December 18, 2017

Buy or Rent? It is not all about the capital gains

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A home functions both as a shelter and an investment. Capital gains are commonly perceived by households as the main source of value when buying as opposed to renting, but I would like to shed some light on other intrinsic value drivers.

The appreciation in house prices can be considered as an external source of value and depends on the overall economic conditions, rates of inflation, and demand and supply in the housing market. Home purchase via a mortgage creates an intrinsic value through building up equity and hedging against the increase in rents.

When the mortgage is fully repaid the household owns 100 per cent of the house and enjoys a period of almost free housing. The intrinsic value depends on the length of the holding period, interest rates, and increase in market rents. The following is a detailed illustration of how two intrinsic value drivers create wealth from buying via a mortgage.

  • Building up equity out of mortgage repayments. The mortgage holder (buyer) can be considered as the holder of a series of call options who has the right to buy additional stakes in the house subject to making the required mortgage repayments. The housing equity at inception is determined by the buyer’s down payment ratio dictated by the mortgage lender. It rises with every mortgage repayment until the mortgage is fully repaid. In Figure 1, I calculated the annual increase in housing equity over the mortgage life for a first-time buyer (FTB) who purchased in Scotland in 1975 with a 25-years variable-rate mortgage loan that matured in 2000 (using historical loan to value ratio (LTV) ratio and mortgage interest rates). The housing equity increased from 23.2 per cent in 1976 to 43.2 per cent in 1990, a 20 per cent increase over 14 years. These 14 years witnessed exceptionally high interest rates that stood between 10 per cent and almost 15 per cent. The interest rate at the outset was 10.5 per cent while actual yield to maturity (IRR) on the entire mortgage loan stood at 11.3 per cent (as at year ending 2000).

    Figure 1: FTB purchased in Scotland in 1975

However, the pace of building up equity over the mortgage life depends on the interest rate. A lower interest rate, other things being equal, accelerates building up equity while a higher interest rate, other things being equal, slows down the accumulated housing equity.

Figure 2 illustrates the impact of interest rate on housing equity by showing how the FTB who purchased in Scotland in 1994 was able to increase the housing equity by 35 per cent over 14 years (from 16 per cent in 1995 to 51 per cent in 2009) as compared with 20 per cent made by the FTB who purchased in 1975).

The FTB who bought in 1995 enjoyed a period of declining interest rate starting at 7.4 per cent in 1995 and declining to 3.6 per cent in 2010 with an estimated yield on the mortgage of just 6 per cent. In monetary terms, the 15 per cent equity differential is equal to £3,892 for the earlier FTB (based on a house price of £23,950 in 1990) and £18,896 for the later FTB (based on a house price of £123,975 in 2009).

Figure 2: FTB purchased in Scotland in 1994

  • Lower housing costs over time. If the cost of renting exceeds the mortgage repayment, the owner’s net savings will be positive (ignoring other costs of buying) and this translates into cash surplus for homeowners. Moreover, when the mortgage is fully repaid the owner enjoys a period of almost no housing costs and saves the entire market rent of his house. To illustrate the above and to show how much you can save by buying, I compared the mortgage repayments of a FTB who purchased in London in 1975 with the cost of renting a similar house. Figure 3 shows that from 1975 to 1983 the mortgage repayments exceeded the market rent of a similar house which means that more equity was being injected into the house by the owner. However, from the late 1980s the market rent dramatically increased while the mortgage repayment remained almost flat. The area between the dotted line (mortgage repayments) and solid line (market rents) after 1982 represents the mounting savings that the buyer achieved over the holding period. In 2011, the buyer saved almost £16,000 compared to the tenant of a similar house.
    Figure 3: Mortgage repayments versus rent in for FTB in London (1975–2011)

Tenure choice is one of the biggest decisions to be made by households and therefore must not be focused on only one factor. It is worth mentioning that buying has other indirect financial benefits such as using the house as collateral to raise a greater and cheaper debt and passing on the housing wealth to a spouse or the next generation.

There are, however, risks associated with buying a house. One of the main risks is the market risk or the risk that the house price falls after buying. In the medium to long term, the above explained two intrinsic value drivers work to mitigate the market risk. This may help those households that are considering to buy but are worried about the future trend in house prices.

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Dr Abdulkader Mostafa, Assistant Professor About Dr Abdulkader Mostafa, Assistant Professor

Dr Abdulkader Mostafa, Assistant Professor, teaches the on-campus Finance courses and a member of the Doctorate Review Committee.