Facts fit for a professor

Q: I am a student undertaking a conjoint degree of commerce (majoring in finance) and property at the University of Auckland.

I am an avid reader of the Weekend Herald and follow your articles with interest. They definitely complement my degree in providing me with an underlying practical knowledge.

As part of my economics paper this semester, we have an essay asking us to "critically examine the widely held belief that home ownership guarantees financial benefits to owners".

I was wondering if you may be able to assist me in giving me a few pointers and helping me head in the right direction.

A: This feels a bit like helping you to cheat - although I suppose it would be legitimate for you to read old columns, so what's the difference?

Anyway, I've decided to not only answer you, but devote the whole column to it. Many people think you can't go wrong with home ownership and they are wrong.

I want to start by apologising for all the numbers. I've wrestled with different ways to tell this story and tried to cut the numbers back. Bear with me, because the message is important.

Everybody has to live somewhere, so what we're really looking at is whether it is always better, financially, to own your own home than to rent.

Economics papers always seem to include assumptions, so here are mine:

* You're considering owning or renting a $300,000 house for five years.

* Annual rates, maintenance and insurance total 1.5 per cent of the home's value, or $4500 a year.

* Annual rent is 5 per cent of the home's value, which is $15,000 a year - or $288 a week.

We'll look first at the situation without a mortgage, because that's simpler. That means you have $300,000 to start with.

If you rent, you avoid paying $4500 for rates and so on, but have to pay $15,000 to the landlord, a net cost of $10,500 a year. And, of course, you miss out on the capital gain on the house.

To do better than owning, you must invest your $300,000 to bring an after-tax return that covers the $10,500 - which is 3.5 per cent - and also more than makes up for the lost capital gain. How easy is that? It depends entirely on what happens to house prices.

Scenario A: Prices rise 11 per cent a year, as they have done, on average, over the last five boom years.

Adding the 3.5 per cent, you would need an annual after-tax return of more than 14.5 per cent. That's possible, but highly unlikely.

Scenario B: House prices rise at the average rate since the early 1960s - a bit more than two percentage points faster than inflation. Now, that's about 5 per cent a year.

To do better than owning, your $300,000 would have to grow by 8.5 (5 plus 3.5) per cent a year after tax. That's more achievable, although you would still have to invest in risky assets, such as shares or a share fund.

Scenario C: House prices are unchanged over the five years. This is not out of line with some economists' predictions. The fact prices have continued to rise lately makes it more likely they will plateau in the near future - perhaps falling for a while and then slowly gaining.

That's easy to beat. You need only make more than 3.5 per cent after tax on the $300,000 to be ahead by renting.

Conclusion 1: Home ownership without a mortgage does not guarantee financial benefits. If house prices don't rise, or rise only a little, it's easy to do better by renting.

Now let's introduce a mortgage. After all, most house purchases are made with the help of a loan.

Theoretically, we could compare borrowing to invest in a house with borrowing to invest in, say, shares. And, in an academic paper, perhaps you should include that.

In reality, though, it's hard for most people to borrow much to invest in shares if they haven't got equity in property as security. Most people, too, find geared share investment too nerve-wracking.

So let's look at a much more common choice. You've got $30,000, which you can put into a $300,000 home or invest elsewhere and rent. If you buy the home, you take a 25-year $270,000 loan at a fixed rate of 8 per cent.

Monthly mortgage payments will be $2084, totalling $125,000 over five years. Of that, about $20,000 will be repayment of principal, the rest will be interest.

We'll use the same three scenarios.

Scenario A: The house price rises 11 per cent a year, to $506,000. Subtract $20,000 of real estate and legal fees and the $250,000 remaining on the mortgage, and your sales proceeds are $236,000.

After allowing for the $22,500 you've spent on rates and the $125,000 you've spent on the mortgage over the years, you're left with a gain of $88,500.

If you had rented, that would have cost you $75,000 over five years. To do better than buying, then, your $30,000 of savings would need to grow to more than $75,000 plus $88,500, which totals $163,500, after tax.

That would require a return, over five years, of more than 40 per cent a year. That's virtually impossible.

Scenario B: The house price rises 5 per cent a year to $383,000. Subtract real estate and legal fees of $18,000, and the same $250,000, $22,500 and $125,000 as above, and you're left with a loss of $32,500.

Don't panic. The negative number reflects the fact that you've had free accommodation for five years.

To do better renting, your $30,000 would need to grow to more than $42,500 ($75,000 minus $32,500), after tax.

Your after-tax return would have to be about 7.5 per cent a year. Like Scenario B above, that's achievable, but only with a fair bit of luck.

Scenario C: The house price stays at $300,000. Subtract real estate and legal fees of $13,000 and the same other costs, and you're left with a loss of $110,500.

That's ridiculously easy to beat. Even if you put your $30,000 under your mattress, after covering the $75,000 for rent you would be $35,500 better off.

As I've said often before, borrowing to invest in anything, sometimes called gearing, makes a good investment better and a bad investment worse.

Conclusion 2: With a mortgage, home ownership can bring huge financial benefits if house prices rise fast. However, if prices stay flat, not only are you not guaranteed benefits but you can suffer considerable financial harm.

Some notes on all this:

* I didn't include a scenario in which house prices fall. While a fall over a year or two is quite likely, it's much less likely over five years. And, over the longer term, we can be confident prices will trend upwards.

Given that most people own their homes - often trading one for another - over decades, you could argue that I'm being mischievous using a five-year example.

However, the assignment doesn't specify time period. And everyone should understand that home ownership is financially harmful over some periods.

Also, over the long term, home ownership isn't necessarily better than renting while investing elsewhere - as shown by our Scenario Bs.

* You could quibble with my estimates of rent, rates and so on. But that won't alter the conclusion.

* Strictly speaking, we should make allowances for the timing of cashflows. But that would affect owning and renting in a similar way, and it would give us even more numbers to deal with. Again, it wouldn't alter the broad conclusion.

* Perhaps most importantly, there are many non-financial benefits of home ownership, such as security, pride and the ability to decorate and garden as you please.

On the other hand, renters have less responsibility, don't need to do maintenance and can move more easily. In any case, that's not what the question is about.

So how did I do, professor?

* Mary Holm is a seminar presenter, author and publisher.