MORTGAGE ESSENTIALS: TO LIVE OR INVEST?
For most, buying a home is the biggest expense and a major piece of an investment portfolio
“All things considered, the third- best investment I ever made was the purchase of my home.”
— Warren Buffett, in his March 2011 annual letter to shareholders.
Vancouver homeowners can be forgiven for thinking they’ve won the lottery. House prices have nearly tripled in the past decade and those who successfully timed the market have earned chortling rights. Long- term owners who bought their homes in 1987 for $ 200,000 could sell them today for $ 900,000 or more; a gain in the order of $ 700,000 or 350 per cent!
But view those numbers like an investor would and a different picture emerges. The annualized return over the 25 years is just 6.2 per cent and that doesn’t take into account annual inflation of 2.4 per cent ( as calculated by the Bank of Canada). Nor does it factor in the costs associated with home ownership, such as maintenance, repairs, renovations, property taxes and insurance. Consider too that the interest charges for a conventional mortgage with 25 per cent down, a 25- year amortization and monthly payments at a rate of 4.2 per cent will amount to $ 122,150. Finally, there’s the opportunity cost of the $ 50,000 down payment.
For instance, the down payment could have been invested in stocks. A portfolio that tracked the S& P/ TSX composite index in the same time would have returned 6.1 per cent per annum with no costs other than a modest management fee for an index fund, typically less than one per cent.
One argument in favour of purchasing a home is you can’t live in a stock portfolio. The amount spent on rent for comparable accommodation will likely approximate the monthly mortgage payment, the only difference being that rent pays off someone else’s mortgage rather than your own.
Besides, the stock market is seen as more speculative and volatile than a house in a good neighbourhood. Between 1985 and 2005, the annual inflationadjusted return of a Metro Vancouver house was 5.38 per cent, compared with 5.47 per cent for stocks. However, the standard deviation for stocks — a measure of their volatility — was 16.6 per cent, more than double that of the house.
Still, like every other market, real estate can have its ups and downs. In a report last year, BMO Capital Markets identified four major price corrections in the Vancouver market: 36.1 per cent from the second quarter of 1981 to the fourth quarter of 1982; 14.4 per cent from the first quarter of 1990 to the first quarter of 1991; 20.2 per cent from the first quarter of 1995 to the fourth quarter of 1996; and 13.1 per cent from the second quarter of 2008 to the first quarter of 2009.
Another negative for the owner- occupied home as an investment is that it is immovable and illiquid. While a poorly performing stock can be sold and replaced in minutes online, a house can sit on the market for weeks or months before an acceptable offer materializes. When it does, there are commissions, often about five to six per cent of the purchase price, and legal bills, to pay.
Unlike stocks, the capital gains on the sale of a principal residence are tax exempt, a benefit of about $ 150,500 using the example at the top of this article. Capital gains on the disposal of stocks are taxable unless they are held in a registered retirement savings plan or a tax- free savings account.
All that being said, investing is not only about chasing yield; it’s about efficient portfolio allocation to minimize the volatility of returns for any given targeted return. In a 2006 paper, Tsur Somerville, associate professor of real estate finance at UBC and director of the UBC Centre for Urban Economics and Real Estate, argued that for most investors, B. C. real estate should form at least 50 per cent of an investment portfolio that also includes Canadian equities and bonds.
Somerville says owneroccupied housing should be considered in the same framework as other investments because it displays the same risk- return trade- offs. It follows buyers should choose a property that is optimal for investment purposes, which might not always coincide with one’s ideal of a “dream home.”
Given that one of the chief objectives of asset allocation is to reduce volatility, it seems appropriate to opt for a fixedrate mortgage. There is enough variance in real estate markets without the added concern of fluctuating interest rates.
It is important to recognize the interest cost on borrowing for investment purposes is tax deductible, but the interest cost on a mortgage is not, a significant difference from the United States, where it is. At today’s low interest rates, B. C. homeowners might be inclined to let the mortgage run its course and invest savings in RRSPS or other financial products. An investor, however, is more likely to eliminate that nondeductible debt as quickly as possible. In the same vein, an investor would hesitate to refinance a mortgage ( i. e., take out a second mortgage) or draw down a home equity line of credit unless the borrowing could be so arranged as to meet the Canada Revenue Agency deductibility test of being for the purpose of earning business or investment income.
The notion that one’s home is an investment vehicle rather than a consumption good is a relatively recent concept and it’s not one that sits comfortably with many homeowners. People buy houses to settle down, start a family, raise children and become part of a community. It’s where we conduct the business of living our lives. A house is more than a store of wealth, one homeowner opined, it is a store of memories.