To buy or not to buy a house, all the aspects to be considered

In current environment, there are some really good reasons to buy a house but also really good ones not to. I will first give a macro-economic panorama of the situation, and the impact on real estate.

Please note that my knowledge of real estate market is mostly limited to Japan and France, where I have in the past bought/sold properties and still hold some. This is nevertheless sufficient to give some important insight at the macro-economic level.

The macro view of the real estate market:

  • Rate are super low today, this is a fact. It may still last a bit, but there will definitely be a limit to that. What most realtors never tell you though is that low rate means high purchase price, meaning it is not a good time to buy when rates are low:

Indeed the Real Estate market, like other market, is driven mostly by supply and demand. Demand is related to the demographics in a given area, although demographics can evolve, such evolution is usually really slow, baring mass immigration. As a result, we can assume the need for shelter is constant on not too long periods of time. If demand is constant, then the buyers pool is. Higher rate or lower rate has no big impact on the portion or earning someone can pay for shelter (should not be more than 30% of net income for most middle class family).

If interest rates decrease, for a given property at a given price, the installment value per month would decrease, that would result in more people being able to afford the said property (people with insufficient income to buy the property if the rates had remained the same would become able to do so), increasing demand and mechanically the price. Alternatively, should the rates be super low like today and start increasing, should the property price remain as high as now, the pool of families being able to afford the monthly installment on a given property would decrease, resulting in slower sells at first and depressing prices at some point.

The conclusion is that rates being low by historical standard is definitely not a good reason to buy; it just means the price of the property being bought is higher than historical standard, so that the installments remain roughly the same. Should you buy without loan and just savings, it is actually a really bad idea to buy a property in low rates environment, as you do not benefit from locking in those low rates with a loan but would be penalized by the decrease of property price should rates rise after purchase.

On the contrary, buying when rates are really high mean the property being bought is cheap. It is an excellent time to purchase in cash. It is still a good deal when buying with a loan, as even if rates decrease in the future, it is possible to refinance (borrow again at lower rates to pay back the initial loan with the higher rates early), while benefiting from the property price appreciation.

Conclusion: in today’s environment, if considering buying, somebody should definitely consider using a loan, and this loan should absolutely be with fixed rate. Buying with floating rates means that, should rates rise, not only the installments would increase, but also that the property price would decrease, resulting in the worst outcome possible.

The only case where one should consider buying with floating rates instead of fixed rates in current environment is if one can pay back the loan quickly (meaning that the person already has the cash, but choose to invest this separatly cash and buy with a loan instead). Should the rates remains the same, the person get the benefit of lower rates (floating rates are lower than fixed rates for a given period), while still earning some income from the investment. Should rates rise, the person has the option to pay back the loan early. It is nevertheless important to consider in what kind of investment the savings are kept. It should be something relatively liquid (that can be sold easily), and something uncorrelated to the rates movement (if rate increase results in loss on the investment side, it means that the person may end up not being able to buy the property with cash due to the loss) or even better, positively correlated to the rates movement (where rates increase would result in investment gain, an kind of investment really hard to find today for an individual).

  • In some markets, the property prices is extremely high (on top of the rate effect described above), due to other reasons:

In France for example, recent laws (rent control…) and stricter and stricter regulations on the builder side result in a dearth of property being built and therefore a shortage of property. This combined with increasing populations in the cities (both from rural exodus and immigration) result in really high prices.

In major world cities (NY, Paris, London, Toronto, Sydney etc.), there is also an important demand from foreign investors. Such foreign investors increase the overall demand and the property prices in such cities.

In Japan, aside from Tokyo (where there are some foreign investments and rural exodus increasing demand), population is decreasing, and has been decreasing for a while. This results in Japan being one of the cheapest developed market to invest in compared to the median income of the population, if out of Tokyo. Special care needs to be taken though, as, with declining demands; some property may end up really hard to sell/rent in the future. This is expected to continue, as I do not foresee massive immigration to compensate this population decline, and I do not foresee Japanese people having more children in the near future (in any case, it would take 20-30years for those children to become buyers and drive the demand higher).

As can be seen, from a macro standpoint, prices are really high today. Can they go higher? Certainly, if the rate policies and the immigration policies etc. carry on, for example Central Bank implementing Negative Interest Rate Policy (NIRP), but I am not convinced on a 20-30years horizon, which is usually the horizon to purchase a home.

The thing to consider when buying a house:

There are a multitude of aspects to consider before buying a house in current environment, given the really high price-tag today.

  • Real estate is an asset that is extremely non-liquid (cannot be bought or sold easily and cheaply):

Selling a property takes months, especially if the seller wants to get a good price. Transactions also come with hefty costs (real estate agents, legal cost, loan processing fees, etc.), usually around 10% of the property value at purchase time, and another 3% at selling time.

It means, when buying, you need to be quite certain you will keep the property for several years. If, for your career, you expect to have to keep mobile, it may not be a good idea to buy a property, unless:

  • You intend to come back in such property in the future (retirement for example).
  • The property can be rented relatively easily.

As a rule of thumb, you need to stay at the minimum 3 years in a purchased property to breakeven, meaning the savings you would have made on the rent, minus all the costs of owning such property offset the purchase and selling price. In some market with more expensive transaction costs or extremely high prices today, it can be even more than that (something like 5-7 years for Paris for example).

If you need to remain mobile and cannot find a property meeting the above 2 criteria, do not buy to live. Consider buying to rent in an area where you consider retiring and use the income to rent where you need to live. It is not the most efficient, due to tax, management fees etc. but it definitely beats buying and having to sell too early. You do not need to buy a house in which you plan to live in the future, some small investment units could be better. The idea is that once you come back in the area, you can manage those properties by yourself instead of relying on an agent.

  • Real estate is a quite low-return investment:

Real estate is not high return investment (it has nevertheless a big list of other benefits that I will talk about later).

The past 20+ years are absolutely not a good example of real estate’s return. During those 20+ years, interest rate have been decreasing steadily, resulting in important prices increase on the period. This is more an anomaly than the norm. Given the fact it will be difficult for rates to go much lower (crossing fingers here, central bankers are actually considering NIRP, which would increase prices even further), capital gain possibilities are limited at that point.

Real estate costs quite a bit to maintain:

Between the income tax, property tax, building maintenance, coop costs for condos, potential damages by tenants, risk of non-paying tenants, time where the apartment is unoccupied, managements fees etc. the rents earned disappear really fast.

Real estate income is limited:

On average, a property price, if well maintained, track inflation in area with limited population growth. Real estate is not well suited for capital gain historically (the last 20years are an anomaly, the longest decreasing rates period in history). Of course, in a particular area, at a particular time, good capital gain can be made, but it requires deep knowledge of that market, usually the shouldering of extra risk (extra cost to renovate for example, or a bet that a train line will be created in the area in the near future etc.). Such gain expectations should be considered as risky as stock market gain appreciation, combined with a cost of transaction far greater than stock and really poor liquidity. In short do not buy a property for capital gain unless you know what you are doing.

The only potential gain from real estate is therefore on the rental income, either earned if rented to a tenant, or saved, if lived in.

Rental incomes are not high, if properly accounted for:

Let’s assume a 100 000 property, with a gross income of 5% (better than what can be obtained in most major cities when decently located already).

You have to account or provision for a lot of hidden costs:

  • Management company to rent the property, usually 1 month rent to find a tenant and 1 month rent per year (so 1/12th of your income is going to the managing company every year, and if your tenant leaves, you have to pay extra)
  • Assume your tenant changes on average every 2 years, and the management company find a new tenant in 1 month (not optimal, but not bad either).

Over 2 years (24 months of potential rent) you would end up with:

-1 for having the building unoccupied 1 month

-2 for 2 years of management company fees

-1 for the management company to find a new tenant

So 20 months of earned rent over 2 years, 10 months per year instead of 12. Your 5% income is already looking like a 4.16% income.

  • Coop costs for condominium: usually 1.5 months rent per year. For a standalone house, coop costs do not exist, but maintenance costs are a lot higher, so let’s assume it is the same 1.5 of extra maintenance for a single house.
  • Maintenance costs: conservatively, for a condo, ½ month rent per year.

So an extra 2 months of rent gone, before any bad things happen: only earning 3.75% now, before tax.

Then there is the property tax (varies too much from one location/country to another, can be anything between less than 1months rent to 2-3 months rent), let’s be generous and say it is only one month rent. Before income tax, you are already only earning 7 months rent out of 12.

And after that let’s assume a 25% marginal tax rate: 2.2% of net return, before the real risks of real estate investment: bad payers, tenants who damage the property, and regulation forbidding to out a non-paying tenant, along with lawyer costs to recover what is due (a crap-shot depending on the tenant). 2.2% net return with that kind of risk is not particularly appealing, but when thinking about the alternatives (close to 0% bonds rate, extremely expensive stock market today etc.), that may still retain some allure.

A good way to increase the income is to do away with the management company altogether.

It allows for:

  • 3 months of fee saved over 2 years, as described above (2 months of fee + 1 month to find a new tenant).
  • Better control on tenant (you can choose them), potentially avoiding some of the above issues.
  • Potentially less delay between tenants, due to the high motivation for the owner (yourself!) to find a new tenant (a motivation that the real estate company may not share to the same extends). In any case, with the 3 months of fee saved already, even if you find a tenant in 2 months instead of 1, you are still ahead.

Now, doing so is extra work (quite a bit actually), requires that you live close to the property (meaning you are back in the situation where you are less mobile somehow), and other risks (can you find a tenant by yourself? You need to redact a proper rental contract etc.).

In some countries, this direct owner to tenant market is quite developed, so it may not be too hard to pull off (like in France for example), in other markets, on the contrary, most transactions still occur through real estate brokers so it may be harder (Japan is the latter case).

Another risk not covered above is taxation risk: a sharp increase in property tax can a have significant impact on the overall investment. In some countries like the USA; it is a real risk in most states.

Still, real estate has a lot of hidden advantages:

  • Inflation hedge:

Real estate keeps its value, in light of inflation, over long period of time. It means the 2.2% net return considered above can also be considered net of inflation. Should there be inflation, the property value would increase, and the rent value should also increase, albeit with a delay.

In current environment:

  • Bonds and stock are far too expensive (meaning almost guaranteed losers over a significant period of time, especially after inflation).
  • Cash is a guaranteed loss over time (inflation is quite high those days in most countries, whatever our beloved governments say, while rates on short term deposits are at rock bottom). Also a big pile of cash at the bank has other risk, when you consider what happened in Cyprus or Greece recently: bail-in of depositors, capital control etc.

So faced with certain important losses on bond and stock, small losses on cash and money market items (along with confiscation risks), real estate’s 2.2% net of tax and inflation do not seems so bad after all.

  • Efficiency of buying to live:

Buying to live has a lot of extra advantages. It solves several of the issues mentioned above:

  • potential damages by tenants
  • risk of non-paying tenants
  • managements fees
  • time where the apartment is unoccupied

On top of that, usually, buying a property to live in comes with several tax breaks, depending on jurisdictions, such tax breaks are usually not available for investment properties.

Finally, saving on rent is more efficient than renting. Imagine a person has a 25% income tax and has the choice to either buy a property to live, or buy a property, rent it out and rent another one to live. Assume the rent paid and received are the same.

Assume the same funding is used in both cases, meaning no difference between the two solutions. Assume the same maintenance needs for your own property and for the bought to lend property (so I ignore both aspects for the below calculation)

Case1: the person rents its own dwelling and buys an investment property to rent it.

Extra income gross is 100 minus all the various charges related to using a management company explained above (from 5% we went to 4.16% before tax or 1/6th gone for management), as those charges are usually tax deductible, so 100-100/6 = 83.3

Extra income tax: 83.3*0.25 = -20.82

Extra expense for own rent: -100

Total: 83.3-20.82-100 = -37.5

Case2: the person buys its own dwelling.

No extra income (so no tax) and no extra expense, no management company issue, no period without tenant.

Total: 0

The gain is indeed substantial, and the risk lower (no agency risk with the management company, no period without tenant, no “bad” tenant issue…).

  • intangible benefits:

Being the owner of your dwelling comes with serious advantages that cannot be quantified as well:

  • Feeling of belonging with your family or neighbors, the kid school etc.
  • Possibility to remodel, renovate etc. when and how you want.

For some people, those benefits will be the main drive toward buying a property.

You will find here an Excel sheet that can be used for Real estate simulation. It is a lot more detailled than anything I have found on the internet so far, especially on Real estate or Banks websites. It allows for realistic simulations, where not everything will go well. Fell free to use it. When distributing it to another person though, I request that you redirect this person to this website.

buy-to-rent-buy-to-live-xls

Comments on the post or the worksheet welcomed!

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