It's commonly accepted that if your monthly Mortgage payment is equal to or less than what you'd otherwise pay in monthly rent, then buying a home is a sound decision.
However, this oversimplifies the rent versus buy comparison.
Let's look at this another way.
It's not accurate to compare mortgage payments to rent.
To do this properly, we must compare the total non-recoverable costs of renting to the total non-recoverable costs of homeownership.
This might sound complex, but I've simplified it into a straightforward calculation.
The 5.5% rule
Before delving in, it's important to establish the underlying assumptions.
A non-recoverable cost refers to an expense that does not yield any residual value.
For renting, it's simply the amount you pay in rent.
For homeowners, pinpointing these is more challenging.
A homeowner has a mortgage payment, which resembles rent and seems like a convenient number to compare. Sadly, it's not that simple. A mortgage payment is not a non-recoverable cost; it comprises both interest and principal repayment.
The non-recoverable costs for homeowners include:
- Property taxes;
- Maintenance expenses; and
- The cost of capital.
It's these costs you need to compare to rent.
Taxes are relatively easy to grasp for most individuals; they're paid to buy, rent and sell and don't offer any residual value. Typically, Property taxes amount to around 1% of the home's value. This represents the first part of the 5.5% rule.
Next, let's consider maintenance costs. These expenses vary widely, from significant undertakings like roof replacements and kitchen renovations, to smaller tasks like replacing a garden fence or redecorating a child's room. Estimating a precise figure for maintenance costs can be challenging, and average data on such expenses is not readily available.
However, a common suggestion is to allocate approximately 1% of the property's value per year, on average, to cover maintenance costs. This represents the second part of the 5.5% rule.
Lastly, we come to the crucial and final aspect of the 5.5% rule: the cost of capital. This non-recoverable cost can be divided into two components: the cost of debt and the cost of equity.
Up to this point, the inputs to the 5.5% rule—property taxes and maintenance costs—are relatively intuitive.
However, the last component, the cost of capital, may be less so, and requires delving into data.
For most homeowners, the purchase of a home is financed through a mortgage. Let's consider the example of a new homeowner who makes a 20% down payment and finances the remaining 80% with a mortgage.
The portion that's financed through the mortgage incurs interest costs. Mortgage interest rates have increased recently, but for ease, let's assume a typical mortgage interest rate of 4% over the long run.
In real terms, part of this interest cost is offset, by appreciation in the property value.
Data from The Credit Suisse Global Investment Returns Yearbook 2018, goes back as far as 1900. According to the report, the global real return for property, adjusted for inflation, from 1900 to 2017 was 1.3%, after accounting for upgrades (the new kitchen or roof repair) covered by our assumed 1% maintenance costs this gives a real return of 0.3%.
Assuming an inflation rate of 2.5%, we can estimate a nominal return of 2.8% for property (2.5% + 0.3%) and a mortgage cost of 4%, so our cost of debt is 1.2% (4% - 2.8%).
Property vs. the stock market
In our example, when a 20% down payment or deposit is made, there's a cost associated with the equity capital. By putting down 20%, you're choosing to invest in a property asset (alternatively, you could have continued renting and invested the amount in stocks).
This alternative choice incurs an opportunity cost, representing a tangible economic cost for homeowners. To try and put a value on it, you need to consider expected returns for both property and stocks. A reasonable starting point is historical data.
Looking back to the The Credit Suisse Global Investment Returns Yearbook 2018, stocks delivered a real return of 5.2% after adjusting for inflation.
Assuming an inflation rate of 2.5%, we can estimate a nominal return of 2.8% (2.5% + 0.3%) for property and 7.7% (2.5% + 5.2%) for stocks, before taxes.
Of course, a 2.8% return might be suitable for global property, but not necessarily for where you live. Perhaps this is closer to 5% or 10%.
Let's address this concern.
The problem, which applies to any asset class, is that markets price assets based on the information available at a given time. The market is an incredible, information-processing machine.
If you knew a buyer could resell your house for £550,000 a year after buying it from you for £500,000, you wouldn't sell it. You can't assume any high, recent historical returns experienced where you live, will continue. Making decisions this way simply isn't sensible.
Instead, you can examine the risk premium that the market has historically assigned to these types of assets and use it as an estimate for the future.
The historical return for stocks includes instances such as the Russian and Chinese stock markets crashing to zero and the aftermath of world wars. While you could argue for the strength of U.S. stocks by selectively cherry-picking data, it's not logical to do so.
If we consider these numbers as they are—2.8% for property and 7.7% for stocks—we would have an expected return difference of 4.9% between the two.
Factors like tax rates and portfolio asset mix can alter the rule (not to mention insurance and moving costs). For example, the 7.7% return for stocks is a pre-tax return. However, in a taxable account, the after-tax return might be lower, reducing your cost of equity capital.
Similarly, if the investment portfolio is less aggressive than 100% equity, the cost of equity capital will decrease. In the context of making financial decisions, this would mean adjusting the 5.5% rule downward, thereby reducing the total non-recoverable cost of homeownership.
To keep things straightforward and conservative, let's round the rule down to 4%. Thus, we now have a cost of equity capital of 4%, and a cost of debt capital of 1.2%.
Assuming a 20% down payment, and a mortgage where the principal is paid off over it’s lifetime, our average cost of capital is roughly 3.5% (this is slightly complicated and is calculated by taking a weighted average of your cost of capital over the life of the mortgage, assuming its paid off at an even rate).
So, taking into account the two earlier costs (taxes and maintenance), our total non-recoverable costs now are 5.5% (1% + 1% + 3.5%).
While rent is an easily visible non-recoverable cost, homeowners also incur such costs, albeit less visibly. The 5.5% rule allows us to compare the non-recoverable costs of renting and owning, on an apples-to-apples basis.
The rent vs. buying calculation
So, here's my calculation for anyone contemplating the renting versus buy decision.
Take the value of the home you are considering, multiply it by 5.5%, and divide the result by 12.
If you can rent for an amount lower than that, then renting is a financially sensible decision.
For example...
You have a £500,000 home, the estimated annual non-recoverable costs would be £27,500, or £2,292 per month.
Conversely, if you find a rental property you adore for £3,000 per month, you can take £3,000, multiply it by 12, and divide it by 5.5%. The outcome in this case is £654,545.
In other words, paying £3,000 per month in rent is financially equivalent, in terms of non-recoverable costs, to owning a £654,545 home.
Undoubtedly, the 5.5% rule oversimplifies the decision-making process.
If this still feels complicated, let me attempt to explain it in a different way.
One of the major expenses associated with owning a home is the opportunity cost of equity capital. When you use £500,000 of your cash to purchase a home, that money is now tied up in property instead of being available for other purposes, such as investing in stocks.
The difference in expected returns between property and stocks represents an opportunity cost. It's a genuine economic cost that homeowners bear, and must be taken into account when making the decision between renting and buying.
The opportunity cost of equity capital varies based on factors like the allocation between stocks and bonds in your portfolio, whether your investments are subject to taxation, and if so, your tax rate.
Depending on these variables, the 5.5% rule may need to be adjusted downward, resulting in lower non-recoverable costs associated with homeownership (in other words, making home ownership less expensive).
Of course, prevailing mortgage rates will also play a large part and alter the rule, for example if you have a fixed-rate mortgage locked in at prevailing rates, a rule closer to 6.5% might be more accurate.
On the other hand, for those with more conservative portfolios, who are purchasing in cash, a rule closer to 4% may be more appropriate.
Regardless, approaching the cost of homeownership in terms of estimated non-recoverable costs simplifies the financial aspect of the rent versus buy decision.
