We Moved! And Renting Still Beats Buying

Edited Photo. Source: Realtor.ca

Check out our new house! A few months ago I outlined some of my own goals for the coming years. I like to practice what I preach, so we've downsized again.

It's our second move in as many years. I'm admittedly a bit tired of moving at this point, so I locked in a longer-term lease.

Once again, we got rid of a lot of crap in the moving process and would say we are well on our way to minimalism. There are very few things left in our possession which we have not actually used or received meaningful benefit from in the past year.

Our first house was a massive. We bought a fixer-upper a few years ago, did a complete renovation, and eventually sold it for next to zero profit—even in a slightly rising house market. That house was a 1970s split entry with 2,000+ sq.ft. finished area. I estimate our wage rate on all the hours of work we put into the renovations was about $10 per hour. Pitiful considering I'm a journeyman carpenter...

A year ago we moved to a still-too-large-for-us duplex which we rented. (Our first experience renting). It was not ideal and didn't help our vehicle costs or other life costs. But it did get me switched on to the ease of renting. I would estimate that house was approximately 1,500 sq.ft. of finished space plus a full unfinished basement.

Just a few weeks ago, with the help of a few friends, we downsized once again into a 2 bedroom, 2 bath row-house. This place is around 1,100 sq.ft. finished area with a double car garage. The size is just about perfect for us, especially considering we live in a city with 6 months of winter. We spend a fair amount of time indoors during those cold months!

A Financial Evaluation

As shared in a post a long time back, in my former rental duplex I was better off renting than owning by a whopping $400 a month. Twenty-five years down the road, I could reasonably expect to be $250,000 wealthier renting that duplex vs. plunging into ownership.

Once again, I did some calculations before deciding to rent our new townhouse. Ownership is always an option, so it should be considered.

Let's do some Moose Math to figure this one out.

Owning

Purchase Price: $320,000
Downpayment: $64,000
Mortgage @ 3%: $1,210/month
Exterior Maintenance/Condo Fee: $280/month
Interior Maintenance Est: $100/month
Insurance: $75/month
Property Tax: $190/month
Total Ownership Cost:  $1,855 during mortgage, or $645 after mortgage is paid off

Renting

Rental Fee: $1,550/month
Insurance: $25/month
Total Rental Cost: $1,575

Required Savings: $1,575 (rent) - $645 (ongoing ownership costs) = $930 x 12 months x 25x Rule = $279,000 Savings Requirement
Downpayment Future Value: $64,000 (1.06^25) = $274,700
Compound Interest on Monthly Difference: $1,855 - $1,575 = $280 [(1.005^300)-1)/0.005] = $194,000
Total Future Value in 25 Years for Renting: $468,700

Simply put, in this evaluation I could choose between fulling owning a mortgage free $320,000 townhouse in 25 years, or having a $468,700 investment account. (All in today's dollars).

Naturally we chose renting once again. I firmly believe most renters who invest will be better off than homeowners in the coming decades.

I'll also mention that our former home equity has grown substantially in the past year of renting. At this point the investment gains alone will pay for several years of rent fees.

Based on my math, our former home equity has grown to the point where it will easily cover the net rent costs (Rent Fee - Ongoing Ownership Costs) for the rest of our lives using a 25x Rule.

Investing the downpayment and rent cash flow difference is a key factor here. The fact that house prices are absurdly high in many parts of Canada just makes this an easier win for renters.

Of course, some would say that I'm discounting the outsized historical return of housing, forgetting the leveraged return aspect of homeownership, or just that stocks are "riskier" than houses.

Well let's dig into some of these commonly held beliefs.

Housing Historical Return

Housing in Canada has been on a tear since the 1980s. You shouldn't be surprised about this. But don't kid yourself, it's not a coincidence and it's not a "new normal".

In the past decades, interest rates on mortgages have dropped from 20% to just 2.5%. This has made the cost of borrowing for housing cheaper. Yet, as a percentage of our income, we are spending more on our housing now than we did back then.

In the 1980s, the typical Canadian family spent 20% of their gross household income on mortgage payments. Today that number is more than 26% of gross income. Considering nearly 30% of our incomes get sucked up in income taxes, this is huge!

Lower interest costs plus higher spending as a portion of income means a huge boost in the value of the underlying asset—your house. This can give the illusion that housing is a good investment. But most economists disagree.

It's more likely that we've hit the "max" amount of our household budget that can be spent on mortgage costs and we've also hit the realistic low of mortgage rates. I believe house prices are only likely to go down relative to income from this point.

Already there is substantial evidence the Toronto market is collapsing. From a price peak early this spring, detached house prices have fallen as much as 20%! There's a lot of home equity being wiped out there.

Pretty much everyone who bought a house in the GTA in the past year is in a negative return situation after selling costs now. As our country's largest market by far, this can set the trend for the whole country.

Over very long periods of time, it's generally accepted that housing returns are comparable to the inflation rate. This is expected since inflation rates and wage rates go hand-in-hand.

Leveraged Returns

Housing in Canada is a highly leveraged asset. With at least $1.35 Trillion in mortgage debt alone—nearly the size of Canada's entire economic output in one year—it's apparent that houses and debt go hand in hand.

High leverage can make gains seem great, but losses really really hurt. When buying with a 5% downpayment, your leverage ratio is 19:1 (you borrow $19 for every $1 you put in). This means you realize a magnified gain or loss compared to the base asset.

To put this into realer numbers, take a $500,000 house and you put down 5% ($25,000). If the price of the house goes up 10%, your return on equity is actually 200%. If the house price goes down 10%, your return on equity is -200%. Closing costs not included. A -100% return means your equity is gone, more than that means you owe more than the asset is worth.

In housing, because of the structure of mortgage pay down, your leverage ratio declines over time. This means that a 10% gain in house prices during the first year after purchasing looks a hell of a lot better than a 10% gain 20 years after purchasing. Likewise, a 10% loss in value is much more damaging in the first years after homeownership.

One way to maintain leverage rates at a reasonable 65%, diversify your assets with some real investments, and be on the right side of the tax equation is to use the Smith Manoeuvre.

It's important to remember that leverage works both ways. It looks really smart when your asset goes up in value, but should be avoided when prices are flat or going down. A lot of investors who appear very successful in rising markets get wiped out by taking on too much leverage.

Risk In Housing

Risk can be measured in many ways. One method is to evaluate loss. In the U.S., during their housing crash of 2006-2012, house prices collapsed nearly 40% nationwide.

In the most overheated housing markets of Florida, California, Nevada, and Arizona, house prices fell as much as 70%. That would be devastating, but it's not out of the realm of possibility. What happened before can happen again. A 70% skid would see detached Toronto homes under $500,000 in the future.

A passive stock-bond portfolio can see a drop up to 50%. If you invest following the Dual Momentum strategy, your max loss is about 20%. Depending on your indicators and limits use, your max loss with trading rules can be less than that still.

The worst market conditions in history during the Great Depression, and not even globally diversified, saw a 70% drop in U.S. stocks.

In my view, housing is roughly as risky as a properly invested stock portfolio. Don't over-leverage, don't assume its not risky just because it's a roof over your head, and certainly don't believe housing prices never suffer from severe corrections.

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Why House Prices Can’t Keep Climbing

House prices in Canada are relentlessly climbing higher from already unaffordable numbers.

While some major markets have taken a small hit or have slowed down (Prairies and some east coast cities), others are still racing head (most of B.C. and southern Ontario).

The average aggregate benchmark price in Canada is close to an enormous $600,000. Around 10x higher than net household income.

The big question everyone should be thinking about: how long will prices continue to go up?

A majority of Canadians, as shown by several recent polls, think house prices will never drop! But I strongly believe we are very close to a housing correction.

In fact, in many markets I think Canadians would be much better off in the long run to sell now, invest the proceeds in a good portfolio, and rent.

Buyer's Suicide

Given current prices, buying a piece of real estate in the greater Toronto region or southern B.C. is financially suicidal. Mortgage payments alone will suck up most of the your household net income. Nevermind maintenance, property taxes, utilities, good food, oversized vehicles, hockey fees, craft beer, rye whiskey, and other important household expenses.

It's all but impossible to accumulate an appropriate downpayment (20%), make the mortgage payments, save enough for retirement, have a safety cushion, and maintain a good quality of life when a decent place sets you back 10x your net income on the low side.

Buying a house with enormous payments will tie your financial future 100% to your house. If the value of your house goes up and you can make the payments, you will scrape along OK; if the value of your house drops or you can't make the payments, your whole financial picture is toast.

I'm seeing it here in Alberta where thousands of people are financially strapped and "stuck" in their houses after a small life hiccup. They can't sell their house because they owe more than it's worth, but they can't stay because they're going deeper into debt being there. All this stress and hardship after a 5-10% drop in house prices!

Know the Value of Housing

Always remember, the intrinsic value of a house is limited to the value of the its shelter. If it makes much more financial sense to rent a place (which provides equivalent shelter value), renting is logically the current better long-term choice. Real estate purchases should not be an emotional decision!

Homeownership in Canada has become a status symbol because of its social connection to wealth. That in itself is a strike against homeownership for a "Moose"; we don't follow the herd.

There is no special medal, no increase in life quality, no road to wealth, and no wisdom in choosing pricey homeownership over sensible renting. The value of housing lies in what it provides, not the form of possession in which it is obtained.

How This Housing Obsession Occurred

Decades ago house prices were reasonable. In the early 1980s, and even in the early 1990s, one could buy a house without selling their firstborn. In most markets, it made financial sense for a gainfully employed family to buy a house.

Since this time period we have seen an enormous drop in interest rates. Arguably interest rates have never been this low since the organization of mankind. In Canada our governments borrow cheap, our homeowners borrow cheap, our banks get money cheap, our provinces borrow cheap, and our largest corporations borrow cheap.

So cheap in fact, asset prices are actually increasing at a higher rate than the interest on borrowing. Translation: borrowed money is basically free.

As a result, house prices go up despite our largely stagnant incomes. When people see prices going up on an asset they don't really have to pay for, well... they get excited. This causes asset prices to increase even more, detaching from normal fundamental constraints. We're not talking pot stocks and Bitcoin here, this is simple household finance.

While it starts slow, the lure of easy wealth begins to burn hotter. By the time we got into the mid-2000s, things were getting really hot. The Financial Crisis shut down housing markets around the world, but in Canada and a few other countries our governments acted quickly to prop up housing markets through low rates, enabling longer borrowing terms, dropping downpayment requirements, and encouraging foreign money into our real estate markets.

This combination of incentives was liking spraying gasoline on hot coals. House prices in key markets went nuts. Annual price increases have tripled, quadrupled, and went up 10 times our wage growth. Home owning Canadians in these markets got filthy rich by mowing their lawns, barbecuing in the backyard, and shoveling snow like they always have.

There is no increase in worker productivity, no great fundamental economy with awesome job growth, and no great leaps in innovation. In fact, our sans-housing economy has been comatose for years. All this wealth has been riding on the price inflation of a single, unproductive, dead asset: four chipboard walls and an asphalt roof.

Why the Party Will End

Here's the thing though... cheap borrowing—the major catalyst for this asset bubble—is coming to an end. The US Federal Reserve Bank (the bank of banks for the capitalist world) has started inching up interest rates. This means mortgage rates in Canada will also go up over time.

Also, prices simply cannot continue rising faster than inflation—we're already past the point of affordability given our larger economic situation. Even if homes go up at a rate just 2% higher than inflation, in 30 years the average place in Canada will cost over $1 million. Vancouver and Toronto will be $1.6M—in today's dollars.

Even if interest rates went down to zero, the payment on a million dollar mortgage would be $3,500 a month. If interest rates normalized to around 5%, the monthly payment would be a massive $5,800. That's 24% higher than net monthly household income!

The only, and I mean only, way house prices can continue to increase faster than the inflation rate over the long term is if one factor changes: household income. Given the lack of productivity growth, I am skeptical that incomes will materially increase relative to inflation.

Given these facts, I believe 30 years from now house prices will be lower than they are today after adjusting for inflation.

Asset price euphoria can only continue for so long. The longer it lasts, the more exciting it is, and the harder and more painful the correction will be. After all, asset bubbles are like a good frat party.

Always do the math and compare to renting before buying a place. Never ignore maintenance/depreciation costs, even if it's a new home. Don't eliminate your required retirement savings just to buy a house—paying down your mortgage a fraction at a time is not a substitute for a healthy investment portfolio. If you must buy, always follow the Moose Rules.

Comments & Questions

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Comments containing links or "trolling" will not be posted. Comments with profane language or those which reveal personal information will be edited by moderator.