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 want 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 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 numbers 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 principle 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 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 of 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 2009 teen 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 downpayment 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 Swiss global investment returns a 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 percent while stocks returned 5.2 percent after inflation if we assume inflation at 1.7 percent then we would be thinking about a 3% nominal return for real estate and a six point nine percent nominal return for stocks I have had many commentators on my other real estate related videos mentioned that 3% might work for global real estate but not for Ontario that's way too low front it should be closer to five for 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 five hundred and fifty thousand dollars if you knew that you wouldn't sell for five hundred thousand dollars we can't assume that high recent historical returns like we've had in 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 is placed on those types of assets over time and use that as an estimate for the future that's six point nine percent historical return for stocks includes Russia and China's stock market's going to zero it also includes the aftermath of world wars if we were to cherry-pick say US stocks and 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 six point five seven percent quite a bit lower than the historical average if we take these numbers as they are three percent for real estate and six point five seven percent for stocks we would have an expected return difference between real estate and stocks of three point five seven percent to keep things simple and to be conservative I think that we can round that down to three percent we now have a cost of equity capital of three percent which is conveniently equal to the cost of debt capital so no matter how you finance the home the cost of capital is three percent we now have a total of five percent of the value of the home that you would expect to pay in 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 five percent rule can be used to think about the unrecoverable 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 the rent versus buy decision take the value of the home that you were considering multiply it 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 twenty five thousand dollars in annual unrecoverable costs or two thousand and eighty three dollars per month it goes the other way too if you find a rental that you love for $3,000 per month you can take three thousand dollars multiplied by 12 and divided by five percent the result in this case is 720 thousand dollars in other words paying three thousand dollars per month in rent is financially equivalent in terms of unrecoverable costs to owning a 720 thousand dollar home there is no doubt that the five percent rule is an oversimplification when we start considering variables like tax rates and portfolio asset mix the 5% rule changes for example the six point five seven percent expected return for stocks is a pre-tax return which is fine in an RRSP or TFSA but in a taxable account the after-tax return might be closer to four point six percent 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 percent 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 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 costs of owning a home is the opportunity cost of equity capital if you pay $500,000 cash for a home you have now spent five hundred thousand dollars 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 chain 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 homeownership 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 RSP and TFS a 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 it could benefit from the information don't forget if you've run out of common sense investing videos to watch you can tune in to weekly episodes of the rational reminder podcast wherever you get your podcasts [Music] [Music] you

Channel: Ben Felix

Views: 727,438

Rating: 4.8542757 out of 5

Keywords: benjamin felix, common sense investing, ben felix, renting vs buying a home, 5 percent rule money, the 5% rule, buying a home in canada, renting a home vs renting an apartment, renting a home vs buying, renting a home 101, renting a mobile home pros and cons, buying houses and renting them, mortgage payments, rent versus buy, unrecoverable costs of owning, true cost of owning a home, cost of renting an apartment, cast for buying a home, case for renting, rent vs buy home

Id: Uwl3-jBNEd4

Length: 10min 36sec (636 seconds)

Published: Sat May 11 2019

Reddit Comments

[u/robertshuxley]

funny I saw this on my youtube homepage as well.
One thing you need to remember in order to get the "monthly rent" for the calculation in the video is to multiply your weekly rent * 52 weeks / 12 months

[u/Craig_nz]

It doest really look at leveraging. I brought a house in 2012 with $20000 down payment. The house value has gone up nearly 100% so my $20000 investment has returned nearly 1500%.

[u/Nichinungas]

Very good video. Without capital gains tax on houses and high immigration : available houses ratio we are seeing higher returns on houses here. Also home loan rates are higher here. So I think the 3% difference quite quickly disappears. Still, makes good points as home ownership has many hidden headaches and is not risk free.