Friday, March 16, 2007

Buy v Rent

A lot has been written about whether it is better to buy your own home or to rent. Much of what I read on this subject is deficient in terms of objective analysis. Common deficiencies include:

1. focusing on selective statistics: a common example is the fact that home owners have, on average, considerably higher net worth than non-home owners. While superficially appealing, this is not a meaningful comparison. It would be more useful to compare home owners and non-owners of similar age and income groupings and possibly further broken down to account for other factors (such as children);

2. claiming that there is one single factor which is a decisive determinant: as an example it is sometimes claimed that the ability to leverage gives property ownership a decisive advantage;

3. making misleading comparisons: a common example is comparing the average house price at some point in the past with the average house price now. Even if the numbers used are specific to the local real estate market, the comparison is still flawed because (i) the average house has often changed during the time period under consideration (in many places they are bigger and have more facilities), (ii) this often ignores costs necessary to maintain the house's condition and (iii) very few houses are "average" or appreciate at the "average" rate;

4. using arbitrary, unrealistic, overstated or understated numbers: an example is long term maintenance and optional improvements. Advocates of home ownership often ignore or understate these while advocates of renting often overstate them;

5. ignoring relevant costs or benefits: advocates of property ownership often ignore the costs of long term maintenance. Likewise, advocates of renting often ignore the more favourable tax treatment given to owner occupied homes compared to many other investments. I have even seen examples which ignore the cost of renting;

6. making illogical or emotional claims: a common example is that a home is a liability or an expense. The former is nonsense (in almost all cases). The latter is true but then all assets are, from an accounting perspective, simply long term expenses which renders the claim irrelevant and misleading. The question is not whether a house is an expense but which or two alternative expenditures is the best way of meeting your accommodation needs.

My own view is that there is no universally correct answer to this question and the best approach is to prepare a detailed spreadsheet comparing the choices on a case by case basis. It is obviously important that the spreadsheet be as comprehensive as possible and reflect all relevant values (of which there are many). My experience is that the analysis is dependent on assumptions or estimates of the following factors:

A. duration: how long a time period you are looking at

B. return: what returns you expect to get on both the property (appreciation) and the alternative (equities, cash etc)

C. rent: what rental you expect to pay

D. interest rates: the interest rates you pay on your mortgage

E. outgoings: what outgoings you expect to pay (including long term maintenance, insurance)

F. transaction costs: commissions, stamp duty, lawyers etc

G. taxes: the impact of taxes on the numbers you come up with

H. will home ownership help or harm your asset diversification

I. the level of gearing you will use for both the house and the alternative investment

One other thing I have learnt through experience is that looking at hypothetical numbers is not that useful. It is important to look at an actual property and to use the numbers for the actual alternative investment that you would make if you rented (as opposed to some theoretical investment).

Given the number of variables, most of which involve making guesses about the distant future, the analysis is very often no better than an educated guess. However, my view is that it is still better to do the analysis than not. Sometimes the results can be surprising. When we brought our first Hong Kong property in 2001, the market was very depressed following the Asian crisis. My very rough calculations at the time showed that buying was better than renting even if I assumed a small annual decrease in the value of the property. I took that as a very strong "buy" signal.

There are also some factors which are harder to quantify or the inclusion/exclusion of which is debatable :

(i) should improvements (as opposed to maintenance) be included in the calculation?

(ii) for the "rent" calculation, what is your alternative investment?

(iii) will the alternative investment be geared?

(iv) what is your risk tolerance?

(v) how much value do you place on the feel good factor of owning your own home?

(vi) how confident are you with your estimates?

(vii) how disciplined a saver are you?

The last point is an interesting one. Concluding that you are better off renting is often justified on the grounds that the money that would otherwise be spent on a deposit, mortgage payments, outgoings etc would be invested in assets that show an expected return higher than the rate of appreciation of the property. This is fine if you actually make those investments. However, if you lack the discipline to do so, all you have done is give yourself an excuse to spend money that you would otherwise be forced to save through the principal component of your mortgage payments.

As a final point, even when I am looking at residential properties for investment purposes, I find it useful to put myself in the position of a potential home owner and consider whether that hypothetical home owner would be better off buying or renting the property I am looking at. I find it helps me to decide if the property is a good investment or not.

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