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Why letting is better than buying – for the time being

30-04-2013

What is best: buy or let? This is an age-old question. In the case of commercial property, the easy answer is that it depends on your company’s expected total return on capital, also known as the weighted cost of capital or required return. This is a concept similar to opportunity cost.
 

Letting a house is superior to buying for own use
A 5-year view

   Buying a house of
 R1 million
 Renting a house worth
 R1 million
  100% equity 100% bond Rent
outflow
Cumulative saving †
Total of outflows ‡ R46 532 -R651 832 -R349 969 R374 139
NPV ≠ of all outflows -R278 003 -R487 749 -R288 167  

Assumptions:

1. The house is worth R1 million today but transfer duty and other transfer costs are assumed away in the case of the purchase scenario
2. Interest only at 10% p.a. is paid in the case of a 100% mortgage
3. The house is sold after  5 years, after having appreciated at 3% p.a. (half of inflation)
4. The initial rental is R6666 per month (which would yield a gross initial yield of 8% should the property be let rather than owner-occupied)
5. The rent grows at the inflation rate of 6% p.a.
6. No capital gains tax is paid on selling the house at the end of the 5-year period
7. The owner pays operating costs like insurance, assessment rates and maintenance, and these grow at the inflation rate.
8. The NPV is calculated using a discount rate of 8%
† Relative to the 100% mortgage-bond scenario
‡ Ignoring time value of money
≠ Net present value (adjusting for the time value of money)

Source:  Rode & Associates

If your company can generate a total return on new capital invested in the company of more than the expected total return on property, then your company should not invest in property but should be letting its space. In fact, you might ask yourself the question: if my company (with its higher risk) cannot even beat property as an investment, what the hell am I doing in my business? Surely, this implies I should rather be a property investor?

But what about residential property for owner-occupier use?

The best way of going about this problem is to compare the cash flows of buying versus letting. To this end, we created three cash flow scenarios, that is

• buy your house with 100% equity,
• buy your house with a 100% mortgage, and
• let the same house at a market-related rental (see the table).

These cash-flow scenarios include the supposed capital appreciation when the owned house is sold after an assumed period of five years.

Crucial in such a comparison is the assumed capital appreciation. We chose to use a 5-year period for this comparison, as we believe, based on our research, that house prices will grow over the next five years at only about half the inflation rate. This is so because house prices are still over-valued by the marketplace by about 25% (see Houses overvalued by 25%: A rejoinder).

Ignoring the time value of money, the 100%-equity “buy” scenario yields a slightly positive cash flow  of R46 000 when selling after five years. However, this is not so bad as, in addition, the occupier also gets a ‘roof over the head’. Compared to this rather positive outcome, the 100%-bond scenario experiences an outflow of R651 000, which is significantly worse than the renting scenario, which returns an outflow of R349 000. This shows that when having to borrow when buying results in a worse outcome than renting. However, in 2004, when we were in a different phase of the residential-property cycle, the situation would have been vastly different. This goes to illustrate that timing (as with any investment) is crucial.

Investors often motivate their decision to buy rather than let by stating they do not want to “make a landlord rich”. However, this analysis shows that if one were to buy with the help of a mortgage bond, the bank is “enriched” even more!

This comparison can be improved by adjusting the outcomes for the time value of money. This is done by calculating the net present value (NPV) – that is, by discounting future in- and outflows. Discounting is nothing but the opposite of compounding interest.  The importance of the time value of money can be illustrated by stating that R1 received today is worth more than R1 received only in five years’ time (the difference being the return one can reasonably expect on R1 over the next five years). We used a discount rate of 8%, which implies that a typical household can – in today’s investment climate – only expect a total return of about 8% per year on investments. The rate of 8% is mute, but a sensitivity analysis shows that using a higher discount rate of 10% does not change the conclusion.

When comparing the three scenarios using the net present value (NPV), we see there is little to choose between letting and buying with 100% equity. However, when gearing the purchase (by 100% in this instance), the outcome is much worse for the owner.

To be practical, this conclusion is of greatest import to households contemplating owning their first house (rather rent!) as well as households that relocate.

In real life, however, consumers out there are not necessarily fully rational – even economists are realising this now!

This article first appeared in Personal Finance magazine, 2nd quarter 2013 (vol. 55).