An Economic Perspective

If you are presently a Tenant anywhere in North America, before you plan to remain a Tenant you should read this Article. There are several good reasons for ownership to prevail over tenancy and the real estate profession is littered with extremely clever pointers as to why Tenants should buy – and buy now. But quite aside from all the hype characteristic of real estate sales, there are five solid economic reasons for Tenants to purchase instead of renting. Here they are:

CAPITAL APPRECIATION

Real estate appreciates over time. This is due to a variety of factors, the most important of which is that bare land does not depreciate. The economic rationale behind this is that bare land cannot depreciate because free, available land diminishes as population increases. You may not notice this immediately if you live right in the middle of the Sahara desert, but in urban environments everywhere there is no question that land is scarce and, in turn, pricey. What depreciates in real estate is the structure, such as the walls, plumbing and electrical circuitry. This is normal functional depreciation due to the constant use – and subsequent wear and tear of the place. But functional depreciation almost never offsets land appreciation, with the end result that even if you mistreat your property you still end up building up equity.

Capital appreciation applies just as well to single-family detached houses as to condominium units. The ‘land’ of a condominium unit is the strata lot, so that if you so happen to live – say – on the twenty-fourth floor of a highrise tower in downtown like I do, your condo unit still sits on a strata lot. And on the twenty-fourth floor your strata lot does appreciate while the structure of your condo is subject to functional depreciation.

RENT MATCHES INFLATION

Inflation, as it is widely known, is defined as the loss of purchasing power of money. Inflation is due to a variety of economic factors and political choices but no matter what our governments do – or fail to do – at any given time, it all boils down to increased borrowing and increased monetary supply and availability which, in turn, decreases the purchasing power of money. In layman’s terminology what this means is that it will cost tomorrow, for the sake of an example, ten cents more to buy a certain good in the economic basket than it does today. You still end up buying the same good, but you pay more for it.

These days inflation is not a problem in North America – at least not the way it used to be. But every year our currencies still lose value, albeit minimally: two percent in the United States and almost three percent in Canada on the respective currencies as of last year’s count. Rent typically increase at the rate of inflation, so that a tenant in Vancouver that was paying – say – CAD $1,000 per month in 2005 can expect to pay CAD $1,030 approximately in 2006. Rent paid is, in essence, the cost of just another service this time offered by a Landlord , and once the rent money is into the Landlord’s pockets it can never be recovered.

MORTGAGE CAPITAL AND INTEREST PAYMENTS

Naturally when you go buy a house and contract out a mortgage with a lender, you will have to pay interest because you are using someone else’s money. But every time you make your monthly mortgage payment you also pay back some of this money. This builds up your equity which then grows over time. Equity growth is typically more evident in the United States where mortgages are amortized in a straight line over the term of the loan. In Canada lenders are more complicated and apply a process known in the business as compound interest, i.e. interest on the interest. Still at about halfway through over a typical 25-year amortization span, in Canada too principal repayment takes over interest payment, so that equity growth builds up faster.

CAPITAL GAINS

Capital gains are not to be confused with capital appreciation, although they are a consequence of it. Simply put, there is a realized capital gain when the amount of money you sell your property for minus the price you paid for it is positive. The real estate market may fluctuate, but it is a matter of fact that house prices increase over time. Economic capital gains are adjusted for inflation and expressed in Dollar/Year. For instance, here in Vancouver a single-family detached home that sold in 1975 for CAD $57,000 in 1975 Dollars may very well sell today for CAD $525,000 in 2005 Dollars.

On a cursory count, CAD $57,000 in 1975 are equivalent to approximately CAD $80,000 in 2005, so that your economic capital gains from the time you bought the house in 1975 to the time you sell it in 2005 are the difference between CAD $525,000 and CAD $80,000 expressed in 2005 Dollars, or a whopping $445,000. You can easily determine from this example how much real estate has appreciated over time in my hometown, with the appreciation already adjusted for inflation.

PRIVACY AND CONTROL

In a Tenancy Agreement you are entitled to privacy typically for the period you pay rent for, subject to the Landlord’s rights. These rights include the Landlord’s right to inspect the tenanted premises on reasonable notice, the Landlord’s right to sell the tenanted premises, the Landlord’s right to repair and ameliorate and so forth. In essence, just because you pay rent that does not make you the owner. The rent simply guarantees your exclusive use of the premises for a certain period of time, again subject to the Landlord’s rights.

Likewise, in most cases you as the Tenant have no control over items such as remodeling, repainting and redecorating. It is true that in most jurisdictions Landlords have a duty to rent premises reasonably fit for human habitation, but then it is also true that many Landlords do not go one inch over and above the minimum threshold required by law. But from an economist point of view, if you spend money you should be entitled to reap the rewards – something you entirely miss out in a tenancy situation.

Too many tenants and renters think that owning a property is a farfetched goal. Yet, now more than ever it is the best time for them to take the plunge and buy real estate. Mortgage rates are still historically low and the buying process is easier than ever.