12M3 blogSpot: October 2007

Broadcast Date: October 9, 2007 (On Channel 7 - Sunrise)
Interview: Phil Ruthven (researcher)

Phil is chairman of IBISWorld. Read Phil's full report (PDF)

Phil Ruthven challenges the perception that renting is ‘dead money’.

Ruthven claims renting can be more economical than buying, if the monetary difference between renting and buying is invested in quality shares or super.

Ruthven also says that interest payments on a house are higher than rent even before capital/principal repayments are made. At the moment, interest rates are actually double rent rates!

There are many forgotten costs involved in owning a house For example:

a) transfer costs (real estate agent fees, conveyancing fees and stamp duty) three or four times over 30 years, given that people own homes on average for around 7-8 years before exchanging them:
b) maintenance costs (huge):
c) alterations & additions to the home (average $120,000 over 30 years):
d) rates (except water):
e) insurance (except contents, as they have to be insured by lessees also)

Other factors to consider
1. The average Australian will live in at least ten (10) homes during his or her life, seven of these independent of parents and mostly as a married person. Of the seven homes, how many should be owned, if any, versus leased?
2. Leasing is different to renting in a number of ways:
a) the time frame is longer (up to 10 years or more), like commercial leases;
b) ownership is different (property trusts, superannuation funds, etc), whereas rental premises are usually owned by individuals or consortiums;
c) the lessee can modify the home, by agreement with the lessor.

Full Report:

HOME OWNERSHIP VERSUS LEASING
Points to Ponder

Phil Ruthven, Chairman
IBISWorld Pty Ltd

1. The average Australian will live in at least ten (10) homes during his or her life, seven of these independent of parents and mostly as a married person. Of the seven homes, how many should be owned, if any, versus leased?

2. Leasing is different to renting in a number of ways:
a) the time frame is longer (up to 10 years or more), like commercial leases;
b) ownership is different (property trusts, superannuation funds, etc), whereas rental premises are usually owned by individuals or consortiums;
c) the lessee can modify the home, by agreement with the lessor.

3. Home ownership has varied between 45% and 75% over the past 130 years (currently 69%). It would be unlikely to ever exceed 75% due to:
a) young people "flatting" when they first leave home;
b) elderly people in nursing homes;
c) people in armed forces, other than government accommodation;
d) people in accommodation provided by their employers (bankers, teachers in rural areas, etc);
e). extended families (eg. widowed parents living with children)

4. Some European nations have very low home ownership, and therefore high propensities for leasing, as can be seen in the exhibit below.

5. Home ownership in Australia was boosted in the post war years via: government policy of low interest rates; assistance with deposits; permanent building societies prepared to lend up to 95% (or more) of the value of the home compared with 67% by banks; employer sponsored home loans at special rates (eg. banks, insurance companies, other corporations).

6. All the above, plus a longish period of inflation, meant that home ownership made good financial sense via cheap or even "free" money (after deducting inflation) and being a hedge against inflation.

7. It is important to remember that home affordability should always be weighed up against alternative investment opportunities.

8. During the last 45-50 years, home ownership became a motherhood issue and came to be treated as a normal thing to do (which it wasn't historically) and a source of emotional security and stability. These latter attitudes will continue on for decades.

Further, most parents believed it to be a form of forced savings, which it was.

9. Over this period, the saying developed that "rent was money down the drain". This was not true, since for most of this time the interest payments on a house were higher than rent even before capital/principal repayments were made. In 2007, interest rates are actually double rent rates! My own apartment is a good example: the lease is around $28,000 per annum. The interest alone, if I was buying the apartment (around $925,000) would be around $74,000, before any capital repayments.

So, it is "interest payments that are money down the drain". And clearly one can make a far better return on the amounts of money used as capital repayments on a house loan (eg. by investing in shares).

Of course, inflation means that capital repayments become easier over time as wages and salaries grow, and principal repayments remain constant.

10. Leasing is recommended for length of tenure and security reasons (i.e 3+2 years, 5+5 years), not renting. Such leases are not easy to find but will become more prevalent as we move through the 21st Century. For decades in the USA and Canada, whole suburbs have been built for leasing only! And leasing has been common in many European countries for over a century. These trends are now only starting in Australia. Leasing of homes will mainly be provided by institutions (property trusts, pension funds, etc), whereas renting of homes is provided mainly by individual owners of homes.

11. If, individuals or families leased their home and invested the difference between the lease costs and the interest-plus-principle repayments in shares, then:
a) they would have been better-off financially even over the past 45-50 years of (sometimes) high inflation;
b) they will probably be better off over the next 45-50 years.

The real questions are:
a) would/will they actually save and invest the difference, or just spend it on other things;
b) is the emotional attachment to owning their home far more important than money.

12. In investing the difference in good blue-chip shares it is well to remember that, from time to time, the sharemarket falls (even crashes), but always recovers in the long run.
The charts below show the rises in the All Ordinaries Index and average established house prices.

The charts below show the make-up of household assets & debt and the upward trend in household incomes. Half the assets are in housing (either owner occupied or investment dwellings), and yet the earnings on these are far lower than in superannuation or direct shares. Fortunately, the proportion of these better yielding investments is growing as a share of total household assets.

13. Now let's look at some examples. One option is to buy (with 10% deposit) or lease an established house worth $475,000 in the year 2007. Assume inflation will average 4% over a 15 year pay-off period , and interest rates will average 9%, bearing in mind the cyclically low rates of inflation and interest rates in the 2001-06 period that are unlikely to continue over the next 15 year period.

a) Buying @ $47,680 per annum fixed over 15 years
Deposit (say 10%) $ 47,500
Interest $ 286,500
Principal $ 427,500
Plus "forgotten" costs $ 427,500 (see Note 15)
True total outlay $1,189,000

The value of the home in 2022 (15 years hence) would probably be around $1,230,000 and that is what another home the same size and type of location would cost in 2022 as well.

In 2022, the home owner has an investment of $1,230,000 and a nominal capital gain after costs of $468,500. But this doesn't include hidden expenditure of some $427,500 as explained in Point 15 later, suggesting a net profit of just $41,000! Not much, so buying a home is a case of forced savings not a good investment

b) Leasing @$21,375 pa initially, rising each year, and investing the difference in shares, assuming an average cumulative gain (capital gain and reinvested dividends) on the growing portfolio of 14.3%5

If lease costs are assumed to be 4.5% per annum of the value of the home being leased (with the home value and, therefore, lease costs increasing over the 15 year period at 4% p.a) then the lease paid over the 15 years will be $427,975 - a lot of money of course. But with $47,500 initial capital plus the difference between paying off the home and leasing ($286,025) being invested in shares (including re-investing the dividends and bonus shares) then the investment at the end of 15 years should be worth around $1,402,400 in the superfund, less taxes or a net $1,192,040. This is a profit of $787,720

But remember, around $427,500 costs over 15 years are involved in "forgotten" or "hidden" costs with home ownership. So, if the lessee was to invest these equivalent outlays (in more shares) that a home owner has to find in addition to interest and capital repayments, any comparison becomes truly embarrassing. At the end of the first 15 years the lessee would have an extra $1,465,000 less taxes or $1,245,250 on top of the aforementioned $1,192,040, totalling $2,437,290. This is virtually double the net worth of the home owner at the end of this 15 year period. The difference is mind-boggling.

14. In the above example, buying a $475,000 home with a $40,000 deposit should result in a fully-owned home worth $1,230,000 at the end of 15 years.

If the home was leased, then investing the difference should result in an investment worth $2,437,290 at the end of 15 years. At the end of 15 years the lessee could pay cash for a $1,230,000 home and still have $1,207,290 in the bank (or, preferably, superfund)!

If you then start with this $1,207,290 for the next round of 15 years (now owning a home outright with no lease payments), then at the end of another 15 years - that is, 30 years from now - you have a home worth $3.2 million and investments worth $6.6 million (after superfund tax) without putting any extra savings in each year! You could retire in luxury with this fortune.

The above conclusions would not vary if a more thorough/vigorous exercise was carried out. On the one hand, the assumptions about the earnings rate on investments (difference between leasing and owning) may be too optimistic, but calculations on ownership costs are understated, as elaborated in Point 15 below.

15. The "forgotten" or "hidden" costs of home ownership include:
a) transfer costs (real estate agent fees, conveyancing fees and stamp duty) three or four times over 30 years, given that people own homes on average for around 7-8 years before exchanging them:
b) maintenance costs (huge):
c) alterations & additions to the home (average $120,000 over 30 years):
d) rates (except water):
e) insurance (except contents, as they have to be insured by lessees also)

These are massive over each 15 years for home ownership. Let us start with maintenance. With home ownership, we do not put a dollar value on our DIY time . But the cost of "maintenance" on the basis of average household income per hour worked in the workplace is $23,000 per year (based on ABS statistics on hours of household maintenance work) plus materials. Over 30 years, this alone is (in today's value terms) around $690,000. In this calculation, I have only included 70-75% of the "maintenance" hours, assuming some of the maintenance could be regarded as hobbies or therapy - or would still need to be done as part of a lease of a dwelling (preferably outsourced for lower costs ). Not to forget the average $120,000 in additions/alterations paid to builders.

The other costs are also significant: transfer costs (four times in 30 years) would be around $110,000 (today's prices); rates and insurance (except contents) add another $55,000 over the 30 year period. These are in today's money terms.

So, around $427,500 costs of owning homes over each 15 year period are involved in "hidden" items in the form of maintenance, alterations and additions, transfer costs, rates, insurance etc.

16. Owning a home as the main basis of retirement is well short of reality. Let us look at a case-study retirement. Assume:

a 1945 born male baby-boomer retiring in 2010 at aged 65 years of age (partner having retired 5 years earlier);
final year income being Australian average household income then around $124,000 in 2010 (c.f $107,000 in 2007);
owns the average home (c. $535,000 in 2010, c.f. $475,000 in 2007);
draws no old-age pension at retirement;
aspires to maintain investment income of one-third of prevailing average household income (rising as that is, year by year) until death and pass on capital to children

17. So, the case study retiree requires:

$41,333 per annum in 2010, rising to $69,000 per annum in 2022:
$827,000 in assets (if owns home as well) from which to draw 5% after tax income that keeps pace with rising inflation and standard of living:
$1,362,000 in assets (if leasing home).

In brief, a dignified retirement with own home, no debt and a third of the prevailing average household income each year until death suggests assets of:
* In 2000 around $ 470,000
* In 2010 around $ 827,000
* In 2022 around $1,800,000

The Australian average is on track for half to two-thirds of these amounts at best! Singaporeans are on track for double (or more) of the above assets at retirement due to much, much higher annual savings (36% of income c.f 9% for Australians) during their working life. Minimum savings levels for one's entire working life is 15% gross annual income to have a dignified, self-sufficient retirement.

A guide to comparative returns in the recent past and near future is shown below. Over the longer term, shares always win.

17. If individuals or couples ought not to own homes, who should or will own dwellings and why? In essence, the same institutions that now own office blocks, shopping centres, factories, warehouses, hotels, tollways and other infrastructure are beginning to own residential dwellings, i.e: property trusts, pension funds, life offices, etc in which the public invest.

Why would they own them? The main reasons are that:
some individual investors love property as an investment and the returns are fair to good as the previous table on Investment Returns showed:

pension funds and life offices like to have prudent and
"balanced" portfolios of shares, property, bonds, cash, etc on behalf of conservative superannuants. Given that returns vary year to year on different investment and that there is always a proportion of a fund's members retiring each year, then having "all one's eggs in the one basket" may not be the best for a policy holder retiring in a given year.

18. So what to do?
a) Do not assume that owning a home is better than leasing, in financial terms. And please don't pass on this furphy to yet another generation!
b) Do not assume that, on retirement, owning a home is enough or even the main backstop: remember retirement can now be for 15-20 years or more, and a big nest egg for investment is critical. We need a nest egg twice the value of the average home; and that involves saving, on average, around 15% of each year's salary; or more if you have left it later in life to start serious planning for retirement.
c) We need to separate emotion from financial sense, but balance them for our own individual happiness. The writer has owned five homes before doing the homework outlined in these "points to ponder"! So, owning one or two homes is probably good for the emotional part of life: one of which will probably be regarded as the "dream home" or satisfying the "Australian Dream" (of home ownership).
d) If deciding to lease, you will need to have tenacity and patience for some time yet because there are not many dwellings available for lease (as distinct from renting) because we are well behind the USA, Canada and Europe in this regard. And, remember, the difference between leasing and owning must be invested to make the exercise worthwhile.
e) Renting is still a viable and sensible option for "short" stays eg just leaving home, on assignment somewhere, first few years of marriage, etc, etc.

19. Terrified of selecting shares on the Stockmarket? Don't try to pick winners. The returns quoted in Points 13 and 16 are using indexed results. All you have to do is ask your stockbroker to buy shares that match the index (preferably All Industrials Index in Australia which matches the Dow Jones) and International Shares. Then sleep nights without worrying. And don't worry with occasional sharemarket falls (or crashes); dividends are usually still paid, and the value of the (indexed) shares always recovers and goes higher.

20. But isn't the home free of capital gains tax and shares are not?

Yes, but:

both the home (principal and interest) and shares are bought from after tax income anyway; so no advantage there.
shares only attract capital gains tax if you sell them - and why would you sell them, even when retiring (you are then living off dividends).
Using your superannuation fund attracts lower taxes for fresh inputs than fresh inputs into capital and interest repayments on owning a home (after tax income!).

21. For those that think the price of homes always goes up, they are right most of the time. But it is interesting to note in the following exhibit that most of the rise in the price of houses occurs in booms which surface only every 15 years. So timing is (nearly) everything.

Read Phil's full report

More info:
IBISWorld

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