The issue of whether it is best to rent a home or buy a freehold property comes up again and again. It is usually dealt with in numerical terms with plenty of heroic assumptions obscuring the important points. I have written such blogs myself. My opening sentence already conveys more qualitative information than many such discussions. You rent a home. You buy a property, which can be a home but is also an asset. This blog tries to clarify some important issues that need to be considered when making this decision.Some are obvious, others less so.
Buying a freehold property is best for those that wish to put down roots in a specific location. The costs of buying and moving are very high. You need to get it right and only have one shot at it. Property can be illiquid so a forced sale can be at a poor price. If circumstances change it can add to the stress and cost of the change. Buying property is a commitment and suitable only for those that are able to commit. Renting is more fluid and flexible. It suits those that are not yet certain where they wish to live and has relatively low costs of moving. The main drawback is availability of suitable properties and the lack of security in the tenancy. This latter point is often misleading. Landlords need tenants so good tenants paying the market rent are probably as secure as homeowners. Moreover, tenancy agreements can be negotiated.
Owning a freehold property confers more independence and responsibility. You are responsible for maintenance, insurance, etc. You have the option of DIY maintenance. Owning a leasehold involves a freeholder and loss of control of maintenance and buildings insurance. Moreover there may be a lack of transparency with little maintenance and unexpected bills, despite a regular service charge (check the sinking fund). There is also the stress and expense of extending the lease. Buying a leasehold without a simultaneous share of the freehold is a dangerous enterprise. Careful note of the ground rent and escalation is advised, especially on new builds. Renting forces you into a continuous relationship with the letting agent and/or landlord. However, if the letting agreement is sensible this relationship should be transparent and predictable. The key to renting is the letting agreement and if this is negotiated carefully later problems are avoided. Once again, landlords need tenants and good tenants have security and peace.
Renting is often viewed as a waste of money leaving you with nothing to show for your time. This is a false view. You are paying for housing services. Buying a property, freehold or leasehold, for owner occupation also involves paying for housing services. The difference is that you simultaneously make an investment in the property in which you live. Most people’s net worth is tied up in the property in which they live, which from an investment perspective is a bad idea. There is no diversification in your portfolio. If you also work locally this could become catastrophic if you lose your job. Owning a property in the area in which there is a single dominant employer is particularly daft. If the employer fails you may have no job and be unable to sell the property. This is why so called ‘depressed towns’ have emerged. Renters can up sticks and move.
The ‘renting is a waste of money’ view is largely based on two heroic assumptions. First property prices always rise. This is not true and in particular areas they may go down even when the overall property market is booming. Second, the only amount at risk is the deposit in the property (Economic Capital is covered in the next blog). Small steady increases in property prices can make attractive returns because property ownership normally involves leverage. If you put down a 10 % deposit on a 500k property and the price rises by 3% then your return on capital, as typically calculated, is 30%. Not bad. However, it is important to keep in mind you are always on the hook for the loan. If all goes wrong you cannot just hand the keys back to the bank and accept the loss of the deposit. Equity can become negative and the house is the asset which you can dispose to clear the debt but it may not provide sufficient funds to do so. Your capital-at-risk is much more than the deposit. So calculating returns as a percentage of the deposit may exaggerate the return.
The cost of housing services is not materially different whether you rent or buy. The difference is that you can recoup some of your costs through a leveraged, albeit un-diversified, investment in the property with some nice tax advantages. The (implicit) rent you pay yourself incurs no tax and the capital gain is tax free. The implicit rent merely covers the mortgage interest, maintenance, and insurance which is included in any rental agreement, so, apart from the potential income tax advantage, is a wash. The real investment kicker is the leveraged capital gain, helpfully free of CGT. The heroic assumption is that a capital gain is always forthcoming, which need not be the case. This is especially true if you buy a leasehold and fail to extend the lease. Moreover lease extension involves more outlay.
It should be fairly clear by now that what home ownership offers in financial terms over renting is the possibility of leveraged capital gain. Given recent history this might seem compelling but it is not without risk. The problem is that it is hard for the person-in-the-street to obtain this kind of leverage in any other way. A bank will give you a mortgage on a specific property several times the deposit and your annual income at a reasonable interest rate but it will not do so for, say, a portfolio of equities. This portfolio might consist of banks, REITs, and house builders. The reason is that whilst the home owner is un-diversified the bank has millions of mortgages spread across the country. The bank is well diversified and is in control of the diversification. Ironically the equity portfolio may be even better diversified but the bank will not extend an equivalent loan. One reason is that an equity portfolio is marked-to-market (valued everyday) but the mortgage portfolio is not. There is an illusion of stability.
If one removes the leverage facility from the equation property returns look less spectacular and equity returns start to impress. It is possible to use your deposit to invest in equities through a tax advantaged wrapper and use the returns to offset the cost of renting. Of course the absolute return will not match the potential of home ownership because of the lack of leverage. If one can persuade a bank to lend for the purpose of investing in a portfolio of equities on the same terms one would see that the choice of rent or buy is best made on the basis of lifestyle and personal needs for services rather than because it is potentially a way to increase net worth. The institutional bias towards leverage for property ownership is distorting the housing market. For many mobile, young people, renting is a sensible choice.