Saturday, October 31, 2009

Buy vs Rent

The following comparison will illustrate how the low interest rates are reducing payments enough to compete with the rental market. Under more reasonable financing terms mortgage costs are not terribly out of line with the rental market. With more creative financing it is easy to see why sales are currently strong.

First consider this 1716 sqft house in South Edmonton for $374,900

Looking on craigslist for rentals in Edmonton I found the following.

The 1680 sqft house is the closest match. The advertised price is $1500 but after a few months the price increases to $1700.

1680 Square Foot Beautiful house in Edmonton's most popular newly developed community called Ellerslie crossing. The house location is seconds walk from ETS bus stop and kids school buses. Close to all amenities. Its next to South Edmonton Common, Anthony Henday, Calgary Trail and Whitemud. The lake is visible from the bonus room....Starting rent of $1500.00 will increase by $50 on December ($1550), January ($1600), February ($1650) and will get fixed at $1700.00 from March, 2010 onwards.



Comparing full asking price and rent results in a ratio of 220. That is fairly high even though it is from one of the more reasonable priced houses on the MLS (there was only one rental to choose from in the neighboorhood).

Looking at the price vs. rent things are a little closer.

Assuming full asking price, 10% down, 2% CMHC premium, 4% 5-year fixed rate and 25 year am.
$1814/month. $674 of which is principal.

There is a premium here, especially when taxes and maintenance are included. However, after 5 years the balance will be $300,255.

A buyer under these terms will end up paying a moderate premium and pay down some of the principal over 5 years. Meh. Not terribly exciting.

However if a buyer chooses a more risky mortgage a more interesting comparison appears.

Full asking price, 10% down, 2.4% CMHC premium, 2.25% variable and 35-year amortization.
$1192/month. $543 is principal (the first month, at least)

So for $1192/month + taxes + maintenance a buyer can move out of an apartment into a house and become a homeowner. The problem of course is not considering the interest costs for the entire duration of the loan and the effect of this stimulus on the asset price itself. Is this a bubble? Are current buyers the greater fools by recklessly overpaying for houses due to blind faith in future appreciation? Not entirely. Buyers may be incorrectly assessing the risk of future financing costs and not accounting for the asset inflation caused by low rates. This is a more subtle mispricing as opposed to a bubble and due to this I expect a less dramatic unwinding.

The type of financing above is an artificial boost to the housing market. What about the rental market? Low interest rates and creative loans reduce demand for rentals as the monthly payments attract people towards becoming homeowners. While rents have been falling partially due to the weak economy, I think another reason is from these financing terms. If/when these financing terms become less attractive the rental market may gain strength.

But its Halloween so we have to consider we may be in a deflationary depression where everything is toast.

4 comments:

Carioca Canuck said...

How much are taxes, utilities and maintenance though ?

Figure on average $150 a month for taxes, utilities can run $200+ on average, and maintenance, well, who really knows how to calculate that factor.

I guess you could say $100 a month stuck away in a savings account for the unexpected event, whenever it does occur, but even then, it's hard to know for sure.

So an extra $450 a month......naw make that $500 a month counting house insurance.

That makes it about $200 more than renting versus the 35 year amortization......and $800 a month more than renting versus the 25 year amortization.

Paying $4,800 a year to become a "35 year homeowner" (which is what the majority of people are doing right now) is hardly a wise financial decision........even if you subtract the estimated mortgage paydown, which gets totally wiped out by RE commissions and a discount on the list price at sale time in 5 years hence.....which is the current marketplace reality and the future one as well IMHO.

Having your personal covenant on the line for the mortgage balance, with zero financial equity gain becasue you purchased at the peak of the RE bubble, when rates were historically low (and nowhere to go but up) is a zero sum game IMHO.

Stay renting........

BearClaw said...

CC,

As a purely financial decision the rent case definetly has merits. My conclusion of the 5-year fixed 25 year amortization is there is a moderate premium to own. This metric has actually gotten worse over the year as rents have fallen, prices and interest rates have increased. Also, houses like this generally have a higher multiple than older apartments or houses with suites.

However you are overstating the rent case. Renter pays utilities for houses so you cannot include that as an extra charge in this example. The 35-year mortgage with maintenance and taxes ends up being cheaper than renting.

$1192+$200tax+$200maintenance=$1592/month

Assuming interest rates stay low the first year $6500 of principal is paid down.

Looking at rent vs buy only considering the initial monthly paments is not a good idea. Obviously there are risks with the interest rates and a decline in values. I do not make very strong points either way but instead showed an example with both sides considered. We obviously disagree on the magnitude of price declines so we will have to wait and see. I don't think you will see a similar house with asking price of less than $320,000 going forward, but I do expect a decrease.

Carioca Canuck said...

True......

All I pay is electricity @ $50 a month to Enmax........water and sewer, taxes, condo fees/common costs are covered in my rent payment. Boardwalk does the same thing, some others do not, and many vary this number obviously (often depending on the property type) by charging you the whole amount of all the utilities, such as most of the SFH that are for rent.....where this is a common practice.

I think that someone renting a SFH had better look harder at buying, than someone renting an apartment or condo, because that is where the delta is the smallest. A condo/apt is where it is the worst.

For me though, it is not so much the monthly delta, but the forward risk.

A 4% mortgage today is one thing.........at between 8% or 12% in 5 years time means you are doomed. Rent does not go up at an equivalent rate to mortgage costs, as in $5-7-900 more a month due to a rate hike, if it even goes up at at all.

If you are a renter, you are still (more or less, depending on the down payment amount) on an equivalent financial footing to a homeowner in 5 years time when you look at the bottom line balance sheet, unless.....

1-Property goes up dramatically - which aint't gonna happen.

2-Property goes down - which will happen regardless of where rates go.

Scary times we live in.......

3-Rates go way up - which has a very good chance of happening.

sixsixii said...

Check the CMHC rate for rentals. You will find that it is a lot different than your primary residence rate.