ACCOUNTANT EXPLAINS Should you Rent or Buy Your Home

If you are dreaming of purchasing your first home, you may be wondering if it really makes sense financially to own a home rather than simply renting. This may especially be the case if you live in expensive cities like Vancouver and Toronto where home affordability is a huge issue. I ran the calculations and I was surprised to find what the best option was based on the current real estate market and interest rates. In this video, I'll be going over common misconceptions that people have when buying versus renting and why it is flawed. I'll run through the numbers on whether it makes sense financially to own versus rent as well as other important considerations that you should know. So let's get into it. Common misconceptions. Many people believe that if the mortgage payment is equal to or less than the rent for the same home, then buying a home is a good decision. However, this is a flawed way of looking at it because the costs that go into owning a home is very different to that of renting. To give a better perspective on making this decision, you would need to compare the total unrecoverable costs to renting versus buying. What unrecoverable costs basically mean is that it's money that you will never see back. In the case of renting, it's relatively simple as it's just a rent payment that you make. However, in the case of owning a home, it gets a bit more complicated as there are more moving parts. First, you have the mortgage payment and while it seems straightforward to compare this amount to the rent, that wouldn't be a very accurate comparison. That's because mortgage payments consist of two components, interest and principal. While the interest that you pay the bank is unrecoverable since it's a cost of borrowing money, the principal payments are recoverable when you sell your home for equal to or greater than your purchase price. Second, other costs of home ownership go under the radar but can add up very quickly. These costs are property taxes, strata fees, and or maintenance costs which are all unrecoverable. Third, there is also the cost of capital. As you know, owning a home is expensive so you would need to save up for a deposit on the home which is your equity and then you would also need a mortgage to cover the remainder of the purchase price, your debt. Just as there is cost of debt which is the interest that you pay, there is also the cost of equity, the deposit that you saved up that you chose to invest in real estate instead of some other investments like stocks. So now that you know the types of unrecoverable costs you should consider when renting versus buying, let's see for ourselves how the numbers work out. Is it really better to own versus rent? Before we jump into the calculations, we need to make some assumptions. Let's say that the purchase price of a condo that you're looking at is $500,000 even. I know that this doesn't get you much in expensive cities like Vancouver and Toronto but for simplicity's sake, let's roll with it. And I actually found something that fits our budget of $500,000, a 422 square feet apartment in downtown Vancouver to use for our example. The property taxes for this particular condo was $1,338 and strata fees are $299 per month. We also need to have an assumption on the mortgage interest rate. Based on RateHub, it appears that there is a range but let's use the average of 5% on a five-year fixed rate. Of course, this really depends on your credit score, income, your deposit saved but let's go with 5% to keep things simple. Now for rent, I found examples for similar units in the same building that goes for around $2,000 a month on average. Now we need to know the cost of our capital. According to this article on Canada Real Estate Statistics, the Canadian housing market averaged a 6.11% yearly appreciation over the past 15 years. This is very high when you compare it to the global real estate rate of returns or even the U.S. real estate market for that matter. And you can see the difference in appreciation between Canada and U.S. in this chart here. Canada's real estate market had a very good run. However, whether this rate of appreciation is sustainable and whether it would hold true in the current high interest rate market is unknown. But for the sake of our calculations, let's be conservative and use half of the rate of return of 6.11% and assume going forward that the rate of Canada's real estate market will be 3% on average. And to compare, we will say the rate of return on stocks or more specifically the good old S&P 500 had a return on investment of 9.33% per year for the past 15 years. Going forward, let's assume a rate of return of 9% on average. Now that we have all the assumptions, let's jump into two scenarios that we'll be using for our calculations. Scenario one is the cost of renting versus buying in the first year alone. And then scenario two is the cost of renting versus buying after five years. Okay, let's jump right into the calculations. Before we start though, let's quickly go over the assumptions one more time. As mentioned, the monthly rent that we will be working with is $2,000 per month, which makes it $24,000 per year. Now, if we were to purchase the same property, it would cost $500,000 with property taxes of $1,338 per year and strata maintenance fees of $299 per month. Now, we're also assuming that 20% of the purchase price will be saved up, which is $100,000 with a five-year fixed mortgage rate of 5%. Now, the rate of return for real estate in Canada, we'll be assuming it is going to be 3% going forward. And for stocks, we're going to be using 9%. Now to jump into the calculations for rent, we're going to be saying that the annual rent is $24,000. And that is pretty simple when it comes to rent. Now, in the case of buying, there are a couple more factors that we would need to consider. The mortgage interest, which is an unrecoverable cost, will be $19,608. And then part of your payments will be going towards which can be a recoverable cost. If later down the road, you sell your property for equal to or more than your purchase price. And in this case, the principal amount is $8,309. Now I'll discuss a little bit more about what I mean by cashflow issue, but let's move on for now. The annual property tax is $1,338. This is assuming that it was the same as the prior year. And for the strata maintenance fees, it is $3,588. And this was calculated taking the $299 per month times 12. Now, this is where it gets a little bit more tricky. For stocks, the rate of return, if you were to invest the $100,000 of down payment, as we mentioned here, if you were to invest the $100,000 towards stocks, let's say the S&P 500, which gave a return of 9% in the past 15 years on average. So we're going to assume going forward, it will also produce 9% on average. Then in that case, your return in the first year would be $9,000. In the case of real estate, we're not just looking at the $100,000 deposit that you saved up. We're actually looking at the value of the property as a whole of $500,000. And in this case, we said that the appreciation of real estate in Canada would be 3% annually on average. And for the return on real estate, it would be 3% times $500,000. And so this is where leverage really kicks in because even if you put down $100,000, the return that you get is on the full $500,000. And so initially while it may seem that stocks give you a better return, but because of the purchase price of your home is greater, the actual return is calculated to be higher. And in this case, the return that you get on $100,000 invested in stocks at 9% is $9,000. And 3% appreciation on the value of a $500,000 home is going to be $15,000. And so the difference between the two is $6,000. And in this case, you can see that it's a negative value, meaning that it's not really a cost per se, but it actually reduces your overall cost because you are netting out greater through your real estate property than investing in stocks. And I will touch a little bit more about this in just a bit as we finish our calculations. So there are three different costs that I put down here, and it might be a little bit confusing, but I will be walking you through it. So when we're comparing purely from a cash flow perspective, we see that in this case, the cash flow in rent is actually a lot less than buying. And the reason being is because of the principal amount, which brings up your total payments that go out every month as a higher amount. And so you can see here that in order to buy the same property, you would actually need to pay out additional $8,843 in cash to upkeep this property. Now, that being said, the principal payment is actually a recoverable cost that you will eventually see back when you sell your property. Considering that you sell your property at equal to or greater than the purchase price, in this case, rent stays the same. And for buying, the unrecoverable cost is a lot lower because we remove the principal as a recoverable cost. And in this case, it is still slightly better to rent than to buy. And lastly, the total unrecoverable cost, including cost of capital. This includes this component right here. And in this case, because the rate of return on your property is greater than stocks, it actually decreases your overall cost. So in this case, it's actually better to buy overall because of the better returns on real estate due to leverage used. Now, these numbers can completely change based on just these factors alone. Now, if we were to assume that the appreciation on real estate is going to be a lot more dismal in the future and we change this to 1%, in this case, we can actually see that there is a cost of capital where it's better to invest your money in stocks rather than real estate. And in this case, it wouldn't really make sense financially to buy versus rent because the cost of buying is more expensive across the board compared to just your rent. So it's really important what your assumptions are when it comes to these calculations. Now, let's move on to Scenario 2 of what the cost will be after five years. So in Scenario 2, after five years, there's a lot more moving parts and it might look a little bit complicated, but let me just walk you through everything so that it makes sense. Now, just going through all the assumptions, they stay all the same with just a few additional changes. The first being that for rent over a five-year period, I don't think it's reasonable to assume rent will stay the same over five years. So we will use an annual rent increase of 2%. All the other assumptions here stay the same with the exception of the targeted annual inflation, which we will use to increase the property taxes and strata maintenance as well. And so we just kept it consistent here and everything else stays the same. And now we'll jump into the calculations one more time. If you were to rent for five years on the same property, the total rent is going to be $124,897. When it comes to buying, your total mortgage interest over that period is going to be $93,615. And for your principal, it is going to be $45,970. I just want to point out in the case of paying your mortgage, you can actually see that over the five-year period, while your total payments stay the same, the split between your interest and your principal actually changes and that your principal payments gets greater and your interest payments actually decrease. And the reason being is because you're paying off your mortgage a bit every single month through these principal payments, which decrease your overall loan amount and that decreases your interest on the loan itself. So over time, the cost of your mortgage actually decreases. Now moving on to property taxes over the five period, it's going to be $6,963. And then for strata maintenance fees, it is going to be $18,672. Now moving on to stocks, the rate of return is going to be $41,158. And this is considering that your rate of return is 9% compounded every single year. And then your real estate rate of return is going to be $62,754.41. In this case, we are assuming that the rate of return is 3% in Canada. Now keep in mind that these rate of returns are nominal amounts, so they do not take into consideration inflation. So they are not net of inflation, but for the sake of simplicity, let's work with these numbers. So similar to scenario one, we could actually see that the benefit of owning real estate is going to be greater than investing that money in the stock market. And the reason being is because you're using leverage. And so the rate of return is on the full $500,000 of the real estate property that you purchase compared to the $100,000, the deposit that you would have invested towards the stock market. And we will go over the three different costs one more time. Now the total cash outflow is going to be greater when it comes to buying because of the principal payments that are going out every single month. And over the five-year period, that adds up to $40,323. So that's something to consider if you don't have the cash to cover both your interest and your principal. Now the total unrecoverable cost, because at the end of the day, you will be getting back your principal when you sell your property. And so in this case, it is actually better to buy than to rent. And there is a savings of $5,647. Now lastly, if we were to also include the cost of capital, because you get a better return on the real estate property, the cost actually comes down quite a bit and is actually better to buy. And you actually end up saving $27,243. And of course, all of these numbers are a substitute change based on what our assumptions are. If we are very pessimistic about the real estate market in the upcoming five years, we could change it to 1% and see how that affects our numbers. In this case, there is a true cost of capital where it is better to have invested that money in the stock market versus real estate. And so the cost of in this case is $20,856, where it's going to be more expensive to buy across the board. As you can see, there are multiple moving parts to this calculation, which really depends on various factors like the home price, deposit save, mortgage interest rate, future rate of return for the real estate and stock market, as well as rental prices. It will be ideal to play around with the numbers and calculate room for error on any of these factors to see how it can affect your finances. This way, you can really make the best decision for you and be prepared for unexpected changes in life. Don't forget other considerations. There are other costs to home ownership that weren't taken into consideration during our calculations in order to keep things simple. However, you should definitely research other applicable home ownership costs that are specific to the province or state that you live in. If I were to use BC, Canada as an example, other large one-time costs when it you need to pay rates between 1 to 3% on the value of the home that you are purchasing. And if you are a first-time homebuyer purchasing a home that is $500,000 or under, you could get a full exemption, which saves you $8,000 in property transfer taxes. Mortgage loan insurance. This applies if the deposit is less than the conventional 20% of the purchase price. So for example, if your is $13,950, which then gets added to the mortgage. Realtor fees. This applies when you eventually sell the property. In BC, it's more common for the seller to be responsible for both the buyer and seller's realtor fees. If you are selling a home for $500,000, your total out-of-pocket realtor commission is $17,850. Now, other non-monetary considerations are, is home ownership right for you? Are you committed to one place compared to renting where you have the freedom to move to different cities after your lease is up and not be tied down to one specific location? Conversely, home ownership provides stability. In the case of renting, you may be forced to move out when you don't want to when you are given notice by your landlord. You also have the flexibility to do whatever you like with your own space and invest it in renovating your own property, which you can't necessarily do when you're renting. There is also risk involved with ownership as a large part of your net worth might be tied up in one asset class. So be mentally and financially prepared for corrections in the real estate market and the responsibilities that come with home ownership. If there are any other considerations I missed, make sure to comment down below. And if you are also on the market for a new car, check out my video here on whether you should buy, lease, or finance. Thanks so much for watching and I'll see you in my next one. Bye!