- The rent versus buy decision for housing
can have a significant financial impact,
but it can also play an important role
in where we live and how we spend our time.
Making the housing decision requires careful consideration
of both the financial and non-financial impacts,
and the way that they interact with each other.
There is no universally right way to approach housing.
In many cases, contrary to conventional wisdom
and societal pressure,
renting is a better option than owning,
both financially and from the perspective of well-being.
I'm Ben Felix, Portfolio Manager at PWL Capital.
In this episode of Common Sense Investing,
I'm going to tell you how to decide
between renting and owning a home.
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Renting a place to live is not throwing money away.
Financial outcomes for renters and owners can be comparable.
I'll explain why that's true later in this video,
but I wanna start with the non-financial considerations
of the rent versus buy decision.
Finances aside, if buying a home will make you happy,
there are a few good argument against it.
This raises the question:
are homeowners happier than renters?
People are really bad at forecasting
what will make them happy in the future,
particularly when it comes to major purchases.
The 2010 paper, Extrinsic Value Orientation
and Effective Forecasting.
Overestimating the Rewards,
Underestimating the Costs,
explains that people who believe materialistic achievements,
like owning a home, will make them happy
can be classified as having extrinsically motivated goals.
Other examples of extrinsic goals
are money, fame, image and status.
Compared to people with intrinsic goals,
like personal growth, intimacy and community,
extrinsically motivated people are less happy in general
and they overestimate the emotional benefits
of achieving their extrinsic goals.
True to this finding, a 2020 study using German data,
finds that people overestimate the long-run
life satisfaction gains derived
from moving from a rented home
to a privately owned property
and that this overestimation is more pronounced
for people with extrinsically motivated life goals.
The 2011 paper, The American Dream
or the American Delusion
uses a data set with housing consumption,
well-being measures and time use patterns
to find that after controlling for income,
housing quality, and health,
the homeowners in the sample are not better off than renters
by multiple measures of well-being.
Instead, they derive significantly
more pain from their home,
potentially due to the time used differences
between renters and owners in the sample.
Homeowners tended to spend less time
on enjoyable activities, like active leisure.
The 2019 study, Home Ownership and Happiness:
Evidence for Switzerland,
finds that Swiss homeowners are no happier
or are even less happy than renters
when other variables like wealth, income, employment,
health and housing quality are controlled for.
A 2011 study using a German sample
finds a marginal but positive relationship
between home ownership and life satisfaction,
while a 2017 study using a United States sample
finds slightly elevated reflective life satisfaction
for owners but finds that owners experience
less intense feelings of happiness than renters,
and that homeowners spend much more time
working on their home than renters do.
One of the driving issues here
is that people tend to hedonically adapt
to their circumstances,
meaning that a change in circumstances
does not have a lasting impact on how we feel day to day.
You can see the problem here.
We overestimate how much happier we will be
by purchasing a home, but once we live there,
the home becomes a condition of life
rather than an aspiration
and its impact on our daily well-being is neutralized.
In the 2010 paper,
If Money Doesn't Make You Happy,
Then You Probably Aren't Spending It Right,
the authors explained that experienced happiness
is shaped more by how we spend our time
than by stable life circumstances,
like how we pay for housing.
After making a major material purchase, like a home,
many people will suffer from buyer's remorse.
The 2010 paper, The Relative Relativity
of Material and Experiential Purchases,
finds in their sample that people are often less satisfied
by their material purchases than their experiential ones
because they're more likely to ruminate
about unchosen options with material purchases
and their satisfaction with their material possessions
is undermined by comparison to other available options,
to the same option at a different price,
and to the purchases of other individuals.
homes are positional goods,
meaning that their appeal comes from,
not only their intrinsic property as a place to live,
but also from how it compares to the homes of peers.
Humans innately compare themselves
to the people around them,
and empirically we know that comparison
matters a lot to happiness.
A 2019 study titled The McMansion Effect:
Top House Size and Positional Externalities in U.S. Suburbs,
finds that new constructions
at the top of the house size distribution
lower the satisfaction that neighbors derive
from their own house size.
These effects are stronger among people
living in larger houses and they decrease with distance
from the larger new constructions.
Homeowners exposed to the construction of larger houses
in their suburb put a lower price on their home,
are more likely to upscale to a larger home,
and they take on more debt.
One of the best ways to deal
with our poor affective forecasts,
hedonic adaptation, buyer's remorse and social comparison
is to make more frequent experiential purchases
rather than few big material ones.
Taking a friend out for dinner,
signing up for a class in an area of interest,
spending on an engaging hobby,
or buying things for other people
are all approaches to spending money
that bring persistent happiness that we do not adapt to.
Buying a home is the antithesis of small frequent purchases.
The term house poor comes to mind.
A circumstance that we do not tend to adapt to is debt,
which is, for most people,
a big part of purchasing a home.
In their book, "Happy Money:
The Science of Happier Spending,"
Elizabeth Dunn and Michael Norton
explained that although the relationship
between income and happiness is fairly weak,
there is a stronger relationship between happiness
and difficulty paying the bills.
In other words, Dunn and Norton say,
"What we owe is a bigger predictor
"of our happiness than what we make."
Households with more debt exhibit less happiness,
and couples with more debt have more marital conflict.
Another circumstance that we don't adapt to
is commuting in traffic.
Even after years of commuting,
people who commute in traffic arrive at work
with higher levels of stress hormones.
This matters for people who move further away from work
to get a bigger house.
They quickly adapt to having more space,
but they do not fully adapt to the commute.
All right, all this happiness talk is moot
if renting is a terrible financial decision.
But renting is not a terrible financial decision.
The cost of renting is very straightforward.
It is the rent that you pay,
plus the cost of renter's insurance,
which is typically much less expensive
than homeowner's insurance, plus utilities.
The cost of owning a home is less straightforward
and leads to many people incorrectly believing
that owning is a better financial decision than renting.
The costs of an owner are property taxes, maintenance costs,
insurance costs, and the opportunity costs
of the equity in the home.
Property taxes can vary a lot depending on where you live.
For the sake of this discussion,
I will use 1% of the value of the home annually.
Property taxes, like rent, are paid in exchange for services
with no residual value.
Homes are depreciating assets.
Depreciation takes two forms.
Physical depreciation,
the normal wear and tear resulting from use,
and functional depreciation, or obsolescence,
as newer construction methods, standards and materials
make older homes less desirable.
There is no escaping these costs as an owner.
You either pay for the cost of maintenance with cash
as you consume the home over time,
or you pay for the depreciation
through a lower sale price in the future.
Either way, the cost is in there.
In "The Rate of Return on Everything, 1870 to 2015,"
the authors find the maintenance costs
between 1 and 2% historically.
Their estimate includes depreciation
and all other housing-related expenses,
excluding interest, taxes and utilities.
Statistics Canada uses 1.5% of the value of the home
as a depreciation expense in the CPI basket.
This figure is in line with multiple academic studies
and the statistical agencies of other countries.
1.5% is for the building only,
so it has to be multiplied by the ratio
of the building value over the land value
to arrive at the depreciation cost for the home.
Based on this, a 1% maintenance cost
is probably a reasonable assumption.
Home maintenance cost can sneak up on you
and they don't typically get included in the numbers
when people tell you how well they did
on their home's appreciation.
Those weekly trips to Home Depot add up.
The opportunity cost of equity
measures the cost of having money invested in a home
instead of in something else.
Something else could be a lot of different things.
I'll assume to start that the opportunity cost
is relative to owning a low-cost portfolio
of total stock market index funds
in a tax-free investment account.
In his book, "Irrational Exuberance,"
Robert Shiller shows,
based on global data dating as far back as 1628,
that real home price appreciation
has been between 0.2% and 0.4% per year.
In "The Rate of Return on Everything, 1870 to 2015,"
the authors estimate the real annual
historical increase of home prices in 16 countries,
from 1870 to 2015, at 1.1%.
Eh, I think we can easily round those to 1%.
In many cities in Canada,
recent history has shown much greater price appreciation,
but that doesn't tell us much about the future.
In fact, if it tells us anything
it's that we can expect lower price returns in the future
as the current ratio of prices-to-rents
is a historical anomaly.
High prices relative to rents
have historically been resolved
by falling house prices, not by rising rents.
In our recent Financial Planning Assumptions Update,
the PWL research team estimates
the expected real annual return
on a 100% stock portfolio to be 4.28%.
To account for fund ownership costs,
like fees and withholding taxes,
we can run this figure down to 4%.
A 4% expected real return on stocks
and 1% for real estate amounts to a 3% opportunity cost
for having equity in real state instead of in stocks.
Taken together, property taxes, maintenance costs
and the opportunity cost of equity
tell us the total user cost of owning a home.
Based on 1% each for property taxes and maintenance cost,
plus 3% for the opportunity cost,
we have an imputed rent of 5% of the home value.
This is what it is costing an owner to live in their home.
Another way to think about this is that you're paying rent
whether you own a home or not.
The 5% figure tells us what level of rent
relative to price equates the cost of renting and owning.
Mortgages make the economics of owning look better
by reducing the initial opportunity cost of equity.
But due to the large cash flow commitment of a mortgage,
in addition to property tax and maintenance,
the 5% user cost figure equating the cost of renting
and owning still works out.
From here, we can have all sorts of fun.
If you're looking at a $1 million home,
your user cost is estimated at $4,166 per month.
If you could rent for the same or less,
renting is financially equivalent.
A more aggressive investor, for example,
someone tilting their portfolio
towards small cap and value stocks,
would have a higher opportunity cost of equity,
and therefore, a higher rent equivalent threshold,
while a more conservative investor would be lower.
So far I have ignored taxes on investments,
assuming that the renter is using their RSP
and TFSA to invest.
Real estate price growth is not taxed in Canada
on the primary residents.
A renter investing in a taxable account
would have a lower after tax opportunity cost,
and therefore, a lower user cost equivalent rent level.
There are some other economic considerations.
Buying a home with a mortgage means forced savings.
People are much more likely to skip an RRSP contribution
than a mortgage payment.
This requires discipline on the side of the renter
to make the numbers work.
Additionally, an owned home is a hedge for housing costs.
Even in crazy markets like we're in today,
owners total costs are likely to be more stable than rents,
which landlords may want to increase.
While hedging housing costs is a good argument
for a long-term homeowner,
house prices in the short run can be volatile.
A volatile price is not such a big deal for a forever home,
but price volatility can become a substantial risk
If you need to move.
Renters have much more freedom of mobility.
They can easily move if there are unexpected issues
with their home, their neighborhood
or their employment situation without needing to worry about
short-term price fluctuations.
Sure, owners can't be rent-evicted
by a greedy landlord in a rising market,
but they're taking on a lot more price risk
in the event that they need to move in a falling market.
Owners are more often forced to commute than renters are.
The literature relating happiness to home ownership
makes it clear that homeowners
are not happier than renters just because they own a home,
even if they expected to be when they decided to buy.
Other aspects of life, like being in nature,
being good at something,
being connected to things outside yourself,
feeling in control and having strong relationships
are much better predictors of happiness than owning a home.
Guiding the housing decision based on these inputs
is a lot more sensible than rushing to own a home
on the pretense that it will make you happy.
From a financial perspective,
renters can expect to match the wealth of homeowners
as long as they understand the user cost of owning
and keep their housing costs within that range.
Owning can result in the kind of windfalls
that we've seen in Canada over the last decade,
but it can go the other way too.
Buying a home today on the expectation
of unrealistically high housing appreciation in the future
is more likely to do harm than good.
In the interest of full disclosure (chuckles),
I recently bought a house after renting
for all of my adult life.
I bought a forever home in a secluded area
within walking distance to a small town with amenities,
hiking trails, and a body of water.
I have a garage big enough to work on my hobbies
and I'm still within a 45-minute drive to my parents.
And since I'm able to work from home,
I don't have a commute.
There were no rentals available in this area,
which swung my decision in favor of buying.
When I lived in the city,
where I knew I didn't wanna stay forever,
there were more rental options available
within walking distance to my office,
which at that time, I had to commute to every day.
It was an easy decision to rent when I lived in the city.
In both cases, I made the decision
based on what worked for my lifestyle,
not some extrinsic or financial motivation
to be a property owner.
Thanks for watching.
I'm Ben Felix, Portfolio Manager at PWL Capital
and this is Common Sense Investing.
If you enjoy this video,
please share it with someone who you think
could benefit from the information. and let's be serious.
A lot of people could benefit
from this information right now.
If you want to hear more like this,
we discussed similar topics in episodes 154 and 170
on the Rational Reminder podcast,
which is available on YouTube and on podcast platforms.
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