Renting vs. Buying a Home: The 5% Rule

Summary

In this insightful video, Ben Felix from PWL Capital challenges the common belief that buying a home is a good decision if the mortgage payment is equal to or less than rent. Instead, he introduces the '5% rule' for a more accurate comparison between renting and buying. The rule considers the total unrecoverable costs of both, including property taxes, maintenance costs, and the cost of capital (debt and equity). By comparing these costs to rent, the video offers a clear financial perspective on the rent versus buy decision. Felix also discusses the impact of tax rates and investment portfolio mix on the rule, suggesting adjustments for different scenarios. The video concludes by emphasizing the importance of considering the opportunity cost of equity capital in the decision-making process.

Takeaways

• 🏡 Comparing mortgage payments to rent is not a direct comparison; it's essential to consider total unrecoverable costs for both renting and owning a home.
• 💭 Unrecoverable costs for renters are straightforward, equating to the amount paid in rent, whereas for homeowners, these include property taxes, maintenance costs, and the cost of capital.
• 📊 The 5% rule is a simplified method to estimate the annual unrecoverable costs of homeownership, which includes 1% for property taxes and 1% for maintenance, with the remaining 3% for the cost of capital.
• 💰 The cost of capital is divided into the cost of debt (e.g., mortgage interest at around 3%) and the cost of equity, which considers the opportunity cost of not investing the down payment elsewhere.
• 📈 Historical data suggests that the real return for real estate is lower than that for stocks, which influences the cost of equity and the decision to rent or buy.
• 🌐 Global investment returns are considered, but it's crucial to use expected returns that factor in current market conditions rather than relying solely on historical trends.
• 🏠 The opportunity cost of equity capital is a significant factor in homeownership, representing the potential returns from alternative investments that could have been made with the down payment.
• 🧮 For aggressive investors who have not maxed out their retirement savings accounts, the 5% rule can be a useful guide, but it may need adjustment for more conservative investors or those with taxable investments.
• 📉 Tax considerations and the composition of one's investment portfolio can affect the cost of equity capital, potentially leading to a modified version of the 5% rule.
• 🤔 The financial decision to rent or buy should take into account not just the direct costs but also the opportunity costs and the potential tax implications of homeownership.
• 📚 For a comprehensive understanding, considering the rent versus buy decision from a perspective of unrecoverable costs can provide clarity and a more informed choice.

Q & A

What is the common perception regarding renting versus buying a home?

The common perception is that if the mortgage payment is equal to or less than the rent, then buying is a good decision.

Why is comparing a mortgage payment to rent considered flawed?

It is flawed because a mortgage payment includes interest and principal repayment, which are not unrecoverable costs, whereas rent is an unrecoverable cost.

What does the term 'unrecoverable cost' refer to in the context of renting and buying a home?

An unrecoverable cost is a cost that you pay with no associated residual value. For renting, it's the rent paid, and for owning, it includes property taxes, maintenance costs, and the cost of capital.

What is the 5% rule mentioned by Ben Felix?

The 5% rule is a simplified calculation to compare the total unrecoverable costs of renting to the total unrecoverable costs of owning a home. It includes property taxes (1%), maintenance costs (1%), and the cost of capital (3%).

What is the typical percentage for property taxes in the context of the 5% rule?

Property taxes are generally considered to be 1% of the value of the home.

What is the suggested average percentage for annual maintenance costs?

The suggested average for annual maintenance costs is 1% of the property value.

How is the cost of equity capital calculated in the 5% rule?

The cost of equity capital is calculated based on the opportunity cost of investing the down payment in stocks instead of real estate, and it is estimated to be 3%, equal to the cost of debt capital in the example provided.

What is the significance of the historical return data for real estate and stocks in the script?

The historical return data is used to estimate expected returns for real estate and stocks, which helps in calculating the opportunity cost and the cost of equity capital in the 5% rule.

How does the expected return for stocks affect the cost of equity capital?

The expected return for stocks, which is currently 6.57% for a 100% equity portfolio at PWL Capital, is used to calculate the opportunity cost and thus the cost of equity capital, which is set at 3% in the example.

What adjustments might be needed for the 5% rule in different scenarios?

Adjustments to the 5% rule might be needed considering variables like tax rates, portfolio asset mix, and the aggressiveness of the investment portfolio. For example, the cost of equity capital could decrease for a more conservative investor or a taxable investor.

How can the 5% rule be used to determine if renting or buying is financially sensible?

The 5% rule can be used by multiplying the value of the home by 5% and dividing by 12 to get a monthly unrecoverable cost. If the rent is less than this amount, renting is financially sensible. Conversely, if the rent paid is higher, you can calculate the home value that makes the unrecoverable costs equivalent to the rent paid.

What is the opportunity cost of equity capital in the context of home ownership?

The opportunity cost of equity capital is the potential return that could have been earned if the down payment money was invested in stocks instead of being used to purchase a home. It is a real economic cost that needs to be considered in the rent versus buy decision.

Outlines

00:00

🏠 Rent vs. Buy: Understanding Unrecoverable Costs

Ben Felix introduces the video's focus on the flawed perception that buying a home is a good decision if the mortgage payment is equal to or less than rent. He emphasizes the need to compare the total unrecoverable costs of renting versus owning a home. Felix explains that an unrecoverable cost is a cost with no residual value, and outlines the 5% rule, which includes property taxes (1%), maintenance costs (1%), and the cost of capital (3%). He also discusses the cost of equity capital, which involves opportunity costs and expected returns on investments, and how these factors should be considered in the rent versus buy decision.

05:01

📊 The 5% Rule: A Financial Approach to Rent vs. Buy

Felix elaborates on the 5% rule, which is a simplified method for comparing the financial aspects of renting and buying a home. He explains that the rule accounts for property taxes, maintenance costs, and the cost of capital, including both debt and equity. Felix provides an example calculation using the 5% rule, showing how to determine if renting or buying is the more financially sensible option based on the unrecoverable costs. He also mentions that the rule is an oversimplification and that variables like tax rates and portfolio asset mix can adjust the rule, potentially making home ownership appear less expensive in terms of unrecoverable costs.

10:02

🎙️ Additional Resources for Investors

The final paragraph offers viewers additional resources for further understanding of investing principles. Felix invites the audience to listen to the 'Rational Reminder' podcast for weekly episodes on investment topics. He also encourages viewers to share the video with others who might benefit from the insights provided on the rent versus buy decision.

Keywords

💡Unrecoverable Costs

Unrecoverable costs refer to expenses incurred that do not result in any residual value. In the context of the video, this concept is crucial for comparing the financial implications of renting versus buying a home. The script discusses how rent is an unrecoverable cost, while mortgage payments are not solely unrecoverable since they include principal repayment. The video emphasizes comparing the unrecoverable costs of renting (the rent itself) with those of owning, which include property taxes, maintenance costs, and the cost of capital.

💡Mortgage Payment

A mortgage payment is a regular payment made by a homeowner to their lender over a set period until the mortgage is paid off. The video clarifies that while it may seem similar to rent, it is not an unrecoverable cost because part of the payment goes towards repaying the principal on the loan. This distinction is important when evaluating the financial decision between renting and buying.

💡Property Taxes

Property taxes are taxes paid to local governments based on the value of the property. They are an example of an unrecoverable cost for homeowners, as they do not provide any residual value. The video uses the figure of 1% of the home's value to illustrate this cost, which is part of the 5% rule the speaker introduces.

💡Maintenance Costs

Maintenance costs are the expenses associated with keeping a property in good condition. They can range from minor repairs to major renovations. The video suggests using 1% of the property value per year as an average estimate for these costs, which is another component of the 5% rule mentioned for evaluating the costs of homeownership.

💡Cost of Capital

The cost of capital includes the cost of debt and the cost of equity. For homeowners, this involves the mortgage interest (cost of debt) and the opportunity cost of the down payment (cost of equity). The video explains that the cost of equity is an often overlooked unrecoverable cost, as it represents the potential return on investment that could have been earned if the down payment were invested elsewhere, such as in stocks.

💡Opportunity Cost

Opportunity cost is the potential benefit that is given up when one alternative is selected over another. In the context of the video, the opportunity cost is the return that could have been earned if the down payment were invested in stocks instead of being used to purchase a home. This is a significant factor in the 5% rule for determining the unrecoverable costs of homeownership.

💡5% Rule

The 5% rule is a simplified calculation method introduced in the video to compare the unrecoverable costs of renting versus buying a home. It adds up property taxes (1%), maintenance costs (1%), mortgage interest (3%), and the cost of equity capital (3%, which matches the cost of debt capital), resulting in a total of 5% of the home's value as the annual unrecoverable costs for a homeowner.

💡Real Estate Investment

Real estate investment involves purchasing property with the intention of generating income or capital gains. The video discusses the historical real return on real estate and compares it with other investment types, like stocks. It is a key consideration in the rent versus buy decision, as it involves evaluating the potential returns against the unrecoverable costs.

💡Stocks

Stocks are shares in the ownership of a company and are a common form of investment. The video uses historical and expected returns on stocks to illustrate the opportunity cost of investing in a home instead of the stock market. It discusses how the expected return on stocks can influence the cost of equity capital component of the 5% rule.

💡Taxable Account

A taxable account is an investment account where the earnings are subject to taxes. The video mentions that the after-tax return on investments in a taxable account can be different from the pre-tax return, which can affect the cost of equity capital and, by extension, the 5% rule calculation for the unrecoverable costs of homeownership.

💡Portfolio Asset Mix

Portfolio asset mix refers to the allocation of different types of assets within an investment portfolio, such as stocks, bonds, and cash. The video suggests that the mix between stocks and bonds, as well as the tax implications of investments, can influence the cost of equity capital and thus the 5% rule's applicability to the rent versus buy decision.

Highlights

The common perception that buying a home is a good decision if the mortgage payment is equal to or less than rent is flawed.

A proper assessment of the rent vs buy decision should compare the total unrecoverable costs of renting to owning.

Unrecoverable costs for renting are simply the amount paid in rent.

Unrecoverable costs for homeowners include property taxes, maintenance costs, and the cost of capital.

Property taxes are generally 1% of the home value, the first piece of the 5% rule.

Maintenance costs are suggested to be around 1% of the property value per year on average, the second piece of the 5% rule.

The cost of capital includes the cost of debt (mortgage interest) and the cost of equity capital.

As of April 2019, mortgage interest is considered a 3% unrecoverable cost.

The cost of equity capital is based on the opportunity cost of investing the down payment in stocks instead of real estate.

Historical real return for global real estate is 1.3%, while stocks returned 5.2% after inflation.

Current nominal expected return for a 100% equity portfolio is 6.57%, affecting the cost of equity capital.

The 5% rule estimates a total of 5% of the home value as annual unrecoverable costs for homeowners.

If rent is less than 5% of the home value divided by 12, renting is a sensible financial decision.

The 5% rule is an oversimplification and can change based on variables like tax rates and portfolio asset mix.

The cost of equity capital decreases if the investment portfolio is less aggressive or if investments are taxed.

For aggressive investors who haven't maxed out their RRSP and TFSA, the 5% rule can be a useful tool in the rent vs buy decision.

For conservative investors or taxable investors, a modified version of the 5% rule (e.g., 4%) might be more appropriate.

Considering the cost of home ownership in terms of estimated unrecoverable costs makes the rent vs buy decision easier to evaluate financially.

Transcripts

- I have talked about the decision

around renting versus buying a home before.

But in this video

I wanted to take a bit of a different angle.

The common perception is that if you can purchase a home

with a mortgage payment that is equal to

or less than what you would otherwise pay in rent

then buying is a good decision.

This way of thinking

about the rent versus buy decision is extremely flawed.

Comparing a mortgage payment to rent

is not an apples to apples comparison.

In order to properly assess the rent versus buy decision,

we need to compare the total unrecoverable costs

of renting to the total unrecoverable costs of owning.

That may sound like a complicated task

but I have boiled it down to a simple calculation.

I'm Ben Felix, portfolio manager at PWL Capital.

In this episode of "Common Sense Investing"

I'm going to give you a simple way to think

about the rent versus buy decision.

(upbeat music)

Before we get to the 5% rule,

I need to lay out the assumptions that have gone into it.

An unrecoverable cost is a cost that you pay

with no associated residual value.

When we are talking about the total unrecoverable cost

of renting, the number is very easy.

It's just the amount that you're paying in rent.

For a home owner the unrecoverable costs are a bit harder

to pin down.

A homeowner has a mortgage payment,

which feels kind of like rent,

making it an easy number to compare to rent.

But it is not a meaningful comparison.

A mortgage payment is not an unrecoverable cost.

It is a combination of interest and a principal repayment.

The unrecoverable costs for a homeowner are

property taxes, maintenance costs, and the cost of capital.

It is these costs that we need to compare to rent.

Property taxes are pretty easy

for most people to grasp.

You pay the tax to own the home.

And there is no residual value.

Property taxes are generally 1% of the value of the home.

That's the first piece of the 5% rule.

Then we have to think about maintenance costs.

Maintenance costs cover a huge range of expenses.

It can be large items like replacing a roof

or renovating a kitchen to maintain the value of the home.

But it can also be small things,

like redoing the caulking in the bathroom.

Pinning down the right number

to estimate maintenance costs is not easy.

And the data on average maintenance costs

are not readily available.

But most people suggest using 1%

of the property value per year on average.

This is the second piece of the 5% rule.

Finally, the last and most important piece

to the 5% rule is the cost of capital.

This unrecoverable cost has to be broken down

into two components,

the cost of debt and the cost of equity.

Most homeowners finance the purchase

of their home using a mortgage.

Let's use a new homeowner as an example.

Say they put down 20%

and finance the remaining 80% with a mortgage.

The 80% that has been financed with a mortgage will result

in interest costs.

As of April, 2019, I can easily find the mortgages online

for just under and just above 3%.

Let's call mortgage interest a 3% unrecoverable cost.

Up until this point. I think that all

of the inputs to the 5% rule are fairly intuitive.

Property taxes, maintenance costs, and mortgage interest.

The last one,

the cost of equity capital is a bit less intuitive

and it requires digging into some data.

In our example for the mortgage, we put 20% down.

It's on that 20% that there's a cost of equity capital.

When you put 20% down

you are making a choice to invest in a real estate asset.

Alternatively, you could have continued renting

and invested the down payment money in stocks.

It is that alternative that creates an opportunity cost

which is a real economic cost incurred

by a homeowner.

To estimate this cost we need to come up

with an estimate for expected returns;

both for real estate and for stocks.

A good place to start is the historical data.

Looking at

"The Credit Suisse Global Investment Returns Yearbook 2018"

We can get an idea of the data going back to 1900.

Globally, the real return for real estate,

that's net of inflation from 1900 through 2017 was 1.3%.

While stocks returned 5.2% after inflation.

If we assume inflation at 1.7%

then we will be thinking about a 3% nominal return

for real estate and a 6.9% nominal return for stocks.

I have had many commentators

on my other real estate related videos mention

that 3% might work for global real estate,

but not for Ontario.

That's way too low for Ontario.

It should be closer to five or 10%.

Let's clear that up right now.

The problem with this thinking for any asset class,

is that markets price assets based

on the information that is available at that time.

You would never sell your house for $500,000,

if you knew that the buyer could resell it a year later

for $550,000.

If you knew that you wouldn't sell for $500,000.

We can't assume that high recent historical returns

like we've had Canada will persist forever.

That is not a sensible way to make a decision.

Instead, we can look at the risk premium

that the market has placed

on those types of assets over time

and use that as an estimate for the future.

That 6.9% historical return for stocks includes Russia

and China's stock markets going to zero.

It also includes the aftermath of world wars.

If we were to cherry pick, say US stocks,

the argument for stocks becomes a whole lot stronger,

but it doesn't make a whole lot of sense to do that.

That was a bit of a digression

but I think it was important to put it out there.

At PWL Capital we do not use the historical return

for stocks as the estimate of future returns.

We use a combination of the 50 year historical return

and the current expected return based

on the price earnings ratio.

The effect of this is that when prices are high,

as they are now relative to the past,

our expected returns are lower.

Our current nominal expected return

for a 100% equity portfolio is 6.57%.

Quite a bit lower than the historical average.

If we take these numbers

as they are: 3% for real estate and 6.57% for stocks,

we would have an expected return difference,

between real estate and stocks, of 3.57%.

To keep things simple, and to be conservative,

I think that we can round that down to 3%.

We now have a cost of equity capital of 3%,

which is conveniently equal to the cost of debt capital.

So no matter how you finance the home,

the cost of capital is 3%.

We now have a total of 5% of the value of the home

that you would expect to pay an unrecoverable costs.

Remember rent is an unrecoverable cost that is easy to see.

Homeowners also have unrecoverable costs

but they are harder to see.

The 5% rule can be used to think

about the unrecoverable cost of renting

and owning on an apples to apples basis.

I think that this thinking can be used as a quick reference

for anyone considering the financial aspect

of their rent versus buy decision.

Take the value of the home that you were considering,

multiplied by 5% and divide by 12.

If you can rent for less than that

then renting is a sensible financial decision.

A $500,000 home would be estimated to have $25,000

in annual unrecoverable costs,

or $2083 per month.

It goes the other way, too.

If you find a rental that you love for $3,000 per month

you can take $3,000 multiplied by 12 and divide by 5%.

The result in this case is $720,000.

In other words, paying $3,000 per month in rent

is financially equivalent in terms of unrecoverable costs

to owning a $720,000 home.

There is no doubt that the 5% rule is an oversimplification.

When we start considering variables

like tax rates and portfolio asset mix, the 5% rule changes.

For example, the 6.57% expected return

for stocks is a pretax return,

which is fine in an RRSP or TFSA,

but in a taxable account the after-tax return might

be closer to 4.6% for someone taxed

at the highest marginal rate in Ontario in 2019,

reducing their cost of equity capital.

Similarly, if the investment portfolio is less aggressive

than 100% equity,

the cost of equity capital decreases.

If we think about this

in terms of making financial decisions,

it would just mean adjusting the 5% rule downward,

reducing the total unrecoverable cost of owning.

I feel like that might be a bit of a head spinner

if you haven't thought about home ownership

from this perspective.

So let me try saying it another way.

One of the largest cost of owning a home

is the opportunity cost of equity capital.

If you pay $500,000 cash for a home,

you have now spent $500,000 on real estate,

as opposed to using it for something else,

like investing in stocks.

The difference in expected returns

between real estate and stocks is an opportunity cost.

It is a real economic cost that the homeowner pays,

and it has to be accounted

for in the rent versus buy decision.

The opportunity cost

of equity capital changes depending largely

on your mix between stocks and bonds,

and whether or not your investments are being taxed,

and if they are being taxed, your tax rate.

Based on these variables,

the 5% rule might need to be decreased,

making home ownership less expensive in terms

of unrecoverable costs.

That is an interesting point to chew on.

The cost of owning a home decreases

if you have maxed out your registered accounts

or if you can't handle the volatility

of an aggressive portfolio.

For any aggressive investor,

who has not maxed out their RRSP and TFSA,

I think that the 5% rule can be a useful tool

in the rent versus buy decision.

For anyone with a more conservative portfolio

or for a taxable investor,

I might use something closer to 4%.

Either way, thinking about the cost

of home ownership in terms

of the estimated unrecoverable costs

makes it much easier to think about the financial side

of the rent versus buy decision.

How do you think about the financial side

of the rent versus buy decision?

Tell me about it in the comments.

Thanks for watching.

My name is Ben Felix of PWL Capital

and this is "Common Sense Investing".

If you enjoyed this video,

please share it with someone who you think could benefit

from the information.

Don't forget,

if you've run out

of "Common Sense Investing" videos to watch,

you can tune into weekly episodes of

The "Rational Reminder" podcast

wherever you get your podcasts.

(upbeat music)