The opportunity cost of home ownership

Welcome to Finance and Fury, The Say What Wednesday Edition – Where every week we answer your questions

Today’s question is from James

Hi Louis, Just a question regarding owning your home. Me and my partner would like to eventually own our own home but we are worried about such a large sum of our overall wealth going into a single asset – our future house. How would you correctly diversify your assets in this scenario, were there any strategies to doing this? Especially with house prices at the moment, it really seems like all your eggs will be in one basket – and for a while.

What I’ve seemed to gather is that owning your own house is more a lifestyle asset and a liability. All I seem to hear is nothing but expenses / fees / costs, a low amount of capital growth all for a relatively high amount of risk. Was this true?

Thanks James – and Awesome points

In this episode – we will tackle this using the economic problem and opportunity costs –

1. The economic problem – that we all have limited resources of savings and cash flow – and need to make this work towards achieving our goals
2. Opportunity costs of doing so – what is the next best thing that we could be doing with our financial resources?-
   1. I.e. putting your deposit towards long term investments or your cashflow going towards the repayment of a mortgage against doing monthly investments

First – What is a home?

– a lifestyle asset – is still technically an asset as it has a value – as long as someone else is willing to buy it off you

1. I personally have never really seen a home as a financial asset – because as James pointed out it technically losses you cashflow when it has a mortgage – and even when it doesn’t from a mortgage, if this has been repaid – with rates, body corporate, ongoing maintenance costs for upkeep on the property
   1. Classification – Can you live off it? Anything that doesn’t make you a passive income but instead loses you cash flow can’t be used for financial independence
   2. Technically – a negatively geared investment property can set you back in FI
2. This being said – renting also costs cashflow
3. That is where the decision does come back to lifestyle and the fact that everyone needs somewhere to live. Everyone needs somewhere to live –
4. Property ownership is expensive – a mortgage is normally the biggest expense –
   1. PI loans eat a lot of cash flow – but the P component can be treated as forced savings that you can’t use
      1. But does decrease your I payments over the long term
   2. Sinking deposits of $100k plus into a lifestyle asset – while it may continue to grow in value long term, you can use this to generate a passive income unless you rent a room out – but then Gov will make you pay CGT on your own home if you ever sell
      1. Opportunity cost of this is using the lump sum to invest instead and cover your rent

Property Capital Growth –

1. I’ve covered this in a few previous episodes (are we in a property bubble and many others) – but Australian property from the mid 1990s has had a meteoric rise
2. Created a situation where people love property out of the expectation of buying and experiencing the same meteoric growth rates –
   3. Pre-1990s wasn’t the case – property grew with wages at around 3.5% p.a. from 1890 to 1990 –
   4. What changed? Banking regulations and the amount people could borrow thanks to declining interest rates
3. But anyone looking to buy property at this stage and get the same price gains should keep in mind that it is reliant on credit growth from borrowings – so if people can afford to keep increasing the size of a mortgage from say $700,000 to $5.4m in 30 years – we won’t get the same price gains –
   1. Looking back on the average mortgage growth over the past 30 years – that is what it has been – from $90-100k to $700k in most of Aus – worse in areas of Sydney/Melb – wage growth at record low rates would only be able to cover $1.9m – so I don’t think so – but may be wrong
4. I personally sold off my last property in 2017 – was lucky timing as the market was at the peak in the area I sold –
   1. Used the funds to invest and build a further passive income – passive income from investments could already cover my rent – so this went into reinvestment

Question of Renting vs Buying

– look at the option of what is the interest cost, rates, BC is applicable, and spending on upkeep versus rental price

1. Rent V Buy – in Aus with the price of property – I prefer renting if it is an apartment in the city – or house in the surrounding suburbs – why?
   1. Example – Apartment I am in at the moment is worth about $650k-$700k – pay just under $2k p.m. in rent –
   2. For same property at a 3.5% interest rate – would be paying $1,500 p.m. in interest at under 3.5% – assuming a 20% deposit of around $130k – but add on Body Corporate and rates – additional $5k p.a. ($420 p.m.) – total interest bill and minimum expenses are the same as the rent –
      1. But opportunity cost of the $130k tied up in the deposit – use this for an investment instead that provides a passive income
      2. Then add on the principal amount of $820 p.m. – at minimum – cashflow wise I am better off by around $1,362 per month – or $16,300 p.a. to direct towards investments
   3. This example doesn’t include the capital works or sinking funds requirement on the place either –
2. This all being said – this is a financial decision – But lifestyle considerations come into play – most people want to own their own place to live long term – avoids dealing with tenancy issues, dealing with real estate agents or the owners selling out of the blue
   1. Comes down to security and ability to make amendments to the property as you like – renovate or paint a wall
   2. Lifestyle isn’t financial though – it is what you want to achieve to suit what you want
      1. If apartment living is what you like – then buying apartments to live in long term can work
   3. Have to buy for now and the future –
      1. Property (even your own) is a long term thing – if you are planning on having kids/starting a family – and want to move to a bigger home in a few years but are buying now – may as well save more and buy a bigger home
      2. Why? Transaction costs – stamp duty, agents fees
      3. Example – Buying an $800,000 place in NSW – stamp duty of $31,777. When you sell it – agents fees of around $20k – so a minimum of around $50k to buy and sell – 6.5% of the value – No guarantees that prices will jump up that much in the time you might want to turn around

3. The risk – Shouldn’t view your own PPR as a speculative risk
   1. Speculative risk is that you lose money on it in the short term through volatility – you are buying for the long term
   2. Buying at $900k to see the valuations drop to $800k sucks – but as long as you don’t need to sell – what does it matter?
   3. The risk of owning a PPR is that it eats all of your cash flow up – through having too large a mortgage or interest rates rising – if this is the case and you have nothing left in cashflow to make additional repayments or to direct towards investments – that can be a risk
   4. Everyone needs somewhere to live – but once you retire you also need something to live off – super or investments –
   5. Worst case – Age pension which isn’t a guarantee

How would you correctly diversify your assets in this scenario, are there any strategies to doing this?

1. The option is using your own property as an investment vehicle –
2. Not advice but a strategy – Create a separate loan facility as an investment loan – and push all your cash/savings into this –
   1. Then draw the months worth of savings that you would have invested anyway to invest – debt recycling
   2. Not for everyone – and now not a great time to do it due to markets being at all-time highs
3. The economic problem of cash flow – This is limited in most situations – as disposable incomes are the restricting factor
   1. Mortgage repayments versus investing the funds
   2. PI repayments – Interest component is covering the costs of interest – the principal is repaying the loan – and is what saves you interest long term – but at the moment rates are low – not expected to go anywhere for a little while – say you could make P repayments over 5 years and
4. Opportunity cost factors (such as paying down debt versus investing) and also diversification factors
   1. Own home shouldn’t be treated as an asset – centrelink doesn’t as you don’t live off it but live in it

The Question – Doing what is right for you long term

1. Me personally – wouldn’t buy an apartment – BC costs and no land to property price ratio –
2. For me land is what is important – now building a new deposit to buy a few hectares of land around 30-40mins from the city – as for me having access to own food that can be grown and fresh water has been my plan for over a year now

Summary 

1. DO the numbers –
2. Look at your cash flow – and opportunity cost 
3. But also – your lifestyle considerations come into play

Thanks for the question James

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