July 28, 2020

I recently watched a YouTube video “Renting vs Buying a Home: The 5% Rule by Ben Felix”. I thought that was pretty interesting as the conventional wisdom is to always buy a home and not rent.

As real estate prices are going through the roof, is it possible that we should rent instead of buy in some scenarios? Is the 5% rule true? And how can it be applied to you?

In this video, I dig deeper into the 5% rule proposed by Ben Felix.

My goal is to find out exactly how much dollar value in rent you should “endure” before you go buy a home.

In this video, you will learn:

  1. What the 5% rule is?

  2. What is the average rent per state?

  3. What is the opportunity cost for not investing in real estate?

  4. How should you think about capital appreciation in real estate?

  5. What should you do if you make 30% from the stock market?

  6. What is the “tipping point” between buying real estate and renting?

Before I made this video, I had no idea what I was going to find!

90% correct transcript

So recently, I came across an interesting video called "Renting Versus Buying: The 5% Rule" by Ben Felix. And he's a CFA and a portfolio manager. So I thought to myself, wow, this is actually quite interesting. I watched a whole video until the end. I took notes. I watched the video again, and I thought to myself, well, is it possible to make a more specific video? Is it possible to dig a little bit deeper? So then we can get more insight out of the 5% rule. So then you can better understand whether you should buy or rent when it comes to housing. So my name is Eric Seto and I'm a CPA I've been investing for over 10 years. And I tried a lot of things that worked and didn't work as well. Before we start, I just want to celebrate another success story in Investing Accelerator here.

John made 33% from MMM in eight months. So congratulations, John for making 33% in eight months from MMM that's a great investment. Now, what is the 5% rule? And does that apply to you now? This principle is actually quite simple. It is: If the value of your home or the home you want to buy x 5% divided by 12 months is greater than your rent. Then you should rent. Now the vice versa is true. So it means that if 5% of the value of your home divided by 12, so it's monthly, is less than your rent, then you should buy a home. So it's actually quite a straightforward rule. And if you didn't watch the video, I'll just quickly summarize for you. Basically, you're trying to evaluate between the cost of renting versus the cost of owning a home. Now, the cost of renting is actually a fairly straightforward, as discussed by Ben, Felix, it is the rent, duh.

I mean, that's very straight forward, but the cost of owning a home, it's actually tricky. And in his video, he broke it down into around four components. The first one is property tax, which he used an assumption of 1%. Okay. It's fairly straightforward. Maintenance costs for the property. And he used an assumption of 1%. Okay. So that's 2% now. And then, mortgage payments, which is the interest rates on your loan is 3%. That is his assumption as well. So this total to around 5%, he also goes into the discussion of whether you could have took the same amount of money and invest in the stock markets that perhaps you can make a higher return. So in that video, he used 1.3% as the return for real estate globally, Net of inflation, and then 5.2% for on a stock markets globally, Net of inflation. So once you do the math, then you will find that the opportunity costs is around 3%.

So in his video, the assumption is that it doesn't really matter where you put the money towards stock or real estate because the cost of capital or the opportunity cost is the same as the mortgage payment. So that's what he's really saying. If you're a little bit confused about opportunity costs, don't worry. We'll actually dive a little bit deeper into this concept because that's actually what majority of this video is about. So let's get started, let's figure out, is it true? Let's figure out where we can take a little bit deeper. When I first started making this video, I have no idea what is going to happen. I have no idea what I'm going to find. So these are the questions that I have before I start, you know, what is the average return for real estate? And I want to know this by state because I'm quite interested to know whether some States are better than another.

Would it make more sense to rent in some States or provinces than others? Now for this analysis, I actually focused on the U S markets, even though I'm Canadian. But so for Canadian folks, you can apply the same logic to Canada. What is the average price increase of real estates by States? And what happens if you use leverage in this case, a mortgage? What about the opportunity costs you gain from the stock markets and what happens if you make 30% a year from the stock market and how does that impact your decision? So I went online and I searched, you know, what is the average price increase for real estates for the last 20 years? So this goes from 2000 to 2019. Now, when you're buying a house, you're living in it, I assume you're not going to be renting a portion of that house out or like a bedroom or two bedrooms out.

So then all you're really getting is the capital appreciation that increase in price of the house over many years now here, I actually sorted it. And you will find that district of Columbia, DC, Hawaii, California, Florida, these have the highest percentage increase in terms of real estate prices and Michigan, Ohio, Illinois, Indiana have to lowest increase in terms of real estate prices. So when you think about it, if you are living in the States on the left hand side is actually much more advantageous to invest in real estate. And it's much easier to make a profit in real estate over the last 20 years on average. So that's the first analysis, very easy to understand. Afterwards, well, I was wondering the inflation rates that was used in Ben Felix video, is it right? So then I went and searched up the last 20 years of inflation for United States and it's around 1.7%. And this data is from the organization for economic cooperation and development. So it is a fairly credible source. The next assumption that Ben Felix has was well, the global real estate return is 1.3%. Now that seemed kind of low to me because I'm from Vancouver and for Vancouver, real estate is crazy. You know, I know about Toronto, Toronto real estate is also going up quite quickly. And if I'm looking at places like California, San Francisco, San Diego,

Hong Kong, New York, all of these places,

The return is actually higher than 1.3%. I'm actually quite surprised that is the assumption. So again, I wanted to check. So I went ahead and calculate the average of real increase in real estate prices. Now, the graph that you saw previously did not adjust for inflation and the graph you see right now, it's actually adjusted for inflation. So here you'll see that the return is actually slightly lower. And for some States, because the increase is so low, that it is actually negative. Now on the left hand side, the green bars you see are all positive and above average, the 1.3%. And on the right hand side, all the blue ones are below average. So that means it is much better or more advantageous for you to invest in real estate because you're getting above average return in those States. Again, D C Hawaii, California, Florida, Nevada, Washington, Oregon, Arizona.

And you can just go through the list and pause the video. And on the right hand side, you'll actually fly three States for the last 20 years, have an average decrease in housing price, which is Michigan, Ohio, and Illinois. And some of them are kind of close to 0%, which is Indiana, Connecticut, West Virginia, Mississippi, and Alabama and so on. So now, you know, when you're watching this video, you can actually look at the state that you're living in and understand where you stand relative to everyone else. So that's quite useful I think. Moving on! The next assumption, I wanted to kind of figure out and find data for is the mortgage rates. And 3% seems actually fair, fairly reasonable to me. That's what I think it is in Canada as well. So I wouldn't be too surprised if that is the same.

So I went on Google and I found a site called Value Penguin, and they have the average us mortgage rates for July 22nd, 2020. So I just grabbed that data down by state. And here, you're going to see that the mortgage rates ranges from 3.6, 5% all the way to 4.2%. Now you will see that the way I sorted this graph is actually consistent with before. So then what this allows you to do is you'll always remember the left hand side is the highest real rate of return or price increase for real estate by States. And on the right hand side is the lowest. So you can see that for the mortgage rate, there's actually no correlation or at least not a very strong one when it is compared to the price increase. So for a place like DC, Hawaii, the price increase is higher, but then the mortgage rate is around the same, even though Michigan has a negative increase in housing price.

But the mortgage rate is still around 3.8% or so. So that's actually quite interesting and I keep this sorting method on purpose. So then you can keep that in mind and you can make that quick observation in a very short amount of time. So now the next one is well, okay. When you are investing in a piece of real estate, there are two parts, your equity, which means the down payment you put in and the principal you pay off over time. And also the part where it is leveraged. Now, what I was interested in is, well, if you're using leverage, does that actually impact your return? And are there situations where you get a negative return when you're using leverage. Now, this might be the case where Michigan, Ohio, and that was very intuitive because the price is dropping to start with.

So if you deduct mortgage on that, then you're going to get a negative return. So then what I did was I took the return and minus the mortgage rates. And this is what I get. You will see that a lot of States now are negative. And on average, it is around a negative 0.9% across the board with only a handful of States are still positive in terms of return when you are using leverage. Now, one thing I want to note here is that this return is calculated using the price increase before inflation minus the mortgage rates. And I thought about it many times and that's actually the one that makes sense because you're using borrowed money. So the person who is lending you, the money will actually have to deduct the inflation. So let me know if you have any problem with this technical part.

So what is the benefits of leverage? Like I said earlier, when you are investing in real estate versus stocks, there's actually a slight difference. Most people, when they invest in stocks, they use cash and not leverage. And that makes a lot of sense because people think stocks are riskier, right? So they use all cash. Now, most people, when they invest in real estate, they get a mortgage because the prices are so high. So it is very rare for some PE people to invest in real estate without a mortgage. That means the dollar value of you investing in a real estate property might be, you know, 500,000, 600,800,000. But the amount of capital you in is not necessarily 800,000. The amount of capital you put in might be 20% like 160,000. This is actually very common in Vancouver, most people, when they invest in stocks, you're not going to put $800,000 in stock, especially when you only have $160,000 in stock.

So when you're evaluating between renting versus buying, you actually, need to take that into consideration because you're going to be borrowing a bunch of money that you may make money on. And of course you will make money on the, your own equity and your down payment, but you also make money on the leveraged money, the borrowed money, the mortgage. Here you're going to find a diagram of me kind of splitting the value of the home into a couple of parts and it is best illustrated if I draw a blue box box here, you can imagine that blue box is the increase in home value over time. Now the average increase is around 5%. This is before minusing inflation. I'm going to split this into two parts. The first part is your down payment. On the right hand side, you're going to see 5% gain on a down payment, but on the left hand side, you know, to 80% you use a mortgage.

So then you actually need to pay the mortgage interest rate, which we know is around 3 to 4%, depending on where you are. So there's a tiny bit of spread you make when it comes to leverage investing with real estate. And that is the green box you see right now. So when you're analyzing your gain, in terms of investing in real estate, using leverage, you need to think about the down payment, the gain on a down payment, the 5%, which is 20% of your money x 5%, and the tiny spread you get on the 80% of leveraged money. That is your total gain. Now, when you look at this total gain, you're going to realize this number actually changes every year. So that's why it is so tricky to calculate it. If you are good with Excel, you can actually model the whole thing out.

But right now I'm just using the first year to do the math. So then you can see it. So for the remaining of the analysis, I mainly focus on year one. So the next question I had was really what is the median home value by State? Because in order to do the gain calculation I did earlier, I need to know the median home value. Zillow one of the property websites had a median home value by state. So then I downloaded that data and here you're going to see the gray bar charts here. And the average is approximately $250,000. And you will see that actually on the left hand side where the home prices increased the most, have the highest home median, home value as well. And on the right hand side of Michigan and Ohio, Illinois, these have the lowest.

So that kind of makes sense because obviously for the last 20 years, Hawaii, Michigan, California, home prices have been going up and up and up. Now, once you combine what I said earlier, the value of leverage, the 5% gain on your down payment, and you use that and calculate with the median home value. Then you can get the value of leverage here. You're going to see that this is on the 80% side, the 80% mortgage. So this is a spread you can make. So then this is in dollar value now and you can see on average, it is actually negative because a lot of States the price increase for home is not high enough to cover the mortgage. So here are going to see negative for most of the States other than DC, Hawaii, California, Florida, Nevada, Washington, Oregon, Arizona, and so on.

If you combine this with the 5% gain on your 20% mortgage, then what you'll get is your total gain, which will then turn a lot of properties positive again, and here, you're going to see a positive $3,000 per year increase in terms of your property value, less property, mortgage interest, and so on. So that kind of makes sense to me. And this is why people still think you're making a return on real estate. And this is mainly driven on a 5% gain you get on a mortgage payment. Now, if you want to calculate your real percentage gain, because obviously the housing prices in certain States are higher than another. So what you want is really the percentage gain, including leverage minus the mortgage costs, which is just spread and so on. And including your 20% down payment, the percentage gain you get is on average is around 2%.

Now, what's interesting is that if you look at DC, Hawaii, California, that actually has quite a high return on your capital when using leverage. So it's around 20 to almost 40%. And that kind of makes sense to me because when you're looking at leverage real estate investing, and if it increases over time, that's actually what I would expect to get around 30% return. But then at the same time, you actually also see a lot of States that have a below 20% return. Even though they are using leverage, even though there's a tiny, positive spread in terms of leverage money and the actual price increase and you on the right hand side, you actually see a lot of States, almost half the States are negative in terms of return. So this really impacts your decision, whether you should buy or rent. And we're going to explore that further until we get to a dollar amount.

So stick with me here. So let's do a quick recap. Now, the cost of owning a home is really 1% property tax, 1% maintenance, 3% mortgage payment. And when we're looking at the opportunity costs, we should really consider it by state because for some States the price increase is higher. So then the opportunity cost is lower. So on and so forth. The benefits of owning a home, the revised equation, which is more complicated is really 1% maintenance costs. That is a cost minus 1% in property tax. This needs to be net off with the real game you get from leverage and equity, and then you minus the incremental gain from the stock market on your equity. And we're going to ignore that for now. What we're going with is really the real gain you get minus maintenance and property tax. Now here, you're going to see a table and in this table, you're going to see that I use three States as an example, just to kind of illustrate to you what I mean.

So for example, let's look at Utah. Now, the median home value for Utah is $351,000. The average increase before inflation is 3.8%. And a mortgage interest rate is 3.9%, so slightly higher. So when you're looking at the total gain on leverage, plus the equity gain, sort of 5% on your 20% down payment, it's around $7,000 per year for a $351,000 home. If you dent deduct the 2% maintenance costs for property tax and so on, then your net gain is $44 a year. So the outcome here is breakeven in terms of your property value, minus the cost of running the property. Now, if you're looking at DC, which is the best case out of all the States, the median home value is $567,000. The average increase is around 6.9%, which is minus mortgage interest rate to 3.9%. And this gives you a total gain on leverage plus equity gain of $46,087.

Now, if you take away 2% of the home value for maintenance and property tax that equates to $11,356. So your Net gain and loss is really a gain of $34,731 every single year. So that means you should buy a home because the cost of you owning a home is positive. It actually covers our costs. It's a lot now for Michigan, which is on the far right. The median home value is around $154,000. Now the average increase in price is 1.9%. And the mortgage interest rate is 3.9%. So the total gain on leverage plus equity is -$4,698. And the reason is because the average increase in price is not that much. So then when you have an 80%, it's a net loss for you. And if you take away 2% of home value for maintenance and property tax. So that is $3,090. The net loss is $7,788.

So that means if you take that number and divide it by 12, that means if your rent is less than $7,788 per year, which is around $650 per month, then you should rent. If you are paying more than $650 per month for rent that you should get a median home. So that's how you should think about it. And I'm just using the best, neutral, and the worst case to demonstrate these numbers. Now so at this point, we have actually gone through quite a number of questions. We talked about the average return for real estate. We talked about whether it would make more sense to rent it in some States and provinces than others, which is true. And what is the average price increase for real estate by States? And what happens if you use leverage? We talk about that spread. Now, the last thing we need to consider is the opportunity costs that you would gain from the stock markets and what happens if you make 30% a year.

So let me bring you back to the concept. Most people, when they invest in stocks, they use cash and not leverage. And most people, when they invest in real estate, they use mortgage, which is cash and leverage together. So if you're evaluating, whether you should invest in the stock market or the real estate markets, then you really need to compare it to return between the two with the dollar amount. And that is very important. So if I go back to the table, I showed you earlier, Utah, DC, and Michigan, but this time I just add a few more columns at the bottom. And the first one is leverage real estate percentage gain and loss in year one. And I'm just calculating that by taking a net gain and loss $44 divided by the $70,000 and to get the 0% approximately and compare that with stock investing without leverage.

And this will lead to the total benefits of owning a home, because you could have took that down payment and invested in the stock market instead. So you would take the -$3067 and divide it by 12. And you'll find out for Utah, if you buy real estate and your rent is more than $250 per month, then it makes sense for you. So if your rent is more than $250 per month in Utah, then you should buy real estate. And chances are a lot of people are going to pay rent for more than $250 per month. Now for DC, that's the best case. And we said earlier you're still gonna get a net positive gain for owning a home. So you're going to be investing in real estate. And finally for Michigan, the worst case there, if you combined the loss you get from real estate, which is actually negative 25%, and this is calculated on the down payment you put in and you add on the additional 5% of stock market gains that you might lose out, then that's a $9,394 loss each year.

So if your rent is more than $782, then you should invest in real estate for a median home value. In this case for Michigan is around $150,000. So after I checked the numbers again, I actually went and check every single state. And I realized Connecticut is actually the State with the highest net loss. So if you rent more than a thousand dollars a month in Connecticut, then you should consider buying a home and I actually did the calculation for every single state. And here you will see the red chart. And this shows you which States that you should always buy real estate instead of renting. And some of the States, you should actually buy real estate if you exceed that number. So we can pause this video and look at it, and these are monthly rent figures. So I already divided by 12 for you. And you'll see that Connecticut is the highest with $1,002.

And for example, West Virginia is $437 per month. And you will see one of the lowest as Oregon, $52 a month. So if you are renting more than that amount, then you should actually consider buying a home. So again, the data is in the comments. So make sure you go there and take a look for your specific States, if you couldn't see it on the YouTube screen. So that brings the video to an end. And I just want to congratulate Jon again for making 33% from MMM in eight months. And my name is Eric Seto. And my mission is really to help people without a financial background to master investing using an hour a week through Investing Accelerator. So we can click on the link below and watch the free webinar on how to get 30% from the stock market in 12 months. So remember to click, watch the video after you sign in and you can enjoy the entire webinar. And to end off, I just want to say the price of the house is to damn... So thank you for watching and I hope you enjoy the video. Please help support me by like subscribe and you can watch the next recommended video here as well. So I'll see you in there.

It's one.

About the author 

Eric Seto

Eric Seto is an investor with over 10 years of experience. He travelled around the world to help with auditing, accounting, purchase and sale of companies.

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