When I talk to my younger clients, one question comes up over and over: should I buy a single-family home or a condo?
The path to Real Estate success involves turning some conventional wisdom on its head. One area that can require reassessment is home-ownership, especially for younger investors who may not have as much capital to play with.
So, is homeownership a sound investment?
To evaluate homeownership as an investment, we need to view it through the lens of capital deployment. We also need a unit of comparison.
First, if we’re comparing purchasing a home (read: appreciating object) to spending money on consumer goods (or depreciating objects), it makes total sense to become a homeowner. So yes, homes—because they are appreciating assets—gain value over time.
But, if we’re evaluating an owner-occupied single-family home as an investment vehicle, we’ll face a different financial analysis. We’ll need to compare a home to other types of passive income generators like a rental property.
As investors, we spend money or tie up capital to make a profit. That’s what a hard-earned bank balance is for. Deploy capital to generate the best returns. That’s the first law of investing. It’s actually the definition of the word “investing”.
If your capital is the golden egg that will get you out of the rat race, are you sure it will mature properly if you place it to a condo or a residential property? The question shouldn’t be “Am I losing money on my single-family home?” It should be “How can I apply my hard-earned savings and capital to generate the most return?”
To answer this question, you must calculate the rate of return on the cash you plug into a rental property, and compare it to what you save on rent plus appreciation on a single-family asset. This will give you two rates of return that you can evaluate side-by-side.
Most people—when they think about owning a home—frame the mathematics of homeownership in terms of saving rent money. But they tend to forget about the golden rule of capital deployment. The golden rule is: spend money to make money or let your capital chase the highest returns.
You mustn’t automatically assume that using your capital to save rent money is the best investment opportunity available to you. Seed capital must make a profit. If you take one expense—rent—off your balance sheet, will it truly open the door to financial freedom?
You can find a sample calculation—of renting versus owning as an investment opportunity—in the Business Case section of my book.
When calculating money “saved” on rent, don’t forget to factor in all the expenses that come with homeownership. Of course, there’s the mortgage. Payments are part principal (capital payments that decrease the overall loan amount), but initially, a lot of the payment is bank interest.
Interest isn’t the only expense: homeownership comes with property taxes, the chimney sweeper, the insurance, the plumber, the exterminator, etc. Many homeowners like to do remodels and renovations. Because these upgrades generate no income, they are—in a sense—also expenses.
Likely you will find homeownership, once you factor in covering all expenses, costs way more than paying rent.
To see P&L statements of renting versus owning as an investment opportunity check out the Business Case section of my book.
3. Tax Implications
There are tax implications to homeownership. When you own rental property, you can deduct mortgage interest as a business expense. All the renovations and maintenance are tax-deductible. Travel expenses, administration and home-office fees, part of your cellphone bill and accounting expenses—all tax-deductible.
Wealthy people sometimes own rental property for tax planning!
The same doesn’t hold for owner-occupied properties. Expenses associated with primary and secondary residences are not eligible for tax deductions.
There is a capital gains exemption when you sell your single-family home (you do not have to pay tax on the appreciation of your property if you occupied it). The rental property comes with a tax liability that comes into existence at the time of sale: the capital gains tax. But this is akin to owning RRSPs (Registered Retirement Savings Plans). You accumulate wealth by investing for years and then when you cash in your investments, you pay tax.
In Canada, capital gains tax is calculated on fifty percent of the appreciation. This boils down to a 25% flat tax on the appreciation of your rental properties. Depending on your tax bracket, it might be more advantageous to pay capital gains than to pay income tax!
4. A Lifestyle Choice
Overall, home-ownership should be viewed as a lifestyle choice, not an investment. When you do the math, you’ll likely find better uses of capital than to park your nest egg in a single-family home.
Should you buy a home then? The answer is, it depends on where you are in your investment journey. Once you have passive income streams and income-generating assets, why not splurge on lifestyle if you have extra capital lying around.
Mindful landlord’s advice: go through the exercise of evaluating return-on-investment before making a decision to purchase a home. You might be surprised! And at least you’ll be making an informed decision.
For a full detailed financial model that will help you compare the two scenarios—renting and owning as an investment opportunity—see the Case Study in my book.