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.
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.
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
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.
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.
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.