A buy vs rent model and a word on P2P property funding

I have been fascinated by the minimalist movement for some time whose ideas aren’t new but are responsible for raising the awareness and furthering the idea that less is more.

Minimalism forces you to prioritise what’s important. Financially, savings in one area directs more money to other more important areas. This leads to an overall reduced level of required savings and from a wellbeing viewpoint, a lower stress footprint.

The buy vs rent decision has shades of minimalism. If renting is generally cheaper than buying, the reduced savings needed to secure roof over one’s head results in more money available for investing.

Why do small businesses rent rather than buy? It’s so that they can devote more cash resources to other priorities, like being competitive. So startups try to be as minimalist as possible to chase dreams. So why do people do that for their businesses and not their lives? The answer isn’t as straightforward as it seems but it really fingers culture and marketing and the lack of financial literacy.

I’m not saying that renting is guaranteed to be better than buying. In fact for full disclosure, I own my home or rather the bank owns it now, but I hope to eventually pay it off someday.  I’m saying people gravitate to buy by default without being aware of the financial reasons.

Some financial theory: the value of an asset is the sum of all its future cash flows being brought back (discounted at an appropriate interest rate) to today’s value. Therefore, today’s value of a property is the discounted sum of all its future rentals (and/or eventual sale).  If a property is to be demolished next year, its value today is just an advance payment of the next 12 months’ rent thereabouts. If you’re going to rent for the rest of your life, there’s no difference financially speaking between renting or buying a place with a lifespan that exactly matches yours and the reason is that you get to invest the savings from not buying to fund future rentals. Same reason as to why you should prefer a term insurance policy with annually escalating premiums over a whole-life policy with level premiums but let’s leave that for another day.

It’s the same for stocks. The value of a company is the sum of all its future cash flows including from any closing down sale if any. So when you buy an Apple share, you’re paying for today’s consensus of all Apple’s future cash flows and you hope that somehow the current market’s idea of that is wrong and that it will go up so you that you can profit from it. The difference, however, is that you can buy an Apple share for a couple of hundred bucks whereas you’d have to spend hundreds of thousands, if not millions, to buy the whole home raising the much-hated affordability issue. You can’t really buy fractions of a home to live in, which makes the latest property crowdfunding idea very interesting for wannabe homeowners. More on that later.

Of course, things can and do turn out very differently in real life but this is just a theoretical foundation to help think about things.

The other observation is that you can either be an investor of Apple or a consumer of its iProducts. This distinction in status is something we are clear about, in fact, take for granted, when we buy things like smartphones. But when it comes to putting a roof over our heads, we are really confused about whether we are housing investors or consumers. The latter would just mean renting. If you are at the same time an owner of the place you live in, you are effectively paying rent to yourself, and very often with onward payments to the bank, which you would otherwise have paid to a landlord just as an owner of Apple shares gets capital rents in the form of dividends. But you mustn’t immediately jump to the conclusion that buying a property is financially the best decision you’ve made even if sentimentally it might be.

The following tables show calculations of what happens if instead of buying, you invest the difference of the notional mortgage repayment and the rent.

Table 1. Buy vs Rent Property Cost RM500,000

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Table 2. Buy vs Rent Property Cost RM1,000,000

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Table 3. Buy vs Rent Property Cost RM1,500,000

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It really puts to rest silly arguments that renters would be left without assets. There may be advantages of buying over renting but renters’ zero asset ownership should forever be consigned to the dustbin of silly financial arguments. In fact, the calculations show, admittedly a bit engineered but hopefully as close as possible to real life, how a renter’s asset accumulation can give an owner a good run for their money for reasons we will discuss.

Some glossary/assumptions/observations.

Downpayment  – this is assumed at 10% of property value, equivalent to 90% financing.

Loan years – the number of years you’re taking the loan, assumed to be 30 years.

Interest rate – assumed to be at the current rate of 4.5% and constant throughout loan years. The constancy assumption is okay as it is assumed that over the long run if interest rate moves, alternative investment returns and rentals would also move with it.

Furnishing and renovation costs – assumed to be 5% of property value.

Property returns – assumed at a long-term rate of 6% with maintenance cost taking away 0.5% p.a. resulting in a net long-term property return of 5.5%. In fact, if you look at housing data, long-term property returns are lower with only the past 10 years performing amazingly.

Alternative investment returns – refers ordinary non-property investment of stock and bond growth portfolio returns of 8%. This is conservative because dividend yields are in the region of 2%. However, some conservatism is adopted as many market observers say future returns may come down. At the end of the day, it still doesn’t change the relationship that at any level of market returns, overall growth risk and returns are going to be higher than property as an asset class.

Rental inflation – assumed to be 50% slower than property returns after signing the initial tenancy.

Total cash outlay = Downpayment + Legal costs + Furninshing & renovation. Invested at alt-investment returns over the notional loan years.

Rental yields = Annual rental / Property value at buy vs rent point.

Future values – of an investment refers to compounded returns over the loan duration. The renter can invest the cash outlay plus the difference between rent and the notional loan repayment.

Future value of rental – the renter’s regular investible sum must deduct monthly rental payments. The growing annuity formula is used to estimate the sum total rentals paid up to the final loan year compounded at the rental inflation rate. This is deducted from the future value of the investment.

Renter’s “gain/loss” – the difference between the renter’s accumulated asset value and the owner’s future property value. The quotes reflect that this difference is only academic since the renter isn’t necessarily in dire straits and has the flexibility for options.

Monthly rental at the end of loan years – what rental looks like after being compounded at the rental inflation rate in the final year of the notional loan duration.

FV in equivalent rental years – how many more years of rental the renter’s accumulated investment can support. Generally speaking, these numbers are conservative because the renter can continue to invest unspent amounts and keep rents down to make the money last.

You can play around with the assumption here

From the tables, 10 things you should consider before you buy/rent a property

1.Initial cash outlay is not little

Don’t think that the downpayment is the only serious money you have to cough out. There’s also legal fees and renovation costs. I haven’t put in agency fees as I think the seller pays for that. I’m not totally sure. Initial costs apart from downpayment could be as much as 5% of the property value. Such costs not spent can obviously be invested.

2. You can also invest the difference between the rent and the instalment

Generally speaking, rents are going to be cheaper than mortgage repayments. This difference is valuable investment juice for the renter.

3. A renter’s investment has many advantages over an owner’s home investment

The renter’s investment will be more diversified compared to the homeowner who puts almost all their eggs into one basket. The renter is also able to choose a higher risk and returns portfolio compared to the moderate risk and return of real estate. But renters are susceptible to behavioural drags of forgetting to invest or for letting emotions get in the way of investing whereas owners are forced to pay the mortgage to avoid losing the home altogether.

4. You should check out the rent of the home you want to buy

Property platforms will show you that rental yields are between 1.5% and 4.5% so it means that you can sniff out some really good rental deals out there. The lower the yield and the further down it is from the loan interest rate, the better to rent. It seems that anything below 2.5% yield at current interest rates raises the chances of a renter’s gain.

5. Feels like rentals rise slower than property returns

Rentals seem to be very sticky. Having been both landlord and tenant myself, this seems to be the experience. Landlords seem to be nice guys, raising rents only every few years. Or maybe there are too many empty homes. Slow rising rents give renters more saving money and nudge them ahead of owners in the investing race. This really depends on the business cycle or location. Either way, be nice back to your landlord and pay on time.

6. Renting gives you flexibility

Renters can upgrade/downgrade. They can rightsize needs. They can have the mobility to live closer to workplaces. These things aren’t so easy for owners to achieve. To avoid living beyond their means, renters have to just follow a rule of thumb of only renting homes they can afford buying,

7. Ownership comes with maintenance

Owners have to spend money to fix the roof and leaking pipes, replace furniture and paint etc which aren’t on the renter’s tab, nudging up further renters’ investable cash. Condo maintenance is possibly higher than landed property, at the latest check averaging around 30 sen psf, higher for more luxurious dwellings. I’ve assumed maintenance to take a 0.5% p.a. bite out of long-term property returns.

8. Renters accumulated assets create a forever housing support fund

Renters’ accumulated investments are in a position to support housing needs for almost forever or at least for the duration of retirement. In the examples given, the fund is equivalent to many decades, in some instances centuries, of the prevailing rental. This suggests that the renter-investor has replicated the buyers’ position of securing housing for forever. This is more so if rent is rising at a slower speed than investment returns.

9. Renters could still buy property at any future point

Generally speaking, a growth portfolio can accumulate faster than property investments which allow renters to keep the buying door open. Again this really neutralises the buying advantage. Even if a more conservative investment was chosen, a renter would have enough time to save for a downpayment AND pay the instalments at that point.

10. Easier to fund retirement and other aspirations with renting

What’s an investment if not to consume or distribute it. If you have a forever housing support fund, you’re very much in a position to liquidate investments piecemeal and consume or use. A property owner can’t do this easily. They can’t sell a brick at a time. There are ways to allow owners to raise funds like renting or securing the property to borrow but it is generally a lot easier for renters rather than owners.

In conclusion, if you really need to own, it may not be a bad idea to buy rather than rent at the bottom of the business cycle. Or buy where your dream home has high rental yields. But clearly, from a purely financial viewpoint, buying is not always the immediate answer.

Given this background, the recent budget proposal to use P2P crowdfunding to promote homeownership is interesting. Details are currently scant but it rightly focuses on reducing the buyer’s cash outlay but it will invariably lead back to rental payments for the crowdfunders. If that is the case, policy should perhaps move away from own-at-all-cost to rent-and-invest. Policy should certainly crystalise financial planning principles and financial literacy. Perhaps a rental crowdfunding social enterprise may be ripe for consideration.


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