Starting Out
I have discussed renting versus buying a home several times before – such as here, here, and here. Today, I want to correct a common misperception on that front, plus provide a sensible solution for helping you decide whether to rent or own your home. I call it the 5% Rule.
We’ll get to the 5% Rule in a moment. First, let’s talk about that misperception. It’s often assumed, if you can purchase a home with a mortgage payment that’s equal to or less than what you would otherwise pay in rent, then home ownership is the way to go.
Unfortunately, this is a mathematically flawed way to think about it. While it’s admittedly easy to come up with the numbers, they don’t offer a meaningful, apples-to-apples comparison.
What’s To Recover?
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 complicated, but my 5% Rule should help.
First, let’s define unrecoverable costs. These are any costs you pay with no associated residual value. In other words, it’s money spent, never to be seen again, in exchange for having a place to live.
Determining the total unrecoverable costs of renting is very easy: It’s the amount you are paying in rent. For a homeowner, the unrecoverable costs are harder to pin down.
A homeowner has a mortgage payment, which feels like rent. This may make it seem like a good number to compare your rent to, but it is not a meaningful comparison. Unlike rent, a mortgage payment is not entirely an unrecoverable cost. It is a combination of interest and principal repayment.
So what are a homeowner’s actual unrecoverable costs? There are three of them:
- Property taxes
- Maintenance costs
- Cost of capital (mortgage interest + opportunity costs)
Instead of inaccurately comparing your mortgage to your rent, we need to compare these three costs to your rent. Generally, they tally up to 5% … thus the 5% Rule (with some caveats I’ll cover as well).
Estimating Taxes and Maintenance
We’ll start with the easy ones, such as your property taxes. As a homeowner, you’ll pay these annually, with no residual value to show for it. They’re generally 1% of the value of the home.
Then there are maintenance costs, which cover a huge range of unrecoverable expenses – from replacing your roof, to renovating your kitchen, to re-caulking the bathtub. It’s not easy to pin down a precise number, and data on average maintenance costs are not readily available. But as a general rule of thumb, I think it’s reasonable to estimate another 1% of your property value per year.
So, figure that taxes and maintenance are approximately 2% of my 5% Rule. Now to the final, more complicated piece: your cost of capital. Spoiler: It’s going to represent the remaining 3%.
Calculating Cost of Capital
You can break down your unrecoverable cost of capital into two components:
- Cost of debt
- Cost of equity
First, the cost of debt. Most homeowners finance the purchase of their home using mortgage debt. For example, a new homeowner may 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 mortgages online for right around 3%, give or take, so we’ll consider mortgage interest to be a 3% unrecoverable cost.
The Cost of Opportunities Lost
So far, I think all of the inputs have been fairly intuitive. But what about the cost of equity on your down payment? It will require a little bit of data-digging to sort out this one.
In our example for the mortgage, we put down 20%. That’s where you incur a cost of equity, because you’ve made a choice to invest those dollars in your home, which is a real estate asset. Alternatively, you could have continued renting, and invested the down payment money in stocks. This “either-or” use of the cash creates an opportunity cost, which is a real economic cost you incur as a homeowner.
To estimate this cost, we need to determine expected returns for both real estate and stocks. A good place to start is the historical data. The Credit Suisse Global Investment Returns Yearbook 2018 offers us data going back to 1900. From 1900–2017 the global real return for real estate (net of inflation) was 1.3%, while stocks returned 5.2% after inflation. If we assume 1.7% inflation, then we would be thinking about a 3% nominal return for real estate, and a 6.9% nominal return for global stocks.
By the way, based on my past real estate videos, I’ve received comments that this 3% figure may be fine for global real estate … but what about our hot market in Ontario? Shouldn’t it be higher here? I encourage you to view the video version of today’s conversation for a tour through the details. But bottom line, I still maintain 3% is the best estimate. It’s based on the risk premium the market has placed on real estate assets over time. I prefer this strategy to speculating on a cherry-picked anomaly such as current Ontario real estate markets.
In any case, the past is all well and good, but what can we expect for future returns? At PWL Capital, we do not use just the historical return for stocks as our estimate. We use a combination of the 50-year historical return, and the current expected return based on the price/earnings ratio. Effectively, when prices are high – as they are now relative to the past – our expected returns are lower moving forward. Thus, our current nominal expected return for a 100% equity portfolio is 6.57%, which is lower than the 6.9% historical average I cited above.
Using these numbers – 3% for real estate and 6.57% for stocks – there is a 3.57% difference in expected return between real estate vs. stocks. To keep things simple and conservative, let’s round that down to 3%.
The Quick Reference
With the above figures, we now have a 3% cost of capital estimate, whether its through a mortgage or a down payment. Add this to the 2% estimates for maintenance and property taxes, and we’ve got our 5% Rule. That is, homeowners can expect to pay about 5% of the value of their home in unrecoverable costs.
Now we can compare the unrecoverable costs of renting versus owning, at least as a quick reference. Take the value of the home you are considering, multiply it by 5%, and divide by 12 months. If you can rent for less than that, renting may be a sensible financial decision. For example, you could estimate about $25,000 in annual, unrecoverable costs for a $500,000 home, or $2,083 per month.
It goes the other way, too. If you find a rental you love for $3,000 per month, you can take $3,000, multiply by 12 months, and divide by 5%. The result in this case is $720,000. So, in terms of unrecoverable costs, paying $3,000 per month in rent is roughly financially equivalent to owning a $720,000 home.
The Inevitable Caveats
There is no doubt that the 5% Rule is an oversimplification. When we start considering variables like tax rates and portfolio asset mix, things change. For example, the 6.57% expected return for stocks is a pre-tax return. That’s fine in an RRSP or TFSA, but in a taxable account the after-tax expected return might be closer to 4.6% for someone taxed at the highest marginal 2019 Ontario rate. This reduces the 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 costs of home ownership.
If your head is spinning a bit, give my video a viewing for a few additional ways to wrap your brain around all this. To cut to the chase:
- If you’re an aggressive investor with a heavy stock allocation – and you’ve not maxed out your RRSP and TFSA – I think the 5% Rule is a useful tool in your home’s rent-versus-buy decision.
- If your portfolio is more conservative, or most of your investments are in taxable accounts, you might use something closer to 4% for your comparisons.
Either way, thinking about the unrecoverable costs of home ownership will make it easier to arrive at meaningful numbers when considering the financial ramifications of whether to rent or own your home.
What are your thoughts on the matter? You may have other reasons to prefer renting or purchasing your living quarters, but I hope this has at least helped you with the financial realities involved. Let me know if you’re left with questions on how the 5% Rule may apply to you.
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