The Future of House Prices

It is also remarkable how different areas of the UK experienced quite different growth and decline pictures, each with their own local reasons.  See the “House Values” spreadsheet for a regional history.  But a home is so fundamental to life that it is likely to remain everyone’s desire for the foreseeable future.  One might conceive of different community lifestyles in years to come, but basically everyone needs their own independent space.  The need for homes should ensure that their market value would match what people can afford.  At least, that is the theory, which has operated in practise for the last 500 years of record keeping.

As our standard of living improves, our capacity to buy a decent house rises also. Houses are not wasting assets like cars. They last a long time if they are well built. Property prices tend to increase in line with what we can afford to buy – this is basic supply and demand economics. While the price of new goods like cars and TVs moves with price inflation, new and “second-hand” houses tend to move with wage inflation. In an economically growing society, wage inflation outstrips price inflation by the economy’s growth rate. Therefore property prices should rise by more than inflation in the long term, and indeed has done so in the past.

So, assuming that property prices are likely to rise over the long term with perhaps occasional dips, but probably not as dramatic as those in 1990, let us compare the cost of renting with the cost of buying over a period of say seven years. The average life of a mortgage is five to seven years, which reflects people’s need to either move to another job area, or simply to move up the price range to match their improving income and prospects. Mortgages seldom last throughout the initial full term, typically 25 years. On the other hand, tenancies tend to be very much shorter.

The cost of buying compared with renting?
We can compare the overall costs of the two methods and then graph our findings. I have made the following assumptions: -

Initial house value:                     £80,000 whether bought or rented.

Increase in house value:             4% per annum on average.

House bought with a 100% mortgage

Mortgage interest rate:              6.25% pa on average over ten years.

Maintenance costs:                    2% of initial house value, rising by 2.5% pa

Buying & selling costs:                2% of value on purchase, 3% on sale.

House rented unfurnished                               

Rent:                                       6% pa of current property value (rising)

Maintenance:                            0.5% of house value, rising by 2.5% pa

Suppose you live in the house for a period of years and then sell it, if you own it, or simply move out if you rent it.  Then add up the total cumulative costs of each method.  Whichever is the lower is the cheapest method overall.  If you subtract the total cost of owning from the total cost of renting and the answer is negative, then renting is cheaper.

The graph in Figure 15 illustrates this difference assuming you stay in the house for the time period indicated and taking into account any profit (after fees) of selling the house.  A negative difference (i.e. below the x-axis) indicates that renting is cheaper.

Using the given assumptions, renting is obviously cheaper for around two and a bit years.  So if you intend to move in under two years, it may be better to rent rather than buy, particularly since the expenses of buying and selling are quite heavy.

But the break-even point depends on the initial assumptions.  The rent assumption of 6% of value is considered low in some areas.  An older property might require more maintenance.  Your particular house may rise in value by more or less than 4% per annum. If the assumption of house price growth is reduced from 4% to 3% per annum, the breakeven point extends from two-and-a-bit years to about three-and-a-half years.

Even a 3% per annum increase in house prices might turn out to be optimistic.  Also, inflation is assumed at 2.5% pa - who knows what it might be in future?  The final outcome of just where this break-even point occurs depends entirely on the input.  The “Buy or Rent” spreadsheet included allows you to enter all your own assumptions, so you can see your own personalised graphical comparison and break-even point.  But remember the old maxim about computers: rubbish in - rubbish out!

I have assumed a 100% mortgage (that means no deposit) in the example, for the sake of simplicity.  If, in practise, you assume a deposit of say £10,000 and a lower mortgage of £70,000, you must also accept that the tenant has the same deposit and would invest it to offset any costs.  The effect is not great, but it is relevant if the return on the deposit differs from the return on the house. 

Rents staircase – mortgage payments are flat.
Despite being able to personalise your buy/rent assumptions, you can still come to some general conclusions.  The most important principle is that rents are fundamentally linked to the property value, and both are expected to increase over the years.  Rents may not increase gradually.  Sometimes they can be fixed for a year or two and then jump up – sometimes areas can go bad and property values and rents go down, but that is more the exception than the norm.  On average, rent is still related to the value of the landlord’s asset and increases over a period like a staircase. 

Conversely, a mortgage payment is based on a fixed initial debt that cannot be altered and does not increase over time, assuming you keep up the repayments.  The payments themselves may vary, but the debt is fixed at the outset.  The interest rate might move up or down in line with the economic situation in general, but the interest payments move in a generally level direction:  rents move upwards and are ultimately related to house prices.

Inflation cheapens debt
Not only is a mortgage a fixed pound-note debt until it is repaid, but inflation actually cheapens it over time.  You effectively borrow expensive pounds but you pay back with cheaper pounds in the future.  The interest rate may fluctuate, but the mortgage payment burden in real terms is likely to reduce with inflation.  Rent on the other hand is likely to increase with inflation since it rises with house values, which rise by more than inflation.

If you measure the overall rental payments made by tenants over say a 25 year period, and compare them with the overall mortgage payments someone might have paid if they had owned the same house, you will find that the average tenant has paid out more money overall, even Council house tenants.  Moreover, although the tenant may start out with a lower month-by-month payment than an equivalent mortgage payer, after a period, increasing rents will overtake the mortgage payments.  In short, a tenant will eventually end up paying more month-by-month and more overall.

The long-term tenant is the ultimate loser
In 25 years time the tenant has nothing to show for his larger outflow, whereas the owner has a house, and after 25 years, the mortgage could well be at an end with the house unencumbered.  Even if the house has not increased in value at all, it is at least worth something, and you thereafter live in it for free.  But the tenant owns nothing, yet has laid out more money.

Furthermore, while the homeowner's mortgage repayments stopped after 25 years, the tenant must continue to pay rent forever - and it will still continue to increase over time. The property owners may be dead by the time they enjoy the final proceeds of the sale of the property, but far better to have the choice to leave some legacy than leave nothing at all, even if it just keeps a cat happy.  Besides, many people would consider moving down to a smaller home when they retire and use any surplus equity gained on their earlier homes to put into income-producing investments.

So in the long term, common sense tells you that buying is better than renting unless you intend to move about a lot.  But even then, it pays to buy a house and rent it to someone else:  we talk about buy-to-let later on.

Technical Note
In strictness, for readers of Part I, who now understand the vital concept of the Internal rate of Return, the graph in Figure 15, showing overall buying costs and rental costs, should illustrate the IRR or the NPV since when comparing cash flows, it is timing that is important.  This is quite true, but over the periods in question, the difference between NPV and cumulative costs are similar.  Calculating the NPV would have introduced an unnecessary level of complication, when all we want is an approximate break-even point.  The assumptions themselves can actually be more wide ranging than the need for absolute accuracy and purity in the calculation methodology.  So I am simply being a pragmatic engineer rather than a dogmatic mathematician.