Tuesday, January 26, 2010

How not to climb the property ladder

Baby boomers and older generations often cite high expectations, and the inability to save, as the main hindrance to the younger generations’ ability to buy their own home. They go into great detail about how much it has always been a struggle to buy a home, and that if young people decreased their expectations and bought something small they could work their way up the property ladder.

I am one of those generation Ys looking to buy my own home, and from this perspective, it is not quite that simple.

The mythical property ladder
The argument that if younger generations decreased their expectations, and maybe bought a small apartment now, so that they could somehow work their way up the ‘property ladder’, is entirely misleading.

For example, a young couple buys an apartment for $200,000 in lieu of a $400,000 house they really want based on the contemptuous advice of older generations. They imagine that in 10 years they might be able to sell for $350,000, netting a profit of around $100,000 to spend on a larger home (after transfer costs). The problem is that larger homes have also increased in price by 75%, so that the $400,000 house is now $700,000. Buying that dream home has gone from a $400,000 prospect to a $600,000 prospect even with the apparent advantage of being on the property ladder.

The way to benefit from increasing property prices is to buy multiple investment properties, so that you leverage the benefits beyond your single dwelling needs.

No more avocados
Next, we can look into the arguments about spending a little less on luxuries to get a person into a home-buying financial position. Dining out, gadgets, and holidays all seem to get mentioned. But if we look into it, these relatively small expenses are not the main factor – the main factor is income.

A hypothetical future home buyer might spend $200 per week on dining out, ‘gadgets’ (mobile phones etc), and travel. That’s $10,400 per year – maybe $3,000 on a trip to SE Asia, $2,000 on gadgets, $2,000 on dining out, and the balance for other luxury items. Let’s see what that money could have done if it were funnelled into a property-buying strategy.

Assuming a starting point with no savings, this hypothetical person (or couple, or family) can save about $58,000 in 5 years assuming they receive 6% on their savings. If they thought they might one day want to live in a home that currently costs $300,000, by the time they save their $58,000 the home is worth $400,000 (at a 6% price growth rate). They now need $80,000 for their deposit. They continue saving instead of splurging and in another 5 years they have $137,000 saved. The home is now worth $535,000. They have enough for a deposit, but the repayments on their home and associated ownership costs are now around $900/week.

So after ten years of saving, living life without those luxuries that make it so much more enjoyable, they are in no better a position than before.

I’ll leave you with a question. If you bought a home for $100,000 in 1990, and the market his risen so that it is now worth $600,000, how much better off are you?


  1. "If you bought a home for $100,000 in 1990, and the market his risen so that it is now worth $600,000, how much better off are you?"

    If I'd paid it off in that 20 yrs then I'd be a lot more than $500K better off compared to a renter. Rents go up by inflation every year..... P&I repayments don't. That's why most houses get paid off well before the 25 yr mortgage term.

    "... if a young couple buys an apartment for $200,000 in lieu of a $400,000 house they really want"

    Why should they be able to afford it ? Surely the older generation who have done the hard yards of saving & investing & 'going without' should have more chance of affording it ?

    I 'really want' a ferrari & a house at the beach.... but I haven't done enough hard yards etc yet.

    Your maths is overly simplistic...
    Buy for $200K... it appreciates to $350K in 10 yrs. Meantime, you've been paying down principle (instead of paying rent), so there's another $100K(?) in equity. And your income has increased @ 4%pa.

    So to buy that $700k house, you have a $250K deposit, and need to borrow $450K. $450K is a little more than double what you borrowed 10 yrs back. But wait... your wages have almost doubled, and in todays low inflation environment, your disposable income HAS doubled, so you CAN afford to service that loan.

    But wait.... there's more....
    Most people pay down their mortgage in 7 yrs, since their wages increase, while CPI stays low & their housing interest costs NEVER increase (on average). So instead of having $150K of equity when you sell your house, you've actually got no mortgage & have $350K deposit for your upgrade to a $700K house.

    The above shows 3 effects that your post failed to address -
    - increased wages & therefore servicability
    - paying down principle
    - paying down extra principle as housing costs are NOT indexed to inflation (unlike rent).

    As a member of those contemptuous old generations, I can tell you that these effects are real :).

  2. Charlimi - could you please expand on your point "your wages have almost doubled, and in today's low inflation environment..."

    Surely if the statement on wages doubling applies across the general population, then it is in contradiction with the definition of a low inflation environment. In order for wages to double in 10 yes inflation would need to average approx 7%

  3. Thanks for the comment charlimi.

    My point with the final question was that to realise the gain in value of your property you need to sell, and if you want to buy another comparable property, you will now have to pay $600,000. Compared to a renter, yes, you probably are better off (although they had a lot of money spare to invest or spend that you didn't, even though they have paid 20yrs rent). Compared to a renter who instead bought your house as an investment property in 1990, you are probably not as well off. I will post a link tomorrow to a spreadsheet I made to clarify my point.

    Your point about paying down principle is not really related to my point about being unable to 'climb the property ladder'. When you pay down principle this is a cost. So when I sell it, my profits do not include the principle I have already paid.

    The reason that I say a $100,000 profit when a $200,000 apartment is sold for $350,000 is that there are significant ownership (maintenance, rates, building insurance etc) and transaction costs in real estate. Agents fees alone for the sale are more than $9,000. It is probably reasonable to net out the interest costs as equal to the equivalent rental costs so that they don't contribute to the calculation.

    I hope that clarifies some of my points.

    Christian, a 4% wage increase for 10 yrs gives you a wage about 1.5times (rather than doubled) in nominal terms, although one would expect that over such a period people could also change to more senior positions to increase their earnings.

    Which makes charlimi's calculation a little different:
    So to buy that $700k house, you have a $250K deposit (still about $100k from profit, but now with $150k of savings), and need to borrow $450K. $450K is a little more than double what you borrowed 10 yrs back. But wait... your wages have ONLY INCREASED BY 50%, .

    Please, I welcome some more thoughts or comments on this idea.

  4. I think you missed the point about P&I repayments NEVER increase... OTOH rent goes up by inflation every year. After a few years, the OO has more disposable income than the renter.

    Disposable income doubles in 10 yrs - put these numbers into your spreadsheet - Inflation 3%, wage growth 4.5%, starting salary $50K and make starting disposable income anything reasonable. You'll see disposable income doubles in 10 yrs. Remember that disposable income is what people spend on non-essentials - like better housing.

    I think we agree that compared to a renter you're $600K+ better off. Buying a house (or getting on the bottom rung of the ladder) allows you to keep up with the non-renters - it stops you getting left behind, and also acts as both forced savings & investment.

    You can pay down principle or you can pay ever increasing rent - from a $$$ in your pocket POV there's no difference... OTOH from your theoretical economic POV there appears to be.

  5. Cameron, I agree that over time you would expect personal earnings to increase as people progress their career into more senior positions etc.

    However, and this is slightly off topic but, I cannot see how the scenario you describe above can be termed a "low inflation environment" as our macro statistitians would have us believe in the current "official" statistics.

    Firstly - if Charlimi is asserting that the general wage growth is 7%pa causing wages to double in 10 yrs, then this wage growth in itself is inflationary and I would consider it high.

    Secondly - if the same house that was 400k is 700k 10 yrs later, then this is house price growth of just under 6% which again in itself is inflationary.

    I agree with you Cameron, house prices in Brisbane are unaffordable and this outragoeus bubble has and continues to be fuelled by greed and poor policy.

    Tax laws such as negative gearing and mass media preaching of "reliable" and "bricks and mortar" property investment has encouraged buyers to pay ridiculously high prices purely for the purpose of reducing their personal tax burden. These investors are banking on an abnormaly high rate of future capital growth to justify their bids, and this vicious bubble will continue to fuel itself whilst the "housing shortage" campaigners continue to feed us their bullsh*t.

    Keep up the blogging, great to see.

  6. "how much better off are you?"

    It depends. If I live in that house, I'm no better off, unless my house has appreciated faster than others for some reason, which means that other people must have missed out. Overall, the typical home owner is no better off than they were 20 years ago: they still own the same house, and can trade for a similar house.

    Josh: partial credit!


  7. It's hard to get ahead in regards to property as there is a lot of sacrificing and there is also finding the right property at the right time at the right price. No-one can predict what the future trends in the property market will do, but everyone says it will always rise and it always has. The difficult decision is finding a property in an area that is good but not overly inflated when you are buying. E.g. When I was looking to buy my first house 4 years ago I could have bought a 3 bed house on Newman Rd at geebung for $250 000 (maybe less as that's what the list price was). My other option was to buy a house which I found at Chermside West that was $295 000 also 3 bed but a bit bigger and built in underneath one street back from a main rd. I went for the quieter street (not on a main road) and bigger house in Chermside West. Rough guess at the value now is around $440 000. I just got in before the area became recognised and over inflated. The first sign of this is houses that area are a bit older and are starting to get renovated or they get removed and new ones get built (once there are a few reno's, more and more get done) and this over inflates housing prices as the area becomes a nicer or more desirable area to live in. The age old advice is buy the worst house in the best street (as this will inflate the price of your house) not the best house in the worst street (as these will keep the growth of inflation of your house down). Now where you make the money is as cameron said is to make multiple investments. The only problem with this is who can afford it? If I could have bought both houses (chermside west and Geebung) back when I was looking to buy my first house I would have, but I couldn't afford to do it on my own (young, low income and single). So if you can afford to buy multiple investment properties then by all means do it but be warned if you cannot then you will lose everything. It is all about finding a fine balance between what you can afford and what you cannot afford and about making wise choices in your investments (a lot of investigating and no impulse buying).

  8. I live in Ontario, Canada and I am thinking of purchasing an income generating property. My question is, should I pay off my principle mortgage which is at prime -.85 (fabulous rate) since I am told there will be tax implications on the rental property if I don't pay off my principle property? Looking for some advice/guidance.

  9. B, sorry but I haven't had much exposure to the Canadian tax laws in this regard. In Australia there are no such implications of the status of your principle residence on the tax liability from investment property.