The decision to either rent or buy can also have far-reaching implications on household cash flows, as well as on wealth. In recent years, huge capital gains were achieved through a surge in the number of people buying residential property, swinging the pendulum in favour of owning as opposed to renting.
It wasn't always this way though, and with the extreme interest rates of the 1990s, rental may have seemed far more attractive to many. Now, with the property market slower, interest rates rising, and residential property yields low, rental may be becoming a more attractive option for some once again.
Often the decision is based on affordability, so before taking out a home loan get advice from one of our home loan consultants
Before you decide, though, consider the following:
The obvious benefits of property ownership are:
- Capital gains accrue to the owner, and although we are currently entering a period of general price deflation, my expectation is that house price inflation will once again rise in future as it normally does, on the back of a resumption of interest rate declines at a stage in 2009 and an economy that I believe will recover to grow solidly in the longer term.
- On one's primary residence, an additional benefit relative to some other investments is that one is partly exempt from capital gains tax.
The less obvious benefits of ownership relate to human nature:
- As opposed to renting, there exists a stronger incentive to invest in one's residential asset and to add value to it through maintenance and alterations. Many of us therefore end up with a far more valuable asset than what we started with due not only to market movements but also due to our additional investment.
- Ownership may encourage greater financial discipline than rental. Because of the incentive to invest in one's asset in the case of ownership, one may sacrifice a significant amount of consumption expenditure (i.e. raise savings levels) over the years in order to finance this investment (either financing upgrades and maintenance, or paying off the bond more quickly), thereby ending up better off financially in the longer term compared to the rental option.
- The non-financial but very important benefit of ownership is the power to shape the asset the way one wants (within the regulations obviously), according to individual tastes and lifestyles, in order to maximise the "usage value" one derives from it.
Rental also has its benefits though:
- Apart from the cash flow uncertainties surrounding bond repayments (which can be fixed for some time of course), property ownership has the added uncertainty of unforeseen costs, which are numerous. These could include routine maintenance which, although we expect it, its costs are tough to calculate accurately, or the unexpected maintenance which could include a burst geyser, the removal of a tree struck by lightning, or a termite problem. Insurance can solve much of this issue but not everything. By renting, one can pass many of these unexpected costs on to the landlord in accordance with the lease agreement. Obviously this still requires that you choose your landlord well.
- The other unexpected costs which are avoided when renting are those associated with possible market fluctuation. Capital losses can be made not only in times of deteriorating economic cycles, but if a particular area deteriorates badly, and property owners as opposed to tenants are the ones having to live with this risk.
- Rental can also be beneficial to people who risk re-location quite frequently. Despite 2006's reductions in transfer duties, they can still be quite significant the further up the price ladder one climbs, along with commissions and other fees related to buying and selling, not to mention re-location costs. Frequent buying and selling in a market that is not currently inflating at the rapid rate of a few years ago could see transfer and moving costs wipe out capital gains. Property ownership, compared to stock market for instance, requires less frequent buying and selling because of higher transfer costs and costs associated with re-location. The greater flexibility in terms of re-locating that rental property can provide is obviously subject to the length and terms of one's lease.
- One also needs to consider the cash flow implications of monthly debt repayments on an owned house versus those on a rental property. These days, rental can be a better option in the short term with regard to cash flows (on many properties, given generally low yields at present, market rentals are less than monthly bond repayments at the start of the loan term these days), but ownership could possibly be the better longer term option.
Take a look at the following (ADMITTEDLY SIMPLISTIC) hypothetical example where a person has the make believe choice of either buying or renting the same house. Let's say that the gross income yield on the property is 8%, in other words annual rental income from the property would be 8% of the value of the house. A further hypothetical assumption for the sake of the example is that operating costs of the property would be 3% of value. Assume also that prime rates average 12% for the 20-year bond period and that the client pays prime minus 1%, i.e. 11% on average.
Now assume that capital value of the property rises by 7% per annum, as does rental and operating costs. For the property owner, the bond repayment in this hypothetical situation doesn't rise over time. While in real life short up and down cycles in interest rates make this unrealistic, but in the long term interest rates and monthly bond payments need not necessarily go up and up such as is normally the case with rentals and operating costs, which vaguely track the country's general price inflation and generally keep rising.
With rentals not covering the monthly bond repayment early in the 20-year period, one may be tempted to go for the rental option. Each to their own, but remember that there is the chance that one may be paying more in the latter stages of the 20-year period when renting, as the hypothetical situation depicted in the graph above suggests. The owner only has to deal with annual increases in operating costs. The tenant, on the other hand, has to deal with rising rental costs each year, and under the above set of assumptions, he begins to pay more than the owner's total bond and operating costs in year 13 in this specific example, while he will also end the 20-year bond repayment period not owning an asset.
In summary
Admittedly, the hypothetical examples in this article are simplistic, and should only be seen as an attempt to illustrate a concept. This article deliberately makes no recommendations as to whether one should buy property as opposed to renting. The reason is that everyone has a different financial situation, a different risk appetite, and different priorities. Its goal was merely to suggest certain factors that should be taken into consideration when deciding between two important alternatives.
If you are considering renting during these uncertain interest rate times, weigh up the near term benefits in terms of greater cash flow certainty and often smaller monthly payments (compared to the full bond holder) when renting, against the benefits of ownership which include the ultimate possibility of fully-owning an asset, which is potentially of great value once one is debt free. Also, there exists the possibility that a few years down the line your rental payments may exceed bond and operating cost payments. In other words, it is possible that renting can be more attractive in the short term but with longer term disadvantages relative to ownership.
John Loos, FNB Home Loans property Strategist