At some point in life you’ve probably been faced with the difficult decision to rent or buy your home. In many cases the decision isn’t so clear. With owning your own home, you’re building equity instead of lining the pockets of a landlord, but at the same time you’re making a decision that’s a lot harder to reverse, as well as burdening yourself with a significant downpayment and significant debt. With renting you’re missing out on what has arguably been the greatest source of wealth creation for the middle class in the last 50 years, but you’re obviously not tied down, financially or locationally.
If you talk to a financially minded person, they’ll likely tell you that you can crunch the numbers to determine if it makes more sense to rent or buy. What’s the monthly rent vs monthly mortgage payment and costs of ownership (taxes, maintenance, utilities, and insurance)? Maybe factor in a view on property prices down the line and you’ve arrived at two numbers you can compare. This approach, while simplistic does provide many with an answer. But I’ll argue that in many cases, there’s actually a third option that would make the most financial sense – buying and renting at the same time.
Now when I say buying and renting, I’m not referring to buying and renting the same property. What I’m talking about is a sort of market arbitrage where you rent in the market that you want to live in and buy in a market that offers higher rental income potential. This strategy tends to work if you live in bigger cities where properties are often more expensive and rental yields often lower. Let me illustrate with my own personal example of how I pursued this rent and buy strategy and walk you through the pros and cons.
In 2011, I was working in downtown Toronto and I wanted to live close to the office. My budget meant that I was looking at renting or buying a small one bedroom apartment. It would have cost in the neighborhood of $300,000 to buy the apartment I was considering or about $1,350 per month to rent. Given interest rates at the time of roughly 3% for a fixed 5 year mortgage, I was looking at about $1,150 a month in mortgage payments. Add in the condo fees, taxes and insurance and I was at about $1,600 cash out of pocket each and every month. If you look at an amortization table, I would have been paying down the mortgage by about $550 per month in the first year, so on the surface it would seem I would have been better off buying ($1,050 per month vs the $1,350 had I been renting). But this obviously neglects to consider the downpayment plus closing costs (estimated at $70,000) that I would have needed to buy the property. Assuming I could have made 5% a year on this investment, that equates to almost $300 per month in lost opportunity cost. So now it would appear that from a financial perspective these options were similar (ignoring property appreciation – more on that below).
| Rent | Buy | |
| Monthly Cash Flow | ($1,350) | ($1,600) |
| Monthly Mortgage Principal Payments | - | $550 |
| Investment Required | - | $70,000 |
| Investment Opportunity Cost (5%) | - | ($300) |
| Net Monthly Impact | ($1,350) | ($1,350) |
Now this simplistic analysis ignored appreciation. The reality is that looking at the Toronto market, that same apartment probably appreciated close to 15% over the last 4 years. Since that’s all upside on the equity, that would have meant an increase of $45,000 over the 4 year period, or just over $900 per month. There are a couple of reasons I don’t factor in price appreciation in my analysis. For one, that price appreciation has also likely impacted the next property you plan to buy in that market (unless you’re moving cities), so it’s not something you’ll likely pocket – especially once you factor in the buying and selling costs which can easily wipe out any gain. Also, nobody knows for sure where the market is going, so while it went up in this case, the housing crash in 2008 highlights that’s not a foregone conclusion.
So from this simple analysis, it seemed I should be relatively indifferent to buying or renting (although less tied down with renting). So what did I do? Instead, I invested in a property in Windsor, Ontario. Prior to buying this property, I had never been to Windsor (about a 4 hour drive from Toronto), nor did I have any real reason to. The property in question was a nice single family home in downtown Windsor – the equivalent of which in downtown Toronto would have probably cost somewhere in the neighborhood of $2-3 million. So I was shocked to find that this particular property was being sold for $105,000. What’s more, with a little bit of investment ($3,000) to fix a few things up, I was able to rent the property for $2,450 per month (inclusive of utilities)! Now if you do the math on that, I was actually making roughly $1,000 in cash flow after costs (and mortgage payments) each month!
| Rent Toronto | Buy Toronto | Buy Windsor | |
| Pre-Tax Monthly Cash Flow | ($1,350) | ($1,600) | $1,000 |
| Monthly Mortgage Principal Payments | - | $550 | $200 |
| Investment Required | - | $70,000 | $30,000 |
| Investment Opportunity Cost (5%) | - | ($300) | ($125) |
| Taxes Owed (39%) | - | - | ($475) |
| Post-Tax Monthly Cash Flow | ($1,350) | ($1,600) | $525 |
| Net Monthly Impact | ($1,350) | ($1,350) | $600 |
Now, my analysis would not be complete without factoring in taxes. The reality is that the income from my property would be taxed at my marginal income tax rate, so that $1,200 per month in income ($1,000 net pre-tax cash flow plus $200 debt paydown) was actually more like $525 post-tax (or $600 considering the opportunity cost). If I was able to scale my Windsor investment up to the same $70,000 that I would have invested in the Toronto apartment, I would have roughly offset the cost of renting in Toronto! Put another way, instead of my post-tax cash-flow being negative $1,350 or $1,600, it would have been roughly 0.
The math behind analyzing this strategy of buying in your home market or in another market is relatively straightforward. Ignoring home appreciation (it also seems everybody has their own views of home prices in their own markets), it becomes simply a matter of comparing capitalization rates between markets. The capitalization rate is the ratio of pre-financing income to the cost of the property. For the property in the other market, you need to make sure to consider vacancy rates, but you can ignore this for the property you would plan to live (since your own vacancy is 0). In my example, the capitalization rate for my Windsor property would be roughly:
($1,000 cash flow + $200 mortgage payment) * (1 – a vacancy rate of ~10% for Windsor) * 12 months / ($105,000 purchase price + $3,000 improvements) = 12.0%
The apartment in Toronto would have had a capitalization rate of:
($1,350 gross rent – $450 in costs such as condo fees and taxes) * 12 months/ $300,000 purchase price = 3.6%
To compare which provides a better deal, simply multiply the capitalization rate of the more lucrative market by 1 – your marginal tax rate (so in my example, 12.0% * 0.61 = 7.3%), and if this is greater than the capitalization rate in your home market (in my case the 3.6%) then you may want to seriously consider this buy and rent strategy (in this case there is obviously a big difference).
I do want to caution, however, that there are a lot of things to consider that I may have skimmed over or not mentioned. For one, it can be difficult to manage a property remotely and so a good property manager is vital (but is also a cost that needs to be considered). Also as mentioned, appreciation is something that can dramatically alter total returns, but for reasons mentioned aren’t considered in this analysis. You should take the time to develop a good understanding of the market you’re considering investing in as general market and rental dynamics can change significantly over time. Furthermore, there may be other tax incentives to owning your own home.
Lastly, I do want to highlight that although a 12% cap rate property is not terribly common, it is still relatively common to find very attractive cap rates in smaller markets that can make this strategy pay off. For Canadian investors, take a look at our recent 5 Year Canadian Residential Real Estate Returns (2010-2015) report for an idea of cap rates in different markets. If you do decide to invest in real estate, I also encourage you to give our real estate analysis software a try. It’s free for up to 3 reports on any properties in North America and can help set return expectations.