Owning vs renting

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House ownership
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Personal finance
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There is no definitive answer for owning vs. renting a house or apartment. There can be a financial answer as to whether it is cheaper to buy or rent. However, other considerations such as emotional, environmental, and flexibility can sometimes outweigh decisions that may not be financially justified.

Financial considerations

Home affordability

The first step in the decision-making process is to determine whether or not you can afford to purchase a home. There are both one-time and ongoing costs to be considered.

One-time costs may include:

  • A minimum downpayment of 5% of the purchase price is needed for the mortgage to be eligible for Canada Mortgage and Housing Corporation (CMHC) Homeowner Mortgage Loan Insurance.[1]
  • For mortgages with downpayments between 5% and <20%, mortgage loan insurance costs between 2.8% and 4.0% of the loan value[2]; this can be paid as a lump sum or added to the loan (mortgages with a downpayment of 20% or more do not typically require loan insurance)
  • For example, the loan insurance premium on a $500,000 home with a 10% downpayment is $13,950[3]
  • CMHC[1] and the Financial Consumer Agency of Canada (FCAC)[4] both estimate that closing costs (legal/notary fees, land transfer taxes, appraisal fee, home inspection fees, property tax and utility adjustments, moving fees, hook-up costs (cable, satellite, phone, Internet), basic furniture/appliances/window coverings, interest adjustments...) are about 1.5% to 4% of the purchase price. CMHC notes that many first time buyers are surprised by these costs [note 1]

Ongoing costs may include:

  • The monthly mortgage payment (with a typical amortization period of 25 years)
  • Property taxes (possibly school taxes)
  • Home/property insurance (owning) or tenant insurance (renting)
  • Condo fees (if you have a condominium)
  • Utilities (water, gas, electricity)
  • Telephone, internet, cable
  • Cleaning supplies/service
  • Landscaping, lawn, and snow removal service
  • Home maintenance costs, representing several percent of the property value each year; FCAC suggests 1-3%[5]

Renting involve none of the upfront costs (except moving and furniture), and fewer of the ongoing costs. If maintenance issues arise, the landlord pays for the repairs.

Rent versus buy calculators

Playing with the following calculators may help you get a feel of what influences the economics of the buy vs. rent decision:

There are many variables to input in such calculators, most of which are impossible to forecast. For example, you know what the five year fixed mortgage rate is now, but amortization is typically 25 years, not five.

Owning: Price appreciation

Real estate prices change over time: mostly upward, but sometimes downward. The long-term price returns of residential real estate are disputed. For example, in Canada, a Re/Max study[6] found that the nominal compounded annual rate of return was 5.3% from 1981 to 2006. Adjusted for inflation, the compound annual rate of return is 1.6%. Statistics Canada new housing price indexes data shows a nominal compounded annual rate of return of 2.7% for the same period.[7] Adjusted for inflation, the compound annual rate of return was -0.9%.

New House Prices vs CPI (Statscan Data).jpg

A TD Economics study[8], using data from the Canadian Real Estate Asssociation -- a real estate industry trade association --, concludes that "Canadian residential home prices grew by an average 5.4% per year during 1980-2012", or 2.1% after inflation. The TD study predicts a future long-term home price appreciation of 3.5% (nominal) per year, taking into account projected economic growth, demographics, etc. For comparison they forecast returns of 3.1% on T-bills, 3.8% on bonds, and 7% on stocks.

There is longer term data available for the U.S.: Robert Shiller has compiled data for the U.S. housing market from 1890 to the present (see his site). For the period 1890 to 2013, the annualized real (after-inflation) return was 0.17%.[9]

Taking into account home price variations only is not realistic, as this ignores the many ongoing costs listed above such as maintenance costs, interest on the mortgage, insurance, and property taxes, plus transaction costs upon resale. A more realistic calculation taking such costs into account is presented below.

Owning: Liquidity, diversification and impact on portfolios

Housing is an extremely illiquid asset.[9] Unlike stocks or bonds, it can take months to sell a home, and there is a risk that if selling during the wrong time, a homeowner can get less than the long term average price.

Housing is also undiversified.[9] A home's value is dependent on local economic conditions and may not track the aggregate residential real estate's market value, even if the housing market in general performs well. Kerzérho (2023) estimates that while the standard deviation of yearly prices for the Canadian residential real estate market as a whole is about 4%, idiosyncratic volatility of individual homes adds another 10-11% to the total volatility of home prices.[10]

Finally, young and/or less affluent people who put most of their savings in their house/condo (as a downpayment and then in mortgage payments) will have less money available to invest in stocks and other liquid assets, which "reduces the benefits of equity market participation".[11] Even if they have some capital left to invest in liquid assets, investors who own homes might choose more conservative asset allocations in their liquid investments to compensate for house price risk.[11]

Such effects are seen at the population level, when household portfolios are examined as a function of wealth percentile, as shown by the following graph known as the "Tracy whale chart":[12][13]

Tracy-whale-chart.jpg

In this 1995 data, the first 30% of US households, in terms of wealth percentile (i.e. the poorest households), hold no real estate or equities. Then the middle class holds a dominant (some would say "disproportionate"[12]) portion of their assets in real estate (presumably mostly their home), but very low proportions of equities. Only beyond the 95th wealth percentile (i.e. the richest households) do the two curves cross, i.e. equities overtake real estate in household portfolios.

Owning: Leverage

Suppose you buy a $500k property with 10% down. Now suppose that the market is frothy and that after one year, the property is worth 10% more than what you paid for it, i.e. $550k. Ignoring all costs and mortgage payments, you have doubled the value of your original $50k, which is a fantastic result but also signals how risky a levered purchase really is. Leverage can obviously magnify losses as well, as many US homeowners learned during the global financial crisis. Buying with a low downpayment means that during the first few years, your home equity (property market price minus loan balance) is very vulnerable to a housing downturn. Conservative homeowners will use the highest down payment that they can, and pay up the mortgage as quickly as possible, at least until they have built-up substantial home equity, e.g. 50% of the current market value or more.

Goetzmann (1993)[14] calculated the annual standard deviation of returns (a measure of volatility) for single family homes in four US markets (Atlanta, Chicago, Dallas, and San Francisco) over a ten year period between mid-1976 and mid-1986. The results ranged from 9.5% and 12.7%, depending on the city. Using data from the Panel Study of Income Dynamics (PSID), Flavin & Yamashita (2002) report an annual standard deviation of 14.2% at the level of the individual house.[15]. This is in line with the 14% figure for individual homes in Canada mentioned above.[10]. Over the period of the Goetzmann (1993) study, the S&P 500 index of US stocks had a standard deviation of 14.0%. i.e., houses were less risky than stocks, or similarly risky depending on estimates. However, when “tax benefits and costs, maintenance fees, mortgages, and rent benefits” were taken into account, specifically with a 80% mortgage (20% home equity), the standard deviations of single family homes increased to the range 19.7-45.3% depending on the market, i.e. levered houses were up to three times as risky as stocks.[14] This should be food for thought for prospective buyers considering a 5% downpayment, i.e. four times more leverage than the situation just analyzed.

Owning: Mortgage as a "negative bond"

As a liability, a mortgage note is a negative bond. If you have $300K in bond funds (loaning money), a $300K mortgage note (borrowing money) offsets the bonds in the portfolio.[16]

The house's fair market value (FMV) is an undiversified and illiquid asset that counteracts the negative effect of the mortgage note. The net asset value (FMV less mortgage note) can become liquid and subsequently diversified when the asset is sold in a competitive market[17]. Implicit rent, which is the amount a homeowner would pay to rent, or would earn from renting the house in a competitive market, is also considered a real (positive) bond. The implicit rent is only like a bond in that you can think of it paying a "coupon", but that coupon is a housing voucher good for a month's implicit rent at a single address.[18][16]

Owning: A comprehensive assessment

King (2014)[19] evaluates the expected returns on housing in Toronto and Vancouver, for both detached houses and condos, using holding periods ranging from one to forty years. The initial property values range from $300k for a condo in Toronto to $850k for a detached house in Vancouver. Two ways of calculating price appreciation are examined: (1) based on historical prices (median MLS prices between October 1993 and October 2011), and (2) based on assumed equilibrium between rents and housing prices. The first approach means that properties are expected to appreciate at rates ranging from 5.0% to 6.4% per year (nominal), whereas the second yields 2.8-3.0% yearly price changes (which is also the increase in rents).

From these expected price appreciations, several costs have to be subtracted: (i) property taxes of 0.6% of the property value per year; (ii) one-time transaction costs (upon resale) of 4% of the property value; (iii) maintenance costs, which can be “full” (e.g., 3% of the property value per year for a single detached home in Toronto) or “deferred” (e.g., 1.25% for the same house); (iii) interest charges on a mortgage amortized over 25 years, with an interest rate of 2.5% to 5%, depending on the holding period. On the plus side, King (2014) adds imputed rent to his calculations, i.e. the household saves on rent by owning a home. He considers a two-bedroom rental apartment for imputed rent calculations[note 2], and uses the CMHC October Rental Market Survey between 1993 and 2011 as the data source for historical rent growth (2.8-3.0%) and current rent (about $14k, depending on the city).

When everything is considered, under the full maintenance scenario, for the single detached house in Toronto, the expected net returns range from -2% (one year holding) to +3.3% per year (forty years holding period), based on historical house prices. If instead the equilibrium price changes are assumed, then the expected net returns on the same house range from -4.3% (one year) to +1.0% per year (forty years). In Vancouver, for a detached house and equilibrium price changes, the expected net returns are negative for all holding periods under full maintenance.

Owning: Taxation

The biggest tax advantage of home ownership is the capital gain exemption. Imputed rent from a owned residence is also non-taxable (whereas actual rent must be paid with after-tax dollars).

The interest on a mortgage is not tax-deductible in Canada, but some people use debt conversion strategies to turn a mortgage into a deductible investment loan (see Smith Manoeuvre for example) to buy stocks. As mentioned above, leverage can magnify both gains and losses, whether applied to a house purchase or a stock portfolio (see [20]).

A lifecycle perspective

Chapurat et al. (2012)[21] consider the house purchase in a lifecycle framework, which integrates human capital (the present value of future income) into the picture. In chapter 11, Housing decisions, they write:

Most “typical” people under the age of forty should not own a house but should rent instead. (…) When you are young the vast majority of your true wealth is locked up in your human capital, which is illiquid (i.e., non tradable) and non diversified. It therefore makes little sense to invest yet another substantial amount of total wealth in yet another illiquid and non diversifiable item like a house. (…) In addition, when you are young your human capital and hence your total wealth is sensitive to the evolution of your wages and income over time. These two factors tend to decline in a recession and bad economic times, just like housing. In other words, there is a good chance that if your wages take a hit, so will your real estate. (…) However, once you are older (say fifty or sixty) and you have unlocked a large portion of your illiquid and nontradable human capital by converting it into financial capital, then you can afford to “freeze” some financial capital and lock it into a home purchase. At that stage, not only do you have more wealth in total, but your balance sheet (and especially your human capital) is likely not as sensitive to the state of the economy as when you were young.

Housing as a hedge against rent risk

Owning a single house is often seen as risky because of the illiquidity, the concentration, and the leverage during the life of the mortgage (see above). A very different perspective is that a paid-for home is a "risk-free claim on housing consumption, which is the single largest good in the households' consumption basket".[22] Rents in the same area may rise in the future, but the homeowner is protected against that, i.e. that risk has been hedged.[23][24] This is a long term perspective (owning for several decades), in which year-to-year property price fluctuations are not a huge concern[22][24], because the asset price risk (the uncertainty about the final selling price of the property) comes far into the future, whereas the rent risk (the uncertainty about future spot rents) comes every year for renters.[23]

This is the same implicit rent logic to home ownership presented above, but the additional insights are that (i) renting can be risky too, especially over the long term[23] and that (ii) the implicit rent "cash flow" (the housing benefit) offered by an owned home is indexed to ongoing changes in spot rent prices for equivalent dwellings.[22] Otherwise stated, "real estate is equivalent to a perpetual indexed bond on housing consumption".[22] While this is an elegant perspective, it ignores the ongoing costs of home ownership, which continue after the mortgage has been paid.

Non-financial considerations

Environment

If you wish to live in the city but prices are out of reach, renting may be a long-term solution.[25] Ignore the “rent is wasted money” argument: you are getting a place to live in exchange for rent, so it’s not wasted money.

If you wish to live in a single family house in the suburbs or in the countryside, it could be difficult to find one available for long-term rental, and buying it may be the only solution.

Having children may influence the buy vs. rent decision, e.g., perhaps you want to live in a certain neighbourhood where there are young families already, or near a certain school. Depending on where this neighbourhood is located, this would push you toward renting or owning.

People looking to buy a place in the suburbs because the inner city it too expensive should take into account commute time, and perhaps the costs of buying and maintaining a second car, in their comparison.

Psychology

Many people get a psychological benefit from owning a home. They like feeling that a piece of property is theirs, and that they can settle in and relax there. Many homeowners get satisfaction from home improvements projects they fund or do themselves. Some people are proud to own a home. For some young adults, buying a home represents a "rite of passage", a "way to announce your adulthood to the world".[26] [note 3]

Alternatively, some people report a psychological benefit from renting: they know that if the roof leaks, they can just call the landlord. And if they need/wish to move to another city, they can do so much more easily than if they owned a home[27]. Plus renters don't need to watch the mortgage market or real estate prices to see if indeed, their property will turn out to be a good investment.

Condo owners share some of the benefits of both house owners and tenants. Many condo owners get a psychological benefit from owning their unit and sharing the maintenance costs of common areas with other unit owners. They like feeling that a piece of property is theirs, and that they can settle in and relax there. They can do home improvements inside their unit. They also know that if the roof leaks, they can just call the condo association to take care of it.

Like renting, ownership is dependent on making monthly/yearly payments. Homeowners should remember that even after the mortgage is paid off, insurance, maintenance and taxes must still be paid. Condo owners also have to pay condo fees and, sometimes, special assessments (replacing much of the maintenance costs of house owners).

A mortgage is sometimes presented as a forced savings plan. But this is more a behavioural argument than a financial one, since people can force themselves to save in other ways, for example by automating the savings process (e.g. monthly transfers to an investment account).[28]

Relocation and home size

The biggest advantage of renting is the flexibility to relocate relatively easily. The situation in which you bought your home can change.

For example, the perfect house you bought a few years ago may now be a grueling cross-town commute from the great new job you were recruited to. The second kid may mean that you need more room. Having the kids leave home means that you're paying for far more space than you need or want.

On the other hand, with the flexibility of renting comes also some instability. The landlord can always raise the rent or ask you to move before you are ready to do so. If you own a house and make the payments, you can stay as long as you desire.[25]

Renting affords the possibility of having just enough house at any time, which has both financial and lifestyle implications. Upgrading or downsizing as an owner is of course possible too, but may take longer and costs more (e.g., sales commission).

Property improvements

An owner obviously has far more flexibility to make improvements to a home than a renter.

Amenities versus customization

Renting can offer a substantially greater number and variety of amenities than buying. For example, upscale apartment buildings can offer a swimming pool, tennis court, and on-site gym. The monthly rent is comparatively lower than a mortgage for a property with the same attributes.

However, there are affordable homes with private outdoor spaces that you can customize to your liking. There aren’t many apartment buildings that come with acres of property that will let you do your own landscaping, keep horses, or grow a garden.[25]

Maintenance versus available time

Buying a house gives you the opportunity to choose a unique and distinct architectural style and to personalize it. But this freedom comes with the responsibility of keeping up with maintenance and repairs. If you don’t enjoy cutting the grass or fixing a leaky faucet, you will have to hire someone to do this for you.

Although renting gives you no control over exterior aesthetics, you don’t have to worry about dealing with wear and tear on your residence. Renting still gives you plenty of opportunity to choose furnishings and decorate your interior environment in a manner that suits your style. And, as a renter, all you have to do when something goes wrong is notify your landlord.[25]

Notes

  1. ^ A Home purchase cost estimate worksheet form is available from CMHC
  2. ^ Some may argue that a two bedroom apartment is not a fair comparison, and that the rental price of a house of the same size and quality than that which is owned should be used for imputed rent calculations.
  3. ^ On the other hand, one Statistics Canada study lists the following five markers of the transition to adulthood: "leaving school, leaving (the parent's) home, working full-year full-time, finding a conjugal partner and having children" (source). Note that buying a home is not in there.

References

  1. ^ a b Canada Mortgage and Housing Corporation (CMHC), What are the general requirements to qualify for homeowner mortgage loan insurance?, viewed April 16, 2022.
  2. ^ CMHC, CMHC mortgage loan insurance costs, viewed April 16, 2022; see also Mortgage Default Insurance (CMHC Insurance) for an easier to understand premium table
  3. ^ Mortgage calculator, viewed April 16, 2022.
  4. ^ Financial Consumer Agency of Canada, Buying a home, modified May 26, 2021, viewed April 16, 2022.
  5. ^ FCAC, Planning your household budget, modified June 28, 2021, viewed April 16, 2022.
  6. ^ RE/MAX Ontario-Atlantic Canada Inc. 25 years of real estate 1981-2006 Viewed August 16, 2009
  7. ^ Statistics Canada New housing price indexes Viewed August 16, 2009
  8. ^ TD Economics Long-run rate of return for Canadian home prices, March 11, 2013, viewed March 2, 2015
  9. ^ a b c Jason Weinstein, Challenging The Notion Of Homeownership As An Investment, Canadian MoneySaver, May 2013 issue, viewed January 26, 2017
  10. ^ a b Kerzérho R (2023) Financial Planning Assumptions (Factor-Tilted Portfolio), PWL Capital, Summer 2023, viewed August 4, 2023.
  11. ^ a b Cocco JF (2005) Portfolio Choice in the Presence of Housing, Review of Financial Studies, v. 18, p. 535–567, DOI 10.1093/rfs/hhi006, viewed April 18, 2022.
  12. ^ a b Tracy J, Schneider H, Chan S (1999) Are Stocks Overtaking Real Estate in Household Portfolios? Federal Reserve Bank of New York, Current Issues in Economics and Finance, v. 5 no. 5 (April 1999), viewed April 20, 2022.
  13. ^ Campbell JY (2006) Household finance. Journal of Finance v. 61 p. 1553-1604, viewed April 20, 2022.
  14. ^ a b Goetzmann WN (1993) The single family home in the investment portfolio, Journal of Real Estate Finance and Economics, 6:201-222, viewed August 4, 2023.
  15. ^ Flavin M, Yamashita T (2002) Owner-Occupied Housing and the Composition of the Household Portfolio over the Life Cycle, American Economic Review 92, 345–362)
  16. ^ a b Bogleheads wiki: Owning vs renting
  17. ^ "Consumer Price Indexes for Rent and Rental Equivalence", Bureau of Labor Statistics, 2007-02-09
  18. ^ Mortgage as a "reverse bond" in Allocation Planning Bogleheads forum discussion, which includes comparison of bond vs. mortgage "liquidity"
  19. ^ P.C.W.N. King, Housing finance innovation and how Canadians may evaluate homeownership as a critical asset allocation, PhD dissertation, Simon Fraser University, Spring 2014, 166 p. (See especially chapter 4, “Homeownership as a critical asset allocation decision”)
  20. ^ J. Chevreau, Half an endorsement for Smith Manoeuvre, National Post, September 19, 2006, viewed April 16, 2022; “What I do "recommend" is what I'd call a "Half Smith" -- paying down a mortgage quickly”
  21. ^ Chapurat, N.; Huand, H.; Milevsky, M.A. (2012). Strategic financial planning over the lifecycle. Cambridge University Press. p. 367. ISBN 0521148030.
  22. ^ a b c d Barras L, Betermier S (2017) The Predominance of Real Estate in the Household Portfolio, European Financial Data Institute (EUROFIDAI) Conference, Paris, December 2017, viewed April 15, 2022 (a version revised in 2020 is available on ssrn).
  23. ^ a b c Sinai T, Souleles NS (2005) Owner-Occupied Housing as a Hedge Against Rent Risk, Quarterly Journal of Economics, v. 120, p. 763–789, viewed April 16, 2022.
  24. ^ a b Rational Reminder podcast, episode 196, Sebastien Betermier: Hedging, Sentiment, and the Cross-Section of Equity Premia, April 14, 2022, viewed April 15, 2022.
  25. ^ a b c d To Rent or Buy? There's More To It Than Money
  26. ^ M. Leong, First-time homebuyers are feeling the weight of Canada’s housing boom, National Post, September 27, 2014, viewed March 5, 2015
  27. ^ C. Robertson, Renting vs. Buying: 55 Pros and Cons, December 17, 2012, viewed March 3, 2015; note, this is a US source, so ignore the tax discussions, e.g. mortgage payments are not deductible in Canada
  28. ^ T. Ellis, Renting vs. buying: the realities of home-ownership, Get Rich Slowly, July 16, 2007, viewed March 3, 2015

Further reading

External links

The Globe and Mail

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