Your Residence: Rent or Buy?
In this article, I will compare the alternatives of the decision to rent or buy your own home after outlining the sometimes hidden costs of home ownership. Perhaps you have heard the statement, “Rent money is dead money!”, or the question, “Why pay someone else’s mortgage?” I have usually heard these lines on television commercials from building companies or real estate agents wanting to sell me a house. Associated with these ideas may be statements like, “when I own my house, I can live rent free”. Can a person live, ‘rent free’?
What this ignores is something economists call, ‘opportunity cost’. The opportunity cost of an action is the value of the best alternative forgone. One alternative to living in the house you own is renting the house to a tenant. By living in the house, you are giving up the rental income. This is the opportunity cost of being an owner occupier. Think of your home as an investment, where you consume the dividend, the dividend being the accommodation your house provides. An example to illustrate. Let’s say you are an owner occupier of a 2 bedroom unit in the leafy suburbs of Holroyd. The unit has a capital value of around $300,0001 and could attract a weekly rent of $2152, or $11,180 per year3. So the cost of living in the unit is $11,180 per year, it is what you gave up by living in the unit. But I hear you say, “but I have to live somewhere!” So you do, but not for free.
Duplex: one to rent, the other to buy
To be aware that the capital invested in the house could be invested in other income earning investments, we can arrive at a better way to measure opportunity cost. The opportunity cost is now the income forgone from an investment to the same value as the house. Let’s say instead of buying this 2 bedroom unit in Holroyd to live in, you buy shares to the value of the house ($300,000). For this example, lets say, at the beginning of July 2004, you buy 57,140 shares of Stockland at $5.25 each, making a total investment of $299,985. From this investment you receive two dividends per year, the first being $11,860.51 in August 2004 and the next being $11,916.68 in February 2005, making a total of $23,777.19 for the year4. After the tax man takes his cut, you are left with an after tax dividend of $16,644.035. So the cost of living in the unit is now $16,644.03 per year, it is what you give up in investment income by owning the unit in which you live.
Now that we can see the cost of home ownership, let us look at the rent or buy decision. Using this example, from a purely monetary point of view, you can use the dividends from the shares to pay the rent on another home, and have $5,464.03 left over in the first year, after tax. Dividends from the shares could rise to cover any rise in rent on your home. However you would have to pay tax on any capital gains from the shares, where capital gains on the family home is tax free.
There are other non-monetary factors in the decision as well. First, the stability of not having to move if the landlord sells to an owner occupier. Second, the feeling of security that ownership brings, even if investment income is forgone.
The decision to rent or buy based on monetary factors will depend on various prices in the market place. House prices, share prices, rents and dividends can all change over time, and so the decision to rent or buy may also change over time. The peak of a housing bubble may be a good time to sell the house, buy an investment and live in a rental. After a housing crash, it may be a good time to sell the investments and become an owner occupier. Non-monetary factors must also be taken into consideration, to the extent you consider them valuable.
References
1 Median sale price of a two bedroom unit in the Local Government Area of Holroyd in the September quarter, 2004. Source: NSW Department of Housing (2005) Rent & Sales Report, no 70.
2 Median weekly rent for new bond lodgements for a two bedroom unit in the Local Government Area of Holroyd in the September quarter, 2004. Source: NSW Department of Housing (2004) Rent & Sales Report, no 69. The sale price and rental do not necessarily refer to the same house, but only the median sale price and new rental transacted in the quarter. I have used the selected statistics for illustrative purposes only.
3 A gross rental yield of 3.7 per cent.
4 A gross dividend yield of 7.9 percent.
5 A tax rate of 30 per cent. Shame taxman, shame!
© Danny Haynes
Lea, 20 March 2006, 15:34:
Hi Danny,Are you suggesting that ppl borrow $ to be able to buy that many shares? (Most have to take a hefty mortgage to buy a house at that price).
* If so, you then have to factor in that that is a much higher risk investment than buying a house. If you can’t meet your mortgage repayments you can sell for a comparable amount; whereas, if you can’t meet your share loan repayments & your shares aren’t worth much at that point-in-time you might be in big trouble!
* If not, and you only invest what you would have used as a deposit, the opportunity cost forgone becomes much less, as you may only have 30k to invest to start with (ie. interest of ~ $1600/yr).
Danny Haynes, 21 March 2006, 20:40:
Lea, you make a good point. I wrote the article using the situation of someone who already owned a house. For someone who is now renting, let me suggest you consider a rent and invest strategy. That is:* work out what it would cost to purchase the house you are currently renting;
* work out what the repayments on a loan for that entire amount would be;
* every week, invest that amount minus your present rent. That is, investment amount = loan repayment – rent.
* build up this investment until the returns can pay for your rent.
From the example, you would require an after-tax return of $11,180 per year, or a before-tax return of $15,972 per year. Again from the example, you would be earning 41.6 cents per share (before tax), so would require 38,395 shares in Stockland. Therefore you would have to own $201,574 worth of shares in Stockland (according to this example).
Then ask, how long would it take to accumulate this investment? How long would it take to purchase the house? Crunch the numbers and compare the rent and invest strategy to the owner-occupier strategy. There are some finer points to these ideas but perhaps another time.
Remember, your landlord is really hurting right now. Imagine this (from the example): his $300,000 asset is earning around $8,400 per year in net rent (after costs); a net yield of 2.8% (ouch!). If he has financed 80 per cent of the unit ($240,000) at 6.95%, then interest is around $16,680 per year. That is a cash deficit of $8,280 (ouch, ouch!).
cheryl kennedy, 14 October 2007, 13:56:
I am trying to get my own home but we are on a pension and no one will look at us. Can you please help.
Thank you.
from cheryl kennedy.
PS, what make it worse is we have no deposit.
Danny Haynes, 16 October 2007, 22:24:
Hi Cheryl, I take it you are trying to purchase a home rather than rent. I can’t help you out with a loan but only some thoughts and advice. I would make a few points:
* There is nothing wrong with renting, and in the current market, I think it makes more sense to rent. Don’t be too eager to take on a mortgage, especially if you have no deposit. This type of finance can be a millstone around your neck.
* Work on a money plan and include some financial goals such as saving for a deposit. I know it can be difficult but take some big decision to see how you can cut expenses. * Invest in yourself to expand your capabilities and possibilities.
* Look at setting up an online bank account to obtain high interest on your savings. I like the St George DirectSaver, the BankWest TeleNet Saver, or ING Direct Savings Maximiser. You can check out the money pages of a Sunday newspapers for basic comparison tables.
Happy to receive further comments.