Renting vs. Buying a Home: The 5% Rule

- 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".

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