Now for the final installation of my Big Three series!
For the finale, we will be talking housing.
As discussed in the kick-off to this series, shelter* makes up 14.7% of median income, or $17,509 (2015).
The Frugal North’s Status
The FN household is currently paying $1,860 a month for shelter costs. This amounts to $22,320 per year. While this is more in absolute dollar terms than the average Canadian household, it’s about 14.8% of our gross income which is in line with the Stats Canada figures.
We are currently renters, so I acknowledge this is 100% an expense. However it allows us to keep transportation cost down by living close to work and allows us to bike/walk to 90% of where we need to go and stay fit!
Something I still like about renting is the consistency – I know without a doubt what my cost will be every month. This makes things easy from a budget perspective allowing us to stash excess cash into RRSPs and TFSAs in a predictable fashion.
The FN household will most likely be looking to buy property next year. But at the moment it’s a hard market in most Canadian cities including Ottawa. And we have done our research (as an Actuary, I can’t NOT do my own analysis and modelling). For the moment, we are happily renting and accumulating what will be a sizeable down payment when the time comes!
Buying a home is typically the single largest purchase for most people across their entire lifespan. As such, people should really consider the multi-faceted beast that is home ownership. As we prepare to buy, there are a few things that are top of mind for us:
- The Opportunity Cost of investing in a lower return asset. Real estate has historically returned less than equities.
- Pulling the New House Price Index (NHPI**) from Stats Canada from 1981 2016 for ‘House Only’ (I wanted to exclude Land purchases) we see Canadian NHPI has increased from 43.1 to 119.5. Over 36 years, that comes out to an average increase of 2.9% per year.
- In comparison, the S&P 500 has averaged 7.9% over the same period.
- Maintenance and Property Tax expenses can be quite expensive!
- Maintenance costs, according to http://www.ratehub.ca, range from 3.0% – 5.0% of the value of a home. This seems a bit high to me but will include big one-off expenses. I’ll assume the average is on the low end of 3.0%.
- Property Tax can vary by municipality but generally are 0.5% – 2.0% of the value of a home. I’ve personally seen an average close to about 1.0% of the value of a home.
- This comes out to an average expense ratio of 4.0% for a house asset returning 3% per year. Compare this to a 0.05% MER for an Index Fund tracking the S&P 500 returning 8% per year.
- Big one-offs such as a new furnace or roofing can cost thousands of dollars at a moment’s notice (Included in the average maintenance costs above; 3%-5%).
- This can be a big cash draw on a household. While some people like having an Emergency Fund of 3-6 months of household expenses, I do not endorse having such a large sum sitting collecting dust in a savings account.
- I prefer having a Line of Credit (LOC) for something like this. The reason being you could take that chunk of money and put it to work compounding interest over time in stock markets.
- When you need the money for a big ticket item, which should be infrequently, use a LOC or HELOC at a low cost of borrowing. You can then pay this down quickly with what you would have been saving as after tax savings. This is a way more efficient deployment of your financial capital!
- Your own human capital going into mowing your pristine lawn, weeding, and ensuring you’ve got the most lush garden on the block every weekend. Home ownership brings about a sense of pride and I get that. But these are man hours you have to put in. Your own human capital. So make sure you’re getting the return on capital you need!
- Buying close to work (<10km to downtown);
- Buying close to work ensures that you can bike or walk to work and keep your transportation costs down. Transportation is a pure cost, while a mortgage payment allows you to build up equity in an asset.
- Housing that is close to the epicentre of a city can increase in value at higher than average rates. This makes housing close to downtown a coveted asset class. While this means you will be spending more cash as a percentage for maintenance and property tax, you can sell this asset when you FIRE and buy something in a more rural quiet area (At least this is what we want to do!).
- Consider the costs of owning versus renting. This probably requires a post of its own, but here are some high level points to initiate percolation:
- Buying a home gives you a physical asset that will appreciate in value. If you have a rental unit, you can produce additional yield on your asset.
- Buying a home opens you up to several types of risks including interest rate risk, asset liquidity risk, and risk concentration.
- Interest Rate Risk: You’re likely using a mortgage to buy a home. As the debtor, you must pay back the principle borrowed plus interest. The interest will vary as lenders adjust their rates over time (depending on economic outlook, risk premium above risk free rates, etc.). As a buyer in today’s market, you should understand that interest rates are at a ultra historically low level. Look at this graph. Rates peaked in the 80s at over 20%! Know the market you’re buying in and how much debt you’re taking on. What is your potential interest cost if rates reverted closer to long-term averages of 7% – 8%?
- Asset Liquidity Risk: If you need to sell your house in a soft market (i.e. buyer’s market) you may not be able to sell at fair market value and may take a hit to sell off your house. This doesn’t happen with Index Funds as these trade in very deep markets (I.e. lots of buyers and sellers at all times so you’ll get pretty close to fair market value for the asset).
- Risk Concentration: Owning a home gives you exposure to Real Estate assets. BUT, you are only owning one single asset. No diversification. If your neighbourhood becomes undesirable for example, you may be left holding the bag. As an alternative, you could get exposure to Real Estate with diversification by holding various REIT funds.
- Finally, as a recap to what was stated earlier:
- House appreciation has been approximately 3% per year across Canada with an expected expense ratio of 4.0%. If you put down 20%, and you need to pay mortgage interest of 3.5% on the 80% remaining, your total expense is then 4.0% + 3.5% x 80% = 6.8% of the value.
- Owning a home is expensive, but the flip side is that you do not need to pay rent. While 3% has been the historical Canadian appreciation, you could boost this yield by renting out your basement, say at a 6% yield for 50% of the square footage of your home. This will boost your yield by 6% x 50% = 3%. Renting is an extremely powerful tool in boosting your yield.
- If you are a renter, you can reap the rewards of:
- Strong rent controls limiting YoY increases in rent;
- Predictable costs, allowing for consistent stashing into RRSPs and TFSAs for effective dollar-weighted average investing;
- Ability to quickly pivot your investments at a low cost relative to owning a home (Index Fund MERs of 0.05%), stronger returns relative to owning a home, and benefit from diversification and liquidity.
- Note the biggest drawback is, of course, that rent is a pure cost, a total expense…which sucks.
Well that’s all I’ve got for this post! What tricks do you have on keeping housing cost down? What do you think of owning versus renting a space?
*Stats Canada defines shelter costs as expenses for mortgage payment/rent, electricity, heat, water and other municipal services, property tax and condo fees.
**The New Housing Price Index (NHPI) is a monthly series that measures changes over time in the contractors’ selling prices of new residential houses, where detailed specifications pertaining to each house remain the same between two consecutive periods.