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 realestate.com.au. "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!
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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.

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...