Rent or Buy? Some Mathematical Principles Might Come in Handy

Penang’s love affair with property seems to know no end.

There is perhaps no question more vexing for young Penangites today than the decision whether to buy or rent a home.

Of course, for many, there is no choice at all. Lacking the substantial deposit required to enter the property market, they live in with their parents by default because their salaries are insufficient to afford rental payments of even a low-medium cost apartment. They can perhaps only rent a bedroom. But for many, the logic of home-ownership is unquestionable. Rent money is dead money. Why pay off someone else's mortgage? Property prices always go up.

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But this one-eyed view of property ownership overlooks some of the substantial costs involved. There's stamp duty, conveyancing, maintenance, local council charges, water bills and more to consider. Plus the hundreds of thousands of dollars in interest payments.

It is almost impossible to know exactly, in advance, what those relative costs and returns will be. With the benefit of hindsight, however, it is possible to look back and see what the returns to renting and buying have been in the past.

Renting is often derided as an inferior choice with slogans such as 'rent money is dead money' and 'stop paying off someone else's mortgage'. However, it is not clear whether owning a home is superior to renting from a financial point of view. If a prospective buyer decides to rent, rather than buy, she could invest the difference in ongoing costs into other assets.

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So, Which is it for Penang: Buy or Rent?

Scenario One

A first home buyer puts down a 10 per cent deposit on a median-priced, free-standing and established home. For reasons of simplicity, they are assumed to take out an interest-only loan and make no additional repayments. Whether home-ownership encourages additional savings over renting is, therefore, not considered. At the end of the 10 years, they sell and realise a capital gain from which the upfront and ongoing costs (including interest) of property ownership are deducted. The value of the future net gain is expressed in today's dollars.

Scenario Two

A person continues to rent and instead invests the deposit amount into a mix of shares and term deposits. The tenant pays rent for 10 years on similar properties to the purchased property. While the purchaser is assumed to stay put for the decade, the tenant is assumed to move three times, incurring moving costs and a month of paying double rent each time. Dividends from shares are reinvested, but no additional savingsare made – on par with the property purchaser making no extra repayments. At the end of the decade, the tenant’s investments are sold and capital gains tax applied. The value of the tenant’s net gain is also expressed in today's dollars.

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For those who have done your cost comparison between buying and selling and still are not able to come to a final decision, here are some common approaches and factors that might help you make that all-important decision.

Here are some mathematical principles, as well as other less empirical methods, of determining if now would be a good time to rent or buy.

Conventional mathematical approach: Price-to-Rent Ratio

Say the average list price of the property is MYR 1,000,000 and rental is MYR 45,000 every year.

The Price-to-Rent Ratio would be 1,000,000 ÷ 45,000 = 22.22.

Interpreted roughly, this means that if you rented this house for 22 years, you would be able to own it by the end of that time.

To use this method to determine if buying or renting is a more attractive proposition, you can consider two guides:

1. According to online real estate website www.trulia.com,

Price-to-Rent ratios that are 15 and under indicate buying as being “less expensive” than renting, whilst Price-to-Rent ratios that are 20 and above indicate renting as “less expensive” than buying. Hence, for a property with a Price-to-Rent Ratio of 22, renting is seen as a more attractive proposition than buying.

2. According to www.numbeo.com, a website conceived to calculate global cost of living,

Malaysia’s Price-to-Rent Ratios are 16.41 (within city centre) and 24.01 (outside city centre) respectively. For a property outside the city centre such as Tanjung Tokong in Penang island, with a Price-to-Rent Ratio of 22.22, you’re under the national outside city centre Price-to-Rent Ratio of 24.01, which makes buying more attractive.

Because there isn’t any globally-recognised “golden formula” in using price-to-rent ratios, you could refer to Trulia’s holistic approach, or use Numbeo’s statistics as a guideline. But generally, it is commonly agreed that it would be better to buy if your Price-to-Rent Ratio is lower, and to rent if it is higher.

However, in view that price-to-rent ratios do not factor in other considerations such as the cost of buying and renting, the time you intend to stay in a property, and of course, your personal preference; it is mostly used as a generic guide and not as the key deciding factor.

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The Time Factor

You may not think so, but time is a factor when deciding between renting and buying, and an important one at that.

Generally, if you plan to stay in a place for just a few short years, buying it may not be a good idea because of the following factors:

1. Every time you buy or sell a property, you’ll incur transactional costs in the forms of legal fees and other related charges. The amount can easily go into five figures.
2. If you sell within five years in Malaysia, you’ll need to pay Real Property Gain Tax (RPGT).
3. You will probably have to spend a sizeable amount for renovations when you first move in.
4. You will have to service substantial amount of interest for your home loan.

All the above can erode whatever earnings you would make from the appreciation in value of your property if you decide to sell it too early.

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You could, of course, opt to rent it out and hope that the rental suffices in paying off your monthly loan instalment. But this involves risk on your part. If you can’t manage to rent the house out or can only rent it out at 50% of your monthly loan instalment, you’ll need to service the rest of your loan commitment out of your own pocket. This could severely affect your lifestyle or hinder your chances of buying another property.

As a general rule of thumb, it is highly recommended that you stay in a home long enough to allow appreciation in property value to overcome the transactional costs. This can be up to five years or more, or much shorter in times of a property boom. But if you’re not so sure about your long-term living arrangement and you’re not financially stable enough to be able to service the monthly repayment, renting might be the safer option for now.

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The Personal Preference Factor

All the “non-emotional” elements (such as affordability and time) aside, it’s a good idea to put your personal preference into the equation when it comes to the battle between renting and buying.

Some people thrive on changes and like the idea of moving to a new environment every year or so. For some, it may not even be a matter of personal preference but a matter of being in a highly mobile job. If you fall under this demographic, renting could be the preferred housing solution compared to buying.

Then there are those at the exact opposite end of the spectrum – people who enjoy living a structured lifestyle, or have fallen in love with a specific location knowing for certain they’d never leave again (at least not in the short term). In this case, buying a home certainly makes a lot more sense than renting.

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Additionally, some people need to enjoy the freedom of changing wall colours every season, hanging paintings wherever they fancy and building DIY contraptions in every corner of the house – which you can do only if you own the place. But for those who rent, they enjoy freedom of another kind – the freedom of not being tied down, of being able to move if they don’t like the place as soon as the rental agreement expires.

Seasoned property investors may argue that even if you don’t live in it, a home is going earn you rental and appreciate in value over time – which makes buying not just the preferred choice, but the only logical choice, when it comes to a home. But not all investors are built the same: there will always be those who would much rather put their money in higher-risk assets (such as stocks) or lower risk assets (such as cash) instead of a home. This, of course, still boils down to personal preference.

Unlike calculations and costs, personal preference is intangible. It is what makes people do what they do whilst others might do otherwise. Say your mind is screaming “rent” when the logical choice is to “buy”, it might be worth your while to listen to that inner voice. Because if you end up hating the place after living in it for one year, you may find that selling it and earning your capital back may not be so easy.

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So, what can we learn?

First, timing is critical. Prices can fall or stagnate and it is sometimes better to rent. However, undeniably, buying has proved the superior strategy in more years than renting.

Second, the returns to property ownership are higher if you don't move as often, avoiding the costs of moving.

Third, if you do rent, the returns to share investing have been superior to other forms of saving.

Advice for would-be first-home buyers

Prospective first home buyers should endeavour to forecast house price appreciation in the future when making their buy versus rent decision.

When it comes to investing, all you need is a time machine, or at least a crystal ball.

Whether you are buying, selling, or just plain interested in real estate,
connect with Penang Property Angel today for professional assistance.