Renting vs. Buying a Home: The 5% Rule

Renting vs. Buying a Home The 5% Rule

The common perception is that buying is a good decision if you can purchase a home with a mortgage payment that is equal to or less than what you would otherwise pay in rent. This way of thinking about the rent versus buy decision is extremely flawed. Comparing a mortgage payment to rent is not an apples-to-apples comparison to properly assess the rent versus buy decision. 

We need to compare the total unrecoverable costs of renting to the total unrecoverable costs of owning. That may sound like a complicated task, but we have boiled it down to a simple calculation. Our team will give you a simple way to think about renting vs. buying a home decision in this article.

What Is Unrecoverable Cost of Renting

Before we get to the 5% rule, we need to layout the assumptions that have gone into it. An unrecoverable cost is a cost that you pay with no associated residual value. When we are talking about the total unrecoverable cost of renting, the number’s very easy. It’s just the amount that you’re paying in rent for a homeowner. 

The unrecoverable costs are a bit harder to pin down. A homeowner has a mortgage payment, which feels like rent, making it an easy number to compare to rent, but it is not a meaningful comparison. A mortgage payment is not an unrecoverable cost. It is a combination of interest and principal repayment. The unrecoverable costs for a homeowner are property taxes, maintenance costs, and the cost of capital. It is these costs that we need to compare to rent. 

1. Property Taxes

Property taxes are pretty easy for most people to grasp. You pay the tax to own the home. And there is no residual value. Property taxes are generally 1% of the value of the home. That’s the first piece of the 5% rule. 

2. Maintenance Costs

Then we have to think about maintenance costs. Maintenance costs cover a huge range of expenses. It can be large items like replacing a roof or renovating a kitchen to maintain the home’s value. Still, it can also be small things like redoing the caulking in the bathroom, pinning down the right number to estimate maintenance costs is not easy. And the data on average maintenance costs are not readily available, but most people suggest using 1% of the property value per year. On average, this is the second piece of the 5% rule. 

3. Cost of Capital

Finally, the last and most important piece to the 5% rule is the cost of capital. This unrecoverable cost has to be broken down into two components, the cost of debt and equity.

Most homeowners finance the purchase of their home and using a mortgage. Let’s use a new homeowner to put down 20% and finance the remaining 80% with a mortgage. The 80% that has been financed with a mortgage will result in interest costs. As of April 2019, we can easily find the mortgages online for just under and above 3%. Let’s call it mortgage interest—a 3% unrecoverable cost up until this point. 

All of the inputs to the 5% rule are fairly intuitive. Property taxes, maintenance costs, and mortgage interest. The last one, the cost of equity capital, is a bit less intuitive and requires digging into some data. In our example, for the mortgage, we put 20% down. It’s on that at 20% that there is a cost of equity capital. When you put 20% down, you are choosing to invest in a real estate asset.

Alternatively, you could have continued renting and invested the down payment money in stocks. That alternative creates an opportunity cost, which is a real economic cost incurred by a homeowner to estimate this cost. 

We need to come up with an estimate for expected returns, both for real estate and stocks. A good place to start is the historical data. Looking at the credit Swiss and global investment returns yearbook in 2018, we can get an idea of the data going back to 1900 globally. The real return for real estate that’s net of inflation from 1900 through 2017 was 1.3%. At the same time, stocks returned 5.2% after inflation. If we assume inflation at 1.7%, we would be thinking about a 3% nominal return for real estate and a 6.9% nominal return for stocks.

Let’s clear that up right now with this thinking for any asset class, markets price assets based on the information that is available at that time. You would never sell your house for $500,000. Suppose you knew that the buyer could resell it a year later for $550,000. That is not a sensible way to make a decision. Instead, we can look at the market’s premium on those types of assets over time and use that as an estimate for the future. That’s a 6.9% historical return for stocks includes Russia and China’s stock markets going to zero. It also includes the aftermath of world wars.

If we were to cherry-pick, say US stocks, the argument for stocks becomes a whole lot stronger, but it doesn’t make a whole lot of sense to do that. That was a bit of a digression, but it was important to put it out there at PWL capital. We do not use the historical return for stocks as the estimate of future returns. We use a combination of the 50-year historical return and the current expected return based on the price-earnings ratio.

The effect of this is that when prices are high, as they are now, relative to the past, our expected returns are lower. Our recurrent nominal expected return for a 100% equity portfolio is 6.5, 7%, quite a bit lower than the historical average. If we take these numbers as they are 3% for real estate and 6.5, 7% for stocks, we would have an expected return difference between real estate and stocks of 3.5, 7% to keep things simple and conservative.

We now have a cost of equity, capital of 3%, which is conveniently equal to the cost of debt capital. So no matter how you finance the home, the cost of capital is 3%. We now have a total of 5% of the home’s value that you would expect to pay unrecoverable costs. 

Remember, rent is an unrecoverable cost that is easy to see; homeowners also have unrecoverable costs, but they’re harder to see; the 5% rule can be used to think about the unrecoverable cost of renting and owning on an apple to apple basis. This thinking can be used as a quick reference for anyone considering the financial aspect of the rent versus buy decision. Take the value of the home that you were considering multiplied by 5% and divide by 12.

If you can rent for less than that, then renting is a sensible financial decision. A $500,000 home would be estimated to have $25,000 in annual unrecoverable costs or 2080 $3 per month. It goes the other way, too. If you find a rental that you love for $3,000 per month, you can take $3,000 multiplied by 12 and divide by 5%. The result, in this case, is $720,000.

In other words, paying $3,000 per month in rent is financially equivalent in terms of unrecoverable costs to owning a $720,000 home. There is no doubt that the 5% rule is an oversimplification. When we start considering variables like tax rates and portfolio asset mix, the 5% rule changes. For example, stocks’ 6.57% expected return is a pre-tax return, which is fine in an RSP or TSA. Still, in a taxable account, the after-tax return might be closer to 4.6% for someone tax at the highest marginal rate in Ontario in 2019, reducing their cost of equity capital.

Similarly, if the investment portfolio is less aggressive than 100% equity, the cost of equity capital decreases. If we think about this in terms of making financial decisions, it would mean adjusting the 5% rule downward, reducing the total unrecoverable cost of owning.

One of the highest costs of owning a home is the opportunity cost of equity capital. If you pay $500,000 cash for a home, you have now spent $500,000 on real estate instead of using it for something else like investing in stocks. The difference in expected returns between real estate and stocks is an opportunity cost. It is a real economic cost that the homeowner pays, and it has to be accounted for in the rent versus buy decision.

The opportunity cost of equity capital changes depending largely on your mix between stocks and bonds and whether or not your investments are being taxed. And if they are being taxed, your tax rate, based on these variables, the 5% rule might need to be decreased, making homeownership less expensive in terms of unrecoverable costs.

That is an interesting point to chew on the cost of owning a home decreases. If you have maxed out your registered accounts, or if you can’t handle the volatility of an aggressive portfolio for any aggressive investor who has not maxed out their RSP N T FSA, the 5% rule can be a useful tool in the rent versus buy decision for anyone with a more conservative portfolio or a taxable investor. 

We might use something closer to 4%, either way. Thinking about the cost of homeownership in terms of the estimated unrecoverable costs makes it much easier to think about the financial side of the rent versus buy decision.

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