The Condo Bible book excerpt chosen by The Globe and Mail to accompany Rob Carrick’s article (see my previous post). Published by The Globe and Mail on Monday, January 13, 2014
From The Condo Bible for Canadians, Everything you must know before and after buying a Condo, by Dan S. Barnabic. Copyright © 2013 by Dan S. Barnabic. Reprinted with permission of Neon Publishing Corp.
Does it make more financial sense to own a condo or rent an apartment?
Investing vs. Renting: “In Principal”
For many people, it is more advantageous to own rather than rent property. Over time, the value of property appreciates, and equity in the property increases as monthly mortgage payments gradually reduce the principal amount of the mortgage. Renters, in contrast, pay a set monthly amount to the owner for use of the space. Instead of building their own equity in the rented property, they are helping the apartment building owner build equity.
But on the other side of the coin, the renter remains worry free with regard to mortgage payments, maintenance costs, taxes, assessments, and fluctuating interest rates. The privilege of peacefully enjoying the rented premises at a set monthly rate may be more advantageous to some than tying themselves to often considerable and unpredictable financial obligations.
It all comes down to a matter of principal and affordability. While most people buy property to build equity or wealth, others choose to build their wealth by saving or investing in business opportunities other than real estate.
To those who think that, over time, real estate is a better asset than the stock market, consider this: $100,000 invested in Coca-Cola stock in 1990 was worth $1-million by the year 2000. Of course, it would have taken one hell of a fortuneteller to convince an investor to put that kind of money into the stock market and all on one stock, to begin with.
This is perhaps an extreme example, and I am by no means suggesting that investing in the stock market is always better than real estate. The fact of the matter is that any investment carries risk.
This chapter tells the story of Mr. Jones and Mr. Smith as a case study of renting vs. owning.
Mr. Jones owns a condominium unit. Mr. Smith rents a unit of the same size in the same complex. The following comparison is based on a five-year period and may apply equally to individuals with small or no equity and those with larger equity in their condominium units. In our example, both Mr. Jones and Mr. Smith start with $67,000 in their savings accounts and earn similar wages, which makes them financially equal.
Mr. Jones decides to invest his savings in the purchase of a condominium unit.
Mr. Smith decides to invest his savings in municipal bonds and use the investment and the interest they earn to defray his rental obligation. The municipal bonds yield 5 per cent per year and mature in five years. For the sake of this case study, even though his monetary return is realized at the end of a five-year period, we will consider it to count as recouping his rent paid during that period.
Mr. Jones buys his condominium unit for $250,000 with a 25 per cent down payment equalling $62,500. In addition, he incurs the closing costs, such as legal fees, mortgage arranging fees, land transfer tax, and other disbursements, all totalling about $4,500. Therefore, his total out-of-pocket cash investment is $67,000, the actual amount of money he had in his savings account before the purchase.
He obtains a five-year term mortgage for the balance of the purchase price of $187,500, amortized over 25 years at a 5.5 per cent yearly interest rate with a monthly payment of $1,132, including principal and interest combined. In addition, Mr. Jones is responsible for a $350 monthly maintenance fee, plus realty taxes of $150 per month. His total monthly obligation comes to $1,632. After five years (60 months), his carrying cost amounts to $97,920. If we add to that his down payment and closing cost of $67,000, Mr. Jones’ overall financial exposure amounts to $164,920.
In comparison, by paying a fixed monthly rent of $1,400, Mr. Smith spends $84,000 during those same five years (60 months) on his rental accommodation cost. Having invested his available cash of $67,000 into municipal bonds, his overall financial exposure after five years amounts to $151,000.
The difference in financial exposure between them over five years comes to $13,920, in favour of Mr. Smith. This difference is important to remember, because, notwithstanding Mr. Jones’s equity position after five years, his overall financial exposure was higher. From this perspective, Mr. Smith comes out ahead of Mr. Jones.
Let’s look more closely at Mr. Jones, assuming favourable, and then unfavourable market conditions.
The Effects on Mr. Jones of Favourable Market Conditions
Let’s assume that, for the first five years, there are no adverse changes in Mr. Jones’s condominium complex – in other words, no special assessments are levied against his unit – and his maintenance fees, mortgage interest rates, and realty taxes remain steady and unchanged. Let’s also assume favourable market conditions during those years – that property values appreciate according to traditional trends.
After the first five years, by making regular mortgage payments, Mr. Jones’s principal on the mortgage is reduced by $20,250. The principal amount remaining on his mortgage after five years therefore drops to $167,250. His original down payment of $62,500 and the paid-off principal of $20,250 now represent the paid equity that he has in his condominium unit, namely, $82,750.
We could add to that a traditional 2 per cent increase in real estate appreciation per year, which in five years amounts to 10 per cent, or $25,000, so the value of Mr. Jones’s condominium unit after five years increases to $275,000, in which he owns a total apparent equity of $107,750, or close to 39 per cent.
Under these favourable market conditions, the difference in Mr. Jones’s overall financial exposure ($13,920), in comparison with Mr. Smith, has been fully recouped. So is his closing cost of $4,500 to buy the unit.
If he sells his unit after five years, Mr. Jones will make a profit of $25,000, representing the difference between the original price of $250,000 and the unit’s increased value of $275,000, putting him way ahead of Mr. Smith, who, as we will see, is barely able to cover his total five-year accommodation from his investment.
In fact, at the end of the first five-year period, Mr. Jones’s equity might have appreciated even more if he had taken the mortgage at the lower, variable interest rate, or the market value of his unit had appreciated at a higher rate due to exceptionally high demand.
During the following five-year period, projections look even better for Mr. Jones because the original down payment and closing costs are not “repeat expenditures.” His overall financial exposure will be lowered to $97,920, representing the carrying cost of looking after mortgage payments, maintenance fees, and real estate taxes.
If market conditions remain favourable, he’ll accumulate greater equity due to the accelerated progression of the payments on the principal of the mortgage and the traditional market appreciation of his unit.
The Effects on Mr. Jones of Unfavourable Market Conditions
However, in the event of adverse market conditions, the value of Mr. Jones’s condominium unit may depreciate.
Real estate is a volatile industry. Market corrections, such as occasional booms and busts, can be expected, though it is hard to predict when they will occur and how long they will last.
Instead of the traditional market appreciation during the first five years of Mr. Jones’s condominium ownership, the market might experience a slowdown and subsequent correction.
In cases like this, properties lose value, sometimes quite rapidly. The loss of value may be quite severe, as witnessed in many urban areas of the U.S. from 2006 onward, when property value, especially of condominiums, decreased as much as 50 per cent.
If Mr. Jones finds himself in such an adverse situation, he may lose the amount of his down payment. Furthermore, he will not gain from the traditional market equity buildup. In fact, his incurred losses may run into thousands of dollars.
It is fair to state that Mr. Jones’s financial well being in preserving and maintaining the value of his condominium unit depends on quite a few variables: the state of the economy, market trends, mortgage interest rates, his job security, and the quality of the management and governance of his condominium complex together with the timing and duration of his ownership in relation to market trends.
If the market depreciates 15 per cent in the five years after Mr. Jones buys his condominium unit, the unit will be worth $37,500 less, due to depreciation, or $212,500. Therefore his apparent equity cannot possibly be more than $212,500 less the outstanding mortgage principal of 167,250, or $42,250. And this despite the fact that he made a $67,000 down payment and paid off a further $20,250 of the mortgage principal.
At that level of depreciation, Mr. Jones’s starting investment of $67,000, plus $20,250 he paid over five years to reduce the principal of his mortgage, erodes considerably from its total of $87,250, leaving him with $45,250 in reduced equity after five years.
In comparison, Mr. Smith’s original cash investment appreciates exactly the same as it would have during favourable market conditions. Although his cash investment and its appreciation on his overall rental accommodation cost are fully utilized and exhausted after five years, he lived in and enjoyed the rented unit of equal value and paid $13,920 less for his overall accommodation over five years.
The Effects on Mr. Smith of Unfavourable Market Conditions
An interesting situation could develop for Mr. Smith should the real estate market and economy turn for the worse. This would create more vacant condominium units, giving Mr. Smith a chance to rent the very same condominium for a lower price, perhaps $1,200 per month. Inflationary trends may drive interest rates up, giving his investments a higher yield. In this scenario, he likely ends up with a sizeable surplus after five years, rather than a very small shortfall.
The market conditions that could affect Mr. Jones adversely, as an owner, may work to the benefit of Mr. Smith, as a renter.
Who Fares Better After Five Years?
It is all about timing. If markets experience exceptionally favourable appreciation due to high demand and low interest rates, Mr. Jones ends up much better off than Mr. Smith. Overall prices may have gone up by as much as 30 per cent, as they did from 2000 to 2006.
But what if they had moved into their units in 1988? During the following five years, Mr. Jones likely would have lost about 30 per cent of the value of his unit due to depreciation caused by adverse market conditions. This would have wiped out his equity. The same can be said for the five-year period, starting in 2006, when real estate catastrophically lost as much as 50 per cent of its value in many U.S. cities.
As you can see in the above example, equity, in the short run, is not always based purely on paying off the principal of the mortgage. Equity is directly dependent on the property’s value, which is largely affected by prevailing market conditions. Buying into real estate for the short-term purpose of building equity is essentially gambling on the state of the economy, interest rates, and market conditions.
On May 11, 2011, the Web edition of the New York Times posted a very interesting analysis of buying vs. renting. According to the paper’s calculator, renting seems to be more advantageous for people who do not plan to stay in the same premises for more than four to five years, and buying is more advantageous for those who decide to stay for a longer period.
Investing vs. Renting: The Long-term Truth
Real estate market trends are influenced, not only by unemployment and interest rates, but also by demand, the cost of building materials and supplies, inflationary trends, and many other factors. These are complex market relationships. Even the best financial analysts do not have the precise answers when it comes to predicting market trends.
Things definitely tilt in a property owner’s favour over a longer period, regardless of the economy and periodical market swings. Owners of real estate properties gradually build up the benefit of equity as the principal of the mortgage debt is reduced and eventually paid off over time.
After about seven years, payments on the principal reduction of the mortgage become more prominent and, depending on the amortization period of the mortgage, the principal henceforth will be reduced more rapidly.
Depending on the amortization period, if the buyer hangs on for 15, 20, 25, or even 35 years, they will have accomplished the goal of living in their property while simultaneously lowering their mortgage debt and eventually paying it off.
Historically, real estate has appreciated in the range of 1.5 to 4 per cent per year except for periodic market corrections. Consumer wages were supposed to follow, but, unfortunately, this has not quite happened. Are consumer wages going to increase in the future to keep pace with overall inflationary real estate trends? Historically speaking, you should not be optimistic.
In the meantime, buyers should exercise common sense when buying property, whether for investment purposes or for personal accommodation. They must be in tune with the marketplace and the state of the economy. The most opportune and favourable time to buy is during a so-called buyer’s market, when many real estate products, including condominiums, are offered at cheaper prices. Buying when the market is high and “going with the flow,” hoping that prices will continue to rise, may not be such a good idea.You cannot predict to a fine degree of certainty when the market will level off and possibly take a downward turn.
Oversupply is one of the most important factors you should watch for when buying any real estate product. An oversupplied market is a buyer’s market. An undersupplied market is a seller’s market.
In our example of Mr. Jones and Mr. Smith, Mr. Smith did not lose any sleep worrying about mortgage interest rates or market conditions. If he elects to rent again, he presumably will save another $67,000 over five years as he patiently awaits the arrival of a buyer’s market to buy his own unit or remains in his rental unit, taking comfort in knowing that his future rental is pre-set and worry free.
As said before, the comparison of Mr. Jones and Mr. Smith applies equally to individuals buying condominium units with little or no down payment and those who purchase their units with a sizeable down payment. The only difference is that the former may lose their units and accumulate great financial liability if the market turns on them, whereas the latter may lose some or even all of their invested and earned equity but are in a better position to remain in their unit and weather the storm.
It is important to note that it is not disadvantageous to rent rather than buy, especially during times of inflated and unaffordable real estate prices. Determining whether to invest or rent in relation to condominium living should be a personal decision based on a clear understanding of the factors, quality information, and a clear perception of one’s values at the time of the intended purchase.
By learning about the cost of maintenance fees, realty taxes, prevailing interest rates, and the conditions of the market, you should be able to draw a reasonably sound conclusion about whether to buy or rent.
Apartment Buildings vs. Condo Buildings
Last, but not least, it is useful to compare apartment buildings and condo buildings.
Owners of apartment buildings are usually business savvy real estate professionals. Whether private person(s) or corporate entities, in most cases they have owned and operated apartment buildings for years. Many corporate apartment owners relegate the day-to-day care of their buildings to an inside or outside management team. They carefully monitor the management team’s performance to ensure that expenses related to maintenance and repairs are within projected budgets.
The owner can simply terminate the management team’s contract if the team does not perform in an honest, responsible, and professional fashion.
Properly run apartment buildings seldom exceed yearly expenses in excess of 55 per cent of the yearly income received from the tenants. These expenses include costs for necessary maintenance, repairs, periodical replacements, the superintendent’s salary, management fees, professional fees (such as legal and accounting), and the payment of real estate taxes.
What about major repairs that the reserve budget cannot meet? Apartment building owners may take out a mortgage loan, possibly in addition to existing financing, to cover these expenses. Or, if they are strapped financially or are unwilling to cover the expenses, they can sell the building in whatever state of repair it is in. In contrast to condominiums, the owners of apartment buildings can decide the fate of their building themselves.
Traditionally, the average markup on the sale of an apartment building has been about $5,000 to $20,000 per apartment unit. But what if the apartment building were improved and converted into a condominium? Each condo unit could be sold for hundreds of thousands of dollars more. This is why many apartment building owners decide to convert their buildings into condominiums. They often can qualify for a permit to make this conversion by performing very slight improvements. Unfortunately, such massive conversions are a major cause for the depletion of available affordable rental apartment units.
Who wins? The owners who convert their building into a condo. They are now worry-free concerning the maintenance of the building. These responsibilities have been shifted onto the shoulders of the unit buyers, who also become the owners of the whole property, including the land and the building, commonly referred to as a condominium complex.