The Wealthy Renter. Alex Avery

PaysOwner Pays

      It’s cheaper to rent a home as a renter than it is as an owner. Sometimes a lot cheaper.

      Paying rent to a landlord is just a cleaner and simpler way of paying for the use of a home, compared to separately paying all of the costs outlined above. Homeowners are cutting out the middleman and paying all of the expenses relating to the home directly, including the interest payable when they borrow the money to purchase the house.

      Now here’s an amazing thing about renting: It’s cheaper to rent a home as a renter than it is as an owner. Sometimes a lot cheaper. There are a number of reasons, and we’ll discuss many of them throughout this book, but they include the fact that renters usually rent smaller places than owners buy; many rental homes in Canada are older than owned homes, and often that means fewer modern features; landlords are more practical and financially disciplined when they spend money on maintaining and renovating rental housing; and landlords often undercharge on rent because they

      *Average two bedroom monthly rent compared to average monthly mortgage payment, based on average home price, 5% downpayment, and a 2.4% mortgage rate with a 25 year amortization. Source: CMHC, 2013.

      expect to make up the shortfall when the property goes up in value (which doesn’t always happen).

      It’s true — in every major city in Canada, it is cheaper to rent a home than it is to buy a home.

      What about when a homeowner pays off their mortgage? Are they still paying rent? Doesn’t the cost of home ownership drop off substantially once there are no more mortgage payments? In fact, the costs of home ownership don’t go down when a homeowner pays off their mortgage. Not even by a penny!

      What does happen is that the mortgage payments, which were a part of rent, disappear, but they are replaced by an “implicit” rent. The implicit rent isn’t a payment that has to be made; it’s a payment you make to yourself.

      Just like maintenance, it’s a very difficult number to figure out, and it can change significantly over time. And because it’s not a number you can see each month, it’s dangerous. If you don’t keep track of implicit rent, it can sneak up on you and become much larger than you’d ever imagine.

      To understand implicit rent, think about it this way: When you buy a house, you take on a large mortgage, and over a long period of time you pay it o

      The amount of income you haven’t earned because you’ve owned your home instead of investing in other things is implicit rent.

      ff. When you do that, you’ve actually done two things. First, you’ve saved up a lot of money over a long period of time, and second, you’ve lived in a home.

      If we separate these two things, you can look at the act of saving up a whole lot of money and look at other things you could do with all that money. You could buy bonds or dividend-paying stocks, or you could buy a rental property. All of which would pay you a regular income. All that money you would have tied up in owning that home could provide a lot of income,

      TABLE 4.2

	Renter	Mortgaged Owner	Unmortgaged Owner
Primary Form of Rent	Rent	Interest	Opportunity Cost
Primary Rent Paid:	to Landlord	to Bank	to Self (and Consumed)
Other RentsMaintenance:	Landlord Pays	Owner Pays	Owner Pays
Property Taxes:	Landlord Pays	Owner Pays	Owner Pays
Utilities:	Landlord/Renter	Owner Pays	Owner Pays
Insurance:	Landlord Pays	Owner Pays	Owner Pays

      and you are entitled to that income because it would be your money. That income — the amount of income you haven’t earned — is the “opportunity cost” of owning your home instead of investing in other things. And that is implicit rent.

      The amount of rent you pay to live in a home doesn’t depend on whether there is a mortgage or not. It depends on how much the home costs. What changes as a homeowner pays down their mortgage is they gradually shift from paying the bank rent to paying themselves rent.

      With the various ways homeowners pay rent, it’s easy to lose track of the total amount of rent there is for a home. What makes it most difficult is the implicit rent.

      Try this: Ask a home-owning friend how much their house is worth. You’ll find that 100 percent (or pretty darn close) of your home-owning friends will have a pretty good guess.

      Now ask them another question: How much implicit rent are they paying to live in their house? You’ll get nothing but puzzled looks. Maybe 1 percent of friends will even take a guess at this number.

      Implicit rent is an opportunity cost, so the cost depends on what alternative investment opportunities are available.

      Now ask it another way: How much could they rent out their home for? You’ll get more answers, but probably half will still have no idea, particularly if they live in a neighbourhood full of homeowners.

      Ignorance is bliss.

      Ask these questions of anyone who owns a home and lives in an expensive city, like Toronto or Vancouver, and then show them how to calculate the number. Once they do the math, they will be shocked by how much implicit rent they are paying.

      Here are a couple different ways to calculate implicit rent. Depending on how you calculate it, you’ll get slightly different answers. Implicit rent is an opportunity cost, and because it’s an opportunity cost, the cost itself depends on what alternative investment opportunities are available. To figure out exactly what the cost is, a homeowner needs to actually change the way they are living — they need to sell their house, rent it out, remortgage it, or somehow otherwise invest the money they have tied up in their home in another investment.

      First, how much implicit rent would a homeowner pay if they were to mortgage 100 percent of the value of their house?

      To calculate this, take a guess at what the home is worth and multiply it by the mortgage rate you can get from your local bank. Any bank website will have posted mortgage rates. For instance, CIBC is currently offering a five-year, fixed-rate, closed mortgage at about 3 percent per year.

      So, for an $850,000 house in Toronto (currently a below-average detached house price), the monthly interest is equal to the price times the mortgage rate, divided by twelve months in a year: $850,000 × 0.03 = $25,500 ÷ 12 = $2,125 per month. (Note that this calculation includes only the interest, or “rent,” portion of mortgage payments.)

      This will easily be the lowest estimate of the cost of implicit rent because mortgage lenders in Canada offer very low rates of interest, since Canada subsidizes mortgage rates through its sponsorship of CMHC. This estimate will also be low because lenders don’t actually offer 100-percent mortgages — they almost always want you to put up some money for a down payment. If you borrow the entire amount needed to buy a home, the mortgage rate rises significantly … if you can find someone to lend you all of the cost.

      Another way to figure out implicit rent is to look at other things you could do with your money rather than own a home. For instance, in Canada many investors have felt comfortable investing retirement money in defensive dividend-paying stocks, including banks, insurance companies, telecom and cable companies, REITs (real estate investment trusts), and pipelines. Let’s assume an investor invests in a portfolio of large, well-known dividend-paying stocks in Canada, generating an annual yield of 4.5 percent.

      Under this scenario, a homeowner could estimate implicit rent by multiplying the house price by the yield on a basket of stocks and dividing by the twelve months of the year: $850,000 × 0.045 = $38,250 ÷ 12 = $3,187.50 per month.

      If you aren’t comfortable with investing in individual stocks, you could consider using the yield on the S&P/TSX