Hey Phil, thanks for writing this! Your article got me thinking, as I’ve lived in situations like this before. I was gonna drop a comment here with thoughts, but then it got too long… so I posted it on my site! Would love your thoughts :) https://kyleschmolze.com/renting-to-your-friends/
Kyle - I'm just noticing this now. Really appreciate you writing up such a thoughtful perspective. I'm going to add it to the main section of the post.
I agree 100% on the main point of your response: Not everything is about financial returns. There are also social returns to consider and social returns are often more important. I genuinely believe this. It is sort of a theme of this newsletter: We believe sharing housing is a great way to deepen relationships and that matters more than strict return maximization, which will make you wealthier but lonelier.
I also agree in principle that a "cost-based" approach to setting rents for friends makes sense and its the same spirit as the "Return on Investment method" in the original post.
Where I differ is probably on what goes into a "cost-based approach" and whether a mortgage payment is in play and fair.
A couple points:
1) The main cost of owning a house is not the direct costs (e.g. tax, insurance) .. the main cost is the "cost of capital." And the cost of capital is very real, even though its indirect. There are usually two "capital costs" to consider - 1) The opportunity cost of the downpayment 2) the interest on the loan.
Downpayment: If I have to pull my savings out of .. let's say .. an index fund (8% return per year) and put it into a house (4% return per year), there is a very real cost i experience in doing that (4% a year) in order to own a home.
And then there's mortgage interest. Most of a mortgage payment does not translate to more equity. It's interest to the bank. For us its roughly 2/3 interest, 1/3 principal. And I think having someone cover a portion of that interest is not the same thing in principle as paying off their mortgage. It's a real cost of owning the home. It's the cost of the capital to buy it.
How you decide to go about quantifying this is ultimately subjective and you can decide not to account for it. But I think its important to establish what the real costs are here so everyone knows what is taking place. And that there are no hidden subsidies.
2) Risk and downside. Owning a home is risky. Having a mortgage is risky.
Most of the time nothing bad happens. Sometimes something really bad happens (e.g. earthquakes, housing market crashes, local laws changing, floods, etc).. The homeowner is on the hook for all the bad things, the renter is not. Putting the homeowner and the rental on equal financial footing despite one of them carrying all the risk and responsibility is a very nice thing for a homeowner to do (and something we do at Radish for example...) but I don't think is a requirement for fairness. It's reasonable to recognize this in some capacity
Lastly, I think there is the practicality of earning equity for rent. If someone is renting over a very long period of time, they can accumulate a meaningful amount of equity and this may be worth it. If not, its likely going to be a world of administrative pain and legality and liabilit for something that amounts to "I own 0.0005% of a house." I think both parties need to be honest whether the juice is worth the squeeze on any "rent-to-own" agreement. And if not there may be other ways of recognizing tenure and contribution that are less complicated and binding (e.g. rent discounts over time, upgrading the space, etc).
Thanks so much for engaging! And apologies for the delay.
> We believe sharing housing is a great way to deepen relationships and that matters more than strict return maximization, which will make you wealthier but lonelier.
Couldn't agree more!
I also agree that it's often not going to be worth it to establish an equity arrangement for someone who only rents for a short period of time. If you're actually going to do a bunch of paperwork (or even just all the emotional and relational labor), it makes sense to introduce some sort of "cliff" renters need to get past. E.g. we can retroactively translate X% of your rent payments into equity if you stick around for Y years. That said, if you go with a super duper simple "IOU" situation, I could imagine it being very easy and worth it for even short periods of time (although they may not stand up in court).
Re: Downsides. I guess it depends which downsides you're referring to. If it's the chance of the market crashing and the house eventually selling for less than it was purchased for, that would be shared downside between all equity holders. But if we're talking about being on the hook to the bank for mortage payments on a property that's now financially underwater because of an earthquake... yeah that's a lot more complicated. LLCs and more comlicated and proper legal structures may be needed to fully share those risks, as the bank won't come after your renters regardless of a nice little MOU you all signed. But if you're planning on living together for many years (as discussed above), it definitely seems doable to work out those risks. Renters may not want to share those risks, but then they shouldn't be buying in. If they want to share the upside, they should be willing to share the downside.
And finally, and perhaps most importantly, I want to push back on the concept of "opportunity cost." Is it a real thing? It's a very common phrase, and economists and bankers will certainly tell you it is, but personally I believe it's a Jedi Mind Trick designed to keep capitalism flowing at it's most-extractive.
By convincing wealthy people that they are "paying a cost" if they make any investments other than the most profitable ones possible, it tells us that rich people *deserve* to make money from their capital (sometimes unbelievable gobs of money). It creates more consent for extractive and downright destructive investments: climate destruction, weapons manufacturing, private equity, etc. After all, why should I "give away" money to a local cafe to open, but is only offering a 2% return, when the destruction economy promises more? Don't I deserve that full 8%? Why should I "pay" for the local cafe more than anyone else?
And of course, these promises are all for naught, because no economy can grow infinitely on a finite planet, and so we are simply heading towards collapse. Instead, let's figure out how to bend capitalism towards true sustainability. One of the first steps of that is to rid capital of the notion that it deserves 8% profit every year.
Thanks very much for this discussion, guys. You both raise important points and I haven't found anything else nearly as useful on the net! Kyle, I'm relieved you added the caveat about wealthy landlords because I think it is unfair to assume that all landlords/investors are wealthy, especially when talking about creative or co-purchasing solutions.
If I may give our case as an example.
My husband and I bought a bit of land 50/50 with a first-home-buyer friend. We now have 2 dwellings on the land (one self-built kitset and one relocated, second hand), which, like the land we financed 50/50 with our friend/co owner. She now lives in one dwelling and the other is rented out (as my family doesn't currently want to move away from our work and schools). Both parties benefit equally from the rental income we get from the third-party tenants.
We've been able to agree on a short-term rental rate for our co-owner friend (of which she gets half back, after expenses) but we haven't worked out a process for recalibrating the rent over the long term. Obviously maintaining our relationship is of utmost importance... but taking on a joint mortgage has real cost and risk to us. Opportunity cost is real too - not because we are missing out on x% return on our investment, but because it impacts what we have available to invest in our own family. We are a single-income family of 4 and we remortgaged our modest family home in order to be able to undertake this co-purchase with our friend.
The trick here is finding an equitable balance so that one party is not favoured over the other in terms of their ability to pay off/benefit from their investment.
Some suggestions we've floated include market-minus-25%; adjusting with inflation; and now I'm working through your return on investment/cost-based model (huge thank you for sharing this!)...I'm yet to convince our friend that rent will likely need to increase over time, but I'm hoping this will help!
Would you adjust the target rate of return over the years to account for inflation? ie real rate of return = annual return – inflation rate? If we don't, in 30 years time the return we get will be worth about half what it is now...and in our case, not enough to buy a takeaway lunch (not that we do that anyway!)!
Hey Phil, thanks for writing this! Your article got me thinking, as I’ve lived in situations like this before. I was gonna drop a comment here with thoughts, but then it got too long… so I posted it on my site! Would love your thoughts :) https://kyleschmolze.com/renting-to-your-friends/
- Kyle
public@kyletns.com if you/anyone wants to chat
Kyle - I'm just noticing this now. Really appreciate you writing up such a thoughtful perspective. I'm going to add it to the main section of the post.
I agree 100% on the main point of your response: Not everything is about financial returns. There are also social returns to consider and social returns are often more important. I genuinely believe this. It is sort of a theme of this newsletter: We believe sharing housing is a great way to deepen relationships and that matters more than strict return maximization, which will make you wealthier but lonelier.
I also agree in principle that a "cost-based" approach to setting rents for friends makes sense and its the same spirit as the "Return on Investment method" in the original post.
Where I differ is probably on what goes into a "cost-based approach" and whether a mortgage payment is in play and fair.
A couple points:
1) The main cost of owning a house is not the direct costs (e.g. tax, insurance) .. the main cost is the "cost of capital." And the cost of capital is very real, even though its indirect. There are usually two "capital costs" to consider - 1) The opportunity cost of the downpayment 2) the interest on the loan.
Downpayment: If I have to pull my savings out of .. let's say .. an index fund (8% return per year) and put it into a house (4% return per year), there is a very real cost i experience in doing that (4% a year) in order to own a home.
And then there's mortgage interest. Most of a mortgage payment does not translate to more equity. It's interest to the bank. For us its roughly 2/3 interest, 1/3 principal. And I think having someone cover a portion of that interest is not the same thing in principle as paying off their mortgage. It's a real cost of owning the home. It's the cost of the capital to buy it.
How you decide to go about quantifying this is ultimately subjective and you can decide not to account for it. But I think its important to establish what the real costs are here so everyone knows what is taking place. And that there are no hidden subsidies.
2) Risk and downside. Owning a home is risky. Having a mortgage is risky.
Most of the time nothing bad happens. Sometimes something really bad happens (e.g. earthquakes, housing market crashes, local laws changing, floods, etc).. The homeowner is on the hook for all the bad things, the renter is not. Putting the homeowner and the rental on equal financial footing despite one of them carrying all the risk and responsibility is a very nice thing for a homeowner to do (and something we do at Radish for example...) but I don't think is a requirement for fairness. It's reasonable to recognize this in some capacity
Lastly, I think there is the practicality of earning equity for rent. If someone is renting over a very long period of time, they can accumulate a meaningful amount of equity and this may be worth it. If not, its likely going to be a world of administrative pain and legality and liabilit for something that amounts to "I own 0.0005% of a house." I think both parties need to be honest whether the juice is worth the squeeze on any "rent-to-own" agreement. And if not there may be other ways of recognizing tenure and contribution that are less complicated and binding (e.g. rent discounts over time, upgrading the space, etc).
Thanks so much for engaging! And apologies for the delay.
> We believe sharing housing is a great way to deepen relationships and that matters more than strict return maximization, which will make you wealthier but lonelier.
Couldn't agree more!
I also agree that it's often not going to be worth it to establish an equity arrangement for someone who only rents for a short period of time. If you're actually going to do a bunch of paperwork (or even just all the emotional and relational labor), it makes sense to introduce some sort of "cliff" renters need to get past. E.g. we can retroactively translate X% of your rent payments into equity if you stick around for Y years. That said, if you go with a super duper simple "IOU" situation, I could imagine it being very easy and worth it for even short periods of time (although they may not stand up in court).
Re: Downsides. I guess it depends which downsides you're referring to. If it's the chance of the market crashing and the house eventually selling for less than it was purchased for, that would be shared downside between all equity holders. But if we're talking about being on the hook to the bank for mortage payments on a property that's now financially underwater because of an earthquake... yeah that's a lot more complicated. LLCs and more comlicated and proper legal structures may be needed to fully share those risks, as the bank won't come after your renters regardless of a nice little MOU you all signed. But if you're planning on living together for many years (as discussed above), it definitely seems doable to work out those risks. Renters may not want to share those risks, but then they shouldn't be buying in. If they want to share the upside, they should be willing to share the downside.
And finally, and perhaps most importantly, I want to push back on the concept of "opportunity cost." Is it a real thing? It's a very common phrase, and economists and bankers will certainly tell you it is, but personally I believe it's a Jedi Mind Trick designed to keep capitalism flowing at it's most-extractive.
By convincing wealthy people that they are "paying a cost" if they make any investments other than the most profitable ones possible, it tells us that rich people *deserve* to make money from their capital (sometimes unbelievable gobs of money). It creates more consent for extractive and downright destructive investments: climate destruction, weapons manufacturing, private equity, etc. After all, why should I "give away" money to a local cafe to open, but is only offering a 2% return, when the destruction economy promises more? Don't I deserve that full 8%? Why should I "pay" for the local cafe more than anyone else?
And of course, these promises are all for naught, because no economy can grow infinitely on a finite planet, and so we are simply heading towards collapse. Instead, let's figure out how to bend capitalism towards true sustainability. One of the first steps of that is to rid capital of the notion that it deserves 8% profit every year.
Thanks very much for this discussion, guys. You both raise important points and I haven't found anything else nearly as useful on the net! Kyle, I'm relieved you added the caveat about wealthy landlords because I think it is unfair to assume that all landlords/investors are wealthy, especially when talking about creative or co-purchasing solutions.
If I may give our case as an example.
My husband and I bought a bit of land 50/50 with a first-home-buyer friend. We now have 2 dwellings on the land (one self-built kitset and one relocated, second hand), which, like the land we financed 50/50 with our friend/co owner. She now lives in one dwelling and the other is rented out (as my family doesn't currently want to move away from our work and schools). Both parties benefit equally from the rental income we get from the third-party tenants.
We've been able to agree on a short-term rental rate for our co-owner friend (of which she gets half back, after expenses) but we haven't worked out a process for recalibrating the rent over the long term. Obviously maintaining our relationship is of utmost importance... but taking on a joint mortgage has real cost and risk to us. Opportunity cost is real too - not because we are missing out on x% return on our investment, but because it impacts what we have available to invest in our own family. We are a single-income family of 4 and we remortgaged our modest family home in order to be able to undertake this co-purchase with our friend.
The trick here is finding an equitable balance so that one party is not favoured over the other in terms of their ability to pay off/benefit from their investment.
Some suggestions we've floated include market-minus-25%; adjusting with inflation; and now I'm working through your return on investment/cost-based model (huge thank you for sharing this!)...I'm yet to convince our friend that rent will likely need to increase over time, but I'm hoping this will help!
Would you adjust the target rate of return over the years to account for inflation? ie real rate of return = annual return – inflation rate? If we don't, in 30 years time the return we get will be worth about half what it is now...and in our case, not enough to buy a takeaway lunch (not that we do that anyway!)!