So, you don’t want to pay off someone else’s bond, right? Intuitively this thinking makes sense and it has been the reason for many people wanting to own a property. However, rental expense never goes away, even if you stay in the house you bought. “How can this be?”, you might ask. You first need to understand the two drivers of return when you invest in a property: (1) Capital return captures the price increase that you can expect over time; and (2) net rental income captures the rental income after deducting relevant expenses.
Luckily there are more than 100 years of data on property prices that can be examined to get an idea of capital returns. If you look at countries like South Africa, the UK, Germany, Spain, France and the US there is a strong correlation between the average price increases for property over the long term and the long-term average inflation rate of that country. In other words, if South Africa’s inflation averaged ±6% over ±100 years, then the average price increase for property was ±6%. If the long- term inflation rate in the US is ±2%, then the average price increase for property in the US is ±2%. What this means is that if you buy a property at fair value (in other words not for a bargain, and not overpaying) you can expect to get a long-term average price increase that matches inflation. Yes, asset classes do go through periods of booms and busts, but we are looking at the average return.
Net rental income is the income you can expect after deducting items such as maintenance, loss of income (due to vacancies or bad debt), levies (including taxes), and the marginal tax rate on income before tax.
Now that we understand the two drivers of return a little bit better, let’s revisit the concept of “rental expense never goes away”. Let’s assume you have the choice of either buying a house or renting that same house. If you decide to rent the house, you will be paying rent. If you decide to buy that house, you will be staying in it and forego rental income. You will not receive any rental income but you will still pay the levies, maintenance, etc. Hence, rental expenses never really go away. The driver of return, however, is capital growth after deducting relevant expenses.
Now that we have established that rent will always be an expense, we are getting closer to understanding when it is better to rent and when we should rather buy. Let’s assume that you are considering buying property by taking out a 20- year bond. This means that if you rent that same property, you have the opportunity to invest the difference between the theoretical bond payment and the rental expense. If the property is trading at fair value, the alternative investment (should you decide to rent) must provide a return above the inflation-like capital return that you can expect on average (should you buy the property and stay in it). You might say, well in that case, there are many other investments that will at the very least match inflation and have a lower risk, e.g. money market accounts. It is not that straight forward, however. It depends on market conditions. If you are able to buy a property below fair value, the capital return over time should (all other things being equal) beat inflation and perhaps provide a very attractive return. On the other hand, if you overpay for the property, the return could be dire.
It might therefore be useful to look at a back-of-the-envelope calculation to get a better idea of fair value (FV):
- Assume an alternative investment provides a return of ± 10% per year.
- Assume long-term inflation of ±6% in South Africa is similar in Namibia.
- The simple formula of total return (% per year) = capital appreciation (% per year) + net rental income (% per year), then becomes: 10% = 6% + net rental income, which means net rental income = 4%.
- Net rental income per year can be calculated fairly accurately, but make sure you use the average throughout the economic cycle’s figures (good, bad and average times). Let’s assume the figure is N$40k p.a.
- Then, 4% = net rental income (N$40k p.a.) divided by FV, in other words FV = N$40k p.a. divided by 4% = N$1M.
The moment you pay more than N$1M in the above calculation, you would overpay for the property, compared to what the alternative investment can offer and vice versa.
It should be noted that if you break even with the alternative investment, you must still compare things like diversification, etc. between the two investments to correctly manage the risk.
There are other intangible benefits to rather buying a property, such as being able to change the place to your liking and not being uncertain about how long you can stay in a place.
Last, but not least, you can do all the calculations and the answer might indicate that it is better to rent, but if you don’t have the discipline to save (compared to the discipline of a bond payment debit order), you might be better off buying.Net rental income (% per year) = net rental income figures per year divided by fair value.