“Rent money is dead money” or so the saying goes. It’s a popular myth perpetuated by plenty of people in the real estate industry.
But when you do the sums, the reality is quite different.
Like any financial decision, there are costs and benefits associated with both buying and renting, and contrary to what you might expect buying doesn’t always come out on top. Here’s what you need to consider when deciding whether to rent or buy, and which option is likely to lead to the best results.
Jump to: Pros of Buying Cons of Buying Pros of Renting Cons of Renting Case for Buying Case For Renting Conclusion
Pros of buying
1) Capital gains. In case you’ve been living under a rock, house prices having been rising, and fast, over the past couple of years. The average Sydney property has risen 26 per cent since the start of 2013 and other major cities haven’t been far behind.
That’s great news for those that own, obviously.
But remember that 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 per cent, which means home ownership is not a guarantee of making money.
2) Buying can magnify your returns. 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 per cent deposit and the bank mortgage covers the remaining 80 per cent, or an 80 per cent Loan to Value Ratio (LVR). Let’s say you buy a property for $500,000 with a deposit of $100,000 and borrow the remaining $400,000.
If you sell the property a year later for $550,000, the property itself has risen 10 per cent in value but your return on investment is 50 per cent since you have made $50,000 profit on a $100,000 investment (i.e. the original deposit).
That’s 5x leverage because you earned a 5x 10 per cent return.
It should be noted that after transaction costs, interest and principal repayments, the actual return is likely to be lower. Also, the opposite would be true if the house price fell from $500,000 to $450,000. Your profit would be -50 per cent or worse after repayments and costs are accounted for.
3) Intangible benefits. 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 too. Average variable interest rates are currently about 4.50 per cent which means that you would pay about $18,000 a year on a $400,000 loan to buy a $500,000 house. That’s almost the same amount as the $19,500 you would pay to rent a similar property for a year.
With interest rates at all time lows there’s a good chance that the 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 per cent over the long term.
2) Opportunity cost. This is a cost that is often ignored or at least not fully understood. 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 cash deposits (currently about 4 per cent), a diversified portfolio (historically 8 per cent), 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 per cent on average.
The cost of selling a house including real estate agent commissions and advertising costs add up to about 3.0 per cent. Therefore the total costs of buying and selling a house are in the vicinity of 7.3 per cent.
And this ignores the ongoing running costs of owning a property which the RBA estimates to be at least 2.6 per cent 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. This is the flip side of the opportunity cost of buying.
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 4% compared to a diversified 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 singles and families who may need to move from place to place due to work, due to bad neighbours or to try out different neighbourhoods.
3) Diversification. When you buy your own home, most (if not all) of your eggs are in one basket. One property in one suburb in one city in one country. That’s alot 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. For example, our Stockspot portfolios contain over 1,400 stocks and bonds from around the world including an allocation to Australian property stocks. So you get the benefit of some property exposure while also spreading your risk across many more investments.
Cons of renting
1) Rental costs. Renting costs have been steadily increasing in Australia. A typical rental yield (annual rent costs / house value) in Australia is now 3.9 per cent but ranges from 2.5 per cent to 5.0 per cent 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. Over the long-term, average rental yields have been 4.2 per cent compared to an average variable mortgage rate of 6.2 per cent. The current lower mortgage rates of around 4.5 per cent have encouraged many to look at buying, however buyers should be factoring in higher average rates for a 30 year mortgage.
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 has enabled services like Pocketbook and Stockspot to make it easy for consumers to budget, save and invest – so keeping up with homeowners is becoming easier for renters in Australia.
We’ve looked at whether someone would be better off buying a house, 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.
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 per cent in our ‘base case’ of 5.5 per cent property growth and 7.5 per cent 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 3 years buying in major cities like Sydney and Melbourne has been a profitable strategy. Sydney prices have increased about 30 per cent since January 2012 so combined with 5x leverage (80 per cent LVR), investors in property would have enjoyed a return of nearly 150 per cent on their initial investment.
What are the risks? Buying with leverage magnifies both the good and bad. So if you buy a Sydney property today with a 20 per cent deposit (80 per cent LVR), the property value would only need to fall 20 per cent in value (i.e. where prices were less than 2 years ago) to completely wipe out the value of your initial investment.
This happened to many property owners in the US between 2007-2010 when property prices fell by 33.8 per cent 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.
Australia was lucky to avoid a house price collapse during the financial crisis but that’s not to say it can’t happen here. Many academics and economists have been warning of the possibility of something similar in Australia. But provided it doesn’t happen and prices continue to increase, leverage will benefit those who own. Over the long term, the value of leverage is roughly equal to (annual return – mortgage interest rate) x leverage.
If a property returns 7 per cent, interest repayments are 5 per cent and leverage is 5x (500k property / 100k deposit) then your return is about 10 per cent. That’s a solid return but relies on property continuing to rise more than mortgage interest rates. This will become more difficult as interest rates eventually rise from their 50-year lows.
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 3.9 per cent in Sydney compared to a long term average of 4.2 per cent), 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 finds that renters are likely to be better off than property owners over the next 7 years based on long-term assumptions. This is consistent with the RBA’s assessment that Australian property is 19 per cent overvalued compared to renting.
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 expect. The big benefit of a property mortgage has historically been the forced savings it encourages.
And with technology enabled investment services, it’s now easier and more affordable to save without a mortgage. Renters today have more options than in the past to stay ahead.