Monday, September 18, 2017

The Wealthy Renter

It seems that everyone wants you to buy a house: your parents, real estate firms, mortgage brokers, and even the government. Alex Avery decided to make a case for renting in his book The Wealthy Renter: How to Choose Housing That Will Make You Rich. His reasonable and balanced analysis contrasts sharply with the usual cheerleading for owning a house.

We’ve all heard people say something like “renting is just throwing money away,” or “why pay your landlord’s mortgage when you can own your own house?” This advice is based on the mistake of comparing rent to a mortgage payment. Typically, renters pay for little other than their rent – maybe a few utilities. Homeowners pay property taxes, maintenance costs, utilities, insurance, and an opportunity cost on home equity. It’s the total of all these costs that we should be comparing to rents.

Avery goes through an example of an $850,000 home and concludes that the cost for an owner to occupy the home is between $4000 and $8000 a month. The high end of this range involves some double-counting and implausibly high maintenance costs,1 but a range of $4000 to $6000 per month is quite plausible. Most people would find this range shockingly high and simply wouldn’t believe it even after seeing the logic behind it. They’d be wrong.

Some might object that homeowners can look forward to gains on the value of their home. Avery gives a series of charts showing that while house prices are up quite a bit since 1991, “Canadian house prices haven’t delivered returns anywhere near those of the Canadian stock market.”

Renting and investing the difference would have made you richer than owning the average Canadian home. However, this analysis is based on low-cost methods of investing in the stock market. For investors who pay Canada’s sky-high mutual fund costs, the gap is smaller, but still favours stocks over houses. A homeowner might proudly say that his home has tripled in value, but he forgets inflation and all the money he spent on property taxes, maintenance, and other costs.

At a time when banks will lend 5 to 7 times your gross annual salary for a mortgage, the author says “if you want to build wealth, there are much better things to spend your money on than housing. Minimizing consumption of housing is crucial to building wealth.”

In addition to comparing owning to renting, Avery gives some detailed analysis of what drives housing prices. This begins with “Buildings never go up in value,” and “Only land can go up in value.” He also analyzes the 6 biggest housing markets in Canada. Toronto house prices are at 40 times annual rents, which is very high. At first I thought this was for comparable dwellings, but I’m guessing this isn’t the case.

What has really allowed homeowners to do well, Avery explains, is leverage. Investing in a house with borrowed money amplifies returns. Of course, stock investors can use leverage too. But leverage comes with risks, whether investing in stocks or a house.

“Home buying needs to be seen for what it really is: an investment in land plus consumption of the glamorous building that has been erected on that piece of land.” This makes it clear why owning a smaller house is better for your long-term finances.

“The thought of never being able to afford a house because house prices have risen so quickly you can never catch up is irrational. So is buying a house to get into the market.”

Avery includes an excellent chapter “How Housing Can Dictate Your Career in Surprising and Unexpected Ways.” This is something I’ve tried to explain to my sons. The exciting job you start with can end up being a trap if you build a lifestyle that needs your full income. Having a huge mortgage can leave you biting your tongue at work for fear of upsetting the boss and losing your job. This is something I’ve seen many times in coworkers.

One of the claimed benefits of owning a house is the forced savings. This is true to a point. If you rent and just spend all your income, you could end up worse off than a homeowner. To get the full benefit of renting, you need to save and invest some of the money you didn’t spend on home ownership. Avery explains several ways to automate your savings.

So, why is there so much cheerleading for owning a home and almost none for renting? “The primary, and often only, beneficiaries of renting are the renters themselves.” Those who benefit from all the forced spending by homeowners are the ones who promote owning. “Renting is the more logical, cheap, flexible, and low-risk way to live.”

Overall, this book gives a very thoughtful analysis of owning versus renting. Unlike most promotion of owning, the author is not a cheerleader for renting. He acknowledges advantages and disadvantages on both sides. I recommend this book to anyone struggling with a decision of whether to buy a home or rent.

1 For the high end of the range of monthly home ownership costs, Avery starts with the asking rent for a comparable house before adding other costs. But a landlord might include allowance for some of these costs in the asking rent. The maintenance cost range goes too high as well. As Avery later explains, “The rule of thumb for maintenance costs is 2 to 5 percent of the value of the house in most markets, and lower where house prices are particularly high.” Essentially, the cost of maintaining a house doesn’t go up much just because the land under it becomes more valuable. So, 5% is an unreasonably high estimate for a house sitting on expensive land, which is the case for most $850,000 houses.


  1. Let me open by saying that I am in 100% agreement, in general.

    Now let me state that I think there's something missing around the leverage. The leverage factor is real, as housing lets an average buyer amp up to several times their income. What adds to the appeal is that with a house, the leverage cost is lower. Mortgages in Canada have been in the 2-3% range, compared to 5% for an unsecured investment loan. There there does exist a good 2-3% cost of leverage factor in favor of buying a home. The second factor is simply that it's easy. It's perceived that anyone can lever up to buy a house, while borrowing 500k to invest in the stock market is - rightly or wrongly - a significant bigger mental hurdle for most.

    Totally agree with the post and book. But I see why the average Joe just buys a house.

    1. @Anonymous: I suspect most people don't compare buying a house to investing in the stock market. People buy a house because they want one, or think it's the thing you're supposed to do when you grow up.

  2. Unfortunately, it is much more difficult to find a nice variety of places to rent than it is to find places to buy. The vast of majority of properties available to rent are lower end. The nicer places are downtown, and as such are very expensive, at least in Ottawa. In my case, they're also far from where I work in Kanata, where there are very few properties available to rent.

    1. @Anonymous: How many do you need? Unless there are literally zero properties that meet your rental criteria, you have a choice of buying or renting. If there really are zero rental options that suit you, that's unfortunate.

  3. Friction and liquidity hasn't been considered. Buying and selling a home is incredibly expensive when considering agent fees, legal, moving costs, etc. Liquidity as well isn't great in a home. If you need to relocate for work, very possible that you could end up carrying 2 places while waiting for one to sell. Renting and instead investing the money you would otherwise have tied up in a house and you can easily put your entire equity into a low-fee passive equity fund for 9.95 and a few basis points in annual fees. If you ever want to extract some equity, a few keystrokes and you are done. Home equity loan on the other hand, will cost you time and fees. HELCOs are also demand loans, bank can call at any time. Just more factors to be taken into everyones own personal equation.

    1. @Anonymous: Good points. Many of these are covered in the book.

  4. I would like to see a comparison of a 3rd option: buying RE to be a landlord and rent to someone else and be a tenant by renting RE to live in. That way, one gets capital appreciation, home ownership expenses become deductible and one has extra income to pay rent. Also, is there a value assigned to owning RE? Thanks!

    1. @Bruce: If you have a mortgage on the property you own, it's unlikely the rent you collect will cover all your costs. So, there wouldn't be extra income to pay rent. The main differences between the scenario you describe and just owning (and living in) a house is taxes: some expenses become deductible and capital gains on a sale become taxable.

  5. The exchange below (broken into 4 pieces) is reproduced here to remove broken links.

    ---- BHCh September 18, 2017 at 6:27 PM

    1. Comparing returns from RE vs shares is tricky and depends on the segment and period of time. Right now Mel Farber is advertising a study which claims that RE has been a better investment.

    2. One aspect you didn't mention - profits from selling your expensive house are completely tax free. That's like a 25% difference vs cap gains in a taxable account.

    ----- Michael James September 18, 2017 at 7:04 PM

    @BHCh: You have to be pretty selective about RE segment and time period for RE to look better than stocks after taking into account all costs (including taxes). The book took into account capital gains taxes.

    I looked for the study you mentioned but didn't find it. Do you have a link?

    ----- BHCh September 18, 2017 at 10:27 PM

    Mel mentioned this study on several of his recent podcasts. Pretty sure he mentioned it during episode #68, among others

    Sorry, I did like the episode enough to listen to the whole thing again and find out when.

    Having said it, I doubt one has to be all that selective to show RE outperforming. In fact... people claiming that shares are guaranteed to outperform usually do historic testing using N American markets. Or at least a huge allocation to the States. Well, US market has been a runaway winner over the last 100 years and for a good reason. US has become a superpower. Markets in Europe haven't done all that well. US may have been an exception and who knows what will happen in the future.

    I have certainly found RE returning just as much as the stock market (at least doubling value every 10 years) but that is also selective and backwards looking.

    ----- Michael James September 19, 2017 at 1:55 PM

    @BHCh: I found the study. According to sections 2.4 and 5.1, they calculate real estate returns by taking price data and adding rent data (net of some costs). The discussion makes it clear that only some costs are accounted for. Significant real estate costs include maintenance and repairs, property taxes, insurance, buying and selling costs, and the time and effort required to manage properties (whether done by a management company or directly by the owner). Over long periods, it would also include demolishing and rebuilding costs, and costs due to abandoning some land entirely (e.g., through wars). Overall, these items are a huge drag on returns and underestimating them makes a big difference.

    The book looks at Canadian real estate and stocks since 1990. This was a good period for real estate, but when all factors were considered, stocks won handily.

    1. ----- BHCh September 19, 2017 at 8:08 PM

      Costs vary depending on circumstances.

      For example if most of the value is in the land then maintenance is waste, from a purely financial point of view.

      Our last house sold for 1.8M (1.6 of it was land) and the annual cost of maintaining, insuring, taxes, was just under 1% per year. And renting a comparable family home in that location would have cost 6%. For us owning was definitely better from the financial point of view, not to mention the intangibles.

      All I am saying is that it's not cut and dry and depends on circumstances.

      ----- Michael James September 20, 2017 at 9:02 AM

      @BHCh: The best choice certainly does depend on circumstances. In Canada today, renting is the better choice in the majority of cases (from a purely financial point of view). But if your rent would have been $9000/month, then I'd say buying and renting were likely both poor financial choices for your house. That much rent is crazy, and it seems very unlikely the house's value would go to $3.6M in a decade and $7.2M in 2 decades. I guess that makes it a good decision for you to sell.

      ----- Anonymous September 20, 2017 at 11:21 AM

      The future is probabilistic. We shall find out if that was right (or buying a place in a different area for 1m).

      What we do know is that buying the place for 750k in December 2004 was financially sound, even if 2016 price tag of 1.8m seemed improbable.

      On top of that one gets free access to good schools and the enjoyment of the place.

      ----- Michael James September 20, 2017 at 11:44 AM

      @Anonymous: I'd replace "financially sound" with "lucky". What you call "free" costs property taxes, maintenance and repairs, utilities, and insurance.

      ----- Anonymous September 20, 2017 at 12:00 PM

      Sure, lucky. It was also lucky buying a place in 1998 and selling at 2.4 times the purchase price in 2004.

      Taxes do pay for schools but the cost has little relation to the quality of education. And you pay this same tax when you rent, albeit indirectly.

      Again, there is no certainty about how the future will turn out. One has to account for different outcomes rather than make guesses.

      Michael James September 20, 2017 at 12:11 PM

      @Anonymous: Everyone's brilliant when things turn out well and unlucky when they turn out poorly. If you're going to call property taxes a wash between owners and renters, then you have to reduce the rent by the amount of the property taxes for comparison.

    2. ----- BHCh September 20, 2017 at 4:37 PM

      True enough, hindsight 20/20. A renter can turn out to be a loser too. Many have.

      And yes, taxes were counted in the 1% vs 6% comparison. Tax was a large chunk of the cost of owning.

      The equation has several factors, location being very important. And the answer is an event tree with probabilities.

      Not saying that renting isn't right just not necessarily nor definitively.

      ----- Anonymous September 22, 2017 at 9:40 AM

      My case in the real world: I own a 1 million$ condo, fully paid, costing $30K in fees, property taxes, insurance etc. An equivalent rental costs $6K per month i.e. $72K or a cost increase of $42K. If I sell my condo and invest the $1 million at 5%, I get $50K in annual revenue. At the marginal income tax rate of 50%, my annual increase in revenue is reduced to $25K - just about half of the additional cost of renting (which is $42K). Renting would require a serious drop in my quality of accomodation in order to benefit from the additional $1 million from the sale of my condo!
      ----- Michael James September 22, 2017 at 9:56 AM

      @Anonymous: I've seen single-family detached homes in Vancouver than rent for less than $6k/month. You can certainly expect investment returns to exceed 5%, on average, and there is no reason to pay a 50% tax rate -- capital gains taxes are much lower and can be deferred.

      ----- Anonymous September 22, 2017 at 12:40 PM

      Agree. But to compare apples with apples, my owned condo is 2000 sq ft (+) parking in an upscale area of Montreal-Westmount. I have not yet seen an equivalent rental in this area at less than $6K and I thought that Vancouver was more expensive than Montreal. As a retiree, depending on a monthly stream of interest and dividends, I would feel very insecure at anything paying more than 5%. Likewise all the tax dodges that i have seen seem to involve both risk and a lack of liquidity. However, I admit that I am not an expert.

    3. ----- BHCh September 22, 2017 at 11:02 PM

      "You can certainly expect investment returns to exceed 5%."

      Gee... I admire your "certainty".

      Anon's calculations are missing return on investment into his condo. There is a ~95% probability that 10-year return will be positive.

      ----- Michael James September 25, 2017 at 8:54 AM

      @Anonymous: I tried searching for 4-bedroom condos in Westmount. one is asking $2695; another is a 6.5 room penthouse asking $5500. No idea how they compare to yours. It seems that you're only counting the interest and dividends from your investments. You are making capital gains as well on any stocks you own -- I wasn't referring to any tax dodges.

      @BHCh: There's a difference between the a priori expected return and actual return after the fact.

      ----- BHCh September 25, 2017 at 10:43 AM

      Certainly. We just need to be consistent. If we are counting (expected) capital gains from shares then we should also account for the expected capital gains from the real estate. Otherwise not comparing like with like.

      And expected total return from shares right now is about 4% - according to Jack Bogle.

      ----- Michael James September 25, 2017 at 11:54 AM

      @BHCh: If we're limiting our horizon to a decade, then we need to take into account the current high US stock valuations as well as the current extremely high Canadian real estate valuations.

      ----- BHCh September 25, 2017 at 10:23 PM

      Yep. And high Canadian stock valuations too. Not a good reason to refuse owning any of these assets but a good reason to be prepared for prices going down and lower returns.

      ----- Michael James September 26, 2017 at 8:55 AM

      @BHCh: Given the lower long-term returns of real estate compared to stocks, I'd say it's reasonable to avoid real estate as an investment. But having some diversified real estate to lower volatility can serve a similar function to bonds.

      ----- BHCh September 26, 2017 at 11:28 PM

      And this is the gist of disagreement.

      Firstly, "expected returns" are uncertain for all assets and will vary depending on location and type of property.

      Secondly, one has to live somewhere and renting in Ontario is a bad option in many situations. Worse with the new rent controls. Obviously a house isn't only an investment.

      Finally, we diversify between asset classes because while we think we know what returns are expected, we are invariably wrong.

      I think it is unwise to have all your net worth in either stocks or bonds or property. That is unless the objective is maximum return and then one should just buy a few stocks.

      ----- Michael James September 26, 2017 at 11:32 PM

      @BHCh: I'm pretty sure we're not going to come to agreement on this.

  6. The exchange below is reproduced to remove broken links.

    ----- gattaca September 22, 2017 at 12:07 PM

    My real world example. Been renting for 20 years in 905 area of GTA. Rent has gone from $750 to $1100 over that time.

    My savings rate has gone up from <5% like most Canadians to near 30%. My income has gone from 35k to 140k.

    I'm an aggressive investor with 100% equity exposure but rarely use margin. My portfolio is barbelled between a handful of large-caps and a basket of juniors. So, my portfolio has experienced a high degree of volatility but it is over $1.5 million. I'm self taught but do have the CFA designation.

    Average house price in my area is about 800k but dropping. Range is between 400k to $1 million not including condos. So, as a renter, I'm ahead of my neighbours assuming their savings rate is in line with the average Canadian.

    ----- Michael James September 25, 2017 at 9:05 AM

    @Gattaca: Sounds like you've done well for yourself. With your rent so low, I'm guessing you're not living in an average house. To make a comparison, we'd have to imagine a scenario where you bought a place comparable to where you're living now.