Thursday, July 17, 2014

Overvalued Ownership

A young couple walk into a bar, and have a look at the wine list. The first wine they see is $50 a glass, and the second is a more reasonable $8. They decide to buy one of each to test this apparently amazing wine. To their surprise, the more expensive wine is only slightly nicer than the other. They conclude, quite rightly, that the first is overvalued. The comparison of two basically similar products is the gist of the analysis recently published in relation to housing by the Reserve Bank of Australia in a paper entitled "Is Housing Overvalued?"

It is an interesting approach, and not one that often appears in media, with price-to-income (such as Demographia's Housing Affordability Survey) and price-to-rent being the common measures. Whilst we don't agree with the RBA authors when they say that it doesn't matter whether house price rises are outpacing incomes when discussing whether house prices are overvalued, looking at the alternative does provide a useful insight into why people might choose one or the other.

Their answer is, at first glance, a little surprising. They find that if the house price appreciates at the same rate as it has, on average, over the last 60 years, then there's no clear financial winner between renting and owning. They go on to say that if, as the RBA expects, house prices appreciate at less than that rate then you will be better off renting than buying. The less expensive wine leaves a nicer taste in the mouth.

They do make it clear that they are only talking about the financial position, and so there may well be a premium people are willing to pay to own rather than rent. This is for a range of reasons that the authors try not to take into account, however this leaves a number of assumptions in their data that may change the numbers significantly. The authors note some of these assumptions but proceed nonetheless, dismissing them as insignificant. It is looking at only some aspects of the wine, and ignoring other factors.We'd like to take a closer look.

This form of user cost analysis relies on the person being able to make the choice. But there is no choice if you cannot afford the alternative! So this analysis is useful only for those able to choose between buying and renting effectively the same property. Having access to the finances, both cash and credit, for the deposit, stamp duty, and other sale fees limits the cohort of people making the choice to a fairly limited number.

We know for instance, that the particular market that this choice is most relevant to - first home buyers - are buying less and less property as investors take advantage.

Respondents to our own affordability survey cited being unable to buy as the main reason they rented, and while it is a small sample-size, the margin of error would need to be truly astounding to ignore the result.

Tenure costs
Whilst inevitably we need to allow some lee-way with the data, there are a couple of crucial differences between the experience of home ownership and the experience of renting that do change the financial situation.

Chiefly, the length of tenure- the paper uses an average length of home ownership of ten years as the basis of comparison. The authors note that they "exclude moving costs, which would be incurred whether one owned or rented."

This is true, though incomplete. We'll accept the average length of home ownership as 10 years, though the source for that may include investors, who buy and sell at a much faster rate. We also know that of the bonds held by the Rental Bond Board in NSW, two thirds are returned within 2 years. This is supported by our affordability survey in which 79% have moved within the last 5 years, and our respondents averaged moves every 2 years.

When excluding moving costs the authors have removed a cost that renters bare approximately 5 times as much as owners- and given we're talking about a cohort of people who are choosing whether to be renting or buying, we can't say that they simply have less stuff to move.

There are a host of costs, both economic and non-economic, related to moving including removalist fees, breaking utility and communication contracts, time spent updating records like driver's licenses, increased travel times, changing schools, and even the possibility of missing out on money entirely.

The researchers also set rent as the rental yield on a property, and leave it to sit at the rental yield every year, so that rent is effectively increasing at the same rate as the property appreciates. Given they are expecting the appreciation to occur at relatively low levels, they also come up with low rent increases year on year.

Unfortunately, this doesn't really play out in the real world. The best data we have available to compare to their data is the CPI for rent across Australia. The series runs back to September 1972, and averages 6% per year over that series- about 3% per year higher than the increases considered in the paper.

This wouldn't matter if the renter in the RBA's calculation was staying in the premises for the whole ten years. Unfortunately, they are moving about 5 times, and leasing out a vacant property is the easiest time for a landlord to increase the rent. This is an important factor that is missing from the data.

We thank the RBA for this research, as it highlights in a number of ways the inequity between renters and home owners plays out in the real world, and the gaps in knowledge in the way many policy makers talk about renting. We have created differences between home ownership and renting through legislation, taxation and expectation that make it difficult to compare the two tenure forms very simply. In other words, its possible you may be better off financially with the cheaper wine, but the headache is worse.

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