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Short Summary
Main recommendation: Instead of comparing a mortgage payment to rent, compare the total unrecoverable costs of each option, and use the "5% rule" as a quick check: if renting costs less than 5% of a home's value per year (divided by 12 for monthly), renting is the more sensible financial choice. The rule adds up property taxes (about 1% of home value), maintenance (about 1% of value per year), and the cost of capital (about 3%, covering both mortgage interest and the opportunity cost of the down payment).
Key Points
- A mortgage payment is not an unrecoverable cost, because part of it is principal repayment that builds equity; only interest, property taxes, maintenance, and the cost of capital are unrecoverable for owners.
- Property taxes are generally about 1% of the home's value per year, with no residual value returned to the owner.
- Maintenance is estimated at about 1% of property value per year, covering everything from roof replacement to re-caulking a bathroom.
- Cost of capital is the largest component, split into debt cost (mortgage interest, about 3% in April 2019) and equity cost (the opportunity cost of the down payment, estimated at about 3%, the expected return gap between stocks and real estate).
- The rule can be adjusted: a less aggressive portfolio or taxable investing lowers the cost of equity capital, so the rule may drop toward about 4%.
Details Worth Noting
- Concrete instructions: To apply the 5% rule, take the home's value and multiply it by 5%, then divide by 12 to get the monthly unrecoverable cost. For example, a $500,000 home has about $25,000 in annual unrecoverable costs, or about $2,083 per month. To go the other way, take the monthly rent, multiply by 12, and divide by 5%: $3,000 per month in rent is equivalent to owning a $720,000 home.
- Concrete instructions: For a conservative or taxable investor, use something closer to 4% instead of 5%. For an aggressive investor who has not maxed out RRSP and TFSA contributions, the 5% rule is presented as a useful starting tool.
- Expected return inputs come from the Credit Suisse Global Investment Returns Yearbook 2018 (real estate about 1.3% real and stocks about 5.2% real, 1900 to 2017, with 1.7% inflation assumed). PWL Capital uses a blend of 50-year historical returns and a price-earnings-based expectation, giving a 6.57% nominal expected return for a 100% equity portfolio.
- The speaker rounds the 3.57% stock-minus-real-estate gap down to 3% to be conservative, and notes that the 6.57% figure is pretax, so an after-tax return in a taxable account could be closer to 4.6% at Ontario's top 2019 marginal rate.
- The speaker argues that assuming high recent real estate returns, such as in Canada, will persist is not sensible, since markets price in known information.
Bottom Line
Judge a rent-versus-buy decision by total unrecoverable costs rather than by comparing a mortgage payment to rent, and use the 5% rule (adjusted down toward 4% for conservative or taxable investors) as a quick benchmark.
