Thursday, January 28, 2010

UPDATE - How not to climb the property ladder

I really appreciated the discussion on my last post, and wanted to clarify some of the issues raised.

My two key points were:
1. The capital gain made from buying a cheap home and upgrading later does not always improve your ability to buy a larger place in the future, and
2. That forgoing life's little luxuries to start a savings plan directed at owning your own home is not always effective.  The 'work hard and save' mantra does not work if prices increase faster than your ability to save.

The issues flagged by readers were that
1. I ignored increased wages
2. I ignored the paying down of principle, and
3. I ignored the fact that rents increase in line with CPI while loan repayments do not.

My response is under the fold.
In light of these issues I have posted a spreadsheet here that compares the true investment outcomes of 3 scenarios; buying a home to occupy, buying a home as an investment but renting where you live, and renting and investing the difference between the rent and the cost of home ownership.

The assumptions are outlined at the bottom of the first worksheet, and you can change the scenarios by choosing from the drop down boxes for each of the inputs in black font in the top white boxes.   The alternative investment option is that rate of return (combining captial gain and income) from other non-property investment to which the cost savings from renting are directed. 

Some scenarios I have run are in the table to the right showing how changing some of the inputs changes the outcome. 

The second worksheet shows the calculations, where in each scenario the annual cost is equal to the home ownership option over 30 years.  Using this common cost we can overcome the issue of paying down principle, and of increasing wages.  Note that rents take about 30 years to reach the current cost of home ownership with compounding 3% annual increases. 

What we learn from this exercise is that buying your own home in today's economy is far inferior to buying a home as an investment, or renting and staying out of the property market completely.

Maybe that is a reasonable position, as buying your own home provides some security for which people are willing to pay a premium.  But the idea that home ownership is an investment, which is a commonly held belief, is far from an accurate interpretation of the facts.


  1. Dear Camerson,

    On your closing paragraph: tt depends what sort of home you buy, and where it is situated. I would say buying an apartment to live in with a view to selling at a profit is a poor investment. However buying a house in a handy position with a larger area of land will likely outperform (especially while population keeps growing)other types of dwelling. Whether one chooses to own a house or not is a personal choice. For me a home allows me the pleasure of gardening, more freedom to do what want (around the house) and the assurance of not be turfed out by a landlord. I am not sure that more land tax would remedy Australia's high house price situation: it would lead to most land being held in the hands a very priveldged few. The rest of us would be plebs renting from them.


  2. I feel the goalposts have been moved!
    You question in the last post was "How much better off is an OO than a renter ?". Todays response is actually to the question "How much better off is an OO than a renter WHO HAS THE DISCIPLINE TO INVEST THE DIFFERENCE ?". I think you'll find the vast majority of renters p**s the difference up against the wall & leave investing in the 'gunna do' basket. Maybe you're different ?

    I found your spreadsheet difficult to follow - maybe labeling all the column headings would help. And the assumptions you make have generated the result you wanted. I (of course) would make different assumptions.

    Assuming 7% growth in house prices is not unreasonable, and also not inflationary.... maybe you can work out why in another post.

  3. Robert, I agree with your apartment/house and land advice. In fact, I follow that myself and would be very hesitant to buy an apartment as a long term investment.

    Charlimi, if we don't consider the same cost it doesn't make sense to measure the same benefits. Whether the majority of renters don't save and ignore investment opportunities does not change the fact that such opportunities exist. Anyhow, if they did not save, they could spend more money on other things which give them enjoyment, while the home owner cannot. To account for this, I believe you need to consider the full opportunity cost of that money, and I have represented this by assuming that if they spend it now, it must be of more value to them than saving/ investing for later.

    I would disagree about the 7% price rise being a reasonable assumption over 30 year period, unless rents also increase by this amount and inflation is quite high (>4%) in which case your alternative investments would also make a high return. For example, if a $300,000 home currently rents for $300per week, that is a 5.2% gross yield. If prices increase by 7% while rents increase by 3%, after 30 years the price is$2.3million, while the rent is $728per week - a 1.7% gross yield. This situation is extremely unlikely. In the long run, rents and prices will increase at the same rate with minor adjustment for interest rate changes.

    I am also interested to hear your argument about how 7% long run growth in house prices is not inflationary.

  4. Cameron, great follow up. Unfortunately the link to your spreadsheet isn't working at the moment. I will drop back in another time to review this topic further once I see it.

    Slightly off the topic of this post, but I would be interested in your views on this anyway. At a macro level, how does Australia measure up against other countries in per capita residential mortgage debt/income? Without having researched this, my view is that Australians tend to have a larger % of leveraged investment in property than other countries. If my view is correct, could this borrowing to fund “unproductive” investment in housing be crowding out potential borrowing to fund investment in businesses which generate employment and other benefits for the economy?

    Charlimi, I am again confused by your argument here.

    Economic theory itself makes many assumptions and rational choice is one of those. Personally, I do not believe that humans make rational choices and this is evidenced by the numerous asset bubbles which have grown and burst throughout history. However, this does not discredit Cameron’s assumption that a renter would invest and save the difference that they would have otherwise paid as repayments on a mortgage.

    I also look forward to hearing more on your views regarding the current “low inflationary environment” and why “7% growth in house prices is not unreasonable”. How can 7% growth in house prices continue over the long term without rent, food, and other prices rising as well? People need to buy at least accommodation and food so I believe eventually wage growth will catch up and produce an inflationary spiral.

  5. Your spreadsheet appears to have 6% costs for an OO as well as 7.5% Interest cost - an assumption that appears more than a little out of whack with reality. You spreadsheet had macros - I'm unable & unwilling to enable macros.

    Perhaps you could put together a post about how individual properties can grow at >7% (long term average growth rate), while inflation stays low. Consider current yields for upper quartile properties, how the total statistical population of properties changes over time, consider that the majority of these aren't purchased on a rational economic basis - ie yield doesn't matter.

  6. No need to enable the macros. I was going to create a user interface but decided not to, but all the calculations will work fine.

    I'm not sure what you mean by the 6% costs for the OO. There is the loan payment (p&i), plus whatever you select as a reasonable maintenance, rates and insurance cost.

    Yes, of course individual properties can achieve long run capital growth above inflation if the location is unique enough, and the increase in the supply of housing occurs in fringe/lower price areas.