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Should I rent or buy my home?

Australian households collectively own assets of $16.7 trillion of which 56% or $9.4 trillion is invested in real estate. 

Smart money move or dangerous national obsession? Let's find out.

Background

Buying your home – it's either the best investment you’ll ever make, according to the media or your most significant liability, according to Robert Kiyosaki, best-selling author of “Rich Dad, Poor Dad”.


Your house is not an asset. Rather it is a liability...Instead of putting money in your pocket; it takes money out of your pocket in the form of a mortgage, utility payments, taxes, maintenance, and more. That is the simple definition of a liability. 

The truth is, it’s neither and both. 

And Mr. Kiyosaki clearly wasn’t paying attention in accounting class the day they covered liabilities. Oh, that’s right, he doesn’t believe in college!

A better way of thinking about whether or not to buy your home is to treat it as a hedge.

Let me explain.

The golden rule is to buy property, not too much, only when the time is right for you.
As adults, we all need somewhere to live. We can choose to buy at the price available on the day by renting, or to fix the price by buying. By renting, we are exposed to the risk of fluctuating rental prices; by buying, we get the certainty of knowing the cost. 

Regardless of what happens to rents or house prices, we have hedged (or eliminated) our risk of future increases in rents.

Over time rents tend to rise in line with wages without an excess supply of available properties. Even though you may be able to rent more cheaply than the cost of buying today, this won't always be true – your mortgage payment does not increase over time but rents will.

Real estate is also the only item we need to consume that maintains some value even when used. It might be more or less than you paid for it, but it still has a value.

This might seem like semantics – but it is essential in how we think about buying a home. If you treat it as an investment, there is the temptation to buy too much or compare it to investing in alternative assets like shares.

But looked at as a form of consumption, it reminds us that less is better. Every dollar we spend on our home is a dollar we can’t spend or invest elsewhere.

Most of the financial stress I see in my work arises from buying too much house or too much car.

Together these typically make up 40% of the average household budget and so are among the most important financial decisions any of us make.

The Cash Cost of renting is usually lower

In Australia, the cash cost of renting, at least in the short term, has almost always been lower than the ongoing cost of buying.

There are three main drivers of this:

  1. There are significant transaction costs in buying and selling real estate. The main cost is stamp duty, which for example, would be $31,207 for a $800,000 property in NSW. This is the equivalent of nine months’ rent.
  2. The rental cost is usually less than the cost of borrowing the money required to buy the property, or the income that is forgone because this money could not be invested elsewhere. The rental yield (annual rent divided by the market value of the property) in Australian capital cities has historically been around 5%, (or roughly $1 per week for each $1,000 the property is worth). Right now this can be as low as 3% in parts of Sydney. This means that a $800,000 property will usually rent for $500 a week or less. 
  3. The standard variable home loan interest rate by way of comparison is around 3% right now – lower than it has been at any other time in the past 50 years and as a result closer to the cost of renting as it's ever been.
  4. Home owners incur a number of expenses that renters don’t. These include rates, maintenance, strata levies, building insurance and the fixed proportion of water charges.

Over time, however, inflation helps push up all of the costs other than the amount the owner has spent to purchase the property, so that at some point the renter’s cash cost starts to exceed the owner’s cash cost.

Over long enough a time period, buying will work out cheaper.

This phenomenon, whereby an initially higher cost to buy is slowly whittled away by inflation, means that given a long enough time period, buying will work out cheaper. How long that period will be is the great unknown. As the famous economist John Maynard Keynes said, ‘In the long run we are all dead.’

In practice, buying delivers certainty and a bunch of intangible benefits. The question for you then should be, ‘is now the right time for me to buy certainty at the expense of flexibility, knowing it will cost me a little more right now?’

There are some circumstances where the fixed option will almost always be more expensive. For example, if you need to move homes in a short period (usually any period less than five years). Here the transaction costs and the increased expenses almost always outweigh the benefits of fixing the costs of housing.

On the other hand, over any long period (usually 10 years or more) over the past 50 years, the fixed option worked out cheaper.

But what about the gain (or loss) in the value of the property?

In some ways this is somewhat academic, because the value of any alternative property is likely to have risen (or fallen) by the same amount, so the increase in wealth can never be realised for so long as you need somewhere to live.

Similarly, any loss can be deferred, so long as you can keep up your mortgage payments and don’t need to move.

The wealth effect, whereby we feel richer because the value of our homes has gone up, can also encourage us to spend more of our incomes. This can secretly whittle away much of the advantage.

It's not a one way bet

RPdata, a property researcher, tracks these things its ‘Pain and Gain Report’ series. The latest report shows that one in five resales are at a loss or a gain of less than 10%. These owners would have been financially better off renting. On the other hand four out of every five resales yielded a gain of 10% or more. The average hold period for those selling for a gain was eight to 13 years.

Oh, and don’t forget we could have invested the difference in cash cost between renting and buying, which could be worth more or less than the increase in the value of the property.

There are other benefits

Nevertheless, home ownership creates discipline around saving, it provides a store of wealth that can be accessed, is favourably treated by our tax and welfare systems, and improves your credit rating, which can lead to lower borrowing costs in future.

Either way, the homeowner gets the benefit of fixed housing costs and all of the psychological benefits of home ownership. These should not be underestimated. Ultimately this is a very personal decision. In my view, the key is buying the right amount of house with a cost that allows you to sit tight through thick and thin (see the 50/30/20 rule for budgeting). Oh and don’t move for a long time!

So how do the numbers stack up?

I'll use the example of a home loan that rents for $500 a week and costs $812,500 which equates to a rental yield of 3.2%. In other words, you need to spend 31 times the current year’s rent to buy the property.

Three individuals have savings of $194,247 which they choose to either invest or use to buy the property.

The initial cost of purchasing the property consists of a 20% deposit ($162,500) plus stamp duty of $31,747 (in NSW). The balance is funded by a mortgage of $650,000 (over thirty years at 3.0%).

Harriet Home Owner

Scenario #1: Harriet Homeowner chooses to buy the property using all of her savings.

Each month she pays principal and interest repayments on her loan of $2,740. She must also pay for maintenance (I assume a typical 1% of the property value per annum), or an initial $677 a month. This cost rises annually with inflation). And of course, there are council rates of $125 which also rise with inflation each year. 

Her total monthly cost is, therefore, $3,542.

I have allowed for property selling costs of 5% of the sale value to pay for agent’s fees, marketing and legal fees and an allowance for minor repairs and staging costs when assessing the value of her property.

Rachael Renter

Scenario #2: Rachael Renter chooses to rent and invests her savings in an investment portfolio.

Rachael pays an initial $500 a week (or $2,173 a month) in rent. Each year the rent rises in line with historic wages growth of general consumer inflation (CPI) + 1%. 

I have assumed CPI is 3% annually, so this means rent rises at 4%. I have also assumed that property prices rise at the same rate, keeping the rental yield constant at 3.2%.

I chose the Vanguard High Growth Index Fund as a benchmark for the potential return because it invests in a diversified portfolio of assets at low cost, and I have a long history of returns available. Over the past 18 years since inception, the fund delivered an annual return of 8.42% (before tax, after fees), made up of 5.3% income distributed each year and 3.11% capital growth.

I have assumed that Rachael pays tax on the distribution each year (at her marginal tax rate of 34.5% including medicare) and reinvests the after-tax amount. The growth in the fund is taxed as a capital gain when finally sold.

Roger Rentvestor

Scenario #3: Roger Rentvestor chooses to buy a property and rents it out. He also rents an identical property in which he lives.

Just like Rachael Renter, Roger pays an initial $500 a week (or $2,173 a month) in rent. Each year the rent rises in line with historic wages growth of general consumer inflation (CPI) + 1%. 

I have assumed CPI is 3% annually, so this means rent rises at 4%. I have also assumed that property prices rise at the same rate, keeping the rental yield constant at 3.2%.

And just like Harriet Homeowner, Roger buys a property using all of his savings.

Each month he pays principal and interest repayments on his loan of $2,740. He must also pay for maintenance (I assume a typical 1% of the property value per annum), or an initial $677 a month. This cost rises annually with inflation). And of course, there are council rates of $125 which also rise with inflation each year. 

He rents out the property and receives rental income of $500 a week from his tenant and pays his agent a management fee of 7% of the rent collected ($35 a week).

Roger is liable for income tax on the net income from the property after allowing for his costs and depreciation. If his income exceeds the cost he will pay tax on the difference. If there is a loss (as is the case for the first seven years), he will be able to offset this against his other income and receive a net tax benefit. This is usually referred to as a negative gearing benefit.

Like Harriet his total monthly cost of holding the property is $3,542 and he receives net rental income (after deducting the agents fee) of $2,021, so he is out of pocket by $1,521.

This cash outflow is reduced by the negative gearing benefit. In calculating his tax, he doesn't include the principal component of the mortgage payment which is not deductible. But he does get an additional deduction for depreciation. I have assumed a typical depreciation amount of $9,000.

In the first month his net tax loss is $1,210. Income: $2,021; less interest paid ($1,679), maintenance ($677), rates ($125), and depreciation ($750). At his marginal tax rate of 34.5%, this creates a net tax benefit of $417 which he receives when he lodges his tax return at the end of the year.

I have allowed for property selling costs of 5% of the sale value to pay for agent’s fees, marketing and legal fees and an allowance for minor repairs and staging costs when assessing the value of his property.

Roger will also pay capital gains tax when he sells the property, based on the difference between the net proceeds and his cost base (his purchase price plus stamp duty, less the depreciation he claimed during the period of ownership)


So how does our trio fare over time?

There are two ways to compare Rachel's, Harriet's, and Roger's financial position. 

  1. How much they spend each month
  2. What the net value of their assets is at any time.

Cash Flow of buying vs Renting vs Rentvesting

Rachael's monthly cost (the blue line) is initially the lowest of the trio and she adds the difference to her savings. But as rent inflation increases her monthly outgoings, over time, the gap narrows and a crossover occurs where Rachael's monthly outgoings exceed Harriet's (the red line) and eventually Roger's (the green line).

Roger's monthly cost is initially marginally lower than Harriet's due to the negative gearing tax benefit, but as his net proerty income turns positive and he starts paying tax, his monthly outgoings exceed Harriet's. Harriet add the difference to her savings.




How long this takes depends on inflation and the relationship between the rental yield and the home loan interest rate. In this example, though, it takes 5 years for Roger and 16 years for Rachael. Right now, with interest rates below the rental yield it is probably as long as it has ever been in history.

But in almost any scenario you can construct it will happen at some point given enough time. Moreover, at year thirty, Harriet's and Roger's mortgages will be paid off and their monthly outgoings will dramatically fall.

Net Asset Position of buying vs renting

This comparison is a little more complex.

In order to equalise the cashflows, I assume that both Rachael and Harriet add to their savings each month where their cashflows are lower than Roger's (and withdraw when their cashflows are higher).

Initially, Harriet and Roger are much worse off because they had to pay the costs of buying their properties (primarily stamp duty) and have to forgo the earnings on their savings used as their deposits.

Rachael can readily access her savings, but Harriet and Roger will need to meet the costs of selling their properties, so these need to be deducted from the value of their properties.

On the other hand, Rachael and Roger will need to pay Capital Gains Tax on their profits, Harriet will not.

For Harriet and Roger, some of their higher monthly outgoings reduce their debts to the bank, increasing their net assets.

Again under most long enough scenarios, there will be a crossover point where Harriet and Roger recoup their initial shortfall through debt reduction and property value growth while the tax due on Rachael’s and Roger's investment growth reduces their profits.



In this example, the crossover for Harriet occurs at year five. Any time after this, Harriet's net assets exceed Rachael’s and Roger's.

Roger's net asset position is better than Rachael's after six.

Lower inflation, lower rental yields, higher investment returns or higher mortgage rates would lengthen the time it takes to get the crossover period.

Conclusion

Over most long enough periods buying your home will leave you better off than renting or rentvesting on a like for like basis. 

But it’s not possible to predict ahead of time how long that period will be.

This does not mean that rent money is dead money.

But if you know where you want to live long term, it usually makes sense to buy rather than rent.

If you choose to rent, you need to save the difference and invest diligently not to be worse off than buying. Few people have the discipline to do this.

If you do buy, be careful how much you spend. Try to spend no more than 5-6 times your annual income.

And don’t be tempted to think that spending on home improvements is always an investment. Most such jobs do not add more than their cost to the value of your home. Do it if it gives you joy, but recognise it is a form of consumption, not a way to invest.

Rentvesting delivers higher returns than renting over long periods due to the ability to borrow more easily to invest in real estate than in shares or managed funds. In effect the comparison between renting and rentvesting is really a comparison between investing in real estate or (in this case) investing in a growth managed fund.



Whatever you do, don’t rush into buying just because your friends are doing it or your parents are badgering you. 


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Vince Scully

Founder and Chief Sherpa

With over 25 years in Financial Services from consulting to management, Vince Scully is the go-to guy for wealth management and financial advice. Vince founded the Calliva Group; a fund manager, product issuer, advisor and lender to Government and private clients. Vince is an advisor to the Wealth Management Industry, and prior to his role as CEO at Calliva, a senior member of Macquarie bank’s infrastructure team.

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