Don't waste money renting get on the property ladder. That's what common sense tell us. So much for common sense, says Tim Bennett.
Booms and busts may come and go, but in the long run the British people know in their heart of hearts that 'you can't go wrong with bricks and mortar' and that 'renting is dead money'. But is this really the case? In conjunction with the BBC's The Money Programme, we decided to run the numbers and find out whether buying a house in Britain really always makes more financial sense than renting one in the long run. We'll get to what we discovered in a minute. But first, why are people so attached to the idea that buying is better than renting?
A nation of homeowners
The current crash is just the latest in a long line of British house-price booms and busts. Last time, in the early 1990s, house prices fell by 37.4% in inflation-adjusted terms. More than 1.8 million families were plunged into negative equity (they owed more on their mortgage than their home was worth) and 76,000 had their homes repossessed in 1991 alone.
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Yet this regular cycle of peaks and troughs hasn't put us off home ownership. Nearly 70% of us own a house rather than rent one. This isn't the highest ratio of home ownership in the world, but it is well above the average for Europe. Across the channel, says Eurostat, the ratio slips to just over 60%, and a bit over 50% in the Netherlands. That's despite much of our property stock being pretty old (Victorian and Edwardian), while new-builds "are getting smaller and being built closer together", says Thisismoney.co.uk.
Of course, the emotional pull of property is substantial. It's nice to paint the walls as often, and in whatever shade, you like. There is a sense of permanence, however illusory, that comes with ownership. And you can't be booted out of a home you own on the whim of a landlord. But then it's hardly any better to be kicked out by a bank if you can no longer afford the mortgage. And UK tenants' rights are actually pretty robust. As rental yields fall, eager landlords will happily sign up to deals that run for several years. While you may lose that sense of permanence, you gain flexibility. Should you loathe your neighbours, area, or colour of the kitchen, you can just hand back the keys and find somewhere more suitable. Not so easy for an owner in a market where transaction volumes are at their lowest since 1978, according to the Royal Institution of Chartered Surveyors (RICS).
So the attractions of property ownership must go deeper than the mere right to paint your bathroom wall a different shade of magnolia every other week. And they do: buying a property is one of the few chances the average person gets to 'gear up' their returns.
The gearing trap
When prices are rocketing, property fortunes are magnified using debt. Here's how it works or rather, worked. Take a property valued at £200,000. You could pay for it 100% cash, if you are wealthy enough. But not only does this tie up a lot of cash, it also limits your potential return on investment. So let's say you put down a 25% deposit of £50,000 and borrow the other £150,000 from a bank. Say the property market rises by 15% over the next 12 months. The property is then worth around £230,000, so you decide to sell. Ignoring costs, a cash buyer would make a straight £30,000 on their £200,000 purchase, banking a 15% return (£30,000/200,000). But that is beaten hands down by someone with a 75% mortgage. That's because if the property sells for £230,000 and the original mortgage of £150,000 is paid off, they walk away with £80,000, having put down a deposit of £50,000. That's a return on the capital invested of 60% (£30,000/50,000) in just 12 months.
Yet to bank that sort of gain, you must get your timing right. In a falling market, gearing works in reverse. Say prices had fallen by 15% instead (about the current rate of annual house-price falls, according to the Halifax). A cash buyer loses 15% if they choose to sell. But with a 75% mortgage, things look far worse. Were the property to be sold for £170,000 (0.85 x £200,000), the mortgage of £150,000 can still be repaid but that leaves just £20,000 over. So the deposit of £50,000 has shrunk to £20,000, a 60% loss. Should the price fall another 20%, sales proceeds of £136,000 (£170,000 x 0.8) wouldn't even be enough to repay the original £150,000 loan. So your £50,000 equity has been wiped out and you owe the bank £14,000. In other words, you're deep in negative equity.
Citigroup reckons this is something that up to three million homeowners could face before this bust is through. That's partly because over the past decade mortgage lenders have been encouraging homeowners to gear up to levels never seen in the past. Before being nationalised Northern Rock offered mortgages of six times salary and several other banks would lend you 125% of the value of a home. In other words, you could borrow £125,000 to buy a house worth £100,000. Their suggestions for what you might do with the extra £25,000 included buying a car, home improvements, or a holiday. Many who may now regret being on the collapsing property ladder were tempted by these deals.
So why not rent?
Renters may never experience the outsize gains that gearing up on a property purchase can deliver, but they also won't end up trapped by a loan that's bigger than their house price. Another key point is that for most people, the 'outsize gains' they make will simply be spent on buying their next house. Everyone needs somewhere to live. So money committed to the property ladder usually stays tied up on the property ladder, unless you're able to downsize. But as a renter, you don't have to fork out for a deposit and other purchase costs. That means you can put that money to work elsewhere. So the question is: if a renter had taken the money they would have spent on a property, and put it in the UK stockmarket instead, is it possible for them to come out ahead of a buyer?
Sometimes renting is the best option
Here's what we did. First, we took three recent seven-year periods (the typical length of time a British buyer holds onto their property, according to Capital Economics) to determine the overall gain or loss for a homeowner. Then we looked at the average renter over the same period, assuming that they had invested their initial deposit and purchase costs in a Barclays UK equity income fund, with dividends reinvested over the relevant period. Next we took the 20-year period from 1980 to 2000 and did the same. There were some problems accurate data on mortgage interest rates and rental yields in particular are tough to get hold of pre-1993 and we had to make a few assumptions (see table below). Even so, our findings may come as a surprise to believers in bricks and mortar.
Looking at the seven-year periods from 1993 to 2000, 1995 to 2002, and 2001 to 2008 we found that, thanks to some big rises in British house prices, a buyer would have been better off, by almost £75,000 in the last case. But take a longer view, from 1980 to 2000 and the picture changes dramatically renting now comes out cheaper, by about £57,000.
So there is nothing special about British property. As with any other investment, if you get your timing right, you will make a profit. But as our figures show, it's absolutely not the case that buying is always better than renting. And renting isn't always dead money it frees you from being tied to your property, regardless of market conditions, and also frees up your money to be invested somewhere more profitable.
Rent or buy: so what should you do now?
House prices have now fallen by more (in nominal terms) than they did over the whole of the last crash. Just last week, the Halifax reported that prices had fallen by 2.2% in October alone, and 14.9% on the year. The reason for such steep falls is simple: banks have stopped lending as freely (mortgage approvals are down by around 60% year-on-year). So people can no longer 'gear up' as sharply from lending 125% of a property's value, many lenders will now demand 20% deposits, and as much as 40% to get the best interest rates. That means that sellers are having to slash prices to secure a deal.
But last week the Bank of England took everyone by surprise, cutting the base interest rate by a full 150 basis points (1.5 percentage points) to 3%, the lowest level since 1955. Janice Morley in the Evening Standard suggested that the "sensible response" was to "take your savings out of the banks... and put it into property", while estate agency Rightmove reported a sharp rise in visits to its website. So is now the time to buy rather than rent?
We don't think so. While few lenders passed on the last 0.5% cut, more agreed to do so this time. But the result for existing or aspiring mortgagees is mixed. According to broker John Charcol, the winners include most people with one of the 250 base-rate tracker products available before the announcement. But many trackers have since been hurriedly withdrawn. Those hoping to secure a new fixed-rate deal, either as a first-time buyer or an existing borrower remortgaging, should also benefit as "the price of the best deals looks set to fall". But anyone already on a fixed rate won't save a penny, of course, and the picture is not great for the 10% of borrowers on standard variable rates (SVR). As Emma Simon in The Daily Telegraph notes, the gap between the average SVR and the base rate has actually risen recently.
And even if there are further base-rate cuts, mortgage rates look unlikely to follow suit. That's partly because mortgage rates are linked to the inter-bank lending rate (LIBOR), rather than the base rate. While that rate has fallen recently by 1.1% to around 4.5% it is still well over the 3% base rate. One bank, complaining it was being told in effect to borrow at LIBOR and lend at the base rate, apparently told Chancellor Alistair Darling last week, "we are not charities", and has already refused to pass on any further cuts. Moreover, many existing borrowers on tracker mortgage deals are tied, perhaps unknowingly, into a minimum interest rate because of 'collar' clauses in the small print. "If your lender has a collar of 3% and your tracker deal is set at 1% above the base rate, your actual rate will never be less than 4%," explains Melanie Bien at Savills.
There's little comfort for first-time buyers seeking the new lower fixed-rate deals either. Arrangement fees are still high £1,000 or more and the best rates are reserved for those with high deposits £19,000 is now typical, says the Council of Mortgage Lenders. Above all, rate cuts won't stop the economy shrinking and people losing their jobs October's Confederation of British Industry survey revealed the biggest jobless rise in 17 years. As such, says the FT's Wolfgang Munchau, monetary policy is "playing little more than a supporting role". So even this huge cut won't revive the housing market anytime soon.
So what should you do if you decide to rent? Prospects for the stockmarket don't look great either for now, so our view would be to keep the money you save on a deposit in cash. But one thing's for sure, stocks will recover before property prices do. As James Ferguson, economist and stockbroker at Pali International points out, stocks tend to start rallying before recessions end, but house prices don't turn around until long after. In fact, in his latest Model Investor newsletter, James says: "I expect house prices to halve and to take nigh on a decade doing it." So renting may be the best option for some time to come.
How we worked out that renting pays
First we looked at owning a house. Property prices rose rapidly in each of the three shorter periods (19932000, 19952002, and 20012008) we reviewed. The capital gain was based on Nationwide average house prices for quarter two the busy spring season at the start and end of each period. Next we deducted up-front costs such as stamp duty 1% on an average British property and 3% for other costs, such as solicitors' fees, surveys, essential white goods and removal costs (all of these are, of course, avoided if you rent a furnished property). Then we took off annual maintenance, which, says Savills, can be assumed to be 20% of a typical property's rental yield.
We then deducted the cost of repaying interest and capital on a mortgage, assuming the buyer put down a deposit of 20%. That may sound high, but don't forget that pre-credit-crunch products such as the 100%+ mortgage were a short-term aberration and have now vanished many lenders have reverted to not lending more than 80% of a property's value. Finally, we assumed that a mortgage would have been taken out for a 25-year term and apportioned both interest and capital repayments accordingly to take account of our shorter periods. Data on typical mortgage rates pre-1993 are hard to find, so we estimated by using the Bank of England base rate plus 100 basis points (1%), applied to the estimated capital outstanding at the start of the period.
For the renter, we started by estimating the cost of renting a typical property. Post-1993 data on rental yields are readily available from Savills. But from 1980 to 1993 a lack of data meant we had to estimate once again. So we took figures supplied by Simon Ward at New Star (Moneymovesmarkets.com) on national yields for 'all types' of British residential property for each year (which includes council housing) and adjusted them, given that residential yields were roughly double national 'all types' yields for the period after 1993, based on data supplied by Savills.
Then we factored in a gain that many renters may not consider. If someone with cash for a deposit and up-front ownership costs chose to rent rather than buy, they would be able to save and invest both in the stockmarket. So we chose a Barclays UK equity income fund with dividends reinvested and invested the cash over the relevant period. The result was a capital gain for all of the periods we reviewed.
We considered doing the same with the annual difference between the cost of renting and owning a property for each year. In the end, we excluded this mainly because renting isn't consistently more or less expensive than paying back a mortgage (ie, during the last decade, a renter would have paid less than a buyer for about five years, according to Savills, and more during the other five). While investing a deposit and up-front costs is fairly straightforward, we reckoned few renters if any would take the trouble to adjust their equity fund up or down each year to take account of a notional saving or loss based on ownership.
As for tax, we ignored it. Any capital gain on your 'principal private residence' or main home is tax free as an owner, but so is a big chunk, if not all, of your profit from shares, as long as you make use of the annual capital-gains tax exemption, or more recently, the Isa allowance.
