Chapter 15: Real Estate
One of the largest financial obligations in life is the task of providing shelter. Often, the first major decision in the process is whether to rent or buy. As we saw in Chapter 6 when we discussed budgeting, monthly costs for housing are a significant expense. Therefore, it’s worth spending some time to consider the varying trade-offs involved. All too often, the debate of renting or buying comes down to what seems to be the simplest argument. One option offers no return, and the other offers the opportunity to build wealth. While this is an important piece of the decision, it’s an oversimplification. Buying and renting both offer pros and cons that need to be considered to decide what’s best for your financial situation.
Home Ownership
Buying a home allows your monthly mortgage payments to go toward building ownership. This gradually increases your net worth and, over time, builds financial security. In addition, once your mortgage is paid off, your monthly costs drop dramatically. Home ownership also provides peace of mind because there’s less of a risk that you’ll be required to move unexpectedly. For many, it also provides a sense of accomplishment.
While there’s plenty of pros for home ownership, there are also several cons. There are additional costs and risks that come along with buying an immobile and deteriorating property. The transaction costs when buying and selling a home can be quite substantial. Therefore, buying a home is often only beneficial if you plan to own it for a lengthy period. Buying property may limit your ability to move if a job opportunity or personal emergency were to require it. Additionally, ongoing upkeep of a home can sometimes result in large, unexpected expenses. For example, the cost to replace a water heater or repair a roof can be substantial, and the timing can be unpredictable. Having a rainy day fund can help in these situations, but risk remains.
Renting
The aspects that make owning a home risky are the same that make renting desirable. With a rental agreement, your commitment is typically quite short, often a year’s lease followed by sixty days’ notice. This ability to come and go as you need is very valuable for anyone with an uncertain future. The risk of anything in the property needing repair falls on the owner. While rent payments aren’t going toward building your net worth, they allow for mobility and prevent unexpected expenses. Too often, rent is considered throwing away your money. Instead, rent should be looked at just as any other product or service you buy. You’re paying for a place to live while you study or work, with flexibility to move and predictability of expenses.
Comparing the Pros and Cons
Deciding between renting and buying is an important choice with implications that could last decades. By weighing your options and running best- and worst-case scenarios, you can decide confidently what’s best for your needs. To demonstrate this decision process, we’ll observe a young married couple as they consider buying a home near downtown Toronto. There’s a lengthy list of possible considerations when deciding between renting and buying. Costs, square footage, location, your comfort with risk and certainty of the future are a small sample. To start, we’ll focus on the first topic of costs.
Comparing Costs
The married couple in our example is looking to buy a home with a budget of $700,000. They plan to provide 20% as a down payment to avoid needing mortgage insurance. In addition to their down payment of $140,000, they’ll need a mortgage of $560,000. They plan to pay off the mortgage over twenty-five years and pay an annual interest rate of 4%. The resulting monthly mortgage payment is $2,940. In addition, the couple will need to pay closing costs of roughly $28,000. This is 4% of the purchase price and includes land transfer tax, insurance and other one-time costs. An important note is that first-time home buyers can qualify for certain refunds. For instance, a land transfer tax refund is available given certain conditions are met. Another possibility is the First-Time Home Buyers’ (FTHB) tax credit. As a result, it’s possible to lower the up-front costs in certain cases.
Beyond up-front costs, the couple will need to budget for ongoing costs in addition to the mortgage. These include maintenance, property tax, insurance, utilities and more. Residential property taxes in Toronto are roughly 0.6% a year, or $4,200 on a $700,000 house. An annual maintenance budget could be 1%, or $7,000. We’ll assume the remaining costs are roughly $300 a month. The result is an average monthly expense of $1,230 on top of the mortgage cost.
Exhibit 39 – Costs of home ownership include both up-front costs and ongoing monthly costs.
With a better idea of the up-front and ongoing costs of buying a home, the couple can decide if it’s right for them. Currently, the couple has a rental unit costing them $2,600 a month, including insurance and utilities. The additional monthly costs of $1,570 for home ownership is a substantial change to their cash flow. In addition, if the couple continues to rent, they can invest their money and allow it to grow. The level of risk the couple can take on the investment depends on how long they’re comfortable waiting before they buy. If they’d like to reassess in a year, their money may be best in low-risk investments, like a savings account or GIC. With more time, they could take on more risk and potentially grow their savings at a faster rate.
Other Factors to Consider
From an initial comparison of the costs, the decision is expanded to the other factors we mentioned earlier. These included square footage, location, comfort with risk and certainty of the future. If they need the additional room to start a family, then there’s value in making the move. However, if it’s farther away from work and friends, it could result in additional time and costs commuting. Some people view home ownership as a major goal in life and place higher value on it than others. There’s risk both for and against buying property, and you’ll need to determine which is more important to you.
If you buy a property and then interest rates increase, your monthly costs could go up. However, if you continue to rent and house prices where you want to live rise, you may not be able to afford your ideal home in the future. Once you know where you want to live and how much you can comfortably afford, you can decide whether to buy or rent. As your needs change, you can continue to reassess and see if a switch from one to the other may be suitable.
Investing in Real Estate
In addition to real estate you live in yourself, a common investment is owning real estate that other people use. We’ve now seen the advantages and disadvantages of renting and buying your home. The flexibility to move as you please and the predictability of not needing to make repairs are very valuable. Providing this value to others presents the opportunity to make a return on an investment in real estate. People are willing to pay you rent for the freedom it provides.
The risks associated with owning real estate are very similar to the risks stocks and bonds carry. There’s a chance you’ll earn less on your investment than you expect, and in the worst-case scenario, you could lose money. By taking on this risk and owning real estate, it’s often possible to earn returns over long enough periods. Often, the increase in value of the property plus the rent charged is greater than the costs. These costs include interest on the mortgage, maintenance, taxes and insurance.
Exhibit 40 – You can earn a positive return through a real estate investment if the following formula holds true. The change in value of the property plus the rent received must be greater than the costs.
Buying an Investment Property
Let’s consider a simplified example of real estate being used as an investment to grow existing savings. A home within walking distance to a university is available on the market for $400,000. An initial investment of $80,000 would provide a 20% down payment to purchase the home. Assuming a mortgage at 5% paid over thirty years, the monthly mortgage payment would be $1,700. The house currently has tenants paying $2,400 a month in rent. Provided that the house remains occupied, the excess of $700 a month can go toward maintenance, insurance, taxes and various other expenses.
In addition to any remaining rent income at the end of each month, the mortgage payments are gradually paying back the loan. With every passing payment, the portion of the home owned by the investor continues to increase. In addition, there’s the possibility that the value of the property will increase with time. Gradually, these can add up to offer a return on the initial $80,000 investment. The amount of the return can vary greatly and depends on a wide range of inputs, including:
the percentage of time the property is occupied
the cost of mortgage payments and other expenses
the amount of rent being charged
the amount the property is changing in value
Buying a Real Estate Investment Trust (REIT)
Real estate investments are popular partly because they offer two attractive features. They’re something you can see, feel and easily understand, and they offer income from the rent payments over time. An alternative to buying a single investment property yourself is to buy partial ownership of a group of properties. Like buying a stock, you can buy units of a real estate investment trust (REIT). With this option, you can diversify your investment by owning a small part of many properties. It also removes the requirement to manage the property and find tenants, as this is handled by the trust.
Final Thoughts
Investing in real estate offers another way to diversify your savings. Often, people assume that history will repeat itself, and while it may, there’s no guarantee. Property values in Canada have increased in value substantially and consistently throughout recent history. However, there’s no guarantee this will continue. When buying a property to live in yourself or as an investment, ensure you’ve done your research. Your decision should be made for the right reasons, and you should consider both the best- and worst-case scenarios.
Key Takeaways
Consider costs, your needs, your comfort with risk and more when deciding to rent or buy.
Investing in real estate offers another way to diversify your savings.
Assuming house prices will continue to rise is risky. Before you buy, consider the case where prices fall.
This blog is a duplicate of the recently self-published book The Snowman’s Guide to Personal Finance available for purchase here.