Renting in Retirement

Canadians value few things more than a home that is owned outright. This might be especially true for retirees. The thinking seems to be that once your mortgage is paid off, your housing expenses evaporate. Unfortunately, this could not be further from the truth.

The alternative, renting, is often frowned upon. Renting is seen as throwing money away. The reality is that renting in retirement can make a lot of sense, both financially and psychologically, when it is properly understood.

The first step to accepting renting as a sensible housing choice is understanding the financial aspect of the decision. To compare the financial implications of renting and owning we need a common ground. That common ground is unrecoverable costs.

Unrecoverable Costs

Rent is an unrecoverable cost. It is paid in exchange for a place to live, and there is no equity or other residual value afterward. That is easy to grasp.

Owning also has unrecoverable costs. They are less obvious and usually get missed in the renting versus owning discussion. An owner of a mortgage-free home still has to pay property taxes and maintenance costs, both unrecoverable, to maintain their home. Each of these costs can be estimated at 1% of the value of the home per year on average.

In addition, an owner absorbs an economic cost for keeping their capital in their home as opposed to investing it in stocks and bonds. This economic cost, or opportunity cost, is a real cost that an owner needs to consider. Estimating this portion of the cost of owning is harder to do. It requires estimating expected returns for stocks, bonds, and real estate for comparison with each other.

Expected Returns

Estimating expected returns is not an easy task; it starts with understanding historical risk premiums. The market will demand more expected return for riskier assets, and this relationship is visible in historical returns.

For stocks, bonds, and real estate, the Credit Suisse Global Investment Returns Yearbook offers data going back to 1900. Globally, the real return for real estate, that’s net of inflation, from 1900 through 2017 was 1.3%, while stocks returned 5% after inflation, and bonds returned 1.9%. If we assume inflation at 1.7%, then we would be thinking about a 3% nominal return for real estate, a 6.7% nominal return for global stocks, and a 3.6% nominal return for global bonds.

To keep things simple and conservative, we will assume that real estate continues to return a nominal 3%, while stocks return an average of 6%, and bonds return 3%.

The Cost of Capital

With a set of expected returns, we can now start thinking about the cost of capital. Every dollar that a home owner has in home equity is a dollar that they could be investing in a portfolio of stocks and bonds. A retiree is unlikely to have an aggressive portfolio of 100% stocks, so we will use the 5.10% expected return for a 70% stock and 30% bond portfolio. The 2.10% difference in expected returns between the portfolio and real estate is the opportunity cost carried by the owner.

It is important to note that asset allocation, which is a big driver of these numbers, will depend on many factors including other sources of income like pensions, tolerance for risk, and portfolio withdrawal rate.

Comparing Apples to Apples

Adding up the unrecoverable costs, we now have 4.10% of the home value between property tax, maintenance costs, and the cost of capital. This is the figure that we can compare to rent.

A $500,000 home would have an estimated annual unrecoverable cost of $20,500 ($500,000 X 4.10%), or $1,708 per month. If a suitable rental could be found for that amount, then renting would be an equivalent financial decision in terms of the expected economic impact.

Other Financial Considerations of Renting

So far, we have looked at pre-tax returns. Taxes could play an important role in this decision. Increases in the value of a principal residence are not taxed. Income and capital returns on an investment portfolio are taxed. This could have an impact on our 4.10% figure during life. It could also have important implications from an estate planning perspective; large capital gains on a taxable investment portfolio could be costly at death. On the other hand, real estate is less liquid than a portfolio of stocks and bonds, and it has high transaction costs.

Diversification is another important factor in this comparison. We have used a 3% expected return for real estate based on the history of global real estate returns. The reality for a home owner in Canada is that they own a single asset in a single country. They are unlikely to get anything close to the expected return of the asset class. They may do far better or far worse with no way to predict the outcome. This increased dispersion of potential outcomes increases the risk for an owner, especially if a large portion of their wealth is in their home.

Renting results in a predictable cost. Having a fixed (though, increasing) monthly expense goes a long way in retirement cash flow planning. A home owner could be required to spend a large lump sum at any time for maintenance, repairs, or modifications to accommodate aging.

Non-financial Considerations of Renting

Understanding that renting can be equivalent from a strictly financial perspective, there are a ton of non-financial considerations. In most cases, these will end up being the basis of the rent versus buy decision for a retiree, especially when the financial equivalence of renting and buying is properly understood.

Renting is less of a commitment. A retiree may move as their children settle, their interests evolve, or their needs change. Not only do real estate transactions come with high costs, but there is no way to predict where the relevant real estate markets will be when you want to move, which introduces real estate price risk. Stocks and bonds also have price risk, but a retiree might be drawing 3.5% of their portfolio each year to cover expenses; this is quite different, in terms of risk, than selling 100% of an asset.

Renting is generally less of a hassle. Forget about the costs of maintaining a home – what about the time? It is easy for a home owner to spend substantial time maintaining their home. This could be seen as a hobby for some, and a hassle for others.

Renting simplifies your estate. Even if we assume that a home and a portfolio will result in a similar amount of after-tax inheritance, in many cases, inheriting a home can be a burden. Maintaining it could be expensive, and selling is not always easy.

Owning has the benefit of flexibility. There is nobody who is able to evict you, increase your rent, or disallow renovation projects.

Renting in Retirement

Robb detailed many more pros and cons of both renting and owning in retirement in another post. Ultimately this decision comes down to a combination of sensible financial decision-making, long-term planning, and personal preference.

I walked through the numbers on the rent versus buy decision in a recent YouTube video, and did a more detailed analysis in this paper.

Benjamin Felix is a Portfolio Manager with PWL Capital in Ottawa. PWL Capital is a wealth management firm that builds diversified portfolios for clients using low-cost mutual funds and index ETFs. You can find more from Ben on his Common Sense Investing YouTube channel, and his weekly podcast, the Rational Reminder, co-hosted by Cameron Passmore.

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16 Comments

  1. Michael James on June 27, 2019 at 8:28 am

    I like your approach of examining unrecoverable costs. You went to the trouble of looking up long-term returns of real estate, stocks, and bonds, but then you changed the numbers to favour real estate. Why not stick with the long-term figures? I can understand being concerned about frothy stock markets, but Canadian real estate is frothy as well.

    As a long-time homeowner, I’m confident that I’ve never had a year where my total maintenance costs were as low as 1% of my home’s value. People are generally bad at estimating totals of long lists of numbers; they tend to guess quite low. When I’ve added up costs, the total is shocking. I’ve replaced the roof, flooring, windows, furnaces, air conditioning, lights, and much more. I own dozens of tools I wouldn’t need if I rented. I pay more home insurance than I’d pay for just contents insurance. The list goes on.

  2. Bill sheridan on June 27, 2019 at 9:50 am

    I guess the point I want to make is to have the children of seniors purchase a condo and rent it to their parents. Parents would choose one and possibly put a down payment to help the children.

  3. Paul on June 27, 2019 at 9:50 am

    I agree with Michael James. You underestimated the cost of carrying a home. I am now a renter after being a homeowner for many years. Heating costs plus electric bill were almost as much as the taxes where the rent I now pay includes all heating costs.

    As a retired and former CFP, I made it a point to work out the numbers. The carrying costs were near the same range of renting a decent quality apartment. Also, if I need to, at some point I could just arrange to draw a monthly income and as long as the percentage is below what I average on the returns of my invested capital, the capital can be retained for a very long time. Most importantly though, we spend 5 plus months in Florida and it is such a relief to not have to worry about the house.

  4. Sarah on June 27, 2019 at 9:52 am

    Yes! Finally an article that allows people to compare apples to apples.

    Until 2017, I was and always thought I would be a homeowner. Then, we had an insurance claim and my rose coloured glasses fell off. Whatever could go wrong, did, and some.

    I have no intention of ever owning a home again and I have high hopes that my parents will also follow suit before they pass.

    Growing up, my Father always told me “you have to pay to live somewhere so, why not pay yourself”. Which was true in itself but from a financial growth perspective, I now see that I likely could have paid someone else and still made more money at the end of the day. And, no insurance claims to deal with. Life is too short for that.

    Regards, Sarah

  5. Dr. MB on June 27, 2019 at 4:19 pm

    Hi Ben,

    For all your reasons is why I recommend my kids rent for a goodly long time.

    My house continues to raid our contingency fund. Anyone who thinks their paid off home is cheap has not kept track of their expenses.

  6. Garth on June 28, 2019 at 4:52 am

    Agree with the financial arguments in favour of renting, but… Good long term rentals with attentive landlords are as rare as hen’s teeth in many areas. Moving is disruptive, expensive, time consuming, hard work, and just generally sucks.

    • fbgcai on June 28, 2019 at 4:59 pm

      @ Garth – you nailed it – the intangible in home ownership is “control” over where/how you live – how you monetize that would be interesting project – I wouldn’t give you a thank you for most rental accommodation and having my life impacted by a disinterested 3rd party (i.e. landlord) – rather my home, my castle on my terms 🙂 – it’s worth every penny to me.

      @ Benjamin and Michael J. – your maintenance cost estimate of 1% may be more accurate if it were based on the actual bricks and mortar value – not the combined house and land value – my real estate is probably 20-25% house value and 75-80% land value – the dirt requires zero (or damn close) maintenance – in my 35 yrs of house ownership my total maintenance is no where near 1% (p.a.) of the total property value – and I track my expenses very accurately.

      @ Bill Sheridan – great idea except I don’t have any kids – now what to do? and I’ve looked at condos – can’t really see the “why” – urban cliff dwelling – and the maintenance fees (without utilities or taxes) for ones that might work for me exceeded my total housing cost (taxes ,utilities, insurance and that ever pesky maintenance) – more expense for a less appealing lifestyle – I don’t get it.

      @ Benjamin – good point about opportunity cost – one way around that is to use a HELOC and invest it – yes there is a risk factor but if you don’t go crazy it will
      work out – it does for me – life is a risk.
      As for your calculation for break even rental cost good luck finding decent rental accommodation with those numbers – maybe in Elliot Lake but I don’t want to live there !

  7. Madrigal on June 28, 2019 at 2:41 pm

    You say the annual unrecoverable cost of owning a house includes property taxes of 1% of the value of the house. So a house assessed as a million dollar house would have to pay $10,000 annually in property taxes.

    But that is more than 15 times the property taxes I am actually paying. Please don’t tell the city what a bargain I’m getting!

    • Rob in Germany on July 26, 2019 at 9:32 am

      My brother lives in Kitchener and his house is valued at around $700,000 and he pays over 6 grand a year in taxes!

  8. Steve Bridge on July 2, 2019 at 1:54 pm

    Ben/Robb,

    Brilliant! Thank you for writing such a well thought out piece on this very important topic. Most people think owning is a slam-dunk but I have argued counter to that for years.

    The question is one that I go over personally as I am a lifelong renter (to date) but am about 10 years away from retirement. I currently live in Vancouver, so no chance I will buy here (unless something extraordinary happens), but have considered retiring to a cheaper place in Canada.

    Thanks again.

    Steve

  9. Gin on July 6, 2019 at 11:59 am

    Love your podcasts by the way.

    Agree with both perspectives brought forward here.

    As previously mentioned, as recent retirees we also had to dip into our contingency funds for costly home repairs and maintenance over the last 2 years. Not something we were planning on. On the flip side, we are not ready to give up the security and flexibility of owning our home.

    I can see us moving into a rental in later years, when we no longer have the appetite or interest in dealing with repairs & maintenance. We would look for a purpose built and professionally run rental. We would avoid renting from an individual landlord, which makes for a less predictable experience and rental cost.

    • Rob in Germany on July 26, 2019 at 9:36 am

      Hopefully you’ll be able to afford one. House prices are stagnating while the condo market is on fire. And it¡s not just young people that are buying.

    • Kitsgirl on July 27, 2019 at 9:57 am

      Good point about renting in a purpose built rental building vs an individual’s rental property. We are in the middle of selling our place and looking at possibly renting before diving back into the home ownership again and your tip would help to stop the madness of having to move from the rental because of someone now selling their rental condo or ‘needing’ it for their son. Thx!

  10. Larry C on July 6, 2019 at 2:22 pm

    Great thought experiment. In my Toronto neighbourhood, the maintenance and property tax percentages you use are too high. My house is conservatively worth $1.2 million and my property taxes are $6000/year or .5%. Add another $6000 or .5% for maintenance-$12000/year is too much-and the spread between buying vs. renting drops the 3.1%. I went onto realtor.ca to see what I could get for $3100/month ($1.2M x 3.1% / 12) in my neighbourhood and I’d have to move into a condo. So it’s a better deal to buy vs. rent here.

  11. Rob in Germany on July 26, 2019 at 9:45 am

    The main reason that people give for buying over renting is being forced to move out. Seen many comments about people being forced to move when the lease is up. When you’ve moved 3 times in 5 years buying looks awfully appealing.

    I’d love to hear from people who rented and built wealth, how did they deal with having to move so often

  12. Susan on July 29, 2019 at 8:34 pm

    Once our mortgage is paid off, we pay property taxes and maintenance. Currently that totals about $10k per year. Bump that up to $12k for easy math of $1k per month. There is no place that we can rent for $1000 per month. So the per month cost of owning is much less. The interesting factor that I haven’t looked at is having $750k in liquid investment vs real estate. I have looked at selling and maxing out RRSP since we have o we $200k of room available. We may end up having to sell since we don’t have pensions beyond CPP so we will have to cash flow our expenses.

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