Renting Looks Cheaper Than Buying

The changing aspirations of the young mean that people are renting for longer. Although seen as the equivalent to throwing money down the drain, could renting actually make better financial sense than buying?

As the housing market has cooled over the past year or so, agents and landlords have reported a steady demand for rented property. This is not surprising, as the modest falls in average house prices reported to date have yet to make much of a difference to first time buyers already priced out of the market. Meanwhile, the prospect of further house price falls, or even a prolonged period of unchanged prices, means that would-be homeowners can take their time before committing to a purchase. But given the British obsession with property, how durable is that demand for rented accommodation likely to be?

Renting out of need not desire?

For many would-be first time buyers (FTBs) affordability has become a major problem. With house prices now almost six times higher than national average earnings, many aspiring FTBs simply cannot raise a large enough mortgage to allow then to get onto the housing ladder. But it would be wrong to conclude that the low level of FTB demand and accompanying high level of demand for rented accommodation was purely a function of deteriorating affordability.

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Over the past twenty years or so, surveys from the Council of Mortgage Lenders (CML) of home ownership aspirations have consistently shown that over a 10 year horizon, 80% of households aspire to own their own home. But when questioned about their aspirations over a shorter two year horizon, the surveys show a steady and substantial decline in ownership aspirations among the under 25s.

This decline in short-term homeownership aspirations is consistent with other recent evidence from GMAC-RFC and the CML. Both have recently conducted surveys which suggest that attitudes towards renting among the young may be changing. In particular, these surveys found evidence of a growing willingness to rent for longer than has been typical in the past. For one thing, people are settling down later than in the past, a key factor for many in the decision to buy. But survey respondents also stated that renting offered more flexibility than buying a property, as well as the opportunity to live in more fashionable areas than they could afford to buy in. Affordability in the owner occupier sector is not the only factor supporting tenant demand.

Despite these changing attitudes, it remains the case that 80% of households still aspire to own their own home on a 10 year horizon. So while younger generations may be happy to rent for longer than in the past, thanks to changing lifestyles, they are not committed lifelong renters. And for many people, the most obvious drawback to renting is that it is ultimately seen as equivalent to pouring money down the drain. At the end of the tenancy, the tenant has nothing to show for the rent that has been paid.

We suggest that the idea that renting offers poor value for money will increasingly be reassessed over the next few years as the housing market goes through a period of adjustment after several years of rapid rates of house price inflation.

Renting is cheaper than buying

Figures from Paragon Mortgages show that in the second quarter of 2005, the average cost of renting a property in England and Wales was £873 per month. The mortgage required to purchase the equivalent property, valued at £155,000, would entail monthly repayments of £919 per month, assuming a 5% deposit and a mortgage rate of 5.63% - the average rate on all new mortgages in the same period.

In other words, a renter would be £46 per month, or around £550 per year, better off than someone taking their first step onto the housing ladder. In fact, based on average rents and the average purchase price of those rented properties, renting has been cheaper than buying the equivalent property since the third quarter of last year, at least from this simplistic monthly payments perspective.

But renting is unlikely to remain cheaper than buying for long. August's 25 basis point cut in official interest rates will have reduced the renting less buying cost differential to just £20 per month. A further quarter point cut, implying mortgage rates of 5.1%, would eliminate the difference entirely. And even if interest rates fall no further, a 3% reduction in the purchase price, or a 3% rise in rents, both perfectly feasible over the coming year or so, would be sufficient to bring monthly mortgage payments into line with rents.

Buying offers short term pain, long term gain?

However, a simple comparison of monthly mortgage and rent payments does not provide an adequate reflection of the relative costs of buying and renting a property. For a start, buying a property has significant up-front costs such as the deposit, legal fees, stamp duty and mortgage valuation fees. Both the money used to meet these upfront costs and the equity that is built up in the property in the form of capital repayments involve a loss of interest income for the buyer. And owner-occupiers will also be responsible for insuring the structure of the property and for its upkeep, costs that a tenant's landlord will bear.

However, although insurance and maintenance costs will rise through time, monthly mortgage payments (by far the largest component of an owner-occupier's monthly costs) will not, at least assuming unchanged mortgage interest rates. Rents, on the other hand, will increase at a rate which is roughly in line with average earnings. Thus, even if the monthly rent is less than the monthly mortgage payment initially, rent inflation will eventually reverse this position.

But how long will it take for a buyer to claw back the upfront costs and lost interest that are involved in property ownership? We have calculated the cumulative costs of renting a property assuming that rents increase by an average of 5% per annum and compared these to the cumulative costs of buying the same property.

The property has a purchase price of £155,000. The buyer puts down a 10% deposit and pays a fixed mortgage rate of 5.5%. The buyer pays stamp duty at 1% and incurs other transaction costs equivalent to 1% of the property's value. Deposit rates, used to calculate the lost interest on upfront costs and housing equity are assumed to be 5%.

Based on figures from the 2003/04 Family Expenditure Survey (FES), we estimate that the average buyer spends £14 per month on buildings insurance and £50 per month on maintenance (we have adjusted the raw average spend per household figures (of £2.30 per week on insurance and £8.20 per week on maintenance) from the FES to reflect the fact that these costs will be borne by the 70% of households who are owner occupiers).

Spending on maintenance and insurance is assumed to increase by 4.5% per annum. Allowing for 2% CPI inflation this gives a real increase of 2.5% per annum in line with the average annual real increase over the past 15 years or so.

When we put all this together, it means that our buyer has initial upfront costs of £18,600 and monthly outlays of £999 per month. The upfront costs are comprised of £15,500 deposit, plus £1,550 in stamp duty and a further £1,550 in other legal, survey and mortgage costs. The monthly outlays include £857 in mortgage payments, £14 for insurance, £50 for maintenance and £78 in lost interest from the money tied up in the deposit, stamp duty and other fees and expenses. Our renter incurs initial monthly costs of £875.

Our calculations show that over 25 years, a renter will spend a total of £513,000 on rent, while an owner occupier will spend £402,000 over the same period, both figures measured in current 2005 prices. In our example, buying has turned out to be £111,000 cheaper than renting the equivalent property, a saving that equates to roughly four times current national average earnings.

But the financial advantages of buying over renting do not accrue from day one. In fact, thanks to the substantial upfront costs of homeownership, buyers are worse off than renters for several years. In our example here, the cumulative costs of buying only fall below the cumulative costs of renting after 161 months or 13 years and 5 months.

Over the past couple of years, this breakeven point has risen sharply. For someone buying with a 10% deposit in the first quarter of 2002, for example, their cumulative costs would have fallen below the cumulative costs of renting the equivalent property after 52 months. But this breakeven point has more than tripled over the past three and a half years. In our view, this is another sign that the housing market has become significantly overvalued.

The increase in the time taken for buyers to claw back their upfront costs through savings on their monthly mortgage payments relative to rents is important, because few households remain in their properties for 25 years or more. According to the ODPM, in 2003, only 37% of owner occupier households with a mortgage had been in their current property for more than 10 years. And the median tenure had been a little under seven years.

Based on our calculations, a buyer is some £19,600 worse off after seven years than someone renting the same property. And for those for whom the rent or buy decision is likely to be most pertinent, i.e. the current generation of actual or potential first time buyers tenures are likely to be even shorter than seven years. After four years, for example, our calculations show buyers are £21,700 worse off than renters.

What's more, such comparisons take no account of the fact that each time they move an owner occupier will be faced with further up-front costs. So a true comparison of the costs of renting relative to buying needs to take account of the costs of buying not only an owner occupier's first property, but subsequent properties as well.

To sell the property in our example, assuming its value has remained at £155,000, our owner occupier might expect to pay approximately £2,715 (1.75% of the value) in fees to an estate agent and a further £500 (roughly 0.3% of the property value) in legal fees. And were he to buy another property at the same price that would involve a further £1,550 in stamp duty and £1,550 in legal and other transaction costs.

Adding in these transactions costs, which total £6,315, would leave our owner occupier a little over £28,000 worse off than a renter after four years. And add in the new 10% deposit that our owner occupier must find in order to move house and that figure rises to just over £43,500. If we incorporate these additional legal and transaction costs of £6,315 then we can calculate that the breakeven point between buying and renting rises from 13 years and 5 months, to 14 years and 7 months. And if we also include the cost of the next deposit, then the breakeven point rises to 16 years and 11 months.

The implication of these figures is that for many younger people who either need or want to retain the ability to move house frequently, the high upfront costs of buying are likely to act as a deterrent to owner occupation for some time to come.

Housing as an asset

So far our calculations fail to take account of the potential for capital growth. For many, one of the most fundamental objections to long term renting is the fact that when the tenancy comes to an end, the renter has nothing to show for all the rent that has been paid, while an owner occupier owns at least part of the house.

Over the past 30 years or so, house prices have risen by an average of 2.5% in real terms. So what happens to our conclusions if we factor in average house price growth of 4.5% to our calculations, (2.5% real house price growth plus 2% consumer price inflation)? We have re-worked our calculations incorporating a constant rate of house price inflation of 4.5%. And we have also defined the breakeven point as being where the cumulative costs of buying (including the transaction and deposit costs of moving to another equivalently valued property), fall below the cumulative costs of renting.

Under these assumptions, the breakeven point between buying and selling stands at 6 years and 4 months, down from our estimate of 16 years and 11 months when no capital gains are factored in.

So even allowing for house price growth at 4.5% per annum, an owner occupier who moved house after four years would find himself almost £17,800 worse off than someone who had rented the equivalent property. And even if he waited for seven years before moving house, the owner occupier would only be a little under £6,700 better off than the renter.

In fact, only if the owner occupier leaves the sector and moves into rented accommodation does he stand to make significant gains over these kinds of time horizons. Taking account of selling costs only, the breakeven point between buying and selling falls to 3 years and 6 months, and an owner occupier would be £4,400 better off than a renter after 4 years and £32,000 better off after 7 years.

House prices face a period of adjustment

But with the housing market coming to terms with the end of several years of very rapid house price inflation, it seems unlikely that house prices will rise at this historic trend rate over the next few years. In fact, we believe that average house prices need to fall by 20% to restore the market to a more sustainable footing. Not everyone agrees with this assessment, but even the most optimistic commentators expect several years of stagnant house prices, or at best below trend house price growth.

We have therefore examined how the breakeven point between buying and renting would be affected under three alternative scenarios for house price inflation. In the first scenario the market enjoys a very soft landing. House price inflation is 2% per annum for five years and 4.5% in subsequent periods. In our second scenario house prices stagnate for five years, and then rise at a trend rate of 4.5% per annum. In the third scenario, house prices fall by 20% over the next three years, and grow by 4.5% per annum thereafter, consistent with our central house price forecast.

The breakeven point is based on two alternative definitions. In the first, we assume that the owner occupier sells and returns to renting incurring only selling costs. In the second, we assume that the owner occupier buys another property and incurs buying and selling costs, as well as the costs of the new 10% deposit.

Time for buying cost to be less than renting

Includes o/occupiers' selling costs only

Gain from buying

Scenario B/even point After: 4yrs :7yrs

1 6y 1m -£12,300 +£8,500

2 8y 0m -£24,800 -£8,800

3 10y 4m -£49,900 -£29,900

Includes costs of move to new o/occ home

1 8y 7m -£32,500 -£14,000

2 10y 3m -£43,400 -£29,100

3 12y 4m -£65,400 -£47,600

Under our calculations, even on the most optimistic scenario for house prices and the most generous definition of the breakeven point, buying only begins to deliver benefits relative to renting after six years. And under a scenario in which house prices initially fall by 20%, it takes more than a decade before buying begins to deliver benefits.

But what if our owner occupier wants to move but remain an owner occupier? Now, even on the very soft landing scenario, where prices rise by 2% per annum over the next five years and 4.5% a year thereafter, our calculations show that he will be £14,000 worse off than a renter after 7 years. In fact, it will take eight and a half years before cumulative costs of buying fall below the costs of renting.

Under the less favourable house price scenarios, the breakeven point between buying and renting rises. Under Scenario 2 where we have five years of stable house prices, the breakeven point rises to more than a decade. In this case, a first time buyer looking to trade up after four years would find themselves £43,400 worse off than someone who had been renting.

In Scenario 3, which incorporates our central forecast for property prices, the breakeven point rises to over 12 years. And in this scenario a new buyer would find themselves £65,400 worse off after four years compared to if they had chosen to rent the equivalent property.

But won't lower interest rates make the option of buying more attractive? While that is true, the impact on the breakeven point in our calculations is not especially large.

Even if house prices move in line with our most favourable scenario, a 2 percentage point fall in interest rates would be needed to bring the buying/renting breakeven point for a moving owner occupier to less than seven years. In other words, if house prices rose by 2% per annum for five years then 4.5% thereafter, mortgage rates averaged 3.5% and deposit rates 3%, then the breakeven point for an owner occupier moving house would fall to 6 years 9 months. Under scenario 3, where prices fall 20% before then rising, this same permanent reduction in interest rates would cut the breakeven point between buying and renting to just under 10 years.

Regional variation

We have also run our calculations for the various regions of England and Wales covered by the Paragon data. Our breakeven point assumes that our owner occupier is moving house and remains a homeowner.

Our calculations show that even on our most optimistic scenario for house prices, only in the East Midlands does the breakeven point between buying and renting drop below six years (65 months), while in London it is highest at 129 months or 10 years and 9 months.

And if prices fail to rise at all over the next five years as in Scenario 2, then the breakeven point rises to at least ten years in every region bar three the East Midlands, the North West and Yorkshire.

In Scenario 3, where prices initially fall by 20%, it takes eleven years or more in every region except the East Midlands before buying begins to deliver benefits relative to renting.

Therefore, the regional figures do little to alter our basic conclusion. Even in the East Midlands, the region where renting currently looks most expensive relative to buying, it is touch and go whether a new first time buyer would be better off renting if he plans to trade up in less than six years.

And the figures also show that in London and the South East, regions where our previous work has suggested that valuations and affordability look least stretched in any historic context, the incentives for first time buyers to rush back into the market do not look high. Even on our most optimistic house price growth scenario, our figures suggest that the breakeven point between buying and renting will over eight and a half years in the South East and almost 11 years in London.

Our calculations suggest that demand for rented property is likely to remain high for some time to come. Thanks to the rapid rise in house prices over recent years, the upfront costs of buying a property have risen sharply and made renting look comparatively cheap.

What's more, with little prospect that homeowners are likely to enjoy spectacular growth in the value of their properties over the next few years, renting is likely to remain relatively cheap for some time to come.

Indeed, our figures suggest that many aspiring homeowners may be better off renting than buying for the foreseeable future. Even if house prices enjoy a very soft landing and rise by an average of 2% a year for the next five years and 4.5% per annum thereafter, a first time buyer who expects to trade up the housing ladder within the next eight and a half years would be better off renting. And if prices fall by 20% over the next few years as we expect, renting will be cheaper than buying for the next twelve years.

Whether the housing market enjoys a hard or soft landing the pressure for first time buyers to get onto the housing ladder or face the risk of being priced out is likely to be weaker for the foreseeable future than it has been for sometime. As a result, the current strength of demand for rented accommodation is not likely to be reversed for the foreseeable future, and the popular perception that characterises long term renting as a waste of money, may need to be re-assessed.

By Ed Stansfield, Property Economist at Capital Economic