Sometimes, a post needs a shout-out. And this one goes out to my friend Kate – who tells me that we are America and Afghanistan on this subject.
You see, Kate wants to buy a house instead of “paying someone else’s mortgage”. I, on the other hand, am quite happy to make that contribution. And seeing as this debate happened in a public setting with gin and a drinking game, it inevitably led to a challenge and an acceptance. Hence this post and a spreadsheet with numbers.
Firstly, some facts (from the SA Commercial Property News website):
- Last year, the South African property market offered a total return of 15.2% – comprising of an income return (rental) of 8.9%, along with a capital appreciation (increase in the value of the house) of 5.8%.
- At the same time, equities returned 20.6% (based on the MSCI South African equity index).
Now I realise that equities are generally riskier than property. However, in general, those two asset classes will move in the same way. When the economy is doing well, property prices do well and equities boom. When the economy is doing less well, property prices get muted and equities crash*. Nevertheless – historically speaking, over long time periods (say, the 20 year period that it takes to repay a mortgage), equities consistently outperform property.
And as for the riskier part – Kate and I are young adults. Ergo: we should be doing more risky stuff like buying equity and playing drinking games with gin.
But those risk/return principles aside, there is another, more pragmatic point to be made about buying property: the presence of hidden costs. Some examples:
- Transfer duty on purchase (about 4%);
- Rates (they add up);
- Repairs and Maintenance (a plumber, an electrician, a new oven top, repainting, replacing wiring, cracked cisterns, leaking tiles, broken tiles, broken windows);
- Levies (everybody wants a well-manicured public area in their complex);
- Water (always part of the rent…);
- An agent taking commission off the rent;
- An agent taking commission off the selling price at the end;
- And so on.
That’s before we even get to the topic of your mortgage repayment. Because you’re probably, as a young adult, going to get an interest rate of, say, 10.5% (the Prime Rate of Interest + 2). I mean – that’s a great rate. But what’s your average rental yield? 8.9%? That doesn’t sound like it’s covering interest, let alone capital…
Which leads me to an example (how I love the numbers):
- You have the option of buying a house for R2 million.
- You’re lucky enough to get a 20 year 10.5% mortgage with a 5% downpayment.
- That works out to about R230,000 per year in mortgage repayments.
- In addition, you work out some other monthly costs: rates, maintenance, repairs, water and levies. Those amount to about R60,000 per year (or R5,000 per month).
- So every year, you pay about R290,000 for your house.
- If you were to rent the property, you’re looking at monthly rentals of about R15,000.
- That works out to an extra R112,000 in cash every year**.
You have two options here:
- You can buy the house, put down the deposit of R100,000, pay SARS transfer duty of R80,000, and then pay annual mortgage repayments and expenses of R290,000 for the next 20 years; or
- You can rent the house for R15,000 per month, take the R180,000 initial costs you’re saving and put it into a passive equity fund, and then take the R112,000 that you would “save” every year and put that amount into the same fund.
Those “savings” if you rent would change every year though. Because if you bought the house, your mortgage remains fixed while your rentals (and other costs) would go up every year with inflation. So let’s assume that the renter (me) would only invest what he saved by not-buying. Also, to illustrate the point, I’ll assume that I would earn exactly the same return on my equity-invested savings as if I bought the house (ie. 8.9% rental return + 5.8% capital appreciation = 15.2% return).
Here’s a graph showing relative worth over time:
What you should notice is, at the end of the 20 year period, assuming equal returns, your net worth as a renter-saver is two-thirds larger than your net worth as a home-owner.
This difference grows magnificently if you assume that the equity return-property return differential remains the same as it did in 2012:
Still sitting at the R6 million mark as a home-owner; but when you rent and invest the difference in equity, we’re looking at the R24 million mark at the end of 20 years.
THEN WHY WOULD YOU BUY A HOUSE?
Well – there are good reasons for owning a home. And I can think of two main ones:
- Because it is sometimes a really good deal
Let me deal with the “qualitative” side first. I’m not talking here about the joy of owning your own home, where you get to bring up your children with the picket fences and the apple tree out back (although – that is a really good reason***). No – I’m talking here about discipline.
The renter-saver scenario requires you to maintain the habit of placing a significant part of your savings into an equity fund every month. If you have a mortgage – you damn well make that payment. You go without food before you default. But if you don’t have any specific obligation as such, you are much more likely to go on holiday with the money. Not so?
Homes work for most of us because they enforce a saving discipline that we would otherwise avoid. And that is the best reason for buying a home. Because then my alternative is irrelevant: you are choosing between owning an asset, and blowing it on fun stuff****.
Which brings me back to the good deal.
When is Buying a House a Good Deal?
Home-buying is generally-speaking a good deal when your rental yields are high. That’s almost stating-the-obvious. But I went to this data set, and discovered that rental yields on two-bedroom apartments in Johannesburg (for 2012) were 13.31%. Which is amazing. So I plugged that into my spreadsheet (with my R2 million example), and even assuming that equity returns are higher, you get a picture that looks like this:
Of course – that’s because your rental returns are more than covering your mortgage repayments. I mean – it’s like buying a house for free. Plus, with those kind of yields, you’re likely to see an upswing in the value of two-bedroom apartments (wouldn’t you start buying those apartments? Driving the price up?).
Let’s compare this to Cape Town, where a similar apartment has a 4.65% rental return. You get this:
Moral of the Story
Don’t buy houses in Cape Town. But if you, like Kate, are looking to buy a two bedroom apartment in Johannesburg – you’re in the money.
Kitty, I apologise.
I blame the gin.
*Which makes sense. If you’re doing not-so-well financially – the first place you go to is your investment portfolio. Selling your house is a dramatic, last resort-y kind of action.
**Lots of people give me the “I’d rather spend an extra R4,000 on a mortgage repayment and own the house at the end than pay rent” story. But you often forget the extra R5,000 odd that you pay every month for levies, rates and maintenance.
***Just one that costs you in terms of where you could have been had you not lived that dream. There are no free lunches!
****And best you be extremely self-honest when making the self-assessment. Because almost all of us impulse-buy at the till*****.
*****One realistic alternative is to force a debit order on your account into a passive equity fund. That way, the money is not there for you to spend from the start.
thebboss April 12, 2013 at 09:10
Oi why must Cape Town property be so expensive???Reply
Thanks for this post – now I don’t have to have this argument again – I can just refer people to this post 🙂
Chris Lazley April 12, 2013 at 22:16
I would still buy a home for the apple tree. And because I’m wary of regular self-discipline over twenty years. This is my favourite post ever.Reply
Anonymous April 16, 2013 at 10:45
Love! Love! Great piece!
Jayson Coomer April 16, 2013 at 10:58
Is that just because you feature in it? 🙂Reply
Siobhan Scallan May 1, 2013 at 22:44
Awesome article! I have gone in circles around this question! Finally explained in layman’s terms. Yay!Reply
Jayson Coomer May 1, 2013 at 22:52
Thanks Scallan! You’re awesome.Reply
Anonymous May 3, 2013 at 10:44
You forgot two vital pieces of information. Leverage and debt diminishing inflation. A 5% rise in property with 9 times leverage yields you a much bigger return than you can get in the equity market. Also, de t diminishes with inflation, so as your rental carries on increasing, if you had to own, your debt would become more insignificant over time. The real downside with property is the illiquidity. When you really need to sell – which tends to be in a recession – it tends to be a buyers market. I firmly believe property investment is the way forward…as long as you can stomach the admin that comes with it.Reply
Jayson Coomer May 3, 2013 at 14:23
I actually didn’t forget the impact of inflation on debt: I assumed that you would rent and invest the saving that you made; and over time, because of inflation, the annual saving decreases (your mortgage repayments remain constant, while your rental income and costs increase with inflation). Eventually, based on current inflation rates, you stop making a saving in about year 15 (using my assumptions). Those figures/graphs already take that impact into account.
And as for the impact of leverage… A 5% rise in property with 9 times leverage just about covers your 4% transfer duty. So if you’re lucky, you make a 1% return on the property as a whole, which works out to 10% on the money you fronted. Add in a real estate commission, and your return is minimal. And it’s really unfortunate because your leverage benefit is always highest in the first year of your mortgage.
If it was only illiquidity, that would be one thing. But it’s not. Because for starters, it’s high transaction costs; and for another thing, there’s the fact that equity investment always has a head-start equal to 4% of the value of the property (the initial transfer duty). That 4% saving is happily generating returns for an equity investor, where a property investment starts off with a 4% loss that it has to recover from.
I’m not saying that property investment doesn’t have a great future. I’m just saying that it’s not always as sensible as most people assume.Reply
garthwatson June 16, 2013 at 19:35
Thanks very much for this post- and your blog in general. You have factored rental returns into your spreadsheets – if you rent to live in the house you buy, do your numbers still work? You own the property so don’t get a rental, but then again you don’t pay rental. Are you saying the saved rental that you don’t pay because you are not a tenant, but an owner is a rental return? I think I’ve answered the question, but I guess it’s another variable you could plug in.
Also, I read your last answer to the question above, why don’t you take the “full property” rate of 15 odd percent and not just the 5 odd percent for capital appreciation when you work out the effect of being able to leverage property investments? You wouldn’t get the rental income on the property if it wasn’t funded with debt.
I’d be interested to know what the numbers are on the full 15% and also if you exclude conveyancing fees.
Jayson June 16, 2013 at 23:14
Thanks for commenting! In answer to your first question – yes indeed. If you live in your own house, you save on paying rent, but you also forgo on earning rental income from the property (so the net impact is zero, or zero return).
Therefore, from a spreadsheet perspective, there’s nothing to take into account – because what you save in rental expense is what you lose in not getting rental income. It’s why they say that you never make money on your first house!
As to your second question, the only return is the capital appreciation on the property for the exact same reason as the above. Your rental income return is irrelevant if you still have to incur a cost to live. The only time it’s worth taking into account is if you are taking the step of owning a second property; or if you are electing to live with your parents (where you pay no rent) while you buy your house (and rent it out).
Obviously, once you move into second property territory, you’re now talking about it as an investment. Which I think can really pay off, especially where you’re getting high rental yields (and actually earning them!). And even if the property returns aren’t greater than equity returns in absolute terms – they’re certainly likely to be safer, which makes them a much better return relative to risk taken!
I hope that answers your question?Reply
Anonymous June 17, 2013 at 18:53
Thanks for taking the time to answer it! Much appreciated. Would you be prepared share those spreadsheets at all? I understand if not.Reply
Jayson June 18, 2013 at 16:38
Sure! I’m just not sure how to share them on the blog. If you mail me at [email protected], I’d be happy to send them to you.
Disclaimer: they’re not prettily formatted or anything!Reply
Anonymous June 24, 2013 at 21:45
Thanks very much!
Anonymous July 25, 2013 at 06:52
J this was a really great post ! I must say I’m finding reading these blogs as addictive as my smoking habit !Reply
Leon Hendricks March 2, 2014 at 20:07
Still my favourite article 10 months on – just read it again!Reply
Kosta March 21, 2014 at 13:15
Excellent article Jayson.
I too have this debate often with my friends. I am, and always have been, in the “equity is better” camp, for all the reasons you’ve laid out above.
Having said that, I have learnt a valuable lesson this past year with regards to the merits of owning property, which I think ought to be considered by your intelligent readers seeking wise investment advice.
My gran had been renting her apartment for the past 10-odd years, and for whatever reason, the owners of the complex decided it was time to give the building a massive face-lift. So they evicted all the tenants. Now whilst research revealed that we could have pursued legal options that would have allowed my gran to stay, I decided it was best to just move her out in light of all the noise and commotion associated with the upcoming renovations. On the bright side, they were considerate enough to give my gran ample notice, but having said that, her having to move home at the age of 89 was still not ideal.
So my view on property has evolved slightly:
1) There is a critical difference between investing in property and owning property. The former is questionable, the latter has its place.
2) For us young adults, when making investment decisions, investing in equity is always better over the long run, provided we have the discipline to invest monthly.
3) The only time we should consider investing in property (instead of equity) is if we find a really good deal. A wise man once taught me that “when investing in property, we make our money when we buy, not when we sell”.
4) Having said that, it is still important to own a property – namely our own home – when we want to settle down, so as to avoid the unsettling risk of being evicted unexpectedly. Similar logic applies to owning our own office (assuming we are self-employed). But these are the only two properties we should ever own.
Great blog by the way. Keep it up.Reply