your personal situation carefully before jumping into buying. Don't just blindly follow the crowd and assume that buying as soon as possible is the best route; and no matter what, try to live within your means.
For many people, as was the case for me, the best answer might lie in the middle That means renting for a number of years while saving a decent down payment, and then buying a place you can carry with mortgage payments that are similar to your former rent. Then you can continue saving while owning; a win-win scenario.
But there are other non-mathematic considerations. For example, many people are terrible savers and will always find a way to spend as much as they earn. In that case, buying property is a way of "forcing" themselves to save; I know people who could rent for 100 years and still not have enough in the bank for a down payment. But that's another issue altogether, isn't it.
But HGTV makes buying a home look so easy and fun!
It's interesting how the above is distorted here in the States, where the government made the incredible decision decades ago to allow mortgage interest to be deductible. No such gift was made to renters. For two countries with such similar housing practices, this is a huge difference.
Of course, one could argue that such deductions led to the inflated housing bubble that has now crashed the global economy. I'm not saying it was a smart policy, just pointing out that it is very different than in Toronto.
As someone who now pays much less on my mortgage for a three bedroom house than I did on rent for a much smaller two bedroom condo, I have to agree with pukegreen. The key is doing the research and taking the time to find something that works best for your living situation.
Also, "the face of taking on so much debt" is much easier to look at when your ability to pay it off is literally all around you every day. A mortgage is not like a credit card, despite your rather ominous description. I will admit the key is having a substantial downpayment, around 20 or 25 % (not 40% like you suggest,) but it's my understanding that banks are simply not giving out the 10 and 5% down mortgages like they used to?
Also, a genuine question; where can I get myself a 4% GIC?
A friend of mine who tends to be too thorough did an analysis of the rent-or-buy decision a few months ago: Part 1, Part 2
His approach, if you don't mind hacking around a bit with a spreadsheet, is more general than this one.
Really horrible assumptions.
Currently big banks are paying 3.2% on GICs for 5 years. The 10 year mortgage is also unsophisticated - people in their 20s shouldn't be locking them selves into a rate for that long, especially given the exorbitant premium - go for the variable, which is currently just over 3% with good credit (BMO listed at 4.75% but no one pays that).
Also, what kind of a place can you get for $1000? Rents for equivalent units are tied really tightly to condo prices thanks to the number of investor purchasers. Someone moving into a $270k condo would not be living in a $1k rental - they're worlds apart since the mean rent includes so much horrific crap at Jane & Finch while condo sales skew to a much higher income demographic.
All that said, I endorse the point of the post - do a serious analysis of rent vs. buy when considering a purchase. You must do a realistic analysis, and not use crap numbers, and you have to do a sensitivity analysis: do a sequence of projections using a range of values to see what your costs and returns could be. Make sure that this range is supported historically (what kind of behavior is normal, what kind of abnormal behavior has happened) and not just plucked out of thin air.
If Torontoist is going to do this kind of service journalism, make sure to get the numbers prepped by a financially savvy and independent person. I'd suggest a CA. This attempt was a strikeout by a well meaning but naive contributor.
In the example, why are the mortgage payments and condo fees the buyer has paid over the years subtracted from the sale price? These have already been paid (like rent), so this amount is money in pocket and would put the buyer ahead. Right?
The maths is wrong. You've double counted.
You should not subtract mortgage payments and fees that have been made over the years.
The correct logic is to say:
"I have $1900 every month. If I buy, it all goes on the mortgage and fees, so I have nothing to save. Then, at the end of ten years, I sell the condo ($490000), pay off the mortgage ($187600) and the agency fees ($24500) and am left with $277900.
"Alternatively, I could rent, save $900 of my $1900 every month (and my initial $27000) and end up with $172000".
So buying has a higher return than renting. Basically, you have massively leveraged your 10% downpayment to exploit the 6% housing market returns. The important point is that this has also massively increased your risk. If condo prices fall, you're screwed. High returns do not come for free.
Ignoring leveraging, the following calculation is a different way to evaluate whether property risk is right for you:
Suppose, instead that you had the cash to buy the condo outright. Then a 6% increase in value every year, minus 1.3% in condo fees and a 5% transaction fee spread out over 10 years (roughly 0.5%), gives you a net return each year of 4.2%. If, instead, you stuck your 270000 in a GIC at 4% and then rented at $1000/month, you'd have to find an additional $1200 per year, which is 0.4% of 270000. So your risk premium is 4.6%.
That means that you get 4.6% extra per year for running the risk that property prices might fall.
unfortunately this entire article falls apart when real world taken into consideration...
Realistically speaking, most people who are looking to buy their first property would be closer to their 30s. That means, they won't be living very long in those condos because very shortly there will be family and kids, therefore a move to a house will be required.
Again, realistically speaking, in the debt based economy with virtually no finance education, few people will have the discipline to put away $900 bucks every month... very few. With mortgage, you dont get a choice, but when you have $1200 bucks in your account, few will want to move $900 to a GIC because psychology of a 5 year term equals that of a "money lost for 5 years"... at least for the majority of people, money "not in the bank account" means money's gone.
Finally, as previous posters pointed out, 1br that you can rent for $1k is not a 1br that would buy for $270k, not even by a long shot.
the problem with this article is that it assumes very poor mortgage and an individual very disciplined with money... even these two assumptions would be hard pressed when put together.
there's a nice little calc to play around with for this exact purpose
http://www.secureapp.com/mbplus/rentbuy.asp
I want to thank Joel and Chione for pointing out the accounting error. I've corrected it in the piece. I've also modified the rates of return, because initially I had taken a best-case scenario for houses (6%) and a worst-case scenario for alternative investments (GIC at 4%--available at ING to the reader who wanted one). Instead, I have averaged the guidance of the economists and real estate agents, and now quote a return on real estate of 4%.
Something I didn't add in this article, but should have, was that housing in the past 50 years has grown on average between 2 to 3%. The leaps in housing have only been recent and give the wrong impression that housing is a sure bet.
Just as some people can buy bad stocks, there are also bad properties that don't give the expected return. The point of this article was to demonstrate that buying doesn't have to be the only way.
Unfortunately, you made a mistake right at the start. You seem to think condo owners don't pay property taxes.
You write, "For condo owners, there are also maintenance fees to worry about (for homeowners, property taxes)."
In fact, condo owners pay both property taxes and maintenance fees.
So what else don't you understand about the costs of property ownership?
arcticlamb, I was just about to point that out too.
In addition to condo fees, us condo owners not only pay rising property taxes, but often a Land Transfer Tax. Plus you're almost always going to pay some sort of insurance on your mortgage, which is another couple hundred bucks as a final "screw you." And unlike renters, if your toilet explodes, you can't go running to your landlord; you own the place, you have to fix it.
As for the agent's commission, you might be able to negotiate that or sell it privately. But yes, being a homeowner is a tough choice, because there are so many ways to get hosed.
Nevertheless, in my case, I would buying was still by far the best proposition. However, I waited until I was able to save up 25% of the down payment, which is pretty much what every single person's advice was. (This is why I'm still so amazed at this subprime mortgage thing, because my lender was adamant about meeting this minimum.) I was fortunate enough to lock into a good five-year rate before I even considered buying.
If you're patient and can save some dough while renting, then more power to you. But ultimately, what you're probably saving for is a good down payment, so you can start building equity. Then again, some people rent their whole lives and don't seem to mind it. I've done both and I much prefer condo life.
Skippy - Mortgage insurance is only mandatory if you've got a down payment under 20%.
This is a valiant effort, but as has been pointed out, flawed in many places.
Paying a mortgage builds equity, paying rent builds equity for someone else. Every mortgage payment gives you more security. If you are renting and lose your job, or suffer some other financial crisis, and can't pay your rent, you're screwed. If you own a house, you have tens, if not hundreds, of thousands of dollars in property at your disposal. If you don't want to borrow more against the property, you can always sell it for a not insignificant sum of liquidity.
And 10% is a ridiculous, if sadly realistic, number. I've chastised every friend of mine who put that little down on a house, simply because they believed it was what they had to do. They've all regretted it. Those that put down 25% or more have been universally content, because the payments are smaller, equity is higher, and property value means more.
On top of that, most first-time buyers are intimidated and ignorant. The key to all real estate is location, and so many people end up buying in terrible locations with no potential for serious improvement, or buy houses that will required tens of thousands of dollars of repairs and upgrades to be considered "nice", or sometimes even insurable. But picking the right place, in the right spot, can yield tremendous returns. There are bargains even in real estate.
I've seen a 14% increase in the ASSESSED value of my condo over the last 4 years, and in reality it's probaby more like 25% in saleable value, even in the current market. Why? Because I bought a place in a great neighbourhood that required minimum work to improve tremendously. Throw in some hard bargainning with the owners and I got a great price on a place that had been ignored by buyers looking for something that required zero work in fancier buildings. Shortly after I bought, people woke up to the potential of my complex and prices skyrocketed.
In the next 6 months, there's a very good chance it will be another great buyers market. Prices are dropping, but rates are at historic lows again as people panic. I'm considering purchasing other places to rent out, so people who avoid buying can pay my mortgage.
Yep, as Pukegreen stated do the math for your personal situation. I lived for years in a rent-controlled apartment; I was able to take my savings and put it into RRSPs and mutual funds.
I bought a condo four years ago, (using RRSPs for a down payment), and its value has increased by almost 50%, way more than the other investments. I bought at just the right time, in the right location and my variable mortgage currently sits at 4%.
I know there are a lot of people who are quite happy to rent, but home ownership is certainly worth investigating.