Home sweet investment

MAYBE home sweet home isn't so sweet after all.

After last fall's stock market crash, which had its origins in the U.S. hous­ing market, the economics of home ownership has increasingly come under fire.

A recent issue of The Economist put the long-held concept of home ownership as the backbone of wealth in a free market society under the microscope.

While the article isn't wholly critical of home ownership, it does look at whether people would be better off renting and then investing the remainder of their savings in the stock market instead of buying a home.

It may be tough to believe, but in some cases, people who rent and invest would come out ahead of homeowners in the long run -- particularly if they lived in certain regions of the United States.

Even here in Canada, home ownership is not as clear a winner as you'd think. Canada's Office of Consumer Affairs started providing last summer -- when real estate was booming -- a calculator on its website comparing home ownership's power to create wealth with renting and employing an aggressive investment strategy. In some cases, if home prices and interest rates are high enough, the latter strategy is more lucrative.

Although that may be the case in some parts of the U.S., where bankrupt homeowners are turn­ing in their keys to the bank, in most of Canada, owning a home is still the best way to accumulate wealth, says Ted Rechtshaffen, a certified finan­cial planner with TriDelta Financial Partners.

"In Canada, under most interest rate scenarios, buying your own house is one of the smartest financial moves you can make," he says.

Over a 25-year amortization period, the interest payments can cost as much as the home's original purchase price.

But the cost of servicing that debt has never been lower. The Bank of Canada's recent move to cut its lending rate to 0.25 per cent has pushed mortgage rates to around the three per cent range, including fixed, five-year terms, some of which are being offered as low as 3.69 per cent, mortgage broker Jeff Sparrow says.

"With interest rates at levels that no one has ever seen before, that argument of rent versus buy is a pretty easy win on the buy side of the equation," says Sparrow, who works with Castle Mortgage Group in Winnipeg.

While interest costs are not tax deductible like in the U.S, or if you were borrowing to invest in the stock market, home ownership is still a tax­efficient way to accumulate savings.

Your home is an investment that will grow tax-free as long as it remains your principle residence, Rechtshaffen says. It is also a tangible asset that provides more than just investment growth.

"A stock portfolio is a piece of paper, whereas with a house, you will hopefully get some enjoy­ment and use out of it," he says.

Home ownership also forces people to save instead of spend. That mortgage payment every month, while paying the bank interest, does help accumulate savings in the form of equity in the home, says Stanley Hamilton, a professor of real estate finance at the Sauder School of Business at the University of B.C. "When somebody puts monthly money into the stock market, it's pretty easy to say, 'Let's skip this month,'" he says. "If you've got a mortgage, it's a bit more challenging to skip."

But home ownership does have drawbacks. Real estate prices typically do not appreciate in value as much as equities.

The best period of real estate growth over a 25-year period was 6.4 per cent annually (1981 to 2006) -- in Barrie, Ont., Rechtshaffen says.

"People look at that and go, 'That's crazy! I feel like I've made so much money on real estate," he says.

"Generally, the stock market over time has shown returns of nine or 10 per cent -- even though it's hard to believe that now."

Despite the prospect of rapid growth, the aver­age investor would be leery of borrowing to invest in the market even though the interest costs are tax deductible. But that same person wouldn't even question using leverage to buy real estate.

"One of the things that people don't realize from an investment perspective is the same people who never have a margin account when they invest, not only do they borrow, but they borrow huge to buy a house," he says.

For the most part, this is a much safer invest­ment for which to borrow than volatile equities, which can drop in value dramatically in very short spans. But home ownership is not without its borrowing risks, particularly in hot markets near their peak.

"When you 'win' a bidding war, you are throw­ing in some really risky money," Rechtshaffen says. "You have overpaid for it, and you might not get it back."

AN even worse scenario is negative equity, in which the value of the home drops below the outstanding balance on the mortgage -- a distinct possibility for those who win bidding wars just prior to a market crash.

"With negative equity, you don't own a home," Hamilton says, adding if the home's value drops tens of thousands of dollars below the loan's bal­ance, it can mean losing the asset entirely. "The market has kicked you in the teeth and now you have to make a decision whether you walk away from it and the implications to your credit rating." Here in Winnipeg, however, the likelihood of being in negative equity is much slimmer than in Alberta or British Columbia, Sparrow says. But homeowners should still pay attention to their cur­rent borrowing costs, including car loans, lines of credit and credit cards. They might even consider refinancing.

"If we can put all of that into one very manage­able payment by using the equity in their home at a 3.7 per cent interest rate, they are ahead of the game," he says, adding it might even make sense if they are required to pay a penalty to break the current mortgage.

"We had a client who had a $7,000 penalty, but over the course of the next two and half years, we are going to save them over $14,000."

Even if refinancing isn't possible, the status quo in Winnipeg is still better than a rent-and-invest strategy -- particularly in this volatile market climate.

"Why pay someone else's mortgage payment for them when you could be paying yours for your own home?" Sparrow says. "While there are other added costs to home ownership, at the end of the day, there are so many more benefits to it."

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Houses by the numbers

Below are two different scenarios using the rent or buy calculator on the Office of Consumer Affairs website. The first shows when renting makes more sense, while the second demonstrates the benefits of home ownership. Keep in mind the calculator is not an accurate measure of all variable costs that go into home ownership and rent­ing. It only helps illustrate some of the costs. It also assumes that the renter uses the down payment that would have been used for a home, and any additional savings from renting rela­tive to owning a home, and invests in equities.

Scenario #1 -- Renting and investing wins

Funds available for real estate (down payment) and/ or investment: $25,000

Disposable monthly income available for housing (monthly mortgage) or investing: $2,535

Estimate of the long-term inflation rate: 2.5 per cent

Estimate of after-tax return on portfolio investments: 7 per cent

Input related to the purchased residence:

Annual equivalent (APR) mortgage rate: 7 per cent Down payment: $25,000 Months until maturity, amortization period (max 360): 360 (30 years) Monthly expenses for pur­chased residence: $400 Expected (after-tax) return on real estate: 3 per cent Market value of the pur­chased residence: $375,000

Input related to the rented residence:

Monthly rent: $1,400 Monthly expenses associ­ated with the rental: $300

Total Wealth, Real Dollars

If savings are all reinvested, total wealth in real dollars is: Buying a home:

Year 5 -- $93,510.36 Year 10 -- $175,237.37 Year 15 -- $273,256.15 Year 30 -- $711,286.02

Renting and investing:

Year 5 -- $94,512.33 Year 10 -- $192,006.98 Year 15 -- $328,748.26 Year 30 -- $1,166,799.30

Rent and invest strategy earns $455,513.28 more.

Scenario #2 -- Home ownership wins

Funds available for real estate (down payment) and/ or investment: $10,000

Disposable monthly income available for housing (monthly mortgage) or investing: $1,163

Estimate of the long-term inflation rate: 2.5 per cent

Estimate of after-tax return on portfolio investments: 6 per cent

Input related to the pur­chased residence: Annual equivalent (APR) mortgage rate: 6 per cent Down payment: $10,000 Months until maturity, amortization period (max 360): 300 (25 years) Monthly expenses for pur­chased residence: $300 Expected (after-tax) return on real estate: 3 per cent Market value of the pur­chased residence: $200,000

Input related to the rented residence: Monthly rent: $1,000 Monthly expenses associ­ated with the rental: $200 Total Wealth, Real Dollars

If savings are all reinvested, total wealth in real dollars is:

Buying a home:

Year 5 -- $ 36,662.12 Year 10 -- $66,751.49 Year 15 -- $100,557.12 Year 30 -- $ 226,461.84

Renting and investing:

Year 5 -- $ 10,811.28 Year 10 -- $ 11,896.96 Year 15 -- $ 13,349.84 Year 30 -- $ 21,377.93

Home ownership strategy earns $205,083.91 more.

-- Source Office of Consumer Affairs