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Does Saving On Rent Make Your House A Good Investment?

November 20th, 2013

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This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.

A nice big house: If you buy this house and live in it, at least you won't have to pay rent. Does this make the house a good investment?

In my book'The Short Book On Investments', I cautioned my readers not to look at a house as an investment. But as a few people pointed out, the discussion was incomplete.

I failed to consider the rent not paid (called 'imputed rent') in the discussion of investment returns.

When you own a home, the rent that you don't pay is like an income stream. Money saved is money earned. This income stream should be included in your calculation of investment returns.

Not considering this is like analyzing stock returns without consideration for dividends. So yeah, my bad.

In this article, we'll consider income streams, and analyze how much that affects the returns on your house.

When you consider the income stream from owning a house, there are three big considerations - imputed rent, maintenance costs and property taxes.

How Much Is Imputed Rent?

First, let's talk about imputed rent. This number will vary from property to property in a big way, but let's talk about Canadian averages. We can calculate the imputed rent by inverting the price-to-rent ratio. If the price-to-rent ratio is 25, 1 over 25 is 4%, so we have 4% imputed rent per year. If the price-to-rent ratio is 20, we have 5% imputed rent per year.

I had a hard time getting recent data on price-to-rent ratios. The latest one I could find was published on Dec 2011. Since then, the ratio has only gone up higher.

According to the data, the price-to-rent ratio in Montreal, Toronto, and Calgary were roughly 35. That means you get nearly 3%/year in 'income' from imputed rent. In Vancouver, the ratio is roughly 60, and you only get about 1.7%/year from imputed rent.

Expenditures Are Bigger Than You Think?

If your'e considering income from property, you should also consider expenditures too. The major items are maintenance and property taxes.

As you can imagine, maintenance costs are difficult to calculate. It differs from home to home, and it also differs from year to year. MoneySense magazine did a pretty in-depth analysis of this stuff, and concluded that it might cost between $4,500 and $10,000 to maintain a house. For an average Canadian home that sells for $450,000, that's about 1% to 2.2%. Other internet sources confirm this range.

What about taxes? Again, it varies, but average seems to be around 1%/year according to some studies.

Cash Flow Of Owning An Average Home

Let's talk about what all this means for an average Canadian home that sells for $450,000. Assuming a price-to-rent ratio of 35, and an average maintenance cost of $7,000 with an average property tax of 1%/year, we can deduce the following.

Income from owning a house = 3% (Imputed Rent) - 1.6% (Maintenance) - 1% (Property Tax) = 0.4%/year

Make of this what you will. Obviously, an extra 0.4%/year won't suddenly make real estate a better investment.

However, you can easily imagine a scenario with different, more favourable numbers. With a lower price-to-rent ratio as well as lower maintenance cost and property taxes, we can easily get 2%/year or more in income for houses. Properties like this exists, and that's why I wrote in the book that there are real estate investors who consistently generate good returns.

But the average person is not an experienced real estate investor. The average person doesn't have the education or the experience necessary to cherry pick bargain homes.

And really, that's not the goal.

The kinds of properties these professional investors buy (e.g. student ghettos) are often not the primary residents that most other people end up buying. These types of properties often generate different returns.

What If Houses Are Cheaper In The Future?

You might concede that what I say is true today, but what if price-to-rent ratios come down to more reasonable levels in the future? A dozen years ago, the ratio stood at between 15 and 30. At a price-to-rent ratio of 20 for example, will give an imputed rent of 5%. That means net income from housing should be 2.4%/year, not 0.4%/year it is today, right?

Wrong.

If home prices come down, then maintenance costs as a percentage of home prices will also go up. By my calculations, if price-to-rent goes to 20, maintenance will go up from 1.6% to 2.7%/year. In that scenario, the net income from housing is 1.3%/year.

But more importantly, think about why house prices are so high today. The reason is simple - mortgage rates are still at historical lows.

The current mortgage rate is around 3.5%/year on a 5-year fixed term. That's against an asset that historically returned 3%/year plus a little bit. If you borrow money at a lower rate than what your asset generates, you make money. Therefore, the average person is currently making a little bit of money on their properties. That's why house prices have been going through the roof.

But historically, mortgage rates have been significantly higher. If you borrowed at 5%/year to buy a property that generated little more than 3%/year, you lost money.

The bottom line is, if price-to-rent ratios do come down significantly, it's likely because mortgage rates are higher. Your overall investment returns will suffer because of these higher rates.

Conclusion

Many people want to buy a home. I get that. Again, I'm not telling people to never buy homes, in the same way I don't tell them never to buy TVs, or travel packages.

But I do want people to see a more truthful picture about owning their own homes as an investment. As far as investments go, there are better options out there. Don't buy a home with the expectation that in 30 years, it'll form the basis for your retirement funds.

This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.