Renting vs Owning: Is the Counterintuitive argument right?
Michael Mendelson’s comments on Joy’s “The Givers and the Takers” entry raised an interesting question about the role of home ownership in building wealth in Canada. He said: “[the] assumption that your parents did very well in their housing investment may be incorrect. You have to ask how they would have done with an alternative investment and renting. Given the huge increase in the value of equities, your parents might today be much wealthier had they instead rented equivalent accommodation and invested well in the market.”
Is the conventional wisdom wrong?
I think it’s dangerous to try to contrast what actually happened with a hypothetical “alternative history.” In doing this, people tend to imagine one thing in isolation, but this is a mistake. (Maybe not the worst blunder, which is to get involved in a land war in Asia, but still a mistake.)
The Economics of the Market
Positing the stock market might have been better investment ignores the way price mechanisms work. Recently, I saw a website showing the average return on the S&P 500 (a US index) was 9.8% annually over the last 50 years. Thus, $1,000 invested then would now be worth $107,000. This is pretty impressive, but misleading. Under capitalism, the 9.8% return is the “price” that the issuers of the various stocks were willing to pay to borrow funds from investors. But if there were more people willing to invest their money, then the return on investment would have dropped. Basic supply and demand.
Likewise, if there had been a higher demand for rental housing versus ownership, then the price of rental would have been higher and ownership lower. With the benefit of 50 years of hindsight, you can posit that one contrarian would do well, but if everyone had tried to behave in that way, it would have fundamentally changed the financial reality they were living in at that time.
Joy mentions in her blog that her parents paid $20,000 for the house they later sold for $680,000. But they didn’t pay $20,000 up front, I assume. Let’s say they paid $4,000 (a 20% downpayment). In that case, their $4,000 turned into $680,000 in about 40 years, which is much better than the stock market.
Monthly Costs
But what about the monthly mortgage payments? Shouldn’t you include them along with the original downpayment to evaluate return on investment? Fair enough – but don’t forget the investor in the stock market still has to live somewhere and pay rent. You can’t live in your investment portfolio. And someone who is paying rent is paying forever. Eventually, a homeowner stops making mortgage payments and can start diverting funds to other investments, including the stock market. (We’re assuming the homeowner doesn’t keep on trading up but is content to stay in a house that is comparable with what is available in the rental market.) So the owner gets the best of both worlds – controlled housing costs and cash to invest.
And let’s not forget that investment income is taxed (either in the year it is earned or the year it is withdrawn from an RRSP). There’s no capital gains tax on primary residences. More evidence that government policies are tilted towards homeownership
What about the periods when there were double-digit returns on investment in stocks and bonds? Wouldn’t renters (who weren’t burdened by mortgage payments) be freer to take advantage of the high interest rates? But the reality is that it was people like Joy’s parents, who had already paid off their mortgage and had savings not enjoyed by renters, who had the funds at hand to take advantage of the various investment vehicles of the time.
The Price Driver – Wages or Activity?
It’s sometimes claimed that, historically, house prices rise at about the same rate as household income, so ownership isn’t such a good deal. I would argue that in areas where long-term rises in house prices track wages, you see places where economic vitality is lower (e.g. rural Canada, the Maritimes, etc.) But even in those places, the monthly cost of renting is no cheaper than of ownership. (If it were, owners would sell up and rent – but they don’t). And renters tend to be the poorer people (even within a locale with generally lower incomes) and so they can’t accumulate any capital.
In areas where there is economic vitality (especially Vancouver, Toronto, Calgary, etc.) ownership of an equivalent unit is a better deal than renting. I’m an owner. For less than my daughter would have to pay for a two-bedroom apartment downtown, our family of four lives in a three-bedroom house with enough space for two self-employed people to have offices. What could anyone rent in Toronto for what we pay? I’m still accumulating equity (tax free) in my housing. And I have money to invest in other things like RRSPs.
More Money Talk
Finally, let’s look at financing rental housing. When lenders evaluate the value of a rental property, they assign a “Cap Rate” to the net operating income. The Cap (or capitalization) Rate is meant to reflect the relative attractiveness of owning rental property versus alternative investments.
Right now, lenders use 8% as the Cap Rate, meaning when they assign a value to a property, they are anticipating an investment will generate an 8% annual return. (The landlord needs to make the mortgage payments and have some income left over for profit.) Renters are paying that return, but homowners aren’t paying 8% for their mortgages right now. (Generally, landlords aren’t, but that’s another story.)
On top of that, landlords actually get a tax break in the form of a 3% annual capital cost allowance. They aren’t passing that on to renters, which tilts the economics in favour of landlords at the expense of tenants. Homeowners don’t suffer that kind of tilt. Speaking of taxes, let’s not forget that the tax rate is over three times as high (in Toronto, at least) for rental property as it is for owner-occupied housing.
Now, you might not like these policies, but that’s they way the system works. And that’s exactly the point Joy was making. There are winners and losers, but sometimes the result is because of policy not personality.
Opening the Window 
All good points but you will see that most of the considerations you note (taxes, etc) were included in the rental versus ownership model I used to compare. One cannot just do this comparison by words: you have to look at numbers using models which incorporate the various factors and more that you note. I applied my rather elaborate model to the past markets in three Canadian jurisdiction, Vancouver, Winnipeg and Newfoundland. Of course, historical patterns do not necessarily repeat themselves, but they give a pretty good indication of what could happen in the future and in advising people about how best to deploy their life savings, it is really all about risk analysis, so this is the best we have to go on.
The bottom line is that housing prices in places like Vancouver and Toronto are extremely volatile. If you bought a house at one of the market bottoms in these cities you will have done very well indeed. But if you bought a house at the top of the market, especially in Vancouver, you will never get your capital back in real terms (i.e. a negative rate of return). In places like Winnipeg and Newfoundland, housing prices did tend (until the last few years) to be much less volatile, but also to be well below the CPI.
My point is that, if we look a housing purely from a financial perspective, it is a tricky and difficult investment, especially for low income households where it may be a case of all their savings eggs in a single basket. It all depends upon the local housing market. My parents bought a house in the North End of Winnipeg for $50,000 in 1954 and sold it in 1988 for $78,000! No one could claim that they did well financially. On the other hand, had they lived in Toronto and bought the equivalent at Lawrence and Younge in 1954, it would have sold for several hundreds of thousands of dollars in 1988.
One factor I did not take into account in my model is the macro-impact of a massive shift to renting, a good point made in your entry above. However, societies where there is significantly more renting (such as Montreal or most of Europe) do not bear out the argument that investment returns would decrease and rental costs would go up. In fact I don’t think you are correct in supposing that there would be more competition for the same number of investment opportunities. Investment opportunities would increase as holders of capital would now have to invest in rental properties (so that assuming the same housing stock is built exactly the same amount of investment in real capital formation would occur in each case).
Anyway, not to go on and on. I just think it is important not to become advocates of instruments (home ownership, savings, education, whatever) instead of advocates of outcomes (good quality affordable housing, comfortable retirement, fulfilling and rewarding work and life with a good job, etc.) It is all too easy to fall into the mode of advocating for an instrument.
What an unusual opportunity! I can comment on one old friend’s response to another, even older friend’s proposition.
If I am not mistaken, Paul’s example underestimates significantly the return on the original $10,000 investment. As I understand the rule of 72, at a rate of 9.9%, that $10,000 would have doubled about once every 7.35 years or about 6.8 times in 50 years to over $1 million.
Michael’s parents should have built in Charleswood (south west Winnipeg) rather than in the North End. The house my parents built in 1954 and sold in the early 90s earned a generous rate of return of about 3.6%, if my memory serves me! Of course, you had to have a septic tank, no sewer available and the bus came once an hour.
Michael is quite right about the variation in ownership and rental rates in Europe, but as Paul and I know from looking at housing costs in 10 countries including six in Europe, comparisons are next to impossible because of the great variations in government housing policies.
Though we ended up not looking at Germany, as I recall it had perhaps the lowest rate of home ownership in western Europe. While that was partially the result of reunification, it also reflected a long standing practice of subsidizing the construction of rental housing in the federal republic for the first 10 years after which the subsidy ended and that rental housing entered onto the market… On the other hand, Netherlands had possibly the most generous policy for mortgage deductibility, so generous in fact that a market developed for interest-only mortgage loans…
I agree with Michael about the risks of housing being your biggest life time investment; however, all investments seem destined to be highly volatile in this era of confusion and complexity in the fiscal policies of most developed countries.
Timing is everything!
Two thoughts come to mind here to illustrate. The first concerns the housing market and the second, the stock market.
I am fond of retelling the anecdote that a friend related to me about his great grandparents.They bought a house in Toronto (Cabbagetown) in 1870 just before the depression of the 1870’s and their family made the decision to sell the house in 1933. They lost money! Sixty Three years of inflation and community change and they sold the house in nominal terms for less than the original selling price. Imagine buying a house in Toronto in 1949 and selling it for less than the nominal price paid back then, in 2012. Even if horribly run down, this simply could not happen today.
Now, on to the stock market. I love those charts, especially the 100+ year charts that show the Dow Jones or the S & P 500 beating the heck out of every other form of investment.
Just one small problem. The Dow Jones index of 100 years ago had just one stock in its portfolio that it still has today – General Electric. This means that at least 29 other stocks were ditched and 29 new ones added…..actually many many more were added and discarded. And guess which ones get ditched and guess which ones get added? The dogs are ditched and the stars are added.
So any investor could just do the same thing… so what’s the problem? The issue is that the index doesn’t sell the dogs and buy the stars in the same way that an investor would be forced to do. Ordinary investors pay commissions in and out and do not benefit from the price-weight averaging that allows the Dow to soar during time periods when a few heavyweight stocks do well. In other words, the index gets to do things that you can’t do and the tricks it can perform are exaggerated over long time periods .
No doubt that an extremely astute investor could do better than Joy’s parents just as many homeowners have fared less well over time with their home purchases and subsequent sales.
These are distractions. The real issue is who benefits most from government programs in the longer term and the answer is that it is not the poor.
John, in my model the return on investment I assumed was the interest rate on 10 year Canada bonds as of January 1 in each year, rather than assuming a good investment in the equity market.
Looking back on my paper (just now) I see that it is rather hard to understand and I should have done a much better job in explaining the modelling and describing it. My model is certainly not the be all and end all. I am sure that there are many who could do a much better job, and I would encourage them to do so.
It is imperative that good social policy be based on as sound analysis as possible, because, as we should all be aware from even the most cursory reading of history, it is readily possible to do much harm while attempting to do good. Consequently, for those of making public policy recommendations our duty is to remain as objective as possible and use the tools available to ensure, at least within reasonable limits, that what we are advocating will actually do good and not harm.