In this article, I invite you to explore a concept that is often overlooked but crucial: “imputed rent.” This concept, though frequently underestimated, can significantly influence your perception of buying a home by offering a new perspective for comparing this investment to others, such as the stock market.
Reflection on My Previous Article
My recent article garnered considerable interest, reaching a record audience with over 11,000 reads. One comment in particular prompted me to reassess my analysis: it pointed out the absence of the concept of “imputed rent” in evaluating real estate returns. After delving deeper into the subject, it became clear that this concept deserves particular attention.
What is Imputed Rent?
“Imputed rent” refers to the value of the housing you receive as a homeowner without having to pay rent. In other words, it is the savings realized by not paying rent, which can be perceived as an implicit dividend. This aspect, often overlooked, can significantly influence the evaluation of a property’s profitability.
In my previous article, I primarily evaluated the return on a property based on its resale value. However, a critique I received made me realize that I had neglected to include this implicit dividend in the analysis of real estate returns. When comparing homeownership to an investment in the S&P 500, it is important to consider housing costs in both cases. As a homeowner, you benefit from this “saved rent,” while a stock market investor must continue to pay rent, which should be deducted from the return for a fair comparison.
Additionally, the leverage offered by homeownership and the non-taxable capital gains upon resale, unlike gains from unregistered stock investments, are essential factors to consider. However, in my previous analysis, I assumed that the stock investment was made within a TFSA, thus sheltered from taxes.
Therefore, comparing real estate returns to those of the S&P 500 without considering these factors would be an oversimplification. Investing in the S&P 500 involves continuing to pay rent for housing, which must be compared to the rent saved by owning a home. The net return on your stock investment must therefore be adjusted to reflect these housing costs.
The Impact of Imputed Rent on Real Estate Returns
“Imputed rent” is not an abstract theoretical concept; it has a concrete impact on the evaluation of real estate returns. For example, if you buy a condo for $400,000 to replace a rent of $1,850 per month (or $22,200 per year), this “saved rent” represents 5.55% of the condo’s price and can be considered an annual dividend to be added to the property’s appreciation.
Bernstein proposed an effective method to evaluate real estate returns by taking these elements into account. His formula is as follows:
Expected return = D + G – C, where:
- D = imputed rental dividend (saved rent),
- G = growth in property value adjusted for inflation,
- C = costs (insurance, property taxes, maintenance, etc.).
This approach provides a clear perspective on the advantages and disadvantages of real estate investment compared to other options. By adding the historical growth adjusted for inflation (about 1% per year) and subtracting recurring costs (about 3%), we arrive at an expected return of:
Expected return rate = 5.55% + 1% - 3% = 3.55%
In my previous article, my decision was based on the concept of opportunity cost. Concretely, opportunity cost involves evaluating what is foregone by choosing one option over another. In the context of buying a home, investing $50,000 as a down payment in real estate means giving up the opportunity to invest that amount elsewhere, such as in the S&P 500, where it could potentially generate higher returns.
To refine this analysis, I developed a new Google Sheet model. This model considers annual rents as an expense relative to the potential return from the S&P 500. On the other hand, I included imputed rent as a “dividend” that partially offsets this expense. This model allows for a more precise comparison of the financial advantages and disadvantages of homeownership versus investing in the stock market.
I also integrated this formula into a Google Sheet model, inspired by the work of Jean-Sébastien Pilote (an excellent Quebecois blogger). I included the broker’s commission upon sale, in accordance with Bernstein’s formula. You can view the Google Sheet model here. Feel free to share it with your friends and family!
Conclusion: When a Comment Makes You Reflect
A simple comment can sometimes lead to deep reflection. As a data-driven geek, I couldn’t resist jumping into my Google Sheet to calculate this scenario and examine the financial implications. This analysis allowed me to refine my understanding of real estate investment by incorporating concepts like “imputed rent.” Thank you for contributing to this reflection and for sharing this analysis, which I hope will help you make more informed financial decisions aligned with your long-term goals.