February 28, 2020

Buying vs renting – most people will give you a similar answer, “Buy a property if you can afford it.” Your parents, friends and the media have always told you that buying property is a safe option, but is it always the right option? Stepping onto the property ladder has become more difficult compared to your parents’ generation. A recent report has shown the widening gap between the average salary and housing prices. Renting has become the only option for many people. However, just because you can, does it mean you should always buy?  We discuss the pros and cons of buying vs renting and break down the costs involved. We show that renting may sometimes come out ahead.

The figure shows that house prices have slowly increased over the average income and the gap is currently very wide.

 

Pros of Buying

Increasing prices of property

You hear it in the news headlines – constant rising property prices. According to corelogic, the median house value in Sydney was $523 845 in 2008. 10 years later, that median value rose to $1 048 371. That’s an average increase of 7.18% per year over 10 years.

The graph shows that property prices for each capital city have gradually increased.

Of course, it’s not always certain that property prices will rise every year, with the Sydney market experiencing one of the sharpest declines of -7.4% in 2018.  Only recently has the market started to recover from its downturn. This shows that the property market has its cycles of growths and declines, however steadily grows in the long term. Buyers need to consider if they are investing over a longer period of time and also consider periods of strength and weaknesses for house prices.

The graph shows the growth cycle of the property market, going from positive growth to negative, back to positive.

Ability to leverage a mortgage for higher gains

Say you have $100 000 in cash sitting around and you invest it for a year. The next year your investment has grown by 10%. Great! You now have $110 000. Now say you could borrow some money to invest $500 000 this year instead. This time, your investment has only grown by 7%. However, if you look at the numbers, your 10% investment made $10 000 profit whilst you gained $35 000 with the 7% investment. By borrowing and leveraging more money, you are able to amplify the gains. This comes at a cost, however, from the lender’s interest rates. For example, the $400 000 you borrowed from the bank came with an interest rate of 3% per year. The next year, after you’ve cashed out of the investment, paid the interest of $12 000 and repaid the principal of the loan, you still end up gaining $23 000. This example is highly simplified, as there are many other factors and costs that we will break down later such as taxes and transaction fees. The opposite can also happen too. If your investment turns sour, you could end up paying much more for your losses!

Tax incentives & discounts

Owning your own home also comes with the benefit of many tax incentives and discounts. If you do sell your home at a profit, you are exempt from capital gains tax. This can eat 50% of your profit with the discount method if you bought shares instead.

Interest on your home loan may seem like it’s paying rent, but to the bank instead of a landlord. However, unlike rent, you can claim the interest as a tax deduction. It’s where you hear terms like negative gearing pop up for investors – the income earned from a property is less than the costs incurred by it, allowing tax benefits for the investor. Even if you live on the property, you may also be able eligible for these tax deductions if you generate any income with the property. This may include if you have your own home office or you rent out a spare room.

Other incentives may also come in the form of government grants and concessions, such as stamp duty concessions and the first home owner grant.

Freedom of living in your own home

Owning your own home also let’s you be able to do whatever you want with it. Any renovations or upgrades you want to make don’t need to go through any landlord. Additionally, you have the stability and security of not being forced to move, something that renters have a looming fear of.

Cons of Buying

High ongoing costs and maintenance 

Buying a property isn’t cheap. Maintaining it is even less cheap. Other than the interest, there are also a lot of other costs to consider. Upfront costs for buying may include the mortgage fees, taxes and government fees, legal fees, inspection fee and moving costs.

Ongoing costs include the mortgage repayment, however also include other unrecoverable fees such as, council rates, utilities, body corporate fees and insurance. When you own a property, you must also account for maintenance and repairs. For example, even if you have a roof that needs to get replaced every 20 years which would cost $10 000, that still needs to get accounted for as a yearly cost of $500. Good planning requires setting up a buffer for the worst case scenario and should be included in any cost planning.

Mortgage repayments

The biggest ongoing cost would be the mortgage repayments. If rent is considered a sunk cost, so would the interest in a home loan. If you take out a loan of $400 000 at a 4.5% standard variable principal and interest loan, you would be paying over $15 000 just in interest per year over the first 10 years. With rental yields ranging from 3-4%, you could expect to pay a similar amount for rent for the same property. As interest rates are currently quite low, it could be possible that you would pay more on your mortgage in a few years.

The graph shows the decreasing interest rates over the years and is at an all time low.

Tied down

Owning a property is a big commitment. You put all your eggs in a basket and can only hope the property value goes up. This also comes with the case that your wealth is tied up in one asset. You face a scenario where you could have used that money to invest in something else with a higher return. For example, you could invest your down payment in shares at a return of 8% per year, compared to the 4% growth rate of your property. Of course, it’s not quite as simple as that, as there are other considerations like the leveraging mentioned before, but it gives you a rough idea of the opportunity cost that is associated with buying.  A common strategy among investors is to refinance their mortgage and use the equity in their home to invest in more property. This gives the benefit of diversification, however could come with risks of multiple loans and higher fees.

Transaction costs

When you eventually want to sell your property, you have to consider all the selling costs that come with it. Marketing and real estate agent fees take a large portion, with the average commission of an agent being around 2.5% of the property price. The costs of selling a house slowly add up with marketing, agent commission and legal fees totaling over 4% of the property value.

Pros of Renting

Flexibility

When renting, you have a lot less commitment and lower risk. You have the option to more easily move around and relocate, whereas a buyer has to commit to selling their property. You also only have to worry about rent and not on mortgage repayments, which in any worst-case scenario carries way higher consequences.

More liquid assets & diversification

When your money isn’t tied down to a house, you are more easily able to invest your savings elsewhere. Assets such as shares are a lot more liquid compared to property. If an emergency happens and you require to cash out, you can easily sell your shares and pay a lot less in transaction costs compared to property. You are also able to diversify your investments, whether you are more passive or aggressive of an investor. You have more control over your investments and are able to choose exactly what you want to invest in.

Predictable and lower costs

When you sign your rental lease, you know exactly what to expect. You can budget accordingly and have to account for fewer unexpected costs compared to a home owner. Costs become more apparent for a renter, compared to a home owner who has a lot more to consider.

Cons of Renting

No returns from rent itself

A mortgage for a property can includes the principal and interest. You are getting some part of the asset when you are paying a mortgage. The interest part of the loan is similar to the rental costs, however even then, there are some tax benefits that can be achieved with the interest. When you pay rent on a property, that money is unrecoverable and is not an investment. It won’t produce any yields for you. The good thing however, is that rental costs are quite low right now. Depending on location and type of property, you can rent a place that you would not usually be able to live in if you were to buy and pay lower on rent compared to the loan interest.

Higher restrictions bound by lease

When you rent, you are bound by the lease. You cannot customise your home without going through the landlord and asking for permission. If the landlord decides to sell the property, you have a limited amount of time before you have to find somewhere new to live. This creates instability in the long term of where you are going to live.

Cost breakdown buying vs renting comparison

We will look at an example comparing if someone was to buy a property compared to someone who rents and invests their savings. We use the median prices of a unit in Brisbane as our base guide to compare similar properties. The median unit in the Brisbane CBD is $530 000 and the median rent is $500 per week.

Upfront costs of buying

Item Cost
Mortgage Fees
Application Fees $150
Valuation Fees $250
Loan Establishment Fee $600
Mortgage Fees Total $1000
Government Fees $1600
Stamp duty $9800 ($6300 if First home buyer)
Conveyancing $1000
Inspection Fees
Building Inspection $500
Pest Inspection $200
Strata Inspection $300
Inspection Fees Total $1000
Connection Fees $100
Moving Costs $1000
Total Upfront Costs $12000

Ongoing Cost of buying

Item Cost (per year)
City Council Rates $1300
Body Corporate $2000
Home & Contents Insurance $650
Utilities (Gas, Electricity, Water) $2400
Maintenance $1000
Mortgage Repayment* $25780
Total Ongoing Cost $33130

*Loan of $424 000 at a 4.5% standard variable rate, principal & interest over 30 years.

The figure shows a principal and interest loan over 30 years. The rate of interest charged decreases as it reaches year 30.

Upfront cost of renting

Item Cost
Bond $2000
Moving Costs $1000
Total Upfront Costs $3000

Ongoing cost of renting

Item Cost (per year)
Rent $26000
Utilities $2400
Contents Insurance $250
Total Ongoing Costs $28650

5 year comparison of Buying vs Renting

Now we have an understanding of the costs involve, let’s fast forward 5 years and compare both situations in buying vs renting. We will compare the return of investment and minus the ongoing costs to get the net difference. Both parties have a savings of $111500, to cover the 20% of the deposit and upfront costs of the buyer. The buyer is a first home owner purchasing a new property and will receive stamp duty concessions and the First home buyer’s grant. Assume we invest the $4480 difference per year in ongoing costs from buying to renting to the renter’s portfolio.

Buyer

Savings $115000
Property Price $530000
Annual Growth Rate 3%
Property Price after 5 years $614415
20% Deposit $106000
Total Upfront Costs $12000
Total Ongoing Costs $36750
5 year Mortgage Payments $128900
Selling Fees $20000
Principal Owed on Mortgage $386510
First home buyer Grant $15000
Net Difference $45254

Renter

Savings $115000
Total Ongoing Costs $143250
Return rate of ASX shares 9.4%
Value of portfolio with yearly addition of $4480 after 5 years $207239
Gross Return $92239
Capital Gains Tax 50%
Investment Value after tax $161119
Net Difference $17869

 

The buyer in this situation comes out slightly ahead by $27385. This scenario has been simplified and various factors haven’t been accounted for. If the tax rate changes for the renter, including any deductions they have may, this may change towards the renter’s favour. More than $46000 is lost from capital gains tax, whereas the buyer doesn’t need to pay any. The renter’s calculations also don’t account for diversified portfolios, management fees and transaction fees. Other factors have also not been considered such as inflation and rent increases.

Changing the numbers

What if we change some numbers around in the buying vs renting comparison? Assuming we keep the other factors the same:

Instead of an annual growth of 3%, we have 2%. The renter comes out ahead $1867.

Instead of an annual growth of 3%, we have 4%. The buyer comes out ahead  $57796.

Instead of the shares increasing at 9.4%, we have 18%. The renter comes out ahead $16567.

Instead of the shares increasing at 9.4%, we have 4.5%. The buyer comes out ahead $47094.

Instead of the mortgage interest rate being 4.5%, it is 3%. The buyer comes out ahead $71633.

Instead of the mortgage interest rate being 4.5%, it is 6%. The renter comes out ahead $18532

Instead of rent at $500 per week, it is $400 per week. The renter comes out ahead $14299

Instead of rent at $500 per week, it is $600 per week. The buyer comes out ahead $69070.

Instead of having a 20% deposit saved, it is 10%(No LMI). The renter comes out ahead $21266.

Instead of having a 20% deposit saved, it is 30%. The buyer comes out ahead $33504.

Download your own Buying vs Renting Calculator here

Graph showing the investment return of buying and renting minus the ongoing costs. Buying always returns postive, whilst renting shows a temporary loss, then gains more than buying.

From the graph over time, we can see that overtime, the ongoing costs for renting is more than the investment returns. However, it reaches a turning point and beats the rate of buying eventually.

Conclusion

There are so many different variables that can come into the buying vs renting discussion. Your own due diligence is required when you weigh up buying vs renting. Sometimes the answer is not always clear and even if you can afford to buy property, it doesn’t always mean it’s the best choice.

Here are some useful points to take away

Buyers

  • Aim to stay long term for the highest gains. Transaction fees take away a large chunk of your earnings. Agent commissions account right away approximately 2.5% of the property price.
  • The property market works in cycles. There are periods of growths and periods of declines. Be wary of the current market trends and learn the best times to buy and sell.
  • The opportunity cost of having your wealth tied up in your home equity. Always have a look at your refinancing options and be on the look out if there are better mortgage options every 2 years or so.

Renters

  • A lot of discipline is required to save. You aren’t obligated to make investments in the same way you are with mortgage repayments. You will not build wealth comparable to a property owner if you do not consistently save.
  • Consider whether you are investing long term or not. Sometimes it is better to aggressively invest when you are younger and be more passive when you get older.
  • Look for different options. Shares don’t have to be your only investment option. You can look at different types of funds, bonds and portfolios, or take a completely different approach and start a business. You have more flexibility and aren’t committed to a big mortgage.

Let us know if you’re deciding between buying vs renting or you have any other topics you want covered, drop us an email at info@propably.com.au