ABC News – 14 July, 2014.
By Michael Janda
It is an age old question – is it cheaper to rent or buy?
Conventional Australian wisdom has it that “rent money is dead money”, but two Reserve Bank analysts have put this to the test.
In research released on Monday, they find whether it is cheaper to rent or buy a home is an even money bet that depends largely on future house price growth.
The research paper finds that if house prices were to keep growing at the average rate of the past sixty years, then buying a house now would be about as costly as renting.
However, if house price growth were to slow in the future – as suggested by many forecasters, including the Reserve Bank’s head of financial stability Luci Ellis – then the average household would be financially better off renting than buying.
The study finds real house prices, also adjusted for the quality and size of the dwelling, rose 2.4 per cent a year on average over the past sixty years.
However, the same measure of house prices has only risen 1.7 per cent a year over the past decade – if this growth rate was to be maintained, it would currently be 19 per cent cheaper to rent than to buy.
No bubble says RBA, but study has limits
A key purpose of the research was to determine whether Australian home prices were overvalued.
The report concludes that Australian home prices have risen faster than incomes in each of the past six decades, which makes an assessment based on the historical price-to-income ratio less relevant in determining whether valuations are fair.
The bank says comparing the cost of buying to its main alternative, renting, is a better way to evaluate whether home prices are reasonable, or moving into bubble territory.
Their conclusion based on the comparison of rental to purchase costs is that, “recent data do not show signs of a bubble.”
The authors note that there are factors that will skew the buy or rent equation for each household, such as how much a household values owning rather than renting their home (which may justify a premium for ownership), and how often a household expects to move (due to the costs associated with buying, selling and moving).
Another potential flaw in the research is the interest rate used – in the research, the Reserve Bank assumes a real interest rate of 3.3 per cent, which it calculates using 10-year fixed mortgage rates with the risk premium subtracted.
However, given that the world is in a uniquely low interest rate environment currently, even the long term 10-year fixed mortgage rate has been skewed downwards from more typical levels, although the RBA data shows it is not at record lows.
As the typical variable rate mortgage runs over 25 years, there is a considerable risk that average interest rates will be higher than those the bank has used, making home ownership less attractive than its calculations suggest.
As an illustration of why the findings of this report need to be treated cautiously, the authors note that studies using a similar methodology in the United States, “find house prices were undervalued near the peak of the US housing boom”, which preceded (and precipitated) the global financial crisis.
As for the two RBA officials that did the research, they took a bet each way: Peter Tulip recently bought a house, while Ryan Fox is still renting.