Buying vs. Renting in Australian Capital Cities: Which is the Optimal Strategy Over the Next Ten Years?
A new strategy: why investors are turning to property debt over stocks
August 28, 2020
Dorado buys into Naval Base
November 17, 2020
Relative to incomes, Australia has one of the most expensive property markets in the world. Yet, as a nation we remain committed to the goal of home ownership.
Partly, this reflects the perceived advantages of home ownership, particularly as a means of wealth creation. A recent article published by Dorado sought to test this theory by comparing the net financial position that would result under two distinct strategies:
Buying the median priced unit in December 2009 with an 80% LVR mortgage and selling after ten years.
Renting the median priced unit in December 2009 and investing the money saved each year in a combination of shares and term deposits.
Similar to other studies, our research took a retrospective approach, focusing on a single ten year holding period ending in December 2019. Our analysis yielded the somewhat surprising result that over the study period, a strategy of renting and investing would have been preferable in most Australian capital cities. Arguably, these results may change over different periods of time and holding period durations.
Whilst a retrospective analysis provides some interesting context around whether buying or renting is preferable, the decision around whether to buy or rent one’s home is, of course, based upon one’s expectations about future property prices, rents and the performance of other asset classes.
In recognition of this fact, this paper builds upon our earlier analysis by taking a forward looking approach, posing the following questions:
What is the likely payoff to those pursuing a strategy of renting and investing in each state/territory capital city over the next decade?
Given the expected payoff to renters who invest surplus funds, what is the required rate of capital value growth in median unit price over the next decade that would provide those who decide to purchase their home with the same net payoff as those who pursue a strategy of renting and investing?
This required rate of capital value growth is then compared to the historical price appreciation over the prior decade to determine the likelihood of whether a strategy of purchasing is likely to match (or even exceed) the expected outcome to renters/investors.
A Nuanced Outcome: Buying vs. renting & investing over the next 10 years
Fig.1 Base Case Scenario: summarising the payoffs under the renting/investing strategy for each of the state and territory capital cities as well as the annualised rate of capital value growth (CVG) required over the next decade to equalise the payoff under the buying strategy with the rent and invest strategy for each city.
Our results indicate that over a ten year holding period, Sydney and Melbourne were the only cities in which a rent and invest strategy yielded a positive payoff, meaning a renter in these cities would have earned more money from their investment than they would have paid in rent. This is due to the significantly higher median unit price and lower relative median rents, meaning that renters would have saved more by renting in Sydney and Melbourne relative to other cities, therefore having more money to invest.
However, this does not necessarily point to a straightforward outcome of buying providing a better payoff than renting and investing in most capital cities. All cities except Sydney and Hobart must achieve a higher annualised rate of capital growth over the next decade compared to the prior decade in order to ensure that the buy strategy yields a payoff that matches the payoff of the rent and invest strategy.
Interestingly, the price growth required in all cities except Canberra and Darwin would require household income to increase by more than it has in the past ten years for housing affordability not to decline in those cities.
Infographic: Difference between historical and required future growth of household income to meet capital growth targets over the next 10 years.
Outcomes Remain Consistent in a Downside Scenario
One potential limitation of the base case scenario is the assumption that investment returns under the rent and invest strategy over the next decade will perform broadly in line with average growth recorded over the prior decade. In recognition of the fact that ‘past results are not necessarily a reliable indicator of future results’, we have rerun a downside scenario with a 2% potential fall in investment returns.
It is interesting to note that the results produced by the downside scenario do not differ greatly from the base case.
Fig.2 Downside Scenario
In the downside scenario, a strategy of renting and investing again yields a positive payoff only in Sydney and Melbourne.This means that a renter in these cities would still earn more from their investment, even with reduced investment returns, than they would pay in rent.
Reflecting the same results as the base scenario, all cities except Sydney and Hobart must still achieve a higher annualised rate of capital growth over the next decade compared to the prior decade in order to ensure that the buy strategy yields an outcome that matches the payoff of the rent and invest strategy.
Household Income Growth Requirements Remain the Same for the Downside Scenario
In both the base case and downside scenario, to achieve a return that matches the payoff of the rent and invest strategy, all cities except Canberra and Darwin must record a higher rate of annualised growth in gross household incomes over the next decade (compared to the prior decade) in order to ensure that housing affordability remains unchanged from their respective June 2020 level.
What does this mean for home buyers now?
With six of the eight state capital cities requiring a higher rate of annualised capital growth over the next decade to equalise buying and renting outcomes, our forward-looking analysis suggests that home ownership may not always be the optimal strategy, at least from a purely financial perspective.
This supports our retrospective analysis findings that the net financial position of those pursuing a renting and investing strategy over the decade ending December 2019 was better than those who opted to purchase their homes in all cities, except Sydney.
Arguably, the increased current level of economic uncertainty arising from the COVID-19 pandemic may further persuade some households to defer their home buying decision. However, as the flow-on effects of the current economic slowdown filter through to both the housing and broader financial markets, new opportunities will be presented to both buyers and renters.
Against this backdrop, the decision to buy or rent, whilst perhaps not as pressing as it may have once been, is likely to remain one of future debate and contention.
Methodology & Assumptions
The starting point of our analysis is the median unit price and median unit rent as at December 2019, which are as follows:
In addition to the above, our analysis requires assumptions regarding future rental growth, stock market performance, interest rates and inflation over the next decade. To simplify matters, our base case scenario broadly assumes that these match their annualised rate recorded over the prior decade. An exception to the above is the fact that future rental growth is assumed to grow in line with CPI inflation (rather than rental growth) recorded in the corresponding capital city over the prior decade. In addition, the discounted standard variable rate used to calculate the mortgage repayments under the buying strategy, is set at 3.45% p.a., the rate we recorded at December 2019. This is assumed to remain the same over the ten-year holding period to reflect an expected sustained lower interest rate environment.
For completeness, we provide an overview of the calculation of the payoffs under the buying and renting strategies below:
Put simply, the payoff to buyers is defined as the financial benefits of buying (i.e. price appreciation), less the initial (one-off) costs of buying, less the ongoing ownership costs.
1. Benefit
Sales proceeds on sale of property in year ten, net of selling costs at 2%.
Note: Sale proceeds in year ten are set/goalseeked so that the payoff for buyers equates to the payoff for renters.
2. Initial (one-off) Costs
20% deposit
Stamp duty
Conveyancing fees
Finance costs, mortgage registration, and search fees
Note: First Home Buyer grants and stamp duty concessions are excluded as our analysis does not necessarily presume that the purchaser is a first home buyer. In addition, the former usually apply only to the purchase of new homes.
3. Ongoing Costs
Monthly mortgage repayments (on a 30-year principal and interest mortgage with a discounted standard variable rate). The current 3.45% discounted standard variable mortgage interest rate is assumed to apply to the first ten years of the loan term (i.e the period under study).
Strata costs
Repairs and maintenance allowance
Council rates and utilities
Home and contents insurance
Note: Where applicable, ongoing costs under both the buy or rent scenarios are assumed to increase each year in line with the corresponding city’s annualised CPI observed over the prior decade.
The payoff to renters is defined as the financial benefits of renting less the initial (one-off) and ongoing costs of renting.
1. Benefits
Money saved each year by renting rather than buying is invested 50:50 in the ASX 200 and a term deposit account
2. Initial (one-off) Costs
Rental bond (equivalent to four week’s rent)
3. Ongoing Costs
Weekly rental payments which increase each year in line with the annual growth in CPI recorded over the prior decade for the corresponding capital city
Contents insurance
Additional moving costs
Note:
Investments are split between ASX 200 (50%) and Term Deposits. Yields are paid each year to investors, net of income tax at 40%, based on the average past ten-year performance of each:
a. ASX 200: Share portfolio grows at 3.2% p.a. with an annual gross dividend yield of 4.0% reinvested each year.
b. Term Deposits: 2.25% p.a
Sale proceeds on the sale of the share portfolio at the end of year ten are net of CGT tax at 40% after applying the CGT discount.
Renters are assumed to move every three years, reflecting the greater flexibility offered by renting.
