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.