Renting vs. Buying a Home: The 5% Rule — Transcript

Full transcript

1. 0:00- I have talked about the decision
2. 0:01around renting versus buying a home before.
3. 0:03But in this video
4. 0:04I wanted to take a bit of a different angle.
5. 0:06The common perception is that if you can purchase a home
6. 0:09with a mortgage payment that is equal to
7. 0:11or less than what you would otherwise pay in rent
8. 0:13then buying is a good decision.
9. 0:15This way of thinking
10. 0:16about the rent versus buy decision is extremely flawed.
11. 0:20Comparing a mortgage payment to rent
12. 0:21is not an apples to apples comparison.
13. 0:24In order to properly assess the rent versus buy decision,
14. 0:27we need to compare the total unrecoverable costs
15. 0:30of renting to the total unrecoverable costs of owning.
16. 0:34That may sound like a complicated task
17. 0:36but I have boiled it down to a simple calculation.
18. 0:39I'm Ben Felix, portfolio manager at PWL Capital.
19. 0:42In this episode of "Common Sense Investing"
20. 0:44I'm going to give you a simple way to think
21. 0:46about the rent versus buy decision.
22. 0:48(upbeat music)
23. 0:51Before we get to the 5% rule,
24. 0:53I need to lay out the assumptions that have gone into it.
25. 0:56An unrecoverable cost is a cost that you pay
26. 0:59with no associated residual value.
27. 1:01When we are talking about the total unrecoverable cost
28. 1:04of renting, the number is very easy.
29. 1:07It's just the amount that you're paying in rent.
30. 1:09For a home owner the unrecoverable costs are a bit harder
31. 1:12to pin down.
32. 1:13A homeowner has a mortgage payment,
33. 1:15which feels kind of like rent,
34. 1:16making it an easy number to compare to rent.
35. 1:18But it is not a meaningful comparison.
36. 1:21A mortgage payment is not an unrecoverable cost.
37. 1:24It is a combination of interest and a principal repayment.
38. 1:28The unrecoverable costs for a homeowner are
39. 1:30property taxes, maintenance costs, and the cost of capital.
40. 1:35It is these costs that we need to compare to rent.
41. 1:38Property taxes are pretty easy
42. 1:39for most people to grasp.
43. 1:41You pay the tax to own the home.
44. 1:42And there is no residual value.
45. 1:45Property taxes are generally 1% of the value of the home.
46. 1:48That's the first piece of the 5% rule.
47. 1:51Then we have to think about maintenance costs.
48. 1:53Maintenance costs cover a huge range of expenses.
49. 1:56It can be large items like replacing a roof
50. 1:58or renovating a kitchen to maintain the value of the home.
51. 2:01But it can also be small things,
52. 2:02like redoing the caulking in the bathroom.
53. 2:05Pinning down the right number
54. 2:06to estimate maintenance costs is not easy.
55. 2:09And the data on average maintenance costs
56. 2:11are not readily available.
57. 2:13But most people suggest using 1%
58. 2:14of the property value per year on average.
59. 2:17This is the second piece of the 5% rule.
60. 2:20Finally, the last and most important piece
61. 2:23to the 5% rule is the cost of capital.
62. 2:26This unrecoverable cost has to be broken down
63. 2:28into two components,
64. 2:30the cost of debt and the cost of equity.
65. 2:33Most homeowners finance the purchase
66. 2:35of their home using a mortgage.
67. 2:37Let's use a new homeowner as an example.
68. 2:39Say they put down 20%
69. 2:41and finance the remaining 80% with a mortgage.
70. 2:44The 80% that has been financed with a mortgage will result
71. 2:46in interest costs.
72. 2:47As of April, 2019, I can easily find the mortgages online
73. 2:51for just under and just above 3%.
74. 2:54Let's call mortgage interest a 3% unrecoverable cost.
75. 2:58Up until this point. I think that all
76. 2:59of the inputs to the 5% rule are fairly intuitive.
77. 3:03Property taxes, maintenance costs, and mortgage interest.
78. 3:06The last one,
79. 3:07the cost of equity capital is a bit less intuitive
80. 3:11and it requires digging into some data.
81. 3:13In our example for the mortgage, we put 20% down.
82. 3:16It's on that 20% that there's a cost of equity capital.
83. 3:20When you put 20% down
84. 3:22you are making a choice to invest in a real estate asset.
85. 3:25Alternatively, you could have continued renting
86. 3:27and invested the down payment money in stocks.
87. 3:31It is that alternative that creates an opportunity cost
88. 3:33which is a real economic cost incurred
89. 3:36by a homeowner.
90. 3:37To estimate this cost we need to come up
91. 3:39with an estimate for expected returns;
92. 3:42both for real estate and for stocks.
93. 3:44A good place to start is the historical data.
94. 3:47Looking at
95. 3:48"The Credit Suisse Global Investment Returns Yearbook 2018"
96. 3:51We can get an idea of the data going back to 1900.
97. 3:54Globally, the real return for real estate,
98. 3:56that's net of inflation from 1900 through 2017 was 1.3%.
99. 4:01While stocks returned 5.2% after inflation.
100. 4:05If we assume inflation at 1.7%
101. 4:08then we will be thinking about a 3% nominal return
102. 4:11for real estate and a 6.9% nominal return for stocks.
103. 4:16I have had many commentators
104. 4:18on my other real estate related videos mention
105. 4:21that 3% might work for global real estate,
106. 4:24but not for Ontario.
107. 4:25That's way too low for Ontario.
108. 4:28It should be closer to five or 10%.
109. 4:30Let's clear that up right now.
110. 4:31The problem with this thinking for any asset class,
111. 4:34is that markets price assets based
112. 4:36on the information that is available at that time.
113. 4:39You would never sell your house for $500,000,
114. 4:41if you knew that the buyer could resell it a year later
115. 4:45for $550,000.
116. 4:47If you knew that you wouldn't sell for $500,000.
117. 4:50We can't assume that high recent historical returns
118. 4:53like we've had Canada will persist forever.
119. 4:56That is not a sensible way to make a decision.
120. 4:59Instead, we can look at the risk premium
121. 5:01that the market has placed
122. 5:02on those types of assets over time
123. 5:04and use that as an estimate for the future.
124. 5:06That 6.9% historical return for stocks includes Russia
125. 5:10and China's stock markets going to zero.
126. 5:13It also includes the aftermath of world wars.
127. 5:16If we were to cherry pick, say US stocks,
128. 5:18the argument for stocks becomes a whole lot stronger,
129. 5:21but it doesn't make a whole lot of sense to do that.
130. 5:24That was a bit of a digression
131. 5:25but I think it was important to put it out there.
132. 5:27At PWL Capital we do not use the historical return
133. 5:30for stocks as the estimate of future returns.
134. 5:32We use a combination of the 50 year historical return
135. 5:35and the current expected return based
136. 5:37on the price earnings ratio.
137. 5:39The effect of this is that when prices are high,
138. 5:41as they are now relative to the past,
139. 5:44our expected returns are lower.
140. 5:46Our current nominal expected return
141. 5:48for a 100% equity portfolio is 6.57%.
142. 5:52Quite a bit lower than the historical average.
143. 5:55If we take these numbers
144. 5:56as they are: 3% for real estate and 6.57% for stocks,
145. 6:01we would have an expected return difference,
146. 6:03between real estate and stocks, of 3.57%.
147. 6:07To keep things simple, and to be conservative,
148. 6:10I think that we can round that down to 3%.
149. 6:13We now have a cost of equity capital of 3%,
150. 6:15which is conveniently equal to the cost of debt capital.
151. 6:19So no matter how you finance the home,
152. 6:21the cost of capital is 3%.
153. 6:24We now have a total of 5% of the value of the home
154. 6:27that you would expect to pay an unrecoverable costs.
155. 6:30Remember rent is an unrecoverable cost that is easy to see.
156. 6:33Homeowners also have unrecoverable costs
157. 6:36but they are harder to see.
158. 6:37The 5% rule can be used to think
159. 6:39about the unrecoverable cost of renting
160. 6:41and owning on an apples to apples basis.
161. 6:44I think that this thinking can be used as a quick reference
162. 6:47for anyone considering the financial aspect
163. 6:49of their rent versus buy decision.
164. 6:51Take the value of the home that you were considering,
165. 6:53multiplied by 5% and divide by 12.
166. 6:56If you can rent for less than that
167. 6:59then renting is a sensible financial decision.
168. 7:02A $500,000 home would be estimated to have $25,000
169. 7:06in annual unrecoverable costs,
170. 7:08or $2083 per month.
171. 7:11It goes the other way, too.
172. 7:12If you find a rental that you love for $3,000 per month
173. 7:16you can take $3,000 multiplied by 12 and divide by 5%.
174. 7:21The result in this case is $720,000.
175. 7:24In other words, paying $3,000 per month in rent
176. 7:26is financially equivalent in terms of unrecoverable costs
177. 7:30to owning a $720,000 home.
178. 7:33There is no doubt that the 5% rule is an oversimplification.
179. 7:37When we start considering variables
180. 7:39like tax rates and portfolio asset mix, the 5% rule changes.
181. 7:43For example, the 6.57% expected return
182. 7:47for stocks is a pretax return,
183. 7:49which is fine in an RRSP or TFSA,
184. 7:51but in a taxable account the after-tax return might
185. 7:54be closer to 4.6% for someone taxed
186. 7:57at the highest marginal rate in Ontario in 2019,
187. 8:00reducing their cost of equity capital.
188. 8:03Similarly, if the investment portfolio is less aggressive
189. 8:06than 100% equity,
190. 8:07the cost of equity capital decreases.
191. 8:11If we think about this
192. 8:12in terms of making financial decisions,
193. 8:13it would just mean adjusting the 5% rule downward,
194. 8:16reducing the total unrecoverable cost of owning.
195. 8:19I feel like that might be a bit of a head spinner
196. 8:21if you haven't thought about home ownership
197. 8:23from this perspective.
198. 8:24So let me try saying it another way.
199. 8:26One of the largest cost of owning a home
200. 8:28is the opportunity cost of equity capital.
201. 8:31If you pay $500,000 cash for a home,
202. 8:34you have now spent $500,000 on real estate,
203. 8:37as opposed to using it for something else,
204. 8:39like investing in stocks.
205. 8:41The difference in expected returns
206. 8:42between real estate and stocks is an opportunity cost.
207. 8:45It is a real economic cost that the homeowner pays,
208. 8:48and it has to be accounted
209. 8:49for in the rent versus buy decision.
210. 8:52The opportunity cost
211. 8:53of equity capital changes depending largely
212. 8:55on your mix between stocks and bonds,
213. 8:57and whether or not your investments are being taxed,
214. 9:00and if they are being taxed, your tax rate.
215. 9:03Based on these variables,
216. 9:04the 5% rule might need to be decreased,
217. 9:06making home ownership less expensive in terms
218. 9:08of unrecoverable costs.
219. 9:10That is an interesting point to chew on.
220. 9:13The cost of owning a home decreases
221. 9:15if you have maxed out your registered accounts
222. 9:17or if you can't handle the volatility
223. 9:19of an aggressive portfolio.
224. 9:21For any aggressive investor,
225. 9:23who has not maxed out their RRSP and TFSA,
226. 9:26I think that the 5% rule can be a useful tool
227. 9:28in the rent versus buy decision.
228. 9:30For anyone with a more conservative portfolio
229. 9:33or for a taxable investor,
230. 9:35I might use something closer to 4%.
231. 9:37Either way, thinking about the cost
232. 9:39of home ownership in terms
233. 9:40of the estimated unrecoverable costs
234. 9:42makes it much easier to think about the financial side
235. 9:45of the rent versus buy decision.
236. 9:47How do you think about the financial side
237. 9:49of the rent versus buy decision?
238. 9:50Tell me about it in the comments.
239. 9:52Thanks for watching.
240. 9:54My name is Ben Felix of PWL Capital
241. 9:56and this is "Common Sense Investing".
242. 9:58If you enjoyed this video,
243. 9:59please share it with someone who you think could benefit
244. 10:01from the information.
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251. 10:12(upbeat music)