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, rm is the mortgage rate, and ralt 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.
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, rm is the mortgage rate, and ralt 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.
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