Josh on Housing – Part 2

My local library has magazine back issues. I was reading a Money, August 2004 article by Paul Citheroe, entitled am I better off Renting or buying a home? on pg 22.

Virgin home loans are now available at 7.34%pa. That’s pretty darn cheap. But still not as cheap as my preferred lender, HomePath (a Commonwealth bank subsidiary). All this cheap money, someone should buy a house, right?

I advocate two positions. One I advance to those people I know that are good savers. That is, buying a home is for suckers. The other I push on those whose money management… leaves something to be desired. Perhaps they show the kind of financial restraint that the Enron accountants did. Anyways, to them, I say “buy a house. Now. Are you still here? Go on, get!”

Paul agrees with me, sort of. He thinks that we’re all spendthrifts, just because our country is going into the hole at $2b/month:

Given our poor track record as savers, I fear that you won’t “rent and buy shares.” You’ll rent and blow the money on lifestyle, leaving you in the situation at retirement with no house and no investments.

But, he says, that’s irrelevant, because of the figures in the article which show you’re better off buying real estate, regardless of the alternative of saving while renting. He give enough hints in the article that I might be able to reproduce his (well, the Macquarie Bank’s) workings and then refute his proposition.

Let’s see:

Buy and repay Rent and invest
Capital Gain 8.7%pa 8.1%pa
Income 4.12% dividend (what’s the franking level?)
Txn costs in $8586 1 month’s bond ($14,300),
1% on shares
Txn costs out 2%? 1%
CGT 50%?
Holding costs $30,543pa interest +
~$3,700pa rates, insurance, etc
$14,300pa indexed

Shares at 8.1% capital gain, 4.12% dividend (what’s the franking level?). Actually, the long term average is about 10% gain; perhaps that’s with taxes paid and dividends re-invested. Don’t know about average dividends or franking levels. 8.1%pa growth for property matches my understanding, which is a long term average of 8%.

Shares with a 1% broker fee (you’d be hard pressed to pay that kind of fee, it ought to be more in the $50 range).

CGT at the marginal rate – I wonder if they 50% discounted it? CGT will only be payable on realization of the asset, which might not happen.

Strata levis (etc) increasing at 3%pa ($19,219 total by year 5), rental of $14300 (figure from NSW dept of housing for 2br flat) increasing at 5%pa ($78,890 total by year 5). I presume these figures are reasonable. Except, $337,500 property (average Sydney property) – is this the same property as the 2br flat used to calculate rent, or is it a better property?

Already I can see a problem – the yield on the property is incomparable to reality. I don’t think they’re comparing apples with oranges – $14,300 rental on a $337,500 flat is about a 4% yield, and you generally don’t see that high a gross yield. More like 2%, perhaps 3%.

30% marginal tax rate, $39086 in savings (questionable), $7K First Home Owner Grant (you might get more than that), acquisition/loan establishment costs of $8586, no stamp duty – (Flash stamp duty calculator, or non-flash) – but no stamp duty is unlikely.

1 month’s rent as bond. Agent fees on property realization 2% (this assumes no advertising etc costs, which is highly unlikely) – I don’t know why they’re indexed at 3%.

Initial mortgage of 337,500 at 7.6%pa fixed for 25yrs $30,543pa.

As he stated, he ignored reno costs of IBISWorld estimated $500pa – a lot on the low side by my figuring, and something your landlord picks up the tab on. You’re going to lose the hot water service every ten or twenty years, a new fence, new carpets, kitchen cabinets, curtains, a lick of paint every five years, new taps every twenty, light fittings, etc. Every 50-100 years you’re going to need to replace the whole house. It all adds up, even if all you’re paying for is materials.

Okay, what about HECS and Medicare? As your taxable income goes down, so do these components.

The analysis wasn’t controlled so that the take-home was the same for both parties. It would have allowed a tax-deductible margin loan to ramp up the share exposure. Apples with apples!

So, after all these random bullet points, I’ve decided that the analysis was flawed, and heavily biased towards home purchase. I did a similar analysis six years ago, and renting came out ahead of borrowing to buy. But the real money was in buying, and then mortgaging to purchase shares. But the spread between margin loans and home loans was a lot larger back then.

For a US-centric view on things, read Misconception: Renting is for Suckers. There, home loan interest is deductible from tax (you can get a similar arrangement here, if you are able to jump through the significantly large hoops).

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3 thoughts on “Josh on Housing – Part 2

  1. Wilson

    My wife and I did some similar (but simpler) calculations a couple of years ago, and arrived to the same conclusion: renting makes more economic sense than borrowing to buy, even without accounting for eventual renovation costs, if the money you save from the mortgage payments is invested – and, in our case, it is.

    There is still a strong emotional component in buying a house, though, especially for my wife – but even she is starting to think that this can wait until we’re significantly older (and until we can buy the kind of house we want without borrowing anything and without spending every last cent we have).

  2. daniel

    Yeah, good point Wilson. I went down the path of buying a house, but it wasn’t for economic reasons.

  3. Peter

    Josh,

    I would advocate a variant of the rent+invest approach. It’s especially for people on modest incomes who still want to live in a handy suburb.

    It is to live in a conveniently-located rental home and buy investment properties.

    As a rough rule of thumb, if rental yields in the area you want to live in are the same as interest rates, buying is reasonable value, given the benefits of ownership. But if rental yields are much less then you’re financially better off to rent your own home.

    Wealth either comes from rental income or capital growth. For the former you want the rental income to exceed costs (if not now, then in 5-10 years). For the latter you want to build the biggest portfolio that you can afford so that even if it only goes up by 5% you’ve gained tens of thousands or more.

    Property investors get a mixture of both, but generally rental income brings in the thousands, while capital growth brings in the tens or hundreds of thousands (it’s also taxed lighter than job income).

    Despite the First Home Owner Grant, buying your own home is expensive, with the mortgage (non tax deductible, unlike in the US) expensive.

    The cost of servicing a property is very roughly 10% of its purchase price per year. If it’s your own home, you’re the only one paying that cost. If it’s an investment, then you’ve got rental income (3 – 6% in a capital city is typical) plus deductions from the taxman (which can include deductions for which no payment is required, such as building depreciation)!

    So instead of shelling out 10% of the property’s value, you end up pay out just 3-5% for the identical property.

    Which means that rental properties are about half to a third of the cost of the same property if bought by an owner occupier.

    So if you could afford to buy one property as your own home then you can afford to buy two or three of the same if rented out. Most people might get 5% appreciation on a $300k house, or $15k pa. But if you have 2 or 3 properties then for the same servicing costs you get $30 or $45k gain pa.

    If something happens to you then it’s more resilient as there’s tenant income as well as job income. And if job income is low the extra rental income helps banks qualify you to borrow more.

    Hence if the bank says no to an owner occupied house you want to buy on the basis of insufficient income, make it a rental and the $10k or so pa extra rent income might get you over the line.

    But it gets much better. If you want to live in a ‘good’ inner or bayside suburb, you pay your landlord around 3 or 4% yield. While you go out and buy in outer metro or regional areas and get double that yield from your tenants.

    If the yields are near interest rate levels (8%+) then servicing costs are negligible and it’s easy to buy multiple properties. And chances are there’ll be enough left over to buy a few shares and maybe a rental in a ‘better’ area as well.

    The 5% rental yield quoted is a reasonable figure for a cheaper flat in an inner area or a basic house in an outer area. However smart buying can net you over 6% or even 6.5%.

    This is for Melbourne – Perth might be harder. Suitable rentable houses within 40km of Melbourne start from around $130k, though a purchase budget of $160k will give many more choices.

    Paying your landlord 3% and get 6 – 10% is great.

    OK, so property in outer suburbs won’t appreciate as fast as inner areas, and as mentioned capital growth is important.

    But consider that the same person who is struggling to buy a $300k house to live in might be able to comfortably sustain a diverse property portfolio nearer $1m (allowing for a bit of time and capital growth).

    So you don’t need much growth for the portfolio to work harder than the average Aussie worker – 5% appreciation gives $50 000 pa.

    Add to that $50k from rental income. Rental income will rise by CPI while interest will fall in real terms. So you won’t be paying out as much.

    So eventually you have this big portfolio that sustains itself with little cash input from you. And you don’t need to be stuck to your job as much as if the mortgage was on your home only.

    This is the nearest thing to perpetual motion I know of.

    Compared to just a job income of (say) $50k and a big mortgage on your own home with no investments, the above is a no-brainer. That is unless you have other reasons to buy your own home.

    I have studied the disparaties of wealth between Australians (a report came out recently). The biggest factor was not whether you went to a private school or even if you have a degree.

    It’s whether you own your own home. There is a difference of something like 20:1 between renters and owner occupiers. This was followed by employment status (Employed/self-employed/retired versus not in labour force) followed by age.

    It is from these surveys that people like Paul Clitheroe get their conclusions and for the broad brush they’re right. But when we talk about smaller groups like 1-5% of the population, other approaches, such as described above can be much more powerful.

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