Tuesday, November 3, 2015

Why (not) rent your home?

Ted Nasmith, An Unexpected Morning Visit

"Why not just get a mortgage and buy the place rather than throwing money away on rent?" That's what people often say to folks like me who rent rather than buy. This post is my response.

Let me start off by saying that I'm neither a housing bear nor a bull. I have no idea which way Canadian real estate prices are going to go. My decision to choose renting over ownership has to do with other factors.

I don't have enough resources to buy a house or condo without getting a mortgage. Those who tell me I'm throwing my money away on rent and should buy are implicitly counseling me to take on a lot of leverage. Let's pretend that I'm comfortable accepting that level of debt. Why should I purchase a home with the borrowed funds and not buy some combination of the Vanguard Total World Stock ETF and the Total International Bond ETF?

To favor a home over the Vanguard ETF option is to assume that the risk-adjusted total return on the home exceeds that of the ETFs. Let's unpack this comparison a bit. ETFs provide a return that is purely pecuniary; some combination of price appreciation, interest, and dividends. Homes also provide a pecuniary return—they can appreciate in value. But a home is special. In addition to the pecuniary return, it simultaneously offers a non-pecuniary return, namely shelter. We can't eat in an ETF, or sleep in it, or entertain friends in it, but we can do these things with a house.

The total return on a home should be about equal to ETFs. Markets are competitive, after all, so if one asset offers an excess return, people will compete to harvest those gains, eventually arbitraging them away. Thus the total expected dividends, interest, and price appreciation from an ETF should be about equal to the sum of a home's expected price appreciation and the value of the shelter it provides. Shelter is a sizable service. This means that a home's expected life-time price appreciation needn't be very large to attract buyers. So an ETF's expected return will exceed a home's potential for price appreciation by a significant wedge. This wedge is the extra pecuniary return on ETFs held.

How big is the wedge? We can try to get a feel for it by looking at long term data. Using numbers compiled by Robert Shiller, I've calculated annualized real returns (i.e. adjusted for inflation) for both U.S. homes and equities going back to 1890. I don't have data that would approximate the Vanguard Bond ETF, and I don't know of any comparably long Canadian data series.


Equities, as represented by the S&P, have provided a real return of 6.5% per year including  price appreciation and reinvested dividends. Shiller's U.S. housing price index has yielded a much smaller 0.35% annualized real return over the last 120 years. Even if we omit the brutal credit crisis years of 2006-2015, U.S. homes still only provide a 0.54% return.

So when anyone boasts that unlike me they're not wasting money on rent, I accuse them of throwing away the extra wedge they could be earning by owning Vanguard ETFs.

Anyone who borrows to harvest the extra wedge on ETFs is left with a problem, however. They can't just sleep on the street, they need to acquire shelter. We're all born with a short position in housing. And that means giving up part of the excess wedge to a landlord. How much of this wedge? Again, since markets are competitive, my bet is that pretty much all of the wedge will have to be forfeited. If there was a significant chunk left over, everyone would choose to rent, driving rents higher until returns had equalized. At the end of the day, there probably aren't significant excess returns to be harvested by either home ownership or renting/investing in ETFs.

There are a few other stylized facts that colour the rent versus buy decision. Buying and selling a home will set you back thousands of dollars in transaction costs whereas it costs less than $25 to buy and sell ETFs. Secondly, a Vanguard ETF can be sold in a few seconds; a home can take weeks. Lastly, it costs just a few basis points to maintain an ETF (think management fees) whereas a house can cost thousands to keep in shape. To compensate for all these drawbacks (which are sizable), a home must offer a pretty high expected return.

What ultimately tips me towards the ETF option is the opportunity for diversification. Leveraging up on a single asset exposed to one street in a single city is a gamble. The two Vanguard ETFs, on the other hand, offer global exposure to thousands of different businesses, both large and small. Between renting and buying, renting seems to me to be the more prudent approach. I'm no gunslinger.

Which leads me in a meandering way back to Robert Shiller, specifically his derivatives markets for home prices. I'd certainly reconsider the home ownership route is if I could hedge away some of the risk of housing price declines, say by swapping out exposure to changes in the price of my home for a more diversified return. Most attempts to create housing derivative markets have failed, so until we have a futures market in housing prices, give me ETFs.

16 comments:

  1. Housing is local, ETFs are national to world. Geographic concentration can increase risk or it can reduce it through wise selection. In most smaller, slower growing, remote areas, renting will be more attractive, while larger, faster growing, denser areas, owning will often be more attractive. Congested areas will have more static supply but increasing demand leading to appreciation with income, so once your income growth slows, it will be better to buy. As housing and employment are somewhat closely tied, this can also mean more cyclical risk. Credit constraints mean many for whom buying would be better are not able to and that population growth will lead to somewhat greater returns. Taxes can also affect these, both income and property depending on your relative position. Renting can also cost thousands when your landlord decides to move in/sell/raise rents/redevelop and you have to move and that can happen somewhat often though is easier to do when you have to.

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    1. "In most smaller, slower growing, remote areas, renting will be more attractive, while larger, faster growing, denser areas, owning will often be more attractive. Congested areas will have more static supply but increasing demand leading to appreciation with income, so once your income growth slows, it will be better to buy."

      This is only true if this is unexpected. The same for the landlord moving you: this factor, as far as it happens regularly, is priced into rents already.

      Delete
  2. This is the stupidest analysis I've come across in ages. First, you can't borrow at today's mortgage rates to buy stocks. If you buy stocks, it is on margin and you are paying higher interest rates. Your whole argument rests on the assumption that you can borrow at the same rate to buy a house or stocks, and you clearly can't. Second, you believe markets are efficiently pricing homes so that the return of homes and stocks are the same, but homes have all that extra risk. Of course, if markets were in fact efficient, they'd price homes cheaper to account for that added risk / upkeep cost! Congratulations, you are an idiot.

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    1. Unknown:
      1) Some people spend their own money on houses and stocks, and that reduces the relevance of different borrowing rates for buying houses vs. stocks.
      2) "extra risk" is compensated by extra return.

      I'm guessing that JP won't bother to answer your rude post. As my friend Craig says, that would be the intellectual equivalent of clubbing a baby seal.

      Delete
    2. " If you buy stocks, it is on margin and you are paying higher interest rates."

      Fair enough. If the bank won't give you a large enough loan, then open a futures account, put in $50,000, and perpetually roll over an appropriate number of S&P emini contracts.

      "if markets were in fact efficient, they'd price homes cheaper to account for that added risk / upkeep cost! "

      Yes, and that's what I meant when I wrote: "To compensate for all these drawbacks (which are sizable), a home must offer a pretty high expected return."

      Anonymous: "Some people spend their own money on houses and stocks, and that reduces the relevance of different borrowing rates for buying houses vs. stocks."

      Yep, we can also run this exercise from a different starting point: I want to invest $500,000 in cash, what do I do? Buy a home straight up? Or invest in ETFs and rent?

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    3. Unknown, you show a real lack of any knowledge of how markets work, while calling others an idiot! Very nice. For instance:

      "First, you can't borrow at today's mortgage rates to buy stocks."

      Right. And you don't think the fact you can borrow cheaply to buy a house is ALREADY FACTORED INTO HOUSING PRICES, thereby negating this advantage?

      This is "market" analysis from someone who hasn't gotten econ 101 and yet calls others names.

      Delete
  3. If you somehow know that you will stay put, then renting is risky, because you can't lock in a rent. Of course you can always move to a lower rent location, but that may be unpleasant.

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  4. Somebody has to own the houses. In equilibrium, it should be a wash, except:

    1. Renting a house from yourself resolves the moral hazard problem between tenants and landlords

    2. We are born with a short position in housing services, and buying a house covers that short position.

    3. The tax system is biased in favour of renting a house from yourself (since you don't pay income tax on rent you pay yourself).

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    1. On the other hand, especially if you plan to move frequently:

      4. Renting a house avoids the high transactions costs of buying and selling illiquid houses.

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  5. The return on/of direct financial claims is taxable – both income and capital gains. Not sure how that composes with EFFs, but in any event the total return is taxable at some rate.

    Neither the capital appreciation nor the non-pecuniary recurring return on housing is taxable. Plus mortgage interest tax treatment - deductible in the US although not in Canada. While financial claims can be financed with deductible interest.

    These tax elements are significant in a complete analysis, I think.

    I don’t buy the “born short housing” meme as an analytical concept. But I think “not long” is a powerful motivator to buy in the face of eternally rising nominal real estate prices.

    (IMO - to be short an asset means you profit monetarily from a decline in its present value. That's not the case in simply not owning a house. And you don't become long an asset simply by eliminating a short position it. A flat position is defined in between - which in this case is simply not owning a house.)

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  6. This is a topical post considering the upward-spiral of certain Canadian real estate markets.

    There are many talking points when comparing housing and equities, but to keep this short I'll address the point you made, "Those who tell me I'm throwing my money away on rent and should buy are implicitly counseling me to take on a lot of leverage."

    It's both interesting and bizarre that Canadians, especially, are so comfortably driven to buy a house (aka utilize a lot of leverage) but they would NEVER do the same to purchase public equities. It's a really weird cultural bias, but also supported by a lack of knowledge of risk, return, true cost, and continual marketing from certain entities.

    I would say the greater bulk of house owners/mortgage holders consider their house to be an investment when it's actually a depreciating durable good and without constant input of new capital (even when mortgage free), the returns will be negative on that "investment".

    As well, with the bond bull now dead, the only thing driving house prices is demand, and who knows how long that will last.

    There are definite pros and cons to both renting and buying, being well aware of them all can only help in making better decisions to achieve your personal and financial goals, whatever they may be.

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  7. There are some basic economics that become distorted in the current currency-war world economy.

    A few of these basics are:

    1. Housing is a depreciating asset. An old house is worth less than a new house.

    2. The land a house is built upon is a non-depreciating asset (they are not making land anymore).

    3. Both land and house are located within larger human community that will have economic tides.

    A currency-war environment (as presently underway) is an economic framework with constantly increasing monetary assets. Some people are the direct beneficiary of the repeated increases; some people are stuck with secondary benefits from the repeated increases. Housing, land, and ETFs are all secondary beneficiaries but ETFs come before land for the ease of trading (closer to being money as an asset class).

    You correctly point out that housing provides shelter, something that money does not provide. Can all of us confidently assume that we will ALWAYS have enough money to trade for the shelter we need?

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  8. I used to be one of those people who said that all the time. Times have changed and many people do not want to be saddled with a mortgage today despite the financial benefits. They are content living in a rental and it really is a great resource for the homeowner. That check coming in is like early retirement for us.

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