Higher Salary but Higher Rent

“It’s not about how much you make; it’s about how much you get to keep” anonymous

Recently, due to COVID-19 and many IT engineers working from home, Mark Zuckerberg, the CEO of Facebook, declared that his employees might be soon allowed to work remotely for as long as they want. But if they were to move out of the Bay Area to the Midwest, for example, they would have to accept lower pay to account for the lower cost of living in their new city.

This story starts to reflect a reality long known that wages are based on the average price level of where workers live, more than on the individual productivity of these workers as classical economic theory claims. I live in Montreal and am more familiar with the Canadian context. In this context, the biggest driver of the cost of living is the cost of housing. Indeed, in most cities in the United States and Canada, housing is the most significant factor. Therefore, say you earn a certain high wage in a big metropolitan city, should you opt for a lower salary in some smaller city somewhere? Say you make one hundred thousand dollars in Toronto, should you move to Montreal for ninety thousand?

Rents and Wages

Valid questions. A first estimate would look at the average rent in different cities and make the comparison. For example, using a comparison that was done in 2018 on the Montreal Blog, the average rent in downtown Toronto for a one-bedroom apartment is $1,194. For the same one-bedroom, it is $698 in downtown Montreal. I note that these numbers are somewhat dated but they are for illustrative prupose.

Therefore, assuming all things are equal (which they are not), moving to Montreal means a saving of $439 per month, or $5952 a year. Therefore, a salary adjusted by just as much would make sense for the same job – or maybe more (say 11k) to account for income taxes. This scheme should work for both employer and employee. The employee gets to live in the city she wishes, and the employer does not pay as much for the wage (although a fairer strategy would be to split the difference).

All well, but as most white-collar professionals know, workers do not remain tenants forever, and at some point, they save enough to buy a home. When they do, part of the money they pay for their mortgages starts building them equity as their properties appreciate. At first, the financial economist will argue that we need not go beyond the simple analysis done above. The economic value of owning property is the same as that of forgoing paying rent. In other words, say you spend your life paying rent and die with an amount saved in some inflation-proof bond. That amount is the same as if you were to get a mortgage on your apartment, pay it over 25 years, and then have the property sold at the time of your death. This theory is backed up by the classical economics of “no free lunch.” If in a city, it was more advantageous to buy than to rent, then most investors would buy properties and rent them out. At some point, the market gets saturated with empty homes that need tenants, and the prices of rents will go down. Conversely, if it was cheaper to rent than it was to buy, most people will rent and will drive down the cost of buying.

But like most economics, the reality is quite different. Arbitrage, the fancy French term for “free lunch,” exists in the real estate market. And a lot of people get richer when they buy their homes versus those who rent their homes. The wealth comes from the appreciation of home prices, which is largely dependent on the city where they live. As they say in real estate, “Location! Location! Location!”.

We thus go back to our comparisons of Montreal and Toronto. Using some quick calculation from data on this site, I found that prices rose in Toronto by 125% over the past decade while they rose in Montreal at 50%. Therefore, someone who locked in a mortgage ten years ago in Toronto and sold it today would be richer than someone who did the same thing in Montreal. Note that mortgage rates are the same for the whole of Canada. They are regulated at the federal level. 

If only I had more money to invest

For a full analysis, we need to consider the opportunity cost of capital. The next best investment to real estate in terms of risk and return is dollar-cost averaging in the S&P 500 index. The historical average return of the S&P is 9.8%. With the last decade being particularly successful, an investment of $500 monthly using this average calculator would return $100,000 today vs. the $60,000 with no interest. Or in percentage terms, a return of 66%.

We are also not considering the effect of taxes. Some provinces or American states offer the same services as others while charging different income and sales taxes. Montreal, for instance, has higher taxes than Ontario. Yet, for a single person (such as this author), the taxes do not bring much value. They are mostly geared towards family benefits and educational benefits. So, we might consider this to be a negative on the Montreal single salaried employee.

Not to get too bogged down in our calculation, but taking our initial investment in a home and accounting for the difference (in terms of down payments and per month mortgage payment) being invested in the S&P 500 and the effect of taxes and assuming a single worker: the net wealth of the Torontonian is a lot greater than that of the Montrealer. This is mainly due to the 125% increase in home prices in Toronto, which dominates all other considerations.

Hence, even if someone might be earning a high salary in Montreal, it would make sense to switch to Toronto for a similar or slightly better salary if they could afford to buy a home (have money set aside for the down payment and can afford the monthly payment for the mortgage).

A down payment on an apartment in the Bay Area

Therefore, we go back to the real estate dimension; experience also shows that the type of apartment that one can get in an expensive city varies a lot versus what one can get in a cheaper city or a suburb. For instance, Montreal had been known for spacious condos with low rents. Something that has not been the case in Toronto. When we get to different apartments, we start getting into the issue of different down payments and different home prices.

And thus, it becomes more of apples to oranges comparison. When the salaries are similar across different cities, then it becomes possible to choose to live in the city that affords one, the best advantages. For example, someone looking for a bigger home might decide to go live in Montreal. In contrast, someone who likes a more bustling city might choose to live in Toronto.

Yet, some metropolitan cities have rents that are so high as to make homeownership impossible given current wage levels. A notorious example is San Francisco in California, where a one-bedroom apartment rents for $3700. In such cases, even what might qualify as an extremely high salary somewhere else in the United States or Canada would be low in San Fran. Thus, workers might not be able to save enough to afford the down payment for homeownership. Some of these homes are over a million and a half dollars on average. And this might be the biggest problem with moving to a big bustling city. Being priced out of homeownership will affect a worker’s future wealth. For example, I calculated for our previous numbers, it would take 2.5 years to accumulate the down payment necessary for a home in Toronto while only needing 1.2 years in Montreal (assuming a comfortable 20% downpayment for a no questions asked mortgage).

In 2013 an influential French economist named Thomas Piketty published a book on capital in the 21^st century. One of the central premises presented was that the rate of capital growth is more significant than the rate of economic growth or labor growth in an economy. Therefore, capital holders, be they in the stock market or real estate or other forms of capital, will see their capital grow faster than they can expect their wages to grow. When it comes to real estate, it is sometimes the most significant investment people make. Add to this, how mortgage rates work and the support of western government to make their citizens homeowners, therefore when it comes to owning your own home, it is one of the best investments that you can make. We will not go into bubbles and pricing anomalies, such as what caused the 2008 financial crisis. But suffice it to say that all investments have risks involved – this, of course, also applies to our investment in the S&P 500 above.

Conclusion

Several conclusions can be made here.

First, when it comes to Mark Zuckerberg and other employers who have been telling their workers that if they choose to live in a different city post-COVID, their wages would be affected. It seems that they are trying to squeeze any potential benefit those workers might get outside their companies and appropriate them for their bottom line. Classical economics, our old friend, tells us that their productivity solely determines workers’ wages: this is the amount of labor output they can produce for a unit of time.

Second, let us assume that there will be more productive workers (from Silicon Valley, for example) in poorer cities. They might become more valuable to local employers. So, the labor market should, in theory, autocorrect, and they would see their wages adjust. It is interesting to note that real estate prices have been increasing in the last few years in Montreal as well as wages. This can be partly attributed to Montreal becoming a new IT hub in Canada thanks to the rise of Artificial Intelligence and the power of the gaming industry there.

Third and finally, the international dimension to the acceptance of remote work might be the biggest post COVID era change. For a long time, workers in the poorer countries were tied to their countries’ wage rates. However, if we use productivity as the single yardstick for workers’ wages, we start wondering how much exceptionally talented workers in poorer countries should earn (such as those talented engineers in India, for example). Should they be paid the same wage as the American and Canadian workers? Should the American and Canadian workers accept to work for less? Or should they, as Mark Zuckerberg is saying, keep earning their country’s wage rate because of supposedly lower costs of living? Maybe this is the topic for another essay.

Acknowledgment

I am grateful for some feedback I have received on earlier versions of this essay and have incorporated it into this version.

The addition of the opportunity cost of capital prompted me to do some calculations with simplified assumptions. You can find them in this excel on GitHub.

Please comment below on what you think.