Thursday, November 18, 2010

On rent vs buy and ludicrous house price assumptions...

Today I would also like to tackle the commonly held idea (in Australia) that renting is “throwing money out the window” and that buying a house is always the best way to build long term wealth. It is very difficult to disabuse people of this notion, but I am going to try my best.

First of all, let’s try a little thought experiment. What would you say to a friend who told you that she had $100,000 in savings, and had decided to take that money to a broker, borrow $400,000 and then invest half a million dollars in the stock market? In the middle of a stock market bubble. You would probably tell her she is completely nuts. This is a highly leveraged investment. If the market falls 20%, then she loses ALL HER MONEY.

So why do young Australians think it is sensible to do exactly the same thing in the housing market? This is a decision to invest your life savings in a single, highly illiquid asset which is quite likely overvalued by 20% to 50%. The thing people forget is that there is an opportunity cost in buying a house. You could choose instead to rent, and invest that $100,000 in a term deposit and get 6-7% entirely risk free. You could invest it in a diversified portfolio of shares or bonds, perhaps earning an even higher rate of return. You could put that money towards starting your own business.

Houses are an asset. And like any other financial asset, whether or not it is sensible to buy comes down to the valuation. 

So let’s start crunching some numbers. I like this Rent vs Buy calculator on the New York Times website. Let’s compare buying a $500,000 apartment in Sydney with renting the same property for $500 a week. You’ll need to click on the “Advanced Settings” tab and correct for some of the US quirks such as tax deductibility of mortgage interest payments.

Let’s assume a 25-year mortgage and plug in the current variable mortgage rate of 7.8%. Now, the most important assumptions here are the expected annual home price change, the expect annual change in rents, and the expected annual rate of return you can make on alternative investments.

Let’s be really conservative, and assume that if we rent we’ll make 5% annually on our savings. And we’ll assume that rents grow 3% annually, a little faster than inflation. Now comes the most important assumption. At what annual rate can we expect house prices to appreciate over the coming 25 years? I have a feeling if you asked the average Australian property investor this question, you would get a lot of answers in the 6-10% range. So let’s take a look at how realistic this would be.

As in my last post, lets assume that household incomes grow at around 4% in the long term. And let's then calculate what would happen to Sydney's ridiculously high price/income ratio of 9.1 for various assumptions of housing price growth over the next 25 years. 

Capital Appreciation (%) Implied Price/Income Ratio
0 3.41
2 5.60
4 9.10
6 14.65
8 23.38
10 36.98
These calculations show you that if you are expecting house prices to grow at even 6% annually in the coming decades, you are smoking something. Clearly somewhere in the region of 0-4% is more realistic, and I would argue for the lower end of that range. 

Let's plug those numbers into the NY Times calculator. Under the relatively optimistic scenario of 4% capital growth, you need to hold the property for 15 years until you come out ahead of renting. At 3% growth, it takes 25 years. Anything less than that is a total unmitigated financial disaster. 

Now, these are very rough calculations and they are very sensitive to the underlying assumptions. They do not suggest that renting is always the better option. But my point is that the standard mantra that buying is ALWAYS better than renting is absolute bollocks. This is only the case if your expectations for long term growth in housing prices are grounded in FantasyLand. 

Unfortunately, a whole generation of Australians has been brainwashed with the idea that owning property is a shortcut to long-term wealth. 

And this can only end in tears...


  1. The preferences of people actually depends on the situation. Both owning and renting can be advantageous over the other but both has some disadvantage too that those home seekers shall need to consider first and analyze on whether to rent or buy a house/property.

    real estate continuing ed

  2. You're right mate. There must be some bloody good weed going around at the moment...

  3. where do you account for the capital gains tax you'd pay on investment income vs. zero capital gains for your principal place of residence?