Tuesday, June 17, 2014

Buy vs Rent. Why we're okay with renting today.

Conventional Wisdom: "Renting is pouring money down the drain" 

We've rented a number of places, we've owned a few homes and we've speculated on a few property flips.  In two weeks from now we will be back to renting a home rather than owning one.  Now many people may assume that we rent because we don't have the money for the downpayment or that we can't afford the monthly payments that come with owning.  But with us thats not the case.  Since we don't view our home as an asset, we look at home ownership differently than most people.  We generally do not feel the need to own a house.  We do not buy a house believing it is an investment but rather a lifestyle choice.  Sometimes owning makes sense for us and other times it does not.  At present, we have chosen to rent because for our lifestyle, renting makes the most sense for us right now.  It also makes sense for us from an economic sense at this point in time, specifically around month to month costs.  In the future this may change and we fully expect that we will own a home again within the next few years.  But not now.

But what about all that money we're throwing away?  Well, I've done some number crunching on the specific house we are renting and I can tell you we are not coming out poorly by renting.  For other homes it may make sense to buy, but we would calculate these numbers on a case by case basis.  I'm only going to focus on the basic math around the rent/buy choice on a monthly cost basis and not around full life-cycle costs (which would include buying and/selling costs of a Real Estate transaction, capital appreciation, land transfer taxes etc) because many people have psychological reasons to either buy or rent and the metrics also change depending on how long you intend to live somewhere, whether prices go up or not, and how emotionally attached you  are to where yo live... so I will leave that up to you to decide whether those types of reasons and parameters affect you.

The House:
The house we will be renting is a 3 bedroom house in a very desirable neighbourhood within a half hour walk to the heart of downtown Kingston Ontario.  It is about a 5 minute walk to the nearest public school, and within a 20 minute walk to Kim's work.   We really like the area and we are prepared to pay a premium to live in this neighbourhood.  The property taxes on the house are $6750 a year.  Based on the property tax mill rate of about 1% of house value, and surrounding sales which are close to a million dollars, I would estimate the house has a market value of about $675,000 or more, which in Kingston is well above average.  We have agreed to rent this house for $2300 per month plus utilities.

So how much are we flushing down the drain each month by renting this house in this desirable neighbourhood?  Lets do a little comparison math:

To buy this house we would need to have a 5% downpayment which would be about $34000.  The remaining $641,000 would be mortgaged.  Since I would only have 5% equity in the house I would need to get CMHC mortgage insurance.  That would cost 3.15% of the mortgage price which would add an additional $20,000 to the mortgaged amount.  So the fully mortgaged amount would be $661,000.  If I had a larger downpayment set aside,  I could put the money into the house but I am not a fan of putting more money than needed into a downpayment... simply because I like my money to be in liquid form and bricks and mortar real estate is very illiquid.  If I get a 25 year amortized mortgage at the lowest 5 year mortgage rate today of 3%, I can pay a monthly mortgage payment of $3128 per month.   In the first year, about $1500 is going towards paying down the principle and the remaining $1628 is going towards interest payment.  As mentioned above the property taxes for the year are $6750 which translates to $562 per month.  If we bought the house, we'd need to have home insurance or we wouldn't be able to get the mortgage.  For a house of this size and value, I'd estimate it would be about $150 through our current insurance company although I may be able to get a lower rate elsewhere.. but I'll go with what my insurance company would pay.   A rule of thumb for general upkeep (painting, repairs, fix-ups, new shingles etc) of a house is usually around 1% of the value of the property... which in this case would be about $6000 per year or about $500 per month.  This number seems a bit high to me, but there are always things that a house needs that we forget to account for so I am going to leave it at $500 per month even though I think it may be more than what I'd likely pay.   This number is also dependent on the age of the house... older houses sometimes just need more upkeep... and this house is 70+ years old.  So to summarize, the total monthly cost to us after buying this house would be $4340:

During the first few years, about $1628 of the mortgage payment each month goes towards the interest cost, so one could make the argument that each month, the remaining $1500 is going back into your pocket in the form of home equity.  You would get that $1500 back if and when you sell the house assuming the house doesn't go down in value.  So if we subtract the $1500 from the Total cost, we get approximately $2840 that is NOT going to your/our bottom line but to either interest, insurance, property taxes or upkeep costs.  

Now of course there are other monthly costs such as utilities, but I have to pay them each month whether I own or rent so I didn't include those.   Don't forget that if we bought we also would have had to front a $34000 downpayment... so there's also that cost and time that we'd have to consider.  Thats $34000 that isn't in my pocket or investment account.  

So contrast the $4340 (or $2840 if you prefer) with the monthly $2300 rental cost of the exact same home, without having to come up with $34000 downpayment up front and I think we're doing well to rent.  As an aside, if I had a potential $34000 downpayment and wanted rather to invest in Real Estate, I could put it into Killam Properties (KMP on the TSX).  They own and operate apartment buildings and manufactured home communities and the stock currently pays a handsome dividend of about 5.75% per year.  The stock is very liquid and I could sell it at virtually any time which is very different than owning a physical building.  If I bought $34000 in KMP stock, I would collect $1955 annually in dividends or about $162 a month that I could apply to my rent cost if I chose to do so.  If I did apply the $162 monthly dividend to the rent cost, it would lower my rent cost to $2138.

So on a month to month basis, the rent of $2300 comes out better than the $4340 (or $2840) monthly costs involved in buying/owning by about $2040 (or $540) per month.  The winning option, with respect to monthly costs in this comparison is renting, yet it is not so cut and dried in there grander scheme of things.   For our current needs we think we're coming out ahead by keeping the deposit in our pocket and renting this attractive house in this sought after neighbourhood.

Tuesday, May 27, 2014

#37 "Hedge" against price inflation by investing in staples you use.

From Investopedia: Definition of 'Hedge'

"Making an investment to reduce the risk of adverse price movements in an asset..."

People like to complain about gasoline prices. They also like to complain about bank fees.  And how about cell phone fees?  Yep, people keep complaining about phone fees.  Energy costs such as electricity generation and delivery, natural gas costs etcetera are generally going up over time... and yep, people sure do complain about them.  Every year all of these products and services increase their cost to consumers like clockwork, sometimes around the rate of inflation and sometimes higher such as in the case of finite resources such as oil and gas.  If the cost of these items is expected to go up over time, and its reasonable to expect that businesses will pass on the cost of these items to customers so that companies can preserve profits, is there a way to either hedge against their price increase or to participate in the increasing value of these consumables?  There sure is!  Buying good companies that produce products or services that people use everyday is a good way to participate in the market.  It is also a way to hedge against rising prices of the products and services they sell.  A good example of this is participating in increasing gasoline prices by investing in Oil and Gas stocks.  We like to focus on companies that pay and increase their dividends over time.  This way when the price of gasoline goes up, we are able to participate in the increase through the accompanying dividend increases.  As the price of gasoline goes up, it costs me more money to fill up the tank of my car... but I also profit from the rising price of the oil and gas stocks that I own.  This is my hedge against price inflation.

The everyday costs/staples that we consume are gasoline, mortgage payments, insurance, phone plan, internet plan, electricity, heating fuel etc... so to hedge these costs we own shares in Oil and Gas companies, Banks, Insurance companies, A Phone and Internet company, Electricity Generation and Delivery companies.  All of the companies pay me a dividend and they all have raised them at or above the rate that they increase prices on their products or services that I buy.

So while some people have a tendency to do nothing but complain about higher prices year after year, we've taken a different approach.  We participate in the higher prices and higher profits through stock ownership.  Since we've been doing this for nearly 15 years now - and the dividend increases have outpaced inflation - many of our bills are now paid for by the cash-flow of the stocks we hold in their specific sectors.... such as our oil stocks now actually pay for our gasoline purchases, our phone company stock pays for our monthly cell phone costs and so on.

Monday, May 26, 2014

#36 Owning a good company is are better than working for one.

"Investors should be rewarded for actually owning companies and gaining returns on their investments." - Mark Cuban

My father and I were discussing wealth creation the other day and he asked whether I knew any multi-millionaires.  Having studied and worked in the Oil Patch in Calgary, I've come to know personally a number of wealthy people with very high net worths, some well into the 10's of millions.  Calgary is a vibrant city with lots of opportunity, and a lot of money moving around within it.  If there is anywhere that rewards calculated risk-taking, it is Calgary.  The overwhelming majority of folks I know who are wealthy did not become wealthy from earning a paycheque.  They became wealthy from either starting and operating businesses or by investing in, or acquiring shares of, companies that go on to be very successful.  I asked one of my high net-worth friends what they their best piece of advice was to generate wealth.  He said it was simple: "Owning a good company is better than working for one"...  i.e. Their key to wealth creation was owning businesses, not working for them.  This flies in the face in what the majority of the school system teaches... to become an employee and rely on a government pension.

The rationale for business (or stock) ownership is this: A paycheque is temporary and you are compensated only in exchange for your labour.  You get paid for the work you do once, but if you stop you get nothing in perpetuity.  Owning a well-run business, or shares of a one, can result in passive cash-flow in the form of dividends and tax-deferred capital appreciation as the business grows for as long as you own your share of the business.  This is one of the reasons I don't understand why people don't take advantage of work-sponsored share matching programs.  Getting shares in a successful company at a discount sounds like a great thing to me....then to benefit from that company ownership for a long time, perhaps long after you've left the company, just seems like a solid way to build wealth to me.  Buying shares privately in an RRSP, TFSA or Taxable account also make sense if you take a long term approach and pick solid companies that will still be around in 10-20 years.  Its not as hard as it sounds.. really.

Taking on the risk of business or company share ownership can lead to sizeable rates of both capital and cash-flow growth.  Growth rates of good companies tend to outpace inflation, and dividends can grow well above the rates of paycheque raises.  Rather than start a business, we chose to invest in companies that had a track record of growing their earnings and increasing their dividends AND ones we think will continue to deliver raises above the rate of inflation.  We regularly get dividend income raises far greater percentage-wise than employment income raises these days.. which means our investments are now bringing us closer to Financial Independence than our paycheques.   Since the rate of growth of our portfolio's dividends alone outpaces our employee paycheques growth, we have put as much as we can into them as early as we can.  This allows the compounding to work in our favour early.