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Friday, April 15, 2005
Renting better than Buying?
I'm going to post an article in the comments section from the March 3rd edition of The Economist. If anybody is thinking about buying, they might be interested.
It is amazing how fast home prices are rising these days.
According to our latest house-price indicators, it is now much cheaper to rent than to buy a house in many countries
WHEN THE ECONOMIST launched its global house-price indicators in 2002, residential-property markets were merely warming up. Today they are red hot in many of the 20 countries we cover: in half of them, prices have risen by around 10% or more in the past year (see table). But for the first time since we started to track them, housing markets in several countries have slowed sharply.
The most dramatic slowdown has been in Australia where, according to official figures, the 12-month rate of increase in house prices fell to only 2.7% in the fourth quarter of last year, down from nearly 19% at the end of 2003. Another index, calculated by the Commonwealth Bank of Australia, which is based on prices when contracts are signed rather than at settlement, shows that average house prices fell by 7% in the year to December; prices in Sydney plunged by 16%. The Reserve Bank of Australia's quarter-point increase in interest rates this week is likely to give prices another downward nudge.
Britain's housing market has also cooled since last summer. The Nationwide index, which we use, was still up by 10% in the year to February, down from 20% growth in July. Other anecdotal evidence suggests that prices have fallen since last summer in many parts of the country.
In contrast, America's housing bubble continues to inflate. Although the rate of increase slowed in the fourth quarter, prices were still up by 11.2% over the year. In California and Washington, DC, housing prices rose by more than 20%. Alan Greenspan, the Fed's chairman, recently admitted in congressional testimony that there may be property bubbles in "certain areas" and a risk that prices could decline. There is certainly evidence that prices are being driven by speculative demand: a new study by the National Association of Realtors shows that one-quarter of all houses bought in 2004 were for investment, not owner-occupation.
House prices are still rising rapidly in continental Europe. French house-price inflation has accelerated to 16%, its fastest on record in real terms and only a whisker behind Spain's 17%. Prices in Italy, Sweden and Belgium are also rising at close to 10%. Excluding Germany, where prices fell again in 2004, average home prices in the euro area have risen by 12.5% over the past year, causing some concern at the European Central Bank.
PUNISHING PRICES, PUNY YIELDS The main reason why housing markets have cooled in Australia and Britain is that first-time buyers have been priced out and demand from buy-to-let investors has slumped. While house prices have soared, rents have risen modestly or even fallen in some cities. In America, Britain, Spain New Zealand and Australia, average net rental yields (allowing for management fees, maintenance and empty periods) have fallen to 3.5% or less, well below mortgage rates. Shane Oliver, the chief economist at AMP Capital Investors, estimates that net rental yields on houses in Sydney are only 1%. Landlords are nowhere near covering their true costs, but many still hope to make their profit from capital gains. That sounds ominously similar to the days of the dotcom bubble, when it was argued that the link between share prices and profits no longer mattered.
According to calculations by THE ECONOMIST (with the help of Julian Callow of Barclays Capital), house prices are at record levels in relation to rents (ie, yields are at record lows) in America, Britain, Australia, New Zealand, France, Spain, the Netherlands, Ireland and Belgium. America's ratio of prices to rents is 32% above its average level during 1975-2000. By the same gauge, property is "overvalued" by 60% or more in Britain, Australia and Spain, and by 46% in France (see chart).
The ratio of prices to rents is a sort of price/earnings ratio for the housing market. Just as the price of a share should equal the discounted present value of future dividends, so the price of a house should reflect the future benefits of ownership, either as rental income for an investor or the rent saved by an owner-occupier. To bring the ratio of prices to rents back to equilibrium, either rents must rise sharply or prices must fall. Yet central banks cannot allow rents to surge as this would feed into inflation. Rents directly or indirectly account for 29% of America's consumer-price index, so rising inflation would force the Fed to raise interest rates more swiftly, which could trigger a fall in house prices. Alternatively, if rents continue to rise at their current annual pace of 2.5%, house prices would need to remain flat for over ten years to bring America's ratio of house prices to rents back to its long-term norm. There is a clear risk prices might fall.
Lower real interest rates might justify a higher p/e ratio. For example, real interest rates in Ireland and Spain were reduced significantly when these countries joined Europe's single currency--though not by enough to explain the whole rise in house prices. In Britain, where tax relief on interest payments has been scrapped, real after-tax rates are close to their average over the past 30 years, and so do not justify a higher price/rent ratio. In America, too, real post-tax interest rates are not historically low, in part because mortgage-interest tax relief is worth less at lower rates of inflation. For instance, if interest rates are 10%, tax relief is 30% and inflation is 7%, the real after-tax interest rate is 0%. If interest rates are 6% and inflation is 3% (ie, the same gap as before), and tax rates stays the same, the real interest rate is 1.2%.
The unusual divergence between house prices and rents does not just affect investors; it also undermines the conventional wisdom that it is always better to buy a house, because "rent is money down the drain". Today in many countries it is much cheaper to rent than to buy.
RENT ASUNDER Take a two-bedroom flat in London, which you could buy for GBP450,000 ($865,000). To rent the same flat would currently cost GBP1,700 a month. In addition to a 6% mortgage rate, a buyer would face annual maintenance and insurance costs of, say, 1.25%. In the first year, the rent of GBP20,400 compares with total mortgage interest and maintenance payments of GBP33,000, a saving of GBP12,600. Interest payments would be less if a large deposit were paid, but in that case the income lost from not investing that money elsewhere has to be taken into account.
Assume that rents rise by 3% a year, in line with wages, while house prices from now on rise in line with inflation of 2%. At the end of seven years (the average time before the typical homeowner moves), you would be almost GBP35,000 better off renting, taking account of the capital appreciation and buying and selling costs. In other words, even without a fall in real house prices--which many believe to be likely--buying a house in Britain today seems a poor investment.
The figures look even more striking in the San Francisco Bay Area, where it is possible to rent an $800,000 house for $2,000 a month. Making the same assumptions about rents and house prices, but also deducting tax relief on a fixed-rate mortgage and adding property taxes, a buyer would pay $120,000 more over seven years than if he had rented. House prices in San Francisco would need to rise by at least 4% a year (2% in real terms) for it to prove cheaper to buy a house. Since 1950 American house prices in real terms have risen by an annual average of just over 1%. To expect them to rise faster from their current dizzy heights smacks of irrational exuberance, to say the least.
I agree that this is true in the markets mentioned in this article, but is probably not true everywhere in the US. There are many areas where housing prices have not escalated at such a rapid pace and where homes are not overpriced.
I would like to see the math behind the statement "at the end of seven years (the average time before the typical homeowner moves), you would be almost GBP35,000 better off renting, taking account of the capital appreciation and buying and selling costs". Not that I don't believe him, but if I ran those same calculations on random homes in Middle America - not California, Las Vegas, or D.C. - I wonder if they would produce the same answer.
STILL WANT TO BUY?
ReplyDeleteMar 3rd 2005
According to our latest house-price indicators, it is now much cheaper
to rent than to buy a house in many countries
WHEN THE ECONOMIST launched its global house-price indicators in 2002,
residential-property markets were merely warming up. Today they are red
hot in many of the 20 countries we cover: in half of them, prices have
risen by around 10% or more in the past year (see table). But for the
first time since we started to track them, housing markets in several
countries have slowed sharply.
The most dramatic slowdown has been in Australia where, according to
official figures, the 12-month rate of increase in house prices fell to
only 2.7% in the fourth quarter of last year, down from nearly 19% at
the end of 2003. Another index, calculated by the Commonwealth Bank of
Australia, which is based on prices when contracts are signed rather
than at settlement, shows that average house prices fell by 7% in the
year to December; prices in Sydney plunged by 16%. The Reserve Bank of
Australia's quarter-point increase in interest rates this week is
likely to give prices another downward nudge.
Britain's housing market has also cooled since last summer. The
Nationwide index, which we use, was still up by 10% in the year to
February, down from 20% growth in July. Other anecdotal evidence
suggests that prices have fallen since last summer in many parts of the
country.
In contrast, America's housing bubble continues to inflate. Although
the rate of increase slowed in the fourth quarter, prices were still up
by 11.2% over the year. In California and Washington, DC, housing
prices rose by more than 20%. Alan Greenspan, the Fed's chairman,
recently admitted in congressional testimony that there may be property
bubbles in "certain areas" and a risk that prices could decline. There
is certainly evidence that prices are being driven by speculative
demand: a new study by the National Association of Realtors shows that
one-quarter of all houses bought in 2004 were for investment, not
owner-occupation.
House prices are still rising rapidly in continental Europe. French
house-price inflation has accelerated to 16%, its fastest on record in
real terms and only a whisker behind Spain's 17%. Prices in Italy,
Sweden and Belgium are also rising at close to 10%. Excluding Germany,
where prices fell again in 2004, average home prices in the euro area
have risen by 12.5% over the past year, causing some concern at the
European Central Bank.
PUNISHING PRICES, PUNY YIELDS
The main reason why housing markets have cooled in Australia and
Britain is that first-time buyers have been priced out and demand from
buy-to-let investors has slumped. While house prices have soared, rents
have risen modestly or even fallen in some cities. In America, Britain,
Spain New Zealand and Australia, average net rental yields (allowing
for management fees, maintenance and empty periods) have fallen to 3.5%
or less, well below mortgage rates. Shane Oliver, the chief economist
at AMP Capital Investors, estimates that net rental yields on houses in
Sydney are only 1%. Landlords are nowhere near covering their true
costs, but many still hope to make their profit from capital gains.
That sounds ominously similar to the days of the dotcom bubble, when it
was argued that the link between share prices and profits no longer
mattered.
According to calculations by THE ECONOMIST (with the help of Julian
Callow of Barclays Capital), house prices are at record levels in
relation to rents (ie, yields are at record lows) in America, Britain,
Australia, New Zealand, France, Spain, the Netherlands, Ireland and
Belgium. America's ratio of prices to rents is 32% above its average
level during 1975-2000. By the same gauge, property is "overvalued" by
60% or more in Britain, Australia and Spain, and by 46% in France (see
chart).
The ratio of prices to rents is a sort of price/earnings ratio for the
housing market. Just as the price of a share should equal the
discounted present value of future dividends, so the price of a house
should reflect the future benefits of ownership, either as rental
income for an investor or the rent saved by an owner-occupier. To bring
the ratio of prices to rents back to equilibrium, either rents must
rise sharply or prices must fall. Yet central banks cannot allow rents
to surge as this would feed into inflation. Rents directly or
indirectly account for 29% of America's consumer-price index, so rising
inflation would force the Fed to raise interest rates more swiftly,
which could trigger a fall in house prices. Alternatively, if rents
continue to rise at their current annual pace of 2.5%, house prices
would need to remain flat for over ten years to bring America's ratio
of house prices to rents back to its long-term norm. There is a clear
risk prices might fall.
Lower real interest rates might justify a higher p/e ratio. For
example, real interest rates in Ireland and Spain were reduced
significantly when these countries joined Europe's single
currency--though not by enough to explain the whole rise in house
prices. In Britain, where tax relief on interest payments has been
scrapped, real after-tax rates are close to their average over the past
30 years, and so do not justify a higher price/rent ratio. In America,
too, real post-tax interest rates are not historically low, in part
because mortgage-interest tax relief is worth less at lower rates of
inflation. For instance, if interest rates are 10%, tax relief is 30%
and inflation is 7%, the real after-tax interest rate is 0%. If
interest rates are 6% and inflation is 3% (ie, the same gap as before),
and tax rates stays the same, the real interest rate is 1.2%.
The unusual divergence between house prices and rents does not just
affect investors; it also undermines the conventional wisdom that it is
always better to buy a house, because "rent is money down the drain".
Today in many countries it is much cheaper to rent than to buy.
RENT ASUNDER
Take a two-bedroom flat in London, which you could buy for GBP450,000
($865,000). To rent the same flat would currently cost GBP1,700 a
month. In addition to a 6% mortgage rate, a buyer would face annual
maintenance and insurance costs of, say, 1.25%. In the first year, the
rent of GBP20,400 compares with total mortgage interest and maintenance
payments of GBP33,000, a saving of GBP12,600. Interest payments would
be less if a large deposit were paid, but in that case the income lost
from not investing that money elsewhere has to be taken into account.
Assume that rents rise by 3% a year, in line with wages, while house
prices from now on rise in line with inflation of 2%. At the end of
seven years (the average time before the typical homeowner moves), you
would be almost GBP35,000 better off renting, taking account of the
capital appreciation and buying and selling costs. In other words, even
without a fall in real house prices--which many believe to be
likely--buying a house in Britain today seems a poor investment.
The figures look even more striking in the San Francisco Bay Area,
where it is possible to rent an $800,000 house for $2,000 a month.
Making the same assumptions about rents and house prices, but also
deducting tax relief on a fixed-rate mortgage and adding property
taxes, a buyer would pay $120,000 more over seven years than if he had
rented. House prices in San Francisco would need to rise by at least 4%
a year (2% in real terms) for it to prove cheaper to buy a house. Since
1950 American house prices in real terms have risen by an annual
average of just over 1%. To expect them to rise faster from their
current dizzy heights smacks of irrational exuberance, to say the
least.
I agree that this is true in the markets mentioned in this article, but is probably not true everywhere in the US. There are many areas where housing prices have not escalated at such a rapid pace and where homes are not overpriced.
ReplyDeleteTrue. But do you think that if they have, these principals apply?
ReplyDeleteI would like to see the math behind the statement "at the end of
ReplyDeleteseven years (the average time before the typical homeowner moves), you
would be almost GBP35,000 better off renting, taking account of the
capital appreciation and buying and selling costs". Not that I don't believe him, but if I ran those same calculations on random homes in Middle America - not California, Las Vegas, or D.C. - I wonder if they would produce the same answer.