When the Bubble Bursts. Hilliard MacBeth
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couple — with an excess of housing assets because the nest is empty — will be worse off when the bubble bursts. This good news for millennials and Gen-Xers applies only to young people who haven’t already bought expensive housing and haven’t taken on more debt than they can handle.
The same holds true for the landlord. When the bubble bursts, the landlord will be worse off and the renter will be better off. Obviously, this increase in relative position for the renter holds true if the renter eventually buys a house because the purchase price will be more affordable. But a correction in house prices makes the renter better off even if they never buy a house as they gain in total wealth relative to the home owner by the amount of decline in the value of assets that is lost by the landlord/owner.
The rent substitute component of housing investment is always present and always has value. This amount is the monthly rent one would have to pay if one didn’t own a house. It can be calculated, with some accuracy, by looking at the cost of renting a home similar to the one that is purchased and comparing that to the total cost of home ownership. While the total rent cost is easy to calculate since a renter pays little beyond the monthly rent cheque, the total cost of home ownership is usually underestimated as prospective owners fail to include all the costs of owning a house. They do this because of inexperience, lack of information, or because they wish to bias the decision in favour of owning because of the intangible benefit to the status of owner versus renter. Shiller calls this “the psychic benefit one gets by owning and living in one’s own home,” and there is no way to measure the dollar value of that.
And, of course, if they are long housing in the context of Buiter’s definition, the true cost of owning a house would include the loss of wealth when the housing bubble bursts. Since it’s been so long that anyone has seen a decline in the speculative component of Canadian housing it would be rare for anyone to include this possible cost in calculating ownership costs. It could be stated in another way: when the housing bubble bursts, the speculative component is the amount of money that a prospective buyer would save by waiting until prices drop. Of course, nobody looks at housing that way. The more common point of view: Why rent when you can be an owner?
We’ve all heard, and perhaps some have repeated, the statement that goes something like, “Why pay rent to a landlord when I can build equity and make an investment through owning a home?” or “Paying rent is like throwing your money away.” I’ve heard it described this way: “Renting is like taking your money, dousing it with lighter fluid, and throwing a match to it.” It’s a universal myth that bears closer scrutiny. Is ownership of real estate a good “investment” today? Has it been in the past? Is it likely to be in the future? We can see from Shiller’s comment that some very smart people have concluded that real estate is not an investment. Let’s see what we can find. The first step to determining the investment value of housing is an accurate and all-inclusive calculation of the true cost of both options.
The Cost of Home Ownership
Usually the largest cost item is the interest on the mortgage loan that is required at the outset of becoming a homeowner. The CMHC website has tools that allow different assumptions on interest rates and mortgage amortization.
Assume a $400,000 mortgage, as this corresponds to the typical single-family home valued at $500,000 in major cities. In some cities like Calgary, Edmonton, Toronto, and Vancouver that amount buys only a very modest single family home.
Here are three interest rate scenarios. I chose these scenarios with rates higher than the 2014 rates to reflect possible interest rate fluctuations over the twenty-five-year term.
Scenario A
Interest rate at 4.80 percent
Total interest cost for twenty-five years = $284,326
Monthly payments are $2,281.09 including both interest and loan amortization.
Scenario B
Interest rate at 6.5 percent
Total interest rate cost = $403,788
Monthly payments are $2,679.30
Scenario C
Interest rate at 5.5 percent
Total interest rate cost = $332,469
Monthly payments are $2,441.57
The cost of mortgage insurance from CMHC would be added to the total of the mortgage. In this example I’ve assumed a $100,000 down payment in order to avoid the insurance requirement, but if insurance is needed the cost would vary between $8,000 and $15,000 depending on the size of down payment and other factors. The insurance protects the bank in the case of default but the home purchaser pays the premium, which gets added to the amount of the mortgage.
One difficulty with this calculation is that we can’t know what interest rates will prevail over twenty-five years of making payments. The interest rate on fixed mortgages is reset every five years and the borrower must live with whatever the going rate is at the time of renewal. On variable rate mortgages, changes can be frequent. For the last five years mortgage interest rates have been less than 2.99 percent (variable rate only) while in 1990 the five-year fixed-rate mortgage offered was higher than 13 percent. We cannot say what the rates will be but we know with certainty that there will be fluctuations, probably higher but perhaps lower from these rates. The smart bet is that rates on average will be higher than the current very low rates. So using an average 6 percent would be prudent in calculating the interest cost of owning a home. Of course, few people use rates that high when deciding to become an owner but they must, if they want to be careful. About two-thirds of all mortgages are of the fixed rate variety. The Bank of Canada historical data shows that the average five-year fixed-rate has been 9.26 percent since 1972. As recently as October 2008 that rate was 7.20 percent. There are discounts to the posted rate but highly levered buyers are not in a position to negotiate.
So taking scenario B, the highest interest rate, the total interest cost is $403,788, or about $16,000 per year. Note that the interest cost is more than the size of the original mortgage balance outstanding.
In addition there are annual costs — I call these ownership costs — such as maintenance, utilities, property taxes, and periodic refurbishment, which some estimate total as high as 4 percent of purchase cost, or about $20,000 per year. For my wife, Nancy, and me this number would be on the low side, as we’ve done many expensive renovations over the years. Those who are more careful about discretionary spending on renovations might get away with less. But recent reports on total home renovation expenditures estimate that Canadians spent at a pace of more than $60 billion per year, so lavish spending in that category is normal. As the total value of housing stock in Canada is approximately $4 trillion, renovations alone, not counting maintenance, utilities, and taxes, would be 1.5 percent of housing value. Property taxes are up to 1 percent annually in most jurisdictions and are likely to go higher in the next decade. So using 4 percent per annum as the total of all those things — taxes, maintenance, renovations, utilities, insurance, etc. — is realistic.
Taking those two items together, we get interest payments and ownership costs make $36,000 per year as the unrecoverable cash cost of ownership. But a homeowner usually can’t pay interest only; there is a required amortization of the principal portion of the loan. We’ve ignored that part of the mortgage cost. That would add another $400,000 to our illustration, which represents the forced savings aspect of home ownership; it’s not a cost of ownership. It’s an investment by the owner in residential real estate. So in comparing ownership costs to rent we leave that amount aside for now.
We note also that the house is twenty-five years older at the end of the mortgage term so there would be a drop in value of the building structure due to depreciation but that might be covered by the maintenance, renovation and refurbishment fund. So let’s just go with $36,000 annually ($3,000 per month) of non-recoverable expenditures.
That’s enough on the cost of ownership. Now let’s examine the cost of renting and then compare the two choices. Let’s assume a rent payment of $2,000 per month. That rent number is arbitrary and loosely based on advertised rents for homes and condos. Also, we can’t know what rent increases will come along in the future.