“Rent money is dead money” or so the saying goes. It’s a popular myth perpetuated by plenty of people working in the real estate industry. However as at June 2018 capital city house prices experienced their first annual fall in 6 years, dropping -1.1%.
With house prices cooling, renting is starting to look attractive again. Like any financial decision, there are costs and benefits associated with buying or renting.
Here we discuss some of the important pros and cons to consider when deciding whether to rent or buy and look at which one has really worked out better over the long term in Australia.
Pros of buying
1) The appreciation (rise) in house prices over time. It’s hard to miss the stories that house prices have been rising, and fast over the past 5 years. The median Sydney property rose more than 70% between 2013 and 2018 and other major cities like Melbourne and Brisbane have seen steady gains.
There are also good tax benefits for owning your own home over the long run because you don’t pay tax on capital gains on your primary place of residence.
But while house prices have consistently risen over the long-term, they can also have periods of weak growth or even fall in value. During the financial crisis, house prices in the US fell by an average of 33.8%. There’s little tax benefit of owning your home if prices fall.
House owners also need to understand and be prepared to cope during periods of house price weakness.
2) Buying gives you the benefit of leverage. When you borrow money to buy a property, the bank lends a percentage of the purchase price to you. In Australia, banks often lend a high percentage of the total value which means the use of borrowed money to invest in the property, or the leverage, can be quite high.
For instance, it’s typical to contribute a 20% deposit and the bank mortgage covers the remaining 80%, or an 80% Loan to Value Ratio (LVR). Let’s say you buy a property for $1,00,000 with a deposit of $200,000 and borrow the remaining $800,000.
If you sell the property a year later for $1,100,000, the property itself has risen 10% in value but your return on investment is 50% (ignoring interest and other costs) since you have made $100,000 profit on the $200,000 original deposit. That’s 5x leverage because you earned a 5x 10% return.
It’s worth noting that after transaction costs, interest and principal repayments, the actual return is likely to be much lower. Also, the opposite would be true if the house price fell from $1,000,000 to $900,000. Your profit would be -50% or worse after repayments and costs are accounted for!
3) Buying also provides some intangible benefits, like the security of not being displaced when the landlord decides to kick you out, and the flexibility to renovate the property.
Cons of buying
1) Interest repayments. If rent money is dead money then interest repayments are the same. Average variable interest rates are currently about 3.75% which means that you would pay about $30,000 of interest each year on a $800,000 loan to buy a $1,000,000 house.
That’s almost the same amount as the $27,000 you would pay to rent a similar value property for a year. With interest rates at all time lows there’s a good chance that the interest rates in 5 or 10 years time will be much higher than now which means mortgage repayments could increase in the future.
The RBA estimates that long term variable mortgage rates have been about 6.20% over the long term. On an $800,000 loan that would increase a typical interest bill to a whopping $49,600. That’s not much less than the average after-tax salary in Australia which means for many people, most of their income could be gone in interest.
2) Opportunity cost. This is a cost that is often ignored or at least not understood very well. It refers to the cost of having your money tied up in a property versus having it available to use elsewhere.
In simple terms, opportunity cost refers to the returns you could get elsewhere instead of putting down a house deposit. That could be returns from bank deposits (currently about 2% per year), a diversified portfolio (historically 8% per year), or investing in your own business.
3) Ownership costs. The transaction costs of buying and selling a property are high. The RBA estimates that the costs of buying a house including stamp duty and other buying costs including conveyancing can be 4.3% on average.
The cost of selling a house including real estate agent commissions and advertising costs add up to about 3.0%. Therefore the total costs of buying and selling a house are in the vicinity of 7.3%.
And this ignores the ongoing running costs of owning a property which the RBA estimates to be at least 2.6% per year including council rates, repairs, depreciation, body corporate fees, water and insurance costs.
Pros of renting
1) Return on your savings. Renting frees up your savings to earn a return elsewhere and depending on where those savings are invested, they may be able to earn a higher return than would be possible in property with the money that’s been freed up.
Returns available in term deposits and savings accounts have been falling recently as the RBA has cut interest rates. This has made other investments like shares and bonds more attractive since bank deposit rates are now under 2% compared to a balanced portfolio of shares and bonds which has historically returned closer to 8% over the long-term.
2) Flexibility. While owning a property provides more stability, renting gives more flexibility. This may be attractive especially for young Australians and families who may need to move from place to place due to work, or schools.
3) Diversification. When you buy your own home, most (if not all) of your eggs are in one basket so to speak. One property in one suburb in one city in one country. That’s a lot of your total wealth riding on a single investment that can be impacted by a whole list of factors outside your control.
Renting allows you to spread that risk across a much broader range of investments. A typical balanced portfolio like our Stockspot portfolios contain over 1,400 stocks and bonds from around the world including property stocks. So you get the benefit of some property while also spreading your risk across many more investments.
Cons of renting
1) Rental costs. While renting may seem expensive, rental yields actually reached a 12 year low in 2018. A typical total rental yield (annual rent costs / house value) for a house in Sydney or Melbourne is now 2.7% but ranges from 2.0% to 5.0% depending on factors such as location, property value and whether it’s an apartment or house.
Rent is the equivalent to interest you pay on a mortgage. It’s the cost of borrowing an asset – in the case of renting, the asset is a property whereas for a mortgage you’re borrowing money.
2) No forced savings. Unlike buying where you are forced to contribute to a mortgage each month (which includes interest and principal repayments), renting doesn’t encourage forced savings. This can make it tempting for renters to spend spare cash rather than setting it aside.
However, technology powered budgeting apps like Pocketbook and investment apps like Stockspot to make it easy for consumers to budget, save and invest – so keeping up with the returns of homeowners is becoming easier for renters in Australia.
Buy vs Rent – the results
We have looked at whether someone would be better off buying, or renting and investing their savings in a diversified portfolio over the next 7 years. The results show the difference in overall financial position based on different possible return rates for property and investing and assumed costs.
A positive number shows where renting is better than buying and the percentage amount reflects the difference in returns over 7 years. Renting beats buying in 16 of the 25 scenarios and by 8.4% in our ‘base case’ of 5.5% property growth and 7.5% investment portfolio growth.
We have used a number of assumptions and different assumptions would impact these results. It should be noted that we have not considered the impact of ‘negative gearing’ which is a tax benefit that may be available if the property is held as an investment. Equally, franking credits on the share part of the portfolio have not been included in the investment returns. We also haven’t put a dollar value on the emotional benefits of owning or renting like security (owning) or flexibility (renting).
The case for buying
Over the last 5 years buying in major cities like Sydney and Melbourne has been a profitable strategy. Sydney prices have increased about 70% since 2013 so combined with 5x leverage (80% LVR), investors in property would have enjoyed a return of nearly 300% on their initial investment. That’s huge!
What are the risks? Buying with borrowed money magnifies both the good and bad. So if you buy a Sydney property today with a 20% deposit (80% LVR), the property value would only need to fall 20% in value (i.e. where prices were 3 years ago) to completely wipe out the value of your investment.
This happened to many property owners in the US between 2007-2010 when property prices fell by 33.8% between April 2006 and December 2011. US homeowners that ended up with zero or negative equity after the property collapse and couldn’t keep up with interest repayments simply ‘handed back’ their house keys to their mortgage lender and their houses were sold to cover the loan.
Where the funds recouped from sale were insufficient to cover the outstanding loan, the banks couldn’t go after the borrower for the subsequent loss because US loans are “non-recourse”.
In Australia however, mortgage loans are “recourse loans” which means that the banks can chase you for any loss they incur when foreclosing your loan. This puts Australian borrowers at more personal risk in the situation of a property bust.
The case for renting
Renting frees up your savings to invest elsewhere; either in term deposits, your business or a diversified investment portfolio. While rental yields are low (just 2.7% in Sydney compared to a long term average of 4.2%), it’s an attractive time to be renting and investing your savings somewhere else that could earn a higher return. This is why rent money isn’t really dead money – provided that savings are invested rather than spent.
Renting also enables you to avoid two big risks:
1) the risk of leverage which could mean your savings are overextended if property prices fall, and
2) the risk of poor diversification. When you buy, all of your eggs are in one basket so your wealth is almost completely reliant on the success of one asset. Renting allows you to spread those risks much more widely.
Our analysis suggests renters are likely to be better off than property owners over the next 7 years based on long-term assumptions. The market cycle, property yields and the current payback period are all suggesting that now isn’t the best time to be buying.
Prospective property buyers should think twice before jumping at the opportunity to sink their savings into a house. Leverage and poor diversification make home ownership much riskier than many people assume.
The big benefit of a property mortgage has historically been the forced savings it encourages. With technology enabled services that help you to budget and invest, it’s now easier and more affordable to grow wealth without buying a house. Renters today have more options than in the past to stay ahead.
The Reserve Bank of Australia (RBA) have recently echoed our views, suggesting that property is overvalued and that one-third of borrowers “have either no accrued buffer or a buffer of less than one month’s repayment”. This puts owners on dangerous footing if interest rates rise.
Over the very long term it’s much of a muchness. Owners and renters over the last 60 years have ended up in roughly the same place. That of course relied on renters being just as disciplined about investing those savings in a portfolio with similar returns.
Sources: ABS, REIA, Global Financial Data, AMP Capital
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|Factor||Long term assumption||Explanation|
|Mortgage interest rate||6.20% per year||While current variable interest rates are around 4.5%, this is a 50-year low and average rates over the next 10 years are likely to be higher. RBA uses 6.20% in their long term assumptions.|
|Property appreciation||3.5% to 7.5% per annum||The average appreciation rate since 1955 was 5.5% so we have looked 2% either side to account for the potential for a weak or strong property market.|
|Property ownership costs||2.60% per year||This is an RBA estimate which includes depreciation, council rates, body corporate fees, water and insurance.|
|Property transaction costs||6.0%||This is conservative compared to the RBA estimate of 7.30%. We have assumed 4% purchase costs which includes stamp duty / conveyancing and 2% sales costs which included real estate agement commissions and advertising costs.|
|Loan to Value Ratio (LVR)||70%||This is roughly the national average which varies from 65% to 75% by state.|
|Loan term||30 years||Typical mortgage loan term|
|Factor||Long term assumption||Explanation|
|Rental yield||4.20% per year||Long term average since 1955 has been 4.20% compared to 3.90% now.|
|Rent increases||2.80% per year||Assumes rents increase in line with the RBA expected inflation rate.|
|Investment portfolio return||5.5% to 9.5% per annum||The 10 year rolling average return of a balanced portfolio after fees was about 7.5% so we have looked 2% either side to account for the potential for a weak or strong stock market and bond market.|
This article was originally posted in April 2015 and has been re-published with updated information in June 2018.