The question of whether to buy a house is best answered by looking at the
reasons for buying a house. There are two basic reasons for purchasing a house:
1) to provide shelter and accommodation and 2) as an investment, to provide an
investment return through rental income and capital appreciation.
The question of shelter is easily answered. If you are considering
buying a house, decide on the type of house that you would like to live in. Say
you want a certain neighbourhood because of the quality of life, the schools for
the kids and the access to highways and rapid transit for commuting to work.
Have a look around for a house for rent that meets your needs. If there aren't
any, it's obvious that you have to buy a house to meet your shelter
requirements. However, if you are reasonably flexible, you should be able to
find a house for rent that is suitable. Compare the rent on this house to the
mortgage payment, taxes and maintenance costs that you would have to make if you
bought this house or a similar one.
For example, let's say that you've found your dream house on Easy Street in
the beautiful Hills of Richmond and you can buy it for $245,000 or rent it for
$1,700 per month. Let's compare the two options. With a down payment of $45,000,
you'd have a mortgage of $200,000. At current rates of around 7%, the monthly
mortgage payment would be approximately $1,200. Taxes would be about $1,800 per
year, which works out to $150 per month. So the total monthly cost of buying
would be $1,350 per month plus maintenance costs. Adding in a $250 monthly
maintenance cost, the total monthly expenses would be $1,600 per month. If we
wanted to be exact, we would recognize that the $45,000 down payment could be
left in the bank and earn an interest rate of 5% in a GIC which would be $2,250
per year before tax and around $1,200 after tax, or around $130 per month. This
would offset our rent, so our total rental cost would be $1,700 less $130 or
$1,570 per month. Thus, the rental cost of $1,570 per month is pretty close to
the total monthly cost of $1,600 of purchasing the house.
It looks like the cost of buying a house is pretty close to the cost of
renting. This is one reason that the housing market is booming in the summer of
1996. Mortgage interest rates are at their lowest levels in years and housing
prices have not really started to recover from their 30% price decline between
1990 and 1996.
This brings us to the second reason for buying a house, the investment
potential. As in all things financial, cash flow is king. If an investor can
buy a house and rent it out for more than his total costs, he will buy the
house. As we have seen, housing prices have combined with low mortgage rates to
make the rent from a house fairly similar to the mortgage cost. If the investor
charges a higher rent or takes a shorter mortgage term with a lower interest
rate and lower payment, the house will almost "pay for itself". This
puts a significant floor under housing prices, and has helped to stabilize the
market in the last year or two.
This compares to buying being far more expensive than renting in the peak
years of the housing market in 1988 and 1989. It was not uncommon for a house
valued at $400,000 to be renting for only $2,000 per month. Mortgage rates were
high, almost double the current level, meaning that the rent should have been
well above $4,000 per month to cover the mortgage. In this environment, however,
house prices were increasing on a daily basis.
People were diving into the housing market and talking up their successes at
cocktail parties. People seriously believed that if they did not buy a house
they would never be able to afford one. Whenever someone pointed out the great
disparity between rental rates and mortgage carrying costs, the response was
that housing was not like other things, it had a "special value".
Financial experts were advising that buying a house, because of its tax-free
capital gains, was the best thing for one's financial health (they didn't
mention the possibly of a capital loss just before the 30% decline). Now housing
prices are down considerably and some financial experts are suggesting renting
because of "baby boomer demographics". They paint a spectre of looming
overhang of baby boomers wanting to sell their monster homes all at the same
time (and retire from their earnings in the stock market!). On a cash flow
basis, buying has seldom been more attractive.
This shows that psychology has an important impact on housing values. When
something is going up in price, market participants and experts find reasons why
that should be the case; when something is falling in price, experts justify why
that should be the case. Most times it pays to be a contrarian and go against
the grain of market sentiment. Where were all these persuasive demographic
statistics at the market peak in housing prices? The real support comes from, as
with all investments, the cash flow characteristics.
Should you buy a house? If you need one for accommodation and find one
reasonably priced versus renting, it is probably not a bad time.
As in all things financial, get a variety of opinions. Talk to your banker,
your real estate agent and anyone else who can shed light on the subject. Good
Luck! |