We bought a house!

Well, we did it!  We pulled the trigger on our largest single expense yet – a house!  I’m not going so far as to calling it an “investment” just yet given it is our principal residence.

Why I chose not to buy a house in my 20’s: (in order of importance to me)
  • Concentration risk: I didn’t want a house (single, illiquid investment with high maintenance and transaction costs) to make up a significant amount of my overall networth / portfolio – in my early 20’s, the value of a house would have likely exceeded my networth!
  • I valued the lower cash costs associated with renting vs. buying
    • In hindsight this ended up to be HUGE since I diligently invested the cash savings from renting vs. buying.  However, if one didn’t save the cash cost differential from renting, he/she would have been better off buying earlier as it would have created “forced” savings
  • I valued the convenience of being close to work / downtown
  • In my singlehood, I valued not having to cut the lawn, shovel the walks, and do everything else that is involved with having a house
So why did we decide to buy a house now? (in order of importance to us)
  • The key reason is that our values have changed.  Now that we are married and have a son, our values have shifted away from the convenience / low maintenance of a downtown condo toward wanting more space and a nice neighborhood
  • It felt right – buying a house is a very emotional decision! A big part of why we bought is because we really liked the house we saw, and just wanted to have a home of our own
  • We’re not as concerned with “concentration risk” noted above given that the house now makes up a much smaller proportion of our networth compared to if we bought in our 20’s
    • One important thing to note here is that we did not overextend ourselves financially.  We ended up buying a house that was well within our means (around 25-30% of what we would have qualified for at the bank)
  • We wanted to feel motivated to make improvements to the place that would benefit us over the long term (if we rented, we probably wouldn’t feel as settled in as if we were to own).  We also found that a lot of houses on the rental market were not well taken care and not necessarily in places that we wanted to live
  • Tax-exempt capital gains!  Since we are using this property as our principal residence, we will not be subject to capital gain tax when we sell it.  Per the Canada Revenue agency website:
  • We have a long term time horizon and plan to live in this house for at least 10+ years.  This makes the economics of the purchase more favourable since various one-time and transactional costs are amortized over a greater number of years (for example, realtor cost, legal costs, and inspection cost)
  • COVID has made our apartment feel smaller!  With three adults and a newborn in a 2-bedroom condo, you can imagine that working / studying / caring for baby can be challenging at times
Our due diligence process:
  • The search
    • My wife and I sat down together to figure out a list of “needs” and “nice to haves”, including preferred vs “blacklist” (less safe) neighborhoods
    • In finding the right neighborhood, I did geek out a bit to try to use “big data” to isolate neighborhoods that met our criteria
      • The City of Edmonton website has data files available for download that show every single property tax assessment in the city (we are talking >100,000 homes!)
      • I filtered out the type of home that we were looking for (e.g. single family detached home)
      • I filtered out homes that were on large lots since a large yard was important to us (> 600 m2)
      • I sorted the list by average distance to downtown (each individual assessment data point gave GPS coordinates so I was able to use math to approximate the average distance to my workplace).  It is important that I am decently close to downtown since I plan on riding my bike to and from work for most of the year
      • Obviously, the neighborhoods closest to downtown (shady “blacklist” neighborhoods aside) sold at a premium to comparable neighborhoods further out
        • After filtering out the shady neighborhoods and then searching for neighborhoods with an average assessment value that was within our target price range, I started to get a really good idea of which neighborhoods we should be targeting
    • We set up a search on realtor.ca that identified homes in our price range in our preferred neighborhoods
    • After looking through hundreds of properties online, we set up viewings and worked with a realtor to view 6 properties
    • The house we ended up making an offer on stood so far above the others we viewed that we put an offer on it right away
      • I don’t know if it was just a coincidence, but we ended up buying in the neighborhood that was at the top of the list once we applied the various filters described above
  • Rent vs. buy analysis
    • Although we had a strong preference for owning a home going forward, we still looked at the rental market to assess value and if there was a deal to be had.  Through our analysis, we found that rental properties in our price range had gross annual rents (before expenses) of between 2.3% and 8.4% of the assessed property value – this equates to net rent (after considering estimated property taxes and maintenance costs) of between 0.3% and 6.4%.  For our place specifically, the estimated gross rent equates to approximately 5.0% and 6.0% (between 3.0% to 5.0% after considering property tax and maintenance).  Therefore, it made sense to capture that return by owning instead of renting.  If we really saw a stellar rental deal and a place we loved, we definitely would have considered renting for a bit longer before buying.  Also, it was nice to have such flexibility.  My wife and I agreed that unless we found something that we were 100% comfortable with and excited about buying, we would continue renting until then
      • We did find one property on the rental market that looked like a stellar deal but it was indeed too good to be true.  It was a $1.3 million house in a fantastic neighborhood that was renting for $2,250 per month (that is around 2.0% of property value, and only about 1.0% after considering the ~$1,000 of property taxes that the owner had to pay).  After maintenance, the owner would probably lose money!  We later found out that the owner was only renting it out for a short term (3 months) before demolishing it to build a new house in the summer.
      • On other homes that had lower “rental returns”, after further inspection we found that in a lot of cases, the places were just expensive due to their location (and not necessarily a house that we would enjoy living in)
      • The other interesting observation from this analysis was that generally, the lower the house value, the higher the rental return in percentage terms.  This is interesting:
        • Out of the houses that met our # of bedrooms and bathrooms criteria, the range in
          • rents was $1,395 to $2,500 (the most expensive was ~1.8x the least)
          • assessed values was $215,000 to $940,000 (the most expensive was ~4.4x the least)
          • It seems that there is a fairly clear “floor” and “cap” on rent prices, however, the relative “floor” and “cap” on values is much different
          • Based on this analysis, if I were to look at purchasing a rental property, I would likely look in the lower price range in order to realize a higher rate of return.  That said, I’m sure there is more to the story here – for example, if you buy a low priced home in a less than desirable neighborhood I’m sure you are more likely to run into issues (e.g. tenant turnover, vandalism, etc.) that increase the risk profile of the property – I guess it is true what they say: the higher the risk, the higher the return
          • If I were looking to buy a rental property, I would also try to broaden my search to include other cities and even countries.  I’ve heard of many people in the financial independence community being able to buy rental properties and realize as much as 12.0% in gross rent (or 1.0% per month)
  • The home inspection
    • I can’t believe that some people choose to skip this important step!
    • Our inspection report cost $575
      • On a percentage basis, this represented less than 0.12% of the overall purchase price of our home
      • I’m MORE than happy to pay 0.12% to make sure that there is not a significant issue with the house that could cost several percentage points to fix later on!
    • Luckily our inspection report came back very clean based on my discussion with the home inspectors.  Just a few minor maintenance items and non-urgent repairs were recommended but nothing large enough for us to request a price adjustment from the sellers
  • The mortgage
    • Although I decided to pay cash for the house (more on this below), I still engaged a mortgage specialist to set up a home equity line of credit “HELOC”
  • The current owners
    • Although our realtor mentioned that it was not usual practice, I requested to speak with the owners to directly ask some questions that we had about the house.  Not only did this give us a feel for the current owners of our house to be, it gave us perspective on the house that we wouldn’t have had otherwise.  Here are some of the questions that we asked (and responses):
      • Have you or the previous owners ever had any water problems or electrical issues?
        • Luckily the answer was no
        • Also, we found out that the house was owned by the same group of family since it was built in 1983
      • Please provide a list of maintenance and improvements done over the years, and the names of companies that completed the work
        • The owners were meticulous in this respect – we found out that they had invested over $90,000 in the house in the last few years and had very good record keeping (cost, who did the work, etc.) 
        • I also asked if they had extra paint and hardware since they recently repainted and installed hardwood – they did and agreed to leave these behind for us 
      •  How much are the utilities every month?
        • Again, the owners were meticulous in this respect and were able to provide several years of utility bills (this was good so we could get a sense of heating and cooling costs).  The meticulous record keeping reminded me of my own expense tracking spreadsheet
      • If you still have the manuals for the appliances, can you please leave them behind?
      • Do you have a trusted neighborhood tradesmen that you would recommend?
      • Any lights that require non-standard bulbs?
      • Any issues with crime in the neighborhood?
      • Any trouble with rodents or insects?
      • Anything that should be fixed before we move in?
      • What do you like / dislike about the neighborhood (any favourite places?)
      • How many kids come by at Halloween? (an unconventional way of figuring out the demographics in the neighborhood)
        • They said 50-90 kids!  I was very surprised by this since I know some other neighborhoods in Edmonton get less than 10 kids
      • In addition, we asked a handful of house-specific questions that I won’t list here
        • They also graciously agreed to give us a walkaround to show us various things about the house – e.g. working the irrigation system, showing us where the shutoff valves are, etc.
  • The lawyer
    • We received a few recommendations from our realtor and mortgage specialist, reviewed google reviews, sent a few e-mails for quotes, and then landed on a firm that we were happy with that agreed to a fixed price engagement.  They also gave us a discount since it was a referral from our mortgage specialist.  What does the lawyer do?
      • Review draft documents and work with the sellers’ lawyer to prepare final documents to complete the sale
      • Handle the transfer of funds via their trust account
      • Land title office search, transfer registration and mortgage registration
      • Tax search
      • Review Real Property Report and advise on whether Title Insurance is required / advised
Paying cash?  Are you mad?
  • I chose to pay cash for my half of the house
  • I am 100% certain that I will be criticized by those in the Financial Independence community and will likely hear things like:
    • “Why would you pay cash when interest rates are so ridiculously low?”
    • “If you can invest for a rate of return that exceeds your mortgage interest rate, why don’t you just do that?”
  • So why did I pay cash?
    • I felt like it wasn’t a bad time to take some cash off the table in the equity markets (time will tell!)
    • I set up a HELOC so I am able to borrow back the money (up to 80% of property value) to opportunistically invest (in public or private markets) whenever it made sense – when I do so, my borrowing to invest will be tax deductible, effectively converting my mortgage to be tax deductible (in Canada, we call this the “Smith Maneuver” – more on this below)
  • I do feel a bit silly right now with my equity allocation sitting around 30%, however, will look to aggressively deploy cash over the next several years – this should be easy to do without a mortgage payment or rent
The Smith Maneuver  
  • Since mortgage interest on your primary residence is not tax deductible in Canada like it is in the US, I decided to perform what has been keyed the “Smith Maneuver” when buying my house
  • Effectively what this involves is:
    • Buy the house with cash and then open up a home-equity line of credit (“HELOC”) that can be used (secured by the home) to buy investments
  • Luckily, per my last quarterly update post, I had quite a bit of cash on the sidelines in anticipation of buying a house soon.  I also ended up selling some of my non-registered portfolio to make the purchase – was able to do so in a way that avoided triggering significant capital gains
  • Disclaimer – borrowing to invest is an advanced personal finance strategy that is not for everyone.  Before considering this for yourself, think carefully about your risk tolerance, time horizon, and consult investment and tax professionals to make sure you do it right! 
  • Initially, I plan to just own the house outright.  To be honest, I’m in no rush to deploy the available credit on my HELOC based on where equity markets are right now.  That said, I will look to opportunistically do so when I feel the time is right (either back in the equity markets or in private investments)
    • As noted above, I calculated that I am effectively getting a 3-5% after tax / low-risk return on my equity by choosing to own instead of rent at this point (based on what a comparable house would rent for).  That said, I won’t be in too much of a hurry to redeploy the funds into an alternative investment unless I feel that I could exceed this return on a risk-adjusted basis
  • Even when I do decide to enter the equity markets with a portion of my HELOC, I don’t plan to push the limit.  Technically I can borrow up to 80% of the home value to invest, however, I think I personally would only be comfortable going to 30-50%
  • More on the Smith Maneuver here: https://smithmanoeuvre.com/what-is-the-smith-manoeuvre/

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