Wednesday, December 22, 2010

Rent vs Buy -- (Updated with new figures)

As auction clearance rates plummet around Australia and the inventory of unsold properties continues to rise, in 2011 we are no doubt going to be told by the spruikers that it is an "excellent time to buy". So let's revisit the question of whether it makes financial sense to buy at today's prices versus renting an equivalent property.

For today's experiment, I have randomly chosen a $685,000 property in inner Sydney that is listed on "Perfect for a single person or couple looking to live the life of luxury and convenience", the unit below is currently being rented out at $750 a week.
Let's compare buying the property with a 20% deposit, and renting, in which case I will assume you invest any savings you make relative to buying and earn a rate of return of 5% (I think this is reasonable for a portfolio of cash, bonds and diversified shares, including overseas exposure).

Now fortunately, the New York Times website has an excellent tool which gives us a graphical representation of the rent vs buy scenarios over time. (you have to tweak the Advanced Settings to account for tax differences in the US and Australia. Contact me if you are interested). Let's say you're a housing bull, and you think prices are going to rise at 6% annually for the term of your 25 year loan. Here's what you can expect below:

You can see that I've plugged in the current standard variable mortgage rate of 7.8%. Now, you might argue that you can get a better deal than this today, and you probably can. But remember that for the purposes of this calculation we are trying to guess what the average mortgage rate is going to be over the 25 year life of the loan. I don't have the data at hand, but the historical average is much higher than the current 7.8%, so I am actually being very generous to buyers in the calculation here.

You can see that in the case above, the buyer will break even with the renter after 6 years, and after 30 years, be around $55,000 better off. So it looks like a pretty good investment.

But how realistic is 6% annual growth over the coming two decades? I would argue that this projection is a total fantasy (see my previous post for more on this). So what if we get 4% annual appreciation, which would bring the long-term appreciation in house prices down to a similar growth rate as household incomes. Let's take a look:

It now takes 19 years just to break even with the equivalent renter. And 4% annual growth for the next 25 years is in my view, still rather bullish. What would happen in a scenario where prices appreciate at a modest 2% pace over the next 25 years, slowly restoring affordability relative to incomes?

It now takes almost three decades for the buyer to break even with an equivalent renter. Finally, let's take a look at the bear case of 0% appreciation.

Obviously, this final case is a total disaster for the buyer.

Now, a few final observations are in order:
  • These calculations assume that if you rent, you actually have the discipline to invest any savings you have made relative to buying. If you are the kind of person that is likely to spend all these savings at the pokies, it might still be better to buy.
  • The outcome of these calculations is highly sensitive to the assumptions for the rate of capital appreciation, rate of annual rent increases, rate of return you can earn on your savings, etc. Plug your own numbers in if you don't agree with my assumptions. This is just a rough reality check -- one that in my observation not enough home buyers perform.
  • This is not financial advice and the decision on whether or not to buy depends on your individual circumstances. There are good reasons to own a house, particularly if you have a family and want the stability that a permanent dwelling provides; this, however, is a separate question from whether or not this is likely to prove a good investment at today's prices.
Cheers and Merry Christmas!
Note: The figures in this post have been updated. I have had a couple of questions from readers about whether or not the calculations assume a FHB grant. I didn't assume that initially, but it is now included. I also corrected the monthly rental figure and have assumed a long-term inflation rate of 2.5%, the midpoint of the RBA's target range. Strata fees of $2000 p/q are also included, as well as utilities, maintenance costs, etc.


  1. This model doesn't take into account rates, water bills, repairs and maintenance etc, which as a buyer you'll have to pay over those 25 years and a renter you don't. I estimate a buyer pays at least an extra third of the cost of the mortgage in the first year (because they paint, fix the garden, repair the leaky gutters, etc), and an increasing percentage after that (because mortgage payments don't go up with inflation). Also, stamp duty and other buying costs would add to the purchase price and to the mortgage. Having rented for a few years and then buying a unit and then upgrading to a house, a mortgage is so much more expensive than rent - and your capital growth is only good for buying another house, a place in a retirement home, a way of leveraging an equity loan or passing on to your kids when you die. The money you save renting you can use when you like - or just save and invest.

    Anyway, I actually like owning my own house and we're only leveraged about 45% (up to 85% if Steve Keen is right), but I think the above example is taking way too few extra costs into account.

  2. Rising Sun -- Thanks for reading. The model takes into account closing costs on the purchase as well as annual maintenance, utilities and renovation costs (which are adjusted annually for inflation). Check the link to the NY Times page and you can change these inputs yourself if you click on the "Advance Settings" tab.

  3. The model also has the selling costs as tax deductible, as it is in the USA, but not in Oz.

  4. Demographix -- You're right, and it also allows for the deductability of mortgage interest payments under the US tax system. To correct for both of these differences you need to change the marginal tax rate input to zero under the Advanced Settings. Dealing with the difference in CGT in Australia and USA is a bit more tricky.

    In any case, this is just intended to be a very rough reality check. Like I said it's very sensitive to the assumptions you make about capital appreciation, interest rates, rental increases, etc, and you may have different assumptions than I do.

  5. Dear FF

    I'm finding this blog very interesting, and having been going back through the older posts. I've come to this one a bit late, some I'm not sure anyone will notice the comment.

    I have one problem with the above discussion, and for that matter the NY Times Calculator. As far as I can tell anyway it assumes the only options are buy now or never buy. The reality is that there are heaps of options along the lines of rent for x years then buy.

    Taking an example from Canberra, house prices are around 1000 times weekly rent. So if you rent a house for $400 you could buy it for $400,000.

    Say you have a 20% deposit, so $80,000 and you can afford interest repayments at a round 8% pa or 0.00148% per week. But no principle. Then the amount you can afford is around $600 per week.

    If you instead rent and save that $200 per week by the end of the year you have around $90,000, or a 12.5% increase in your deposit for the next year. So for the loan to value ratio to stay the same the property would have needed to also go up 12.5%.

    Now even the bullish commentators don't claim that much, and the less you have to start with the larger the change (more than linear). So if you only had 10% deposit the house price would need to go up more than 25% before the LVR stayed the same. AND this ignores holding costs on the house.

    And so after one year your LVR would improve even with massive house price inflation. and the better your LVR the more you pay down the principal at each step since the interest repayment will be less of the weekly repayments.

    Thus as I see it anyway, atleast in Canberra (which is meant to be a very tight rental market) you are better of renting even if house prices continue to go up at 10% YoY up until you have saved something approaching 40% deposit, when the interest will about match rent.

    Personally I don't think they will stay at that rate, but by my above working it is almost never better to buy than rent at the current rates, regardless of the holding costs, risk of market down turn etc etc.

  6. Anon -- Thanks for the comment. As you point out, the NY Times calculator is a bit simplistic. I used it mainly because it produces a nice graph of the rent vs buy scenario over time. In any case, there are many ways to look at the rent vs buy calculation but most of them seem to point in the same direction, as you've shown for Canberra.