It’s that time of year when some students are thinking about where to live next year. Students with a bit more imagination think about buying a place and renting it out.
I asked some related test questions during the Fall term and many of the answers by REH students show a deep commitment to the industry. The answers also indicate that the analytical skills are not as deep as I had hoped: some students asserted that owning a property is always better than renting. Given the importance of this question and the fact that it touches on many other conceptual and practical, it seems worthwhile to discuss and unpack the ideas in a couple of posts.
In round numbers, the monthly rent for a bedroom in Guelph is about $450. The alternative is to buy a house and rent it to a bunch of friends. That revenue can be used to pay for the various expenses of being a landlord. So, is it easy?
The first step would be to search for the right kind of house.
So, a price of about $300,000 should be about right.
Most students have little savings and not a great credit history. So there will be a high loan to value ratio (say 95 percent or $285,000). The day that you meet the mortgage officer is too late to check your credit record (, ) or improve it; the bank is unlikely to offer a discount. So, suppose that the interest rate is 4.00 percent. (There will also be a mortgage insurance premium embedded in the mortgage but we will ignore it). Using the calculator in Excel, the monthly mortgage payment is $1499 (using a 25 year amortization with the Canadian policy of semi-annual compounding; Excel cannot do that calculation without extra work, so I will use the simpler number of $1504 in this demonstration).
Unlike renters, owners are liable for property taxes. For residential properties in Guelph, the current total tax rate is 1.26 percent of the assessed value (which, in theory, would be the market value of $300,000).
Owners are also on the hook for basic utility costs (heating, water, electricity). Suppose that is about $150 per month. It is possible to reduce the utility costs by turning down the room temperature or to take short or cold showers. But, the tenants may not be less than enthusiastic if the goal is to increase your profit.
So, what are the monthly costs?
- Mortgage payment 1504 (of which the repayment of principal would be $554)
- Property Taxes 315
- Basic Utilities 150
- Total 1969
Some people will note that this calculation does not recognize the possibility of capital gains. Or the cost of your time or risk.
A good owner would also perform regular maintenance expenses to maintain the resale value (if only to avoid costly emergencies). (Can you can save by doing the work yourself?)
This calculation is also something like a best case scenario in the sense that everything goes as expected.
- What if your tenant/friend gets laid off from his part time job and cannot pay the rent for a couple of months?
- What if he or she leaves school and sublets to somebody they found on kijiji? Do you know about the tenant from Hell?
- What if the furnace needs replacement or the plumbing breaks on the night when you thought that you could be studying for that big test?
- How long until the roof needs to be replaced? (You did remember to set up a capital reserve account for those expenses, just like they taught in ACCT 2200, didn’t you?)
- What if there is a power failure throughout the city?
- What do you do during the summer to prevent break-ins and vandalism, even after you pay for home insurance?
- Who mows the lawn or shovels the sidewalk?
Let’s call it the equivalent of $200 per month.
If these costs are split four ways in this four bedroom house then the break-even rent is $492. If you (the owner) were planning to live rent free then the break-even rent is above $700.
Still, the big hope is that price increases create equity without any effort. History has shown this effect to be significant. It is also debatable since, as stock brokers say, “past performance does not guarantee future returns.” Hopefully, future performance will be enough to overcome the fees normally charged by a real estate agent and the lawyer fees and that the price will peak on the specific day that you graduate and sell your university residence.
Because the loan-to-value ratio is 95 percent, the RoI could be great if house prices rise. Leveraging an investment in this way can increase the RoI but it also magnifies the risk: it would take only a 5 percent drop in prices to put you “under-water”, where the mortgage is worth more than the house.)
So, this vaguely good idea that buying a home is a source of easy money looks not so easy when converted into the hard numbers of a financial statement. Some people have the skills to make it work and some people get lucky. Others aren’t or don’t. If it is shocking then that shock is, of course, the reason to look at the numbers before making any big decision. This spreadsheet allows you to vary these numbers as you please, to decide which category you fit into. Later postings will discuss these concepts in greater depth and link them to other issues.
PA, with help from JL