Should we remain renters or buy a house?

Reader's Question: My husband and I are 40 years old, live in Australia, and have no kids. We own a small business and have annual income between $80k and $100k. We live within our means, have no debt, and save about $30k to $50k per year. We do not contribute to superannuation (tax-advantaged retirement plan) because we prefer to manage our investments on our own. Our savings and investments (mostly common stock) are currently worth about $400k. Instead of buying a house, we have chosen to rent, since local real estate prices are very inflated, making renting much cheaper than buying. However, I am wondering if we should invest in real estate so as to diversify and have some place to live further down the line. How do you see renting vs. buying? Do you think we are on the right track to a comfortable retirement in about 15-20 years?

Rent vs. Buy Analysis

As with many financial decisions (e.g., invest in stocks or bonds?, use leverage or not?, continue to hold a stock or sell it now?), much can be said about the choice between renting and buying a house, but we only really find out tomorrow if we truly are making the right decision today. I'll go through an example using the U.S. real estate market, and then return the discussion to a broader perspective.

Back in 2000, just after the stock market had peaked and the dot-com crash was beginning, my family and I arrived in the city we currently live in. At that time, the local residential real estate market was firm with median-priced homes around $400k, and prices were rising at a solid though moderate mid-single digit annual rate. Being new to the area, we initially rented, paying $1,700 per month for an average-size house on a quiet street in a good school district. While renting, I occasionally would run through a quick rent vs. buy analysis, similar to the one I imagine you are now doing. Assuming no mortgage, the pre-tax calculation is simple, at least in principle (income taxes and a mortgage complicate matters but the main variable remains the relative investment performance outlined below):

Renting: As renters, we were paying 12 x $1,700 = $20,400 per year in rent, and the owner was responsible for all property tax, homeowner's insurance and necessary repairs on the house. Since the $20,400 annual rent was about 5% of the estimated $400k price of a comparable house at that time (in the year 2000), we can write:

Annual cost of renting = 5% of price of house.

Buying: If we were to buy a comparable house, we would need to sell $400k worth of investments (mostly stock), foregoing whatever future return we might realize, and use this money to buy the house, which itself would show some rate of price appreciation. The financial burden of 1) paying property tax and insurance (about $4,000 annually on a $400k house) and 2) performing repairs or at least putting money aside into a reserve account for major repairs (e.g., roof replacement or painting) to be performed at some point in the future (estimated at another $4,000 annually), together add up to $8,000 per year. So, in approximate percentage terms, we have:

Annual cost of buying = 2% for property tax, insurance & repairs + (S - R),

where S is the estimated future annual percentage return on investments (mostly stocks) to be sold in order to buy the house, and R is the anticipated future annual percentage price appreciation of the house (real estate).

From an investment point of view, renting should be preferred over buying when the annual cost of renting is less than the annual cost of buying, i.e., when 5% <> R + 3%. In other words, as a rough rule of thumb: If stock market returns exceed house price appreciation by more than 3% (i.e., 300 b.p.) per annum, one can expect be better off renting a house (and owning stock) instead of (selling the stock and) buying a house.

The graph below shows how stock market returns (S&P 500) have compared to house price appreciation (for the Seattle area where I live) for the eight years between 2000 and today.


(click graph to enlarge)

During 2000-2002, when the stock market fell sharply, I expected the sell-off in equities to exert noticeable downward pressure on local real estate prices, but the correlation between the stock and real estate markets was weak. When the stock market turned around in late 2002, initiating an extended five-year bull run, real estate price appreciation accelerated as well. Currently, amidst fallout from the subprime crisis here in the U.S., the housing market seems softer than the stock market, which itself is largely moving sideways as the economy flirts with recession.

In my family's case, after an extended house search, encompassing a few years but focussed on a small neighborhood with very little available inventory, we finally found the right house, liquidated other investments and closed escrow, switching from being renters to homeowners in early 2005. in retrospect, we managed to capture the bulk of the rapid price appreciation our local real estate saw in 2004-2006, and have ended up being on the correct side of the rent-vs.-buy dichotomy for each of the past three years.

Assessing the Future

Like you and everyone else, I wish I had a crystal ball to predict the future. If I could correctly forecast the relative performance of the S&P 500 versus my local real estate market, I would always know whether to be a renter or homeowner. Short of knowing the future, however, I look to "softer," more qualitative factors--such as being partially "hedged" through having exposure to both the stock and real estate markets, the freedom to replant a garden or repaint a room without consulting a landlord, peace of mind from having neither rent nor a mortgage to pay, and so on--for assurance that owning a house and allocating much of the balance of our investment portfolio to the stock market is the right decision, at least for now.

For a comparison to other markets, you might wish to read the Global Property Guide article here covering the state of housing markets around the world, giving both price appreciation and rent figures for many countries. Some highlights, with emphasis on the Pacific Rim (including both Australia and the U.S.), are:

House Price Appreciation (2007, in local currency):

Shanghai 28%
Singapore 28%
Hong Kong 11%
Australia 11%
UK 10%
South Korea 9%
Japan (6 major cities) 8%
New Zealand 7%
Canada 6%
Japan (nationwide) -1%
U.S. (average of indices) -2%.

Rental Yield (gross rent as percent of house price):

Shanghai 7.8%
Sydney 5.9%
London 5.4%
New York 5.0%
Tokyo 4.7%
Hong Kong 4.2%
Singapore 2.8%

Offhand, I would guess that at some point during the next couple of years a few of the hotter real estate markets around the Pacific Rim will see declines similar to what the U.S. (particularly the submarkets like California, Florida and Las Vegas, Nevada, which rose fastest on the way up) is now experiencing. How your neighborhood real estate market in Australia is impacted is really something you, being local, should have a better handle on than I do.

When making your decision, keep in mind that a) the future is hardly ever crystal clear, and b) it is the relative future performance between whatever particular investments you will sell (the "S" above) and the specific house you will buy (the "R"), that will allow you (and only retroactively!) to determine conclusively if you made the correct rent vs. buy decision in prior years.

Overall, seeing that you and your husband are entrepreneurial, hardworking, persistent in your saving habits, self-directed in your investing, and debt-free, I am optimistic that either path, i.e., renting or buying, will lead you to the comfortable retirement you are targeting. Best of luck in the years ahead!