So Oliver was at a Christmas party in his Victoria hood. “I heard two of the women saying that they are committed to putting in a hot tub, and other lavish additions rather than buy down their mortgages or pay down their debts, just because,” he writes me. “They are caricatures of themselves, poster children for ‘house porn’. They have massive mortgages on massive houses. They are dancing on the Titanic and don’t even know it, or want to.”
This goes to a point on that list of ten things which will happen this year, published New Year’s Day (because this blog has no life). Most people are about to walk into the jaws of change – destructively creative change – and haven’t a clue. They confuse real estate with security, investing with risk and debt with wealth. They’ll soon learn it’s not what you can carry that counts, but what carries you.
“You are completely right when you say most people just don’t get it,” Oliver muses. “Although I’ve explained it to my friends warning them till I’m blue in the face, they don’t believe it. I feel like P.T. Barnum. There’s one born every minute.”
Well, Olly, let’s give this one final try before we abandon humanity. Here is a simple illustration of why owning a hunk of dirt may not always a better proposition than renting one. Porn aside, of course.
Let’s start with a million dollars. For that you can buy a semi-renovated piece of crap Vancouver Special, or a new house on a 25-foot-wide lot in North Toronto made of pressed corn flakes, glue-imbued studs, face brick and, of course, granite c-tops and a Wolf stove.
Or, you can rent either of these places for about $4,000 a month, or $48,000 a year. Which is likely to be the better deal financially, over the next five years? A horny homeowner would say there’s no contest – why throw you money away on rent and have nothing to show for it after five years? But is that just the hormones talking?
Well, let’s buy the house for cash. Of course, it does not cost $1 million because of closing costs which add at least 2% to the purchase price (and remember in Toronto there is double land transfer tax to cough up). That takes a minimum of $20,000. Plus if we sell this place after the five year period, that transaction will also have a price – roughly 5% for realtor commission (excluding legals and moving). There’s another $50,000 you’ll never get back.
Now let’s be generous and assume that between January 2012 and the winter of 2017 real estate values in Canada stagnate – you are able to sell for exactly what you paid. That, by the way, is unlikely to happen given a weak economy, record household debt, higher rates, demographics and tighter credit. But just to be fair, we’ll ignore the real estate correction.
So during the five years you have also shelled out money for property taxes and insurance (we won’t count utilities, home improvements or featherings you’ll never get back, like window coverings). This will average about $10,000 a year ($7,000 for taxes and three grand for insurance on a $1 million home), or $50,000 over five years.
Okay, so buying and selling cost $70,000, while occupancy costs (not faced by a renter) add another $50,000. That’s $120,000 over five years, or $2,000 a month – hey, just half the cost of renting!
But from an accounting point of view, the $1 million you started with has been diminished by your transaction and occupancy costs. You really have just $880,000 left.
So let’s rent the sucker instead. The million bucks will not be spent acquiring ownership, but invested instead. And we’ll invest it with great caution and conservativisim, in true Canadian milquetoast spirit. We will put three-quarters of it in the stable perpetual preferred shares of major Canadian banks and insurers paying a fixed dividend. The other quarter will be split between highly-rated corporate investment grade bonds and large REITs. The yield will be at least 5%.
Rent of $4,000 a month ends up being $240,000 over five years. But there are no property taxes no pay. No building insurance. No closing costs moving in. No transactional fees moving out.
Meanwhile the million dollars generates $50,000 a year in returns. Because the lion’s share of that is in the form of dividends, allowing you to collect the dividend tax credit, taxes are minimal, giving a net of about $42,500 (depending on income). Over five years, that’s $212,500 in investment earnings which, natch, you apply to the rent.
So sixty months later the cost of living has been $27,500, or $458 a month.
And you have basically all of the $1 million left. The financial advantage of renting over owning turns out to be huge.
And what of the risk?
Yes, rising interest rates will affect the capital value of the fixed-income assets, but it’s not rocket science to sell before bank rate changes and repurchase at lower prices subsequently. In any case, the yield continues unabated. With real estate, however, a homeowner’s powerless to hedge against the eroding equity that a market correction brings, thanks to the same changes in interest rates. I know which position I’d rather be in.
Give it another shot, Oliver. Take a whiz into the tempest of public opinion. But don’t hold your breath (or stand downwind). It’s nigh unto hopeless.
I hear porn does that to you.
