I am enjoying this format because it provides information on real estate markets not readily available (see Part 1 for the skinny). There is currently no free source out there green-lighting certain areas of Canada or the US. You could join the Real Estate Investment Network to get hot tips about where to buy in Canada, among many other useful things I’m sure, or just use these fundamentals and analyze markets that interest you. If the same analytical approach taken to equities was applied to real estate we would have a wealth of analysis available for the public. They could use it to guide their home purchases and increase the market’s efficiency.

Until something comes along, I’ll be stuck doing my own investigations.

I wanted to do another Canada / US comparison because some people might have thought I cherry picked New Haven to prove a point. Actually, I picked it because it is an area of interest.

I’d like to look at the fundamentals of 2 more cross border markets. I have decided to look at Cambridge, MA and Calgary, AB. Calgary was the hottest market in Canada for a while, but is now cooling off. I’m curious to see how the fundamentals look during this cooling process.

Cambridge, MA is a great area to spend time in. Being home to 2 of the best educational institutions in the world doesn’t hurt. I visit every summer but haven’t the foggiest what the real estate market is like.

Here’s a quick overview of the guiding factors in my analysis.

Take time to look at published information and data from trusted sources when looking to buy in an area. For Canadians, the CMHC, Royal Lepage, and individual city’s sites offer quality stuff.

In addition to getting good data, you also need to know which data is critical for understanding an area’s potential to support a strong real estate market. Taken from pg 39 of Don Campbell’s book Real Estate Investing in Canada, the 12 key fundamentals that affect real estate values are:

Passive Factors (out of your control):

1. Mortgage Interest Rates

2. Increase in Average Incomes

3. Increased In-migration and Demand

4. The Ripple Effect

5. Local, Regional, and Provincial (State) Political Climate

6. Transportation Expansion

7. Areas in Transition

Active Factors (in your control):

8. Creating Highest and Best Use

9. Buy Wholesale, Sell Retail

10. Quality Marketing

11. Renovations and Sweat Equity

12. Speculation

We’ll be looking at the passive factors because they do not depend on a specific property and you have no influence over them. You need to make sure factors out of your control will support your purchase.

Factors 4-7 require a little more digging and insight than the first 3. The ripple effect concerns positive effects on prices in one market after a nearby town or city has experienced a “boom”. Canadians should think of Milton, being the ripple effect of Mississauga and Oakville, which were ripple effects of Toronto at one point.

The political climate concerns the area government’s ability to conceive, support, and implement development initiatives that bring people and capital to it. Some areas clearly excel in this regard. Waterloo Region is consistently viewed as a winner in this department. The City of Brantford, however, usually falls down on the implementation side and would get a lower rating.

Transportation Expansion concerns the construction of new highways that cut commute times to the big cities. Public transit improvements also have a positive effect on property prices, especially when they are within 500m of a new station or line. Vancouver (actually the GVR) is a great example of this. REIN has a great report to give you more details.

Areas in transition are often difficult to define. The word “gentrification” comes to mind. It could be an old rundown urban area that has recently seen more families move in. They buy old houses and either fix them up or tear down and build shiny new ones. This activity encourages restaurants, bars, and grocery stores to move in, bringing more people now that the area has amenities. In short an area in transition is clearly on its way, but not quite there, to becoming a great place to live.

So let’s look at Calgary, AB. It’s the heart of Alberta’s oil kingdom and the oil boom has created a huge growth in employment. The number of people moving there from all over Canada is staggering, so one can understand why property prices went a little nuts. Let’s see what the numbers say:

I was able to get population and income data from the City of Calgary.

The total population increase over this 5 year period was 12.5%. This is almost twice the Canadian average for the same period.

For the City of Cambridge, MA the population trend has been slightly upward at 2.1% growth from 2000-2007.

Advantage: Calgary

Now looking at average income growth for Calgary, we would expect to see the same growth trend.

From 2002-2006, growth has been solid from $73000 to $90700, representing a change of 24% before inflation.

Cambridge, MA doesn’t have a great deal of charts available, so I’ve pieced together the data. Median Household Income growth before inflation from 1999-2007 was 19%. This is very good relative to other cities I have looked at.

Both cities clearly have solid income growth, yet only Calgary has had above average population growth.

Let’s now look at property prices and see if these fundamentals are echoed.

Calgary Median House Prices

As you can see, prices have gone crazy in the past 4 years. Growth in property prices from 2000-2007 was approximately 161%!!! This will be hard to match in any environment and prices have seen a cooling, not a collapse, since their peak in 2007. I’m not sure if the population growth (though above average) and income growth completely justify such an increase, so it will be interesting to watch over the next 2-3 years.

Cambridge, MA has not had close to the same price performance of Calgary (very few places have!). Yahoo Real Estate provides data from 1999-2007 that shows an 85% increase in the median house price. This is a very good performance over an 8 year period but only half as much as Calgary.

Growth has also slowed in the last 18 months and prices are actually showing a slight decrease.

In comparison then, the price performance in both markets has been excellent. Calgary has a substantial advantage on the fundamentals because of the high population growth it has experienced. In income growth, both areas have shown above average performance.

Neither market has seen price decreases of 10-20%, rather it has been a slower cooling after the “boom” which is also a positive sign of the areas as a whole.

And the winner is……Calgary, by a substantial margin because of the population growth figure that will serve to support the real estate market well into the future. Cambridge is simply not growing as fast despite rising incomes and an 85% increase in prices over the last 8 years.

So there you are, a specific analysis of the fundamentals for two real estate markets allowed us to understand their behaviour. Go ahead and apply these fundamentals to other US cities. If the cities have great fundamentals and prices are still dropping it may be a great time to buy. Just be sure to do your homework!

I’ve decided to start a new segment of posts on the site called “On the Radar”. When I come across a stock that catches my interest i’ll outline the story in post form so you can see my justification for why I like the stock. This will help me perform thorough research on my stock picks and hopefully give you some ideas in the process. The first stock in the segment is Nucor Corp. (NUE).

Nucor is a steel company operating in the United States with customers across North America. Last year Nucor produced 22 million tons of steel and steel products, including hot-rolled steel, cold-rolled steel, metal buildings and steel joists. It is also North America’s largest recycler of scrap metal. Nucor controls about 20% of the US market and about 60% of sales are to the construction industry with automotive making up another large portion. The U.S. steel stocks have been on fire lately as a decline in finished steel imports to the United States has increased demand for locally manufactured steel. The weak dollar, high shipping rates, and strong overseas demand has kept imports from reaching American shores. This limits the supply locally which forces U.S. steel companies to run at full production capacity and allows them to raise spot prices on steel. As long as demand remains strong these companies should continue to have great pricing power. According to the International Iron and Steel Institute global production remains below historic trends and likely will lag global consumption, despite rapidly rising steel prices.

Nucor is up 20% over the past year but has underperformed compared to competitors U.S. Steel (up 55%) and AK Steel (up 100%). Nucor is only 8 points off its 52 week high and is cheap on a valuation basis trading at 15x trailing earnings and 10.4x forward compared to U.S. Steel at nearly 25x trailing and AK Steel at 18.5x trailing. Nucor recently increased guidance for its second quarter earnings due to strong shipments and higher margins. The company now expects Q2 earnings in the range of $1.75 to $1.80 per share compared to their previous forcast of $1.55 to $1.60 per share and well above consensus analyst estimates of $1.69 per share. That represents an increase of nearly 54% over Q2 2007 on the low end of the estimate. This bullish outlook likely means that analyst estimates for the full year are on the low end meaning Nucor is undervalued and has significant room to the upside. The earnings increase even reflects the dilution of outstanding shares of more than 3% due to Nucor’s common stock offering of 27.7 million shares that closed on May 29th, 2008. On the news shares of NUE jumped nearly 9% to $80.54 but pulled back all the way to $74 and currently sits at $75.50 per share. I’ve been watching this one for a while and I jumped on the opportunity to buy in on the pullback below $75 per share. I expect global demand to remain strong through 2008 and into 2009 and Nucor should perform exceptionally well in this environment.

A key component Nucor’s long term growth strategy includes pursuing strategic acquisitions of downstream steel products. Execution of this strategy has resulted in annual capacity more than doubling over the past year to 4 million tons. Recent acquisitions include Verco in steel decking, Harris Steel Group in rebar fabrication, cold finished bars, & metal grating, LMP Steel in cold finished bars, Magnatrax in metal buildings, and Nelson Wire in wire mesh. Continuing this strategy Nucor announced last week the acquisition of Ambassador Steel, one of the largest independent fabricators and distributors of rebar in the United States. With its strong growth strategy Nucor should continue to increase its footprint in the U.S. steel market.

I think this is a great stock with great potential over the next two years. I think you can get into this one anywhere near $75 per share with a lot of room to the upside.

(Disclosure: Long Nucor)

Lately I have been trying to implement the deep-in-the-money calls options strategy that I explain in a recent post through my paper trading account at Investopedia. On April 22nd I outlined our first success with Microsoft calls and a second idea with Corning Inc. With the stock trading at $25.73 I bought 10 of the August $20 calls for a premium of $5.91 per share for a total capital investment of $5910. Sometime last week the premium on the calls hit our target of $6.91 per share and the position was sold for a gain of $1000. Good for 17% in less than two weeks. The move was thanks to a solid earnings report by Corning where both earnings and revenue saw strong double digit growth. In addition, guidance was raised for the upcoming quarter and full year. In the same time-span the stock price increased approximately 5%, again illustrating the leverage of options.

In a comment on the previous post Jeff from Blue Moat illustrated a potential downfall of this strategy. Essentially his point was, the strategy is great when it works but if you pick a bad stock you can end up down 95%. The leverage of options is great when it works for you but when it goes the other way it can translate into serious losses. One way to get around this may be to put in a stop loss order after the calls are purchased. In the same way we limit our gains to $1000 we can limit our losses to $1000 as well. As long as you are smart about your stock picks you should be able to stay on the winning end of the trade the majority of the time. Stay tuned for more potential stock ideas for this strategy.

Jeff McLarty from the financial blog Blue Moat was nice enough to write a post on his site answering some of my options related questions that have come about regarding some of the recent posts on this site. Anyone interested in understanding the nitty gritty of options trading should check it out. He explains in depth the terminology and fundamentals behind both sides of an options trade (puts and calls), as well as the possible scenarios at expiration. Also, if you’ve never visited his site before you should give it a read. Its one of this sites that I visit regularly. He’s a fellow Waterloo alum, so you know that he’s good people.

One specific question that I had was related to the covered calls strategy that I wrote about recently. My understanding was that the only way to exit the contract was to let the options expire (ideally worthless so you keep your shares and the premium). However, Jeff left a comment on the post saying that another way to exit the trade is to buy the calls back. As the calls near expiration the options become less valuable and, as a result, the premium will decrease in value (this illustrate the time value of options). Therefore, your profit will be the difference between the premium you collected and the premium you pay to buy back the calls. Typically he buys the calls back when they are very close to worthless. Why risk losing the potential upside in the stock for an extra $0.05 per share. He almost always sells the front one or two months, usually one or two strikes out of the money. Of course there is the risk of losing your shares with this strategy but the idea is to sell the calls at local peaks where, if the stock does hit the strike you wouldn’t mind taking the profit and selling your shares anyway. Plus you are pulling in the premium every month that options expire worthless. The ideal stock for this strategy would be a slow moving stallwart that trades in a well defined range so you can easily identify the sell points (the local peaks).

Thanks again to Jeff from Blue Moat for sharing his expertise with us and answering some of my questions.

Here is the continuation of my quest to produce a systematic tool for identifying if you should buy or rent. Keep in mind that when you combine these insights with some diligent research, you should feel confident in making a decision.

The previous post discussed your Plans for Savings and % Down Payment as key indicators. Below is the complete list.

Key Variables affecting the Rent vs. Buy decision:
• Level of Financial Education
• Plan for Savings
• % Down Payment
• Property Market
• Stock Market
• Nature of Income
• Location

4. Property Market
If you consider the purchase of your home to be an investment, it would be wise to investigate the current status of the market for such an investment. In case you’ve been living in a bubble for the past year (actually, you couldn’t because it burst a while ago…..), you’ll know that the US Real Estate Market is tanking. This is a macro trend that doesn’t apply to all areas however. Certain markets in the US are still strong due to good fundamentals. See my post outlining the fundamentals.
Buy or Rent? Let’s account for the status of the property market before making our decision. A large assumption in our calculations is an annual rate of increase in house prices for your area. After researching historical performance, it is important to calculate the average annual increase for the last 5,10, and 25 years.

Combine this with a sustainability check. If you’re seeing rates over 20%, your market is bound to see come cooling in the near future (gradual or otherwise).

If you’re seeing high rates that are not likely to continue, renting might be a good option until you’re able to understand what form the cooling will take.

However, if prices are crawling at 2-4% a year and the area has good fundamentals, buying now is probably a better choice than renting. Either you might see more rapid price increases in the future or continued steady increase. Both are great conditions to be a homeowner in.

In the event your market is experiencing a long decrease there will clearly be some reasons behind it. Examine the fundamentals, and if they look really bad, prices may not reverse themselves in your lifetime! Renting would then be the way to go. In this case, make sure you get your Financial IQ up because you won’t be able to make your money from a primary residence.

In the event that your area has been depressed for a while, but could be on the “up and up” in terms of community development and steady population increases, you may be getting in a little ahead of a boom. Make sure you review the fundamentals thoroughly to ensure things are as good as they appear. Buying in an improving area is every homeowner’s gravy train, so this would clearly be a green light special.

In short, if the fundamentals in your area look strong and price increases have stayed reasonable (0-12%), buying is a good choice, all other factors being equal.

If the fundamentals look bad or your market has been really hot (Hello Saskatoon, or Calgary 2 years ago) with increases well over 20% for 3-4 years straight, find a good rental and wait for things to cool down.

Keep in mind that you should perform a forward looking cash flow and balance sheet analysis for the next 5 years to make sure that your favored option does indeed work out better.

Again, if you’re going to rent, you need to keep piling the savings into investments to truly realize any advantage calculated. Buying cars and trips with the cash will provide no lasting value to your balance sheet.

On a scale from 1-5, give yourself a 1 if the Market in your area is stable or “coming around” with solid fundamentals. You would score a 5 if your area is getting more like a ghost town all the time (bad fundamentals).

5. Stock Market
The other key assumption going into a Rent vs. Buy decision analysis is an expected rate of return on money invested. Your ability to generate a decent return will, along with all the other factors, be critical if you choose to rent. When renting, areas for growing your money are generally equities / funds / derivatives, starting a business, and buying an income property. I suspect most people would favour the first area because it seems easier (just click “BUY” and you’re good to go).

With relevance to the big decision, volatile markets or those that are clearly unstable require a high financial IQ to navigate. Obtaining the required return outlined in Part 1 of this series would therefore be difficult. This means that buying a house would be easier to handle and to count on a stable return.

In times of low volatility or sustained growth, it might be possible to achieve some steady, solid returns. This may give the illusion that renting is the way to go even for those with low Financial IQ. However, keep in mind the required rate of return to match the BUY scenario outlined in Part 1.

Give yourself a 1 in this category if the Stock Market is extremely volatile or going sky-high. A score of 5 would correspond to a market that is just out of a recession and has encouraging fundamentals to drive future growth (see: CHA CHING!). I think currently we’d be around a 3, because we are clearly in the middle of a recession, but there are plenty of good buying opportunities.

The Property and Stock Markets are going to have a large influence on your decision because they are the source of your 2 biggest assumptions in the balance sheet calculations. Your cash flow analysis will not really be affected by these variables as an increase in the value of your home or stock will not put cash in your pocket. Now if you plan to buy an investment with some type of payout (dividend or income trust distribution) be sure to include it in your cash flow analysis.

We’re moving along in the decision making process and I’m sure most of us already have an idea of whether Renting or Buying would be best.

We’ll finish up the analysis next time when we total the points up and look at the Nature of Income and Location.

On April 4th I wrote a post on implementing the deep-in-the-money calls strategy with Microsoft calls. To recap I bought 10 of the July 2008 $24.00 calls for $5.15 on March 26th. Sometime last week the July calls reached our target of $6.15 and the good-till-canceled limit order executed to lock in our $1000 gain. This means that in three weeks we made nearly 20% by carefully implementing the deep-in-the-money calls strategy. The best part of this is that in the same time frame the stock price moved less than 2%. A great example of the leverage of options.

So lets try and repeat this success. Corning Inc. makes the specialty glassware that goes into LCD screens and has a new technology for bendable fibre optic cable for fibre-to-the-home internet connections. They are cheap on a valuation basis, trading at 19x trailing and 13.5x forward earnings. The have been trading fairly flat for the past year but, based on the fundamentals and the company’s performance, could be due for a breakout. The stock is currently trading at $25.73. Looking out to the August 2008 calls will give us four months to get the required move in the stock. The August 2008 $20 calls (GLWHD.X) at a current cost of $5.91 per share fit the bill for this strategy (strike price $20 + option premium $5.91 - stock price $25.73 = $0.18; which is well under our threshold of $1.00). Therefore, we will place a limit order to purchase 10 of the August 2008 $20 calls at a cost of $5.91 per share. Once the order fills we will immediately place a good-till-canceled limit order to sell the calls $1.00 above our purchase price (~$6.91). This will insure that if we get the required move in the stock price our gains will be locked in.

Once again I will keep you posted on the progress.

In keeping with the options theme I decided to write a post on another fairly straight forward, easily applied strategy…covered calls. In this strategy an investors holds a long position in a stock and simultaneously sells call options on the stock to generate extra income from the position. A call option is a contract giving the owner the right (but not the obligation) to buy a specific number of the underlying shares at a specified price within a specified time frame. By selling calls against your shares you are selling the right for someone else to buy those shares at a certain price before a certain date. The price is determined by the strike price of the option and the date is determined by the option’s expiration date (options expire on the 3rd Friday of each month). To obtain this right the purchaser of the calls must pay you a premium, known as the option premium. Confused yet? Let’s take a look at an example to clear things up. Let’s say you own 1000 shares of XYZ stock currently trading at $25 per share. To generate some passive income from these shares you sell 10 May 2008 call options on XYZ at a strike price of $30. Remember each option contract represents 100 shares of the underlying stock so this transaction includes your entire position. The purchaser of the calls pays you the option premium of $1.00 per share (total of $1000). There are three scenarios that can play out from the time of the sale until the 3rd Friday in May:

1) The XYZ shares trade flat (somewhere below the $30 strike price). In this case the options expire worthless, you keep your shares and the premium from the calls. By selling the calls and collecting the premium you have outperformed the stock by 4%. You can repeat the process for the next option cycle, hopefully with the same outcome.

2) The XYZ shares fall in price. The options expire worthless, you keep the shares and the premium. Because you still own the shares you are on the hook for the decline in the stock price, but by collecting the option premium you have supplemented your losses. Once again, rinse and repeat.

3) The XYZ shares rice in price above the $30 strike price. In this situation the options are exercised and you are paid $30 per share for your position. Your upside is capped in this case at $31 per share (the strike plus the premium). If the stock had risen to $35 you would be missing out on $4 per share in upside.

In the covered call strategy you are reducing your downside risk by collecting the option premium each month. And because you have to own the underlying shares you would research the initial purchase just like with any other stock. If the option is exercised and you lose the shares, just take the 5-10% gain, plus any collected premiums, and move on to the next stock. Although the covered call can be implemented in any market condition, it is most often employed when the investor feels the stock will trade in a narrow range over the lifetime of the call contract. This strategy is a fairly simple one that anyone can do to generate extra income from shares they already own.

Stay tuned for a real world example of how to apply this strategy.

Over the past 8-10 months every magazine and television channel has been discussing the fact that US Real Estate prices are tanking. This trend is well covered in the macro sense but up in the Great White North we get few specifics.

I wanted to do a little comparison between 2 areas that I have some experience with, New Haven, CT and Kitchener-Waterloo, ON. It will also highlight that all of Canada is not tied to US performance, contrary to opinions of many people I have met. On the plane or in the airport, when the topic of Canadian Real Estate comes up, people automatically seem to think that our entire market will collapse because of the US situation.

Teachable Moment: Don’t believe people’s opinions on topics like this. Instead, take time to look at published information and data from trusted sources. For Canadians, the CMHC, Royal Lepage, and individual city’s sites offer quality stuff.

In addition to getting good data, you also need to know which data is critical for understanding an area’s potential to support a strong real estate market. Taken from pg 39 of Don Campbell’s book Real Estate Investing in Canada, the 12 key fundamentals that affect real estate values are:

Passive Factors (out of your control):

1. Mortgage Interest Rates

2. Increase in Average Incomes

3. Increased In-migration and Demand

4. The Ripple Effect

5. Local, Regional, and Provincial (State) Political Climate

6. Transportation Expansion

7. Areas in Transition

Active Factors (in your control):

8. Creating Highest and Best Use

9. Buy Wholesale, Sell Retail

10. Quality Marketing

11. Renovations and Sweat Equity

12. Speculation

I was curious how New Haven was doing because I visited there a few summers ago and found some interesting areas. I could have picked many other US cities I like, Boston / Cambridge, Phoenix / Scottsdale, Portland (Maine), and pretty much all of North Carolina and Florida. After a little searching on New Haven, I found the following chart that summarized the real estate market fairly well.

In the chart you can see prices have dropped over 10% from Q3/07 to Q4/07. This doesn’t even cover Q1/08, which data should be coming in for any day now. This decrease is substantial and should get some attention. However, I can’t take my eyes off the massive drop in the number of units sold. In one quarter homes sales dropped from 370 to 75!!! This is an 80% drop!!

Wow, now I realize the real crunch for property owners. A city with a population of 124,000 only had 75 properties change hands in 4 months! The real estate agents must be scared. This would seem to be a great buyers market because there must be a huge inventory of homes, condos, and investment properties. I would be curious to see what has happened to rents during this collapse of home sales in New Haven.

But let’s look a little deeper into the New Haven market using some of the 12 fundamentals.

Mortgage Interest Rates:

They have been low when compared to historical values over the past 30 years. The interest-only mortgages and other unique products also assisted in reducing borrowing costs and therefore stimulating home buying.

Increase in Average Income:

Estimated median household income in 2005: $30,603 (it was $29,604 in 2000)

New Haven	$30,603
Connecticut:	$60,941

Estimated median house/condo value in 2005: $188,200 (it was $109,200 in 2000)

New Haven	$188,200
Connecticut:	$271,500

Besides being around half of the state average, New Haven’s median income has essentially remained stagnant from 2000-2005, while house prices were increasing 72%. Does this make sense to you?

Increased In-migration and Demand:

The population of New Haven increased by 0.3% from 2000-2006. The addition of 375 people is hardly enough to justify a 72% increase in property values.

I can keep going through these fundamentals, but I think you already know the answer. The last 4 passive factors become more central when looking to predict an area’s future behaviour and we can skip them for this analysis.

Conclusion: New Haven’s fundamentals didn’t justify the increase in home values and they were bound to go back to reality. I realize that this may seem obvious now after looking at the fundamentals, but I truly believe I wouldn’t have been able to justify a BUY and HOLD investment in this market. It would have just been speculating and I don’t have the capital or risk tolerance to be doing that.

So let’s move on to Kitchener-Waterloo, where there is a large pool of skilled labour, a diverse mix of manufacturers and innovative tech companies, and great universities.

Here’s a summary of their real estate market:

As you can see there are a few differences from the New Haven chart, not sure if you can detect the sarcasm here or not…

For KW from 2000-2005 prices rose approximately 41%. This is good stuff for sure, but not as good as New Haven’s 72%.

As you can see the increase in number of MLS sales has also increased steadily.

Let’s look at the fundamentals now:

Mortgage Interest Rates:

Canadian rates are in a similar position to the US, low compared to historic levels. The difference in Canada is that interest only mortgages and subprime borrowing is around 5% of the market compared to 20% in the US. I got this info from the Real Estate Investment Network’s site, where they have a great speech by CIBC economist Benjamin Tal.

The climate is good enough to stimulate buyers, but not at a pace like the US.

Increase in Average Income:

Along with the median family income in KW being above the provincial and national average, unlike New Haven, it also rose about 10% from 2000-2004. This is a solid indicator of a region’s health, assuming inflation is also low.

Increased In-migration and Demand:

Just looking at the population increase for KW from 2001-2006 gives a good indicator of what is happening. A total of 25,201 people were added to the KW population for growth of 8.1%, almost 70 times the growth of New Haven over a similar period!

Conclusion: This case is also open and shut. Solid population and wage increases along with low interest rates bode well for KW.

If you had to pick the sustainable market, would it be New Haven or KW? You guessed it, even though KW’s house price increase was only 57% of New Haven’s performance, their underlying factors lean vastly in favour of KW for the long term.

So there you are, a specific analysis of the fundamentals for two real estate markets allowed us to understand their behaviour. Go ahead and apply these fundamentals to other US cities. If the cities have great fundamentals and prices are still dropping it may be a great time to buy. Just be sure to do your homework!

Here is the continuation of my quest to produce a systematic tool for identifying if you should buy or rent.

The previous post discussed the Level of Financial Education as a key indicator. Below is a complete list of the key variables.

Key Variables affecting the Rent vs. Buy decision:
• Level of Financial Education
• Plan for Savings
• % Down Payment
• Property Market
• Stock Market
• Nature of Income
• Location

2. Plan for Savings
Following up on my previous post, the next factor in the Rent vs Buy decision concerns your plan for savings. A large portion of savings is generally used to purchase a personal residence, tieing up a large amount of capital in the process.

Ask yourself what you would use the down payment money for if it didn’t go toward a house? If your answer would be to buy a car or some other consumable, buying a house is likely right for you because it would force you to put the money “away”.

However, if you can see yourself using the capital to purchase an investment property, start a business, or invest it in a great company, then you should at least consider renting. Definitely perform a detailed cost analysis with cash flows and equity projections to compare the 2 scenarios.

As for scoring, if you would spend your savings on shopping, travel, cars, etc. before investing it, give yourself a 1. If you would leverage it in real estate or through another investment, give yourself a 5. If you would plan on dumping it into a mutual fund give yourself a 3.

3. % Down Payment
My post regarding COCR / ROI variation with down payment amounts highlighted that lower down payment amounts are better for investment cash flow but worse for equity or a quick sale. These rules will be different for a primary residence and require more description.

Down payment amounts affect the rent versus buy decision because a low down payment will increase the mortgage owed. By putting down less than 20%, one would either be able to afford a larger property by using all of their savings or find one in their budget but use a small portion of their savings. Either way your expenses will be higher than putting down 20% or more to reduce your mortgage amount.

Complete a cash flow analysis because the higher mortgage payment might make renting substantially better. Then calculate the money you would save by renting and compare it to how much you would gain in “appreciation” if you owned. This number should give you an indication of the true winner in the debate.

Score yourself from 1-5 once again. A score of 1 would mean you intend to put down as little money as possible to get into a house (5%). Score yourself a 5 if you plan on putting down 20% or more.

Stay tuned for the next post outlining the Property and Stock Markets and their influence on the Rent vs, Buy decision.