This article was first published in the first quarter 2017 edition of Personal Finance magazine.
Should you buy your home, or would you be better off renting? There was a time when the conventional wisdom said that owning your own home was the very foundation of financial security and wealth creation. Today, an increasing number of people – or so it seems from the often heated online debates – argue that homeownership does not make financial sense.
Each side flourishes statistics and anecdotal experience that supposedly clinches their side of the argument. However, what is often trumpeted as a universal truth can turn out to be an expression of self-interest, or an attempt to justify a decision retrospectively.
Any financial decision should be based on your specific circumstances, not what is true for someone else. Deciding between buying and renting comes down to comparing, over the long term, the returns and expenses associated with owning a home with the returns you could earn if you rented and invested. The “and invested” part is a crucial aspect of the case for renting: the money that would otherwise have gone into a more expensive home loan should be invested in an asset class that will out-perform physical property over the long term.
Last year, a buy-or-rent calculator for South Africans was launched on Rolling Alpha, the blog of Jayson Coomer, a chartered accountant with a Masters degree in finance, who describes his day job as “fixing companies”.
In his introduction to the calculator, Coomer neatly sums up the dilemma facing anyone trying to decide between buying and renting: “There are so many variables that affect your decision to buy a house. There’s the price of the house, the mortgage, interest rates, insurances, renovations, transfer fees, capital appreciation rates ... the list goes on and on. And because there are so many unknowns, it’s almost impossible to try and work out whether or not you should just rent instead. And this problem gets worse when you try to think about more difficult questions like ‘How long am I going to stay in the house?’ and ‘What if I did something different with the money – what impact would that have?’”
The calculator, he goes on to say, “takes you through a list of all the big questions of homeownership, and it calculates the monthly rental you’d have to be paying before it would make more sense to buy the place”.
The calculator guides you through seven steps. At each step, you must input certain variables by either moving a slider or typing in the figures. The calculator requires the following information:
Step 1. The price of the home you want.
Step 2. How long you plan to live in the property.
Step 3. The size of the home loan, the interest rate on the loan, the term of the loan, and the deposit (if any) you will put down.
Step 4. The return on your investment. You must enter the estimated annual return on your property, the annual rental escalation, the annual return your savings could earn if they weren’t being ploughed into your home loan, and the annual rate of inflation.
Step 5. The costs of buying a home. Based on the property price, the calculator automatically calculates the transfer duty, the standard conveyancing fee and home-loan registration costs. You must enter any other “standard costs” and what you intend to spend (if anything) on fixing up or renovating the property.
Step 6. The costs of selling your home. You enter your marginal tax rate, which the calculator uses to calculate whether you will pay capital gains tax. The calculator takes the exclusion of R2 million on a primary residence into account. The other numbers you input are the estate agent’s commission, the cost of compliance certificates, the bond cancellation fee and any pre-sale repairs or renovations to make the property more attractive.
Step 7. The occupation costs. For the ownership side of the equation, you must estimate the monthly rates, annual maintenance costs, homeowner’s insurance premium, monthly utility charges and levies if you buy in a sectional title scheme. For renting, you estimate the monthly utility costs that won’t be covered by the rent, and the renter’s insurance (if required by the lease).
Once you’ve entered all the numbers, the calculator will tell you that, if you can rent the property for less than “X rand” a month, you’re probably better off renting than buying, “although that’s assuming that you actually manage to save the savings”. The calculator then shows you, in some detail, how it crunched the numbers and arrived at the final answer.
Personal Finance asked three past winners of the Financial Planner of the Year Award for their opinion of the calculator. Wouter Fourie, Peter Hewett and Warren Ingram, all of whom have the Certified Financial Planner qualification, said the
calculator does take into account the variables needed to make an informed decision about whether to buy or rent. Fourie, a director of Ascor Independent Wealth Managers, said he would use the tool when advising his clients about homeownership. However, he said the calculator doesn’t seem to take into account that homeowners live “rent-free” for the rest of their lives once a loan has been paid off, while enjoying growth on their asset.
The planners liked that the calculator makes it easy for you to see how the outcome will change if you adjust the variables, such as the deposit and the term. However, a criticism was that the sliders do not always move to the exact amount you choose. They said the calculator would force you to think through all the costs – not just the loan repayments – associated with homeownership, which prospective first-time buyers often overlook or underestimate.
Choosing the right variables
The extent to which you can rely on the answer depends on the quality of the information you enter. In some cases, the internet will yield the information you need. For example, if you don’t know the price of the property you want to buy, you can use the search function on a website such as IOLProperty to get an idea of the price of the type of home you plan to buy in a specific suburb.
But the calculator also requires you to make assumptions about future house-price growth, investment returns and inflation, among other variables. This is where things can get tricky. The steps in the process raise the following issues:
How much you pay for the property will affect your repayments, and also the rental if you decide to rent the place instead. It will also affect your acquisition costs and your occupation costs – maintenance, rates and insurance premiums.
The time factor
The message from our planners was clear: how long you intend to stay in a property is the most important consideration when choosing to buy or rent. This is because it will take time for the property to appreciate in value enough to allow you to recover your buying and selling costs, such as transfer duty and conveyancing fees. At the same time, annual rental escalations, which usually exceed inflation, mean that, at some point, your rent will be more than all the costs associated with homeownership.
Coomer, who describes himself as a traditional renter, says that you should avoid buying if you plan to make significant lifestyle changes, such as changing jobs, getting married or having children, that will require you to move to a smaller, bigger or more convenient place in the near future.
Ingram, an executive director of Galileo Capital, says you should not buy if you don’t plan to live in a property for at least eight years. If you move every five years, it’s highly likely that you’ll actually destroy your wealth, he says. For this reason, Ingram says he advises people not to buy their first or second homes, but to wait until they have decided where to put down roots, which usually coincides with starting a family. While renting, you should be saving “like mad” so that you can put down a large deposit. During this period, you should also borrow responsibly, so that you will have a good credit record when the time comes to ask the bank for a home loan.
One of the arguments for renting is that you are free to pack up and leave. Thanks to the Consumer Protection Act, a tenant can terminate a fixed-term lease on 20 business days’ notice for any reason, although the landlord is entitled to charge a reasonable penalty to recover any resulting loss of income. However, being able to break a lease at the drop of a hat gives you the freedom to move around only if you can find suitable alternative accommodation. The latest vacancy survey from TPN, a credit bureau that specialises in residential letting, shows that the demand for rental accommodation in Cape Town vastly exceeds the supply, whereas the market is more or less in equilibrium in Gauteng. Therefore, although you may want the freedom associated with renting, you need to establish whether the dynamics of the property market where you live make that freedom attainable.
If you bought a property assuming that you would live in it for the long term, but are forced to relocate for job-related reasons, you can let it out instead of selling. However, you will have to employ a managing agent, who is likely to charge between 10 and 12 percent of the monthly rent. In addition, Ingram says, if you decide to buy your new home while renting out the one you left, the bank won’t assume that the property will be rented out for 12 months of the year. It will assess whether your cash flow will sustain two mortgage bonds, if necessary. So if your cash flow isn’t healthy, you may have to rent your new home, but you can use the rental income from the property you bought to neutralise the rental you have to pay.
Your home loan
Ingram says it’s unlikely that a bank will grant you a 100-percent home loan; the minimum deposit is about 20 percent of the purchase price.
The prime lending rate is currently 10.5 percent. The home-loan interest rate you pay will depend on your credit record and the size of your deposit: the bigger the deposit, the better your chance of securing a lower interest rate and reducing the total financing charges over the term of the loan.
Over the past 20 years, the prime lending rate peaked at 25.5 percent in August 1998, while its lowest level was 8.5 percent, in July 2012. Between 1996 and 2015, the prime rate fell below 10 percent from September 2010 to November 2015. But how high, or low, rates will go over the next 20 years is one of the big conundrums of this exercise. The prime rate moves in tandem with the repo rate (seven percent in November 2016), and the South African Reserve Bank uses the repo rate to control inflation, which is influenced by a host of factors, such as the exchange rate, the oil price, macro-economic conditions and the global economy. In 2000, the Reserve Bank adopted a policy of inflation targeting: using the repo rate to keep the year-on-year increase in headline inflation to between three and six percent. Between 2000
and 2016, the highest prime lending rate has been 17 percent, in September 2002, when the repo rate was 13.5 percent.
When it comes to choosing your home-loan term, remember that a longer term will reduce your monthly instalments, but will inflate the total amount you pay back to the bank. For example, on a bond of R1 million, with an interest rate of 10.5 percent and deposit of R20 000, your monthly instalment will be R8 964 on a 30-year bond, as opposed to R9 784 on a 20-year bond. However, you will end up paying R879 011 more at the end of 30 years than you would if you paid off the loan over 20 years.
Returns and inflation
Home loans are usually taken out over 20 years, so we have used that period of time when researching inflation and returns.
Based on figures from Statistics SA, the average inflation rate between 1995 and 2015 was 6.2 percent a year, but it was 6.5 percent between 2005 and 2015. Most financial planners use an inflation rate of six percent when making assumptions about the future.
When it comes to the growth in property prices, people usually turn to house-price indices – mainly those produced by Absa, First National Bank (FNB) and Lightstone. Each index is based on a different methodology and none of them includes every single transaction that takes place. Remember that a house price index is not a measure of property values, but captures pricing trends from properties that actually changed hands.
The headline figures in these indices obscure how the market is faring in different regions and price segments and between types of ownership. Take, for example, the residential property indices published by Lightstone in October 2016. Nationally, the index showed that prices were growing by an average of 4.95 percent (before inflation). But they were growing by 7.9 percent in the Western Cape, and 5.5 percent in Gauteng and KwaZulu-Natal. In Cape Town, prices were growing by over 10 percent, on average, compared with between three and six percent in the major metropolitan areas of Gauteng. Nationally, sectional-title properties were out-performing the national average (5.2 percent), whereas freehold properties were under-performing (3.9 percent). Even more telling were the differences by price segment. Price inflation among low-value properties, defined by Lightstone as selling for less than R250 000, was 24 percent, whereas luxury properties (more than R1.5 million) were growing by only three percent.
Of course, no national or regional index can capture the factors that drive up the prices of properties in certain suburbs, or that make one property more desirable than a similar property in the same neighbourhood. For that level of detail, you can buy reports from Lightstone, or you can ask an estate agent who specialises in a particular area.
However, if you want a “bald” national average, according to the Absa House Price Index, the average property appreciated, in nominal terms, by 11.03 percent a year between 1995 and 2015. (By “average”, the index means a property of between 80 and 400 square metres, with a value that does not exceed R4 million.) This period includes the property boom that peaked in 2004/5 – nominal price growth hit 32.24 percent in 2004. However, if one looks at the period from 2006 to 2015, growth has been far more moderate: 6.88 percent a year.
Estimating rental increases presents a similar challenge, unless you’re a tenant and use the escalation in your lease. According to TPN, rents nationally increased by 2.9 percent, on average, in the first half of 2016. But there were wide variations across the country. In the Western Cape, for example, the average increase was over 12 percent, whereas average rents were actually falling by the same percentage in the Northern Cape. Rental increases were just over three percent in Gauteng and KwaZulu-Natal.
What returns can you expect to earn if you invest the money you save by not having a mortgage? If you know precisely where you want to invest your money, you can look up its past performance over a particular term and base your projection on that. However, past performance is definitely not a guarantee of future performance, and the consensus among asset managers is that future returns from the equity market will be lower than they were over the past decade.
Don’t forget to factor in the investment costs to arrive at your net return.
If you are satisfied with basing your projection on average returns, you could use these figures from the Old Mutual Investment Group, which provides the following average annual nominal returns by asset class over the past 20 and 10 years:
• Equities: 14.3 percent (20 years) and 14.1 percent (10 years);
• Listed property: 16.9 percent and 17.5 percent;
• Bonds: 11.7 percent and seven percent;
• Cash: 9.9 percent and 7.3 percent; and
• Global equities: 14.5 percent and 15.4 percent (in rand terms).
Since you will be investing your savings for the long term, they should be invested mainly in inflation-beating growth assets, such as equities.
As pointed out previously, to make renting a viable proposition over the long term, you must take the money you would otherwise have spent on acquiring and maintaining a home and save it for the same term as your home loan. But, as we know, most South Africans are poor savers. And many people are renting because their financial commitments don’t allow them to save for a deposit.
Coomer says: “There’s no doubt that homeownership comes with higher annual costs. You’ve got the higher maintenance and insurance costs – and then there’s the interest on the mortgage repayments. But if, by renting, you can’t actually invest all those costs you’re not incurring, then just buy the house. If you want to check that, just go and slide the ‘investment return’ arrow to the zero percent return. You might notice that it will often drive the ‘effective rental’ negative. That negative effective rental means that someone would have to pay you to rent the house in order for it to be more worthwhile than buying.”
Hewett, the chief executive of Hewett Wealth, says that, in most cases, buying makes sense over the long term, because the growth wipes out the costs. He says the following example is another way of looking at the rent-or-buy equation. If you took out a home loan of R1 million, at an interest rate of 10.5 percent, the repayment over 20 years would be about R10 000 a month. You could rent a property of the same type for about R8 000 a month and save about R2 000 a month in other costs – a total saving of R4 000 a month, or R48 000 a year. If you invested that money and earned 10 percent, you would earn R4 800 a year, a compounded return of R52 300. Your property has to appreciate by only 5.23 percent a year to make buying a better proposition that renting.
Fourie says you “make your profit” when you buy property, not when you sell: you must purchase it at a price that’s appropriate. To do this, you have to research the areas in which you plan to buy and not buy when the market is overheated.
First-time buyers must avoid what FNB property economist John Loos calls “buyer panic”: when property prices are rising rapidly, aspirant buyers believe that if they don’t buy a property now, they’ll “never” be able to enter the market in future.
A word about costs
The calculator uses the property price you enter to calculate the transfer duty and conveyancing fees. However, it can be a challenge to estimate the other costs associated with homeownership if you have not bought and sold a property before. Here are some guidelines:
• Estate agent’s commission. The commission charged by a low-cost agent, such as Steeple (from 1.7 percent) and Property Fox (1.5 percent), will be less than that demanded by a “traditional”, full-service agent (between five and seven percent, excluding VAT).
• Property rates. The default setting on Coomer’s calculator is one percent a year of the property value. If you don’t know the rates on a property you want to buy, you should look on property websites for the rates of properties in your price range in your chosen suburb.
• Homeowner’s insurance. If you buy in a sectional title scheme, the levy will include the premium for this type of cover, so you can set the slider at zero.
• Renovations. A common mistake by home-buyers is to over-capitalise – outlaying money on improvements that they won’t be able to recover when they sell. Nearly all suburbs have a ceiling price: a limit above which properties will sell only in exceptional circumstances. Estate agents recommend that you do not invest more than 25 percent of the property value on improvements and renovations, even less when the market is subdued. You should not embark on extensive renovations until you know what type of buyers a suburb attracts, to ensure that the renovations will suit their lifestyle requirements.
• Maintenance costs. The rule of thumb is that maintenance costs are about one percent of the value of the property. However, if you buy in a sectional title scheme, you need to provide for maintenance and repairs inside your section only, because your levy will cover maintenance and repairs to the exterior (the common property).
• Utilities. If you are buying into a sectional title scheme, your levy is likely to cover water, sewerage and refuse, so you don’t have to allocate a separate amount for these expenses.
• Levies. The monthly levies cited in advertisements for sectional title properties do not take account of any special levies that the body corporate may have to raise. Recently implemented legislation will require schemes to build up minimum reserves, so you should expect levies to be higher than they are now.
The retirement issue
One issue that is often overlooked in the buy-or-rent debate is the implications of not owning your home once you reach retirement, when your income usually drops.
Ingram says one of the things that caused him to rethink the advantages of owning is the fate that befell pensioners who poured their capital into buying their “dream homes” on the KwaZulu-Natal south coast. In the wake of the global financial crisis, they saw their property values fall by up to 50 percent. Meanwhile, because these towns are decaying and plagued by crime, the retirees can’t sell and they have no liquid capital.
A major benefit of renting and investing, Ingram says, is that you can liquidate your capital easily, whereas property is a very illiquid asset.
Hewett says this highlights that property, like any other investment, has risks, and when it comes to property, the biggest risk is buying in the wrong area. Therefore, would-be buyers should spend a lot of time doing research into an area before committing to a purchase.
Both Hewett and Fourie say that renting in retirement is a financial risk, because it’s unlikely that the income generated by your investments will be sufficient to keep pace with the rental increases, which tend to be above the inflation rate.
Hewett says that even if, in retirement, you end up stuck in a property that does not appreciate in value, or even loses value, your occupation expenses will be lower than if you rent.
• Ooba has six calculators that home-buyers will find helpful, including a deposit-saving calculator (how much you need to save, and for how long, in order to save up for the deposit you need), a repayment calculator (what your monthly repayments will be), an amortisation calculator (the portion of your monthly instalments that will reduce the capital you borrowed and the portion that will be used to pay off the interest) and an extra-repayment calculator (how much you can save on your total home loan costs if you pay in extra once-off or regularly).
• You can find historical repo rates and prime lending rates on the website of the South African Reserve Bank.
• You can obtain the Lightstone property indices by going to www.lightstoneproperty.co.za.
• For rental escalations, go to www.tpn.co.za.
• For the returns of collective investment schemes over periods up to 30 years, go to www.persfin.co.za.
• You can check the latest conveyancing costs and Deeds Office fees by going to www.ghostdigest.com.