Housing overvalued, but savings overtaxed: buying may still make sense

It was an unusual but welcome move by the RBA to weigh into the popular debate on whether the Australian residential housing market is overvalued. In publishing a research discussion paper titled “Is Housing Overvalued?”, it took the rare step of explicitly trying to answer the big economic question on everyone's mind.

While the RBA’s research papers can sometimes be esoteric, its foray into more topical economic issues should be welcomed. It injects rigour into the debate, which can sometimes be driven by less informed research or by participants with an agenda. It not only helps inform ordinary citizens on the big issues affecting them, it is also useful for markets to understand what is informing the central bank’s views.

Given the unsuccessful attempts by the RBA to talk down the value of the dollar, one wonders if a paper called “Is the Australian dollar overvalued?” is forthcoming.

This paper was unique in that it used a new dataset that used matched data of prices and rents of properties, whereas previous research relied on separate series of rents and prices, assuming there was no difference in quality of houses for rent and those for purchase. 

The paper’s approach is to directly compare the costs of renting and buying a house, and use the difference as an indicator of whether houses are overvalued. It neatly breaks down the different components of home ownership and compares them to rental yields. 

The components are: real interest rate, running costs, annual average transaction costs, depreciation, and most importantly, expected capital appreciation. A simple equation that results is

The only real unknown in the equation is pi, the expected capital gain. A useful way of answering the question of whether housing is overvalued is to consider the expected capital gain that will cause the equation to balance.

On this basis, the key finding of the report is that the housing market is fairly valued if house prices continue to grow at their historical 49-year average of 2.4% p.a in real terms, but 19% overvalued if they grow at the 10-year average of 1.7% p.a. Tellingly, the RBA points out that 1.7% “currently may be closer to a consensus assumption”. Adjusting for the inflation assumption, the capital appreciation rates are 5.2% and 4.5% p.a in nominal terms. In other words, if you’re happy to live in a house for 10 years and are confident house prices will grow by at least 5.2% p.a on average over that period, go for the great Australian Dream.

Mortgage rate is not equal to investment return 

While the conclusion thus far is sound, there is one simplifying assumption which limits the practical use of this paper for individuals considering whether to buy or rent. It also likely overstates the level of overvaluation of housing. 

This is the assumption made that there is no difference in the mortgage rate and the post-tax opportunity cost of owner’s equity. The authors claim that this assumption is applicable to those with little investible financial wealth, and that buying a home is comparable in riskiness to investing in assets such as shares, which have a real historical pre-tax return of 6.9% since 1979 or 7.3% since 1883. 

In the first instance, neither of those rates are equal on a post-tax basis to the assumed mortgage rate of 6.2%, which is paid out of post-tax income. The pre-tax investment return needed to be equivalent to the mortgage rate is a heady 9.4% for income earners in the 34% tax bracket, and an even higher 10.2% if they are in the 39% tax bracket. Thus even if we use shares as a proxy to the opportunity cost of owner’s equity, we find their long run post-tax return is significantly lower than the mortgage rate. 

Furthermore, the opportunity cost is usually far lower than the mortgage rate, since no renter is likely to place all of his investable funds in risky assets. Cash, term deposits and lower-risk assets are likely to make up a significant portion of an average renter’s portfolio. 

In the equation below, the authors state that the mortgage rate component R is actually a weighted average of the opportunity cost of owner’s equity and the mortgage rate. e is the proportion of equity in the owner’s home, r^m is the mortgage rate, and r^alt is the opportunity cost of owner’s equity.

Hence, as an owner’s equity in his/her home grows, the mortgage rate component of the equation shrinks, reducing the cost of home ownership compared to renting.

Imputed rent and Tax
The cost of housing tends to be the biggest barrier to achieving financial freedom, given its large. Being able to live in your own home without having to work to pay the rent or mortgage is an approximate definition of financial freedom.

Theoretically, this financial freedom should be achievable whether one buys their home or accumulates enough savings that the income generated pays for the rent. But in reality, there is a tax distortion that makes it far easier to achieve financial freedom by buying your own home. 

This is because investment earnings are taxed at the full marginal rate while the benefit derived from living in your own home (what economists call ‘imputed rent’) is tax-free. 

This pushes up the required rate of return one needs to earn on investments before it equals the rental yield. It also slows down wealth accumulation for renters, since their surplus savings are taxed at their marginal rate while homeowners’ savings are funnelled into tax-free imputed rent. In other words, over the long run, an individual with a steady income is likely to be better off buying a house than renting the same house. The key caveat is that they have to live in it long enough to ride out the volatility of house prices. 

While house prices can drop 40% over the next 1-5 years, they are less likely to do so over 10, and have a very small chance of not holding their value of 20. Hence, the longer you are happy to live in a particular house, the higher your chances of being better off over that duration.

This is why the Australian middle-class formula for wealth creation by getting on the property ladder as soon as possible tends to work. 

Net Worth Projection 

Another way of looking at whether to buy or rent is to project an individual’s net worth in each scenario. A simple scenario for an ordinary individual looking to buy a modest house worth $400,000 is instructive. 

Let’s say this person has saved up the 20% deposit for the house. We use the RBA’s variables for interest rate and running costs of ownership of 6.2% and 1.5%, but slightly more realistic assumptions for rent (say $380/week vs RBA’s 4.2% yield assumption which would imply a rent of $320, a dream for any Sydneysider). We use a generous investment return of 5% pre-tax, much higher than most term deposit rates available at the moment, and a free cashflow of $3,500. This should reflect the situation for most ordinary Australians in metropolitan areas.

The chart above shows the net worth projections for that individual if he rented or bought, with no capital gain, and with a capital gains equal to inflation of 2.8%.

As can be seen, the average punter is far better off buying even if house prices only keep pace with inflation. Indeed, the required capital gains to break even in 3, 5 and 10 years are 3.1%, 1.5% and 1.1% p.a. In other words, over ten years, it is better to buy even if the house depreciates 28% in real terms over that period! Even if they don’t grow at all (and hence effectively depreciate in real terms), he will be better off buying if he holds on to it for 23 years. Note the assumption of 0% nominal growth over this period is extremely conservative and implies a real depreciation of around 76% over that period. 

Of course, the numbers will vary with every circumstance, but the point is that wealth creation is faster when you don’t pay almost half your investment earnings in tax, and instead pay to own the home you live in. 

Conclusion 

The conclusions to draw from all this are: 

·       The housing market is 20% overvalued based on what the RBA calls consensus capital growth rates;
·       But it’s probably not as overvalued as that given the lower opportunity cost for most individuals, and the unseen tax benefit on imputed rent.
·       If you  can see yourself living in a house for 10 or 20 years, chances are you’re better off buying it than renting it.
·       This does not constitute financial advice. Do your own numbers. 

WWI Centenary as India comes of Age: Time to Renew the Commonwealth

The centenary of the First World War comes at a time of great generational change, as the millennials and the first digital natives come of age. Coinciding also with the start of the Asian century, this presents a perfect opportunity to rejuvenate the Commonwealth. 

Democratic institutions are threatened around the world. As the free world faces fundamentalist Islam, and a rising authoritarian China and Russia, there is an urgent need to focus on and assert the values of the free world. A great mass of the population of free countries belongs to the Commonwealth of Nations. With Europe in structural decline and the US turning inwards, it is vital that the Commonwealth takes up the fight for democratic and liberal values.

The rise of the British Empire changed the world forever. No other historical force has shaped the modern world to such an extent or touched as many people on such a scale. It is the reason that I, an ethnic Indian am writing this in English, the language I am most familiar with, in Australia, a country I easily assimilated into. 

In what Daniel Hannan has described as 'Anglobalisation', the British Empire and later the Commonwealth has left behind a global community sharing a common language, legal system, academic culture, and to a lesser extent a cultural milieu.  Yet the predominant emotion associated with the British Empire over the last hundred years have been acrimony, resentment and betrayal. This has translated into apathy for the Commonwealth. 

This is not terribly surprising. The last hundred years witnessed the worst excesses of British imperialism. India was rewarded for its loyalty and bravery in World War I not with self-government but with a brutality that dwarfed the worst caricatures of the Kaiser. For sacrificing hundreds of thousands of its sons, the Punjab was rewarded with martial law and the slaughter of Jalianwala Bagh, where hundreds of unarmed men, women and children were enclosed and shot dead in cold blood by an unrepentant General Dyer. To rub salt in Indian wounds, Dyer received little formal reprimand, and was hailed as a hero by sections of British society, with the Morning Post collecting the equivalent of a million pounds to present to him. Britain snubbed Indian demands for dominion status on par with the white realms, ultimately losing the goodwill of its Indian subjects.

In the rest of the Anglosphere, the last hundred years witnessed Britain abandoning its family to cosy up with its neighbours, when it joined the EU and abandoned its trade links with Australia and New Zealand, who could not compete with the generously subsidised agricultural industry of Europe. 

It is therefore not surprising that there is little love for the Commonwealth and the soul of the old British Empire that it embodies. The decolonisation process happened relatively recently, and there are still many who remember life in the shadows of a Union Jack. Singapore and Malaysia only became independent 57 years ago. It is understandable that the views of that generation and those that followed them are shaped by the struggle against a foreign imperial power, often with a racial dimension.

My grandparents lived in a world where the white man literally ruled. My parents grew up in the shadow of colonialism, where the white man no longer ruled, but towered as a superior wealthy caste that ruled in all but name. Theirs was the first generation of the great Indian diaspora, which fought racism to give their children a better future in faraway lands.

Generation Y is really the first to be born unburdened of this history. This generational change coinciding with the centenary of World War I presents a unique opportunity to rejuvenate the Commonwealth. For the first time, all the descendants of the British Empire can genuinely count themselves as beneficiaries of that historical phenomenon which has forced us into a common patrimony. Regardless of the horrors and injustices our ancestors inflicted or suffered, we are today fortunate to be born in the Anglosphere- a loose, informal community of free countries which offers us a gateway into every continent on Earth and almost every major culture.

For the first time, a generation can look back at the remarkable events of the First World War without being influenced by personal experiences of colonialism or its aftermath. We can objectively see the diverse peoples of the Anglosphere coming together to defend an empire that although imperfect, was the genesis of our modern lives.

The focus on Commonwealth contributions to the World War I in Britain this year has dusted off sepia-tinged, forgotten stories from a period of the British Raj, when the Indian Independence movement was still a struggle within, not against the system. A time when there was a degree of respect and good faith between the British rulers and their Indian subjects, who like Gandhi were proud subjects only demanding their right of self-rule. We see photos of letters sent by Queen Mary to her “Indian sisters” who had been widowed by the War, and hear BBC programs of a hospital at the Royal Pavilion in Brighton set up for wounded Indian soldiers, where the British were most careful with dietary requirements (having learnt their lessons from the 1857 mutiny).[1]

India comes of Age

As the western world succumbs to its demographic and fiscal deficit, it is India’s moral duty to carry the torch of the Anglosphere into this century. After a thousand years of subjugation, its time has come. The election of Narendra Modi could prove to be a turning point in Indian and world history. Modi, the first PM to be born in independent India, embodies the optimism and confidence of India’s burgeoning, aspirational youth.

At first sight, the election of a man who shuns English in favour of Hindi and the first PM from outside the anglicised Delhi elite would appear to be bad news for the Anglosphere. However, this would be taking a myopic view. Modi’s Hindu nationalism is necessary to allow India to shrug off its last vestiges of colonial complex and come to its own in the eyes of the world.

While India may have won freedom, it has remained culturally colonised. English trappings such as a convent education and fluency in English are still viewed as social status symbols. The higher up you climb in Indian society, the more anglicised you need to be. This was so ingrained that it showed until recently even in the Hindu nationalist Bhartiya Janata Party, where senior leaders such as LK Advani belonged to what author Tavleen Singh has described as the elite world of the ‘Delhi Durbar.’ Modi is the first politician from the grassroots of the real India to shatter the glass ceiling to high office.

India can best contribute to the Anglosphere if she rediscovers her place there as a self-confident nation true to herself and her ancient, diverse and pluralistic Hindu civilisation. India has always been its own civilisation, but it was brought into the modern age by the Raj, and will continue to have a natural affinity to the Anglosphere.

When Modi first entered Parliament as the PM, his first act was replete with accidental symbolism. As he approached the steps of the Central Hall of Parliament, Modi went down on his knees and touched his head to the sacred temple of democracy, in the manner Hindus enter a temple. It was a humble tribute to the voters who put him there and encapsulated a beautiful cross-cultural acknowledgement of universal truths. Here was the personification of Hindutva (Hindu nationalism) paying homage in the most Indian way to Westminster democracy.

That act was symbolic of the exciting potential India has in store if it takes up the torch of righteousness and liberty in the international community.  The most precious values of the Anglosphere are universal in nature. A true statesman like Modi steeped in the Hindu tradition of dharma (righteousness) should quickly find common ground with the Anglosphere and its allies in pursuit of the common values of democracy, religious freedom and liberalism. While liberal values have not been especially prevalent in modern India, they do have deep roots in Indian culture and civilisation, as discussed in Amartya Sen's The Argumentative Indian.

A resurgent, newly confident India can put its unique cultural stamp on the universal values that have been borne by all progressive societies in human history. Perhaps the best way for India to get back at Britain for the Raj would be to remind an ailing Britannia of what Anglosphere values really are, and what she has lost.

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[1] http://www.telegraph.co.uk/history/world-war-one/11026562/How-Brighton-Pavilion-became-a-temporary-hospital-for-Indian-soldiers-in-WW1.html