Part 1
There are many reasons for deciding for or against a property for owner-occupation. Owning your own property is often also a question of your preferred lifestyle. However, this series of articles is all about the financial aspect of the decision. You will learn how to make a financially sensible renting or buying decision in your individual situation and how to calculate it yourself. This first part is all about the basics. It shows you everything you need to consider when making your decision:
- The alternative investment to owning a home (spoiler: you're on GetQuin and should know it)
- Which costs are incurred when buying a property or renting and are relevant for a comparison
- Which parameters and variables need to be taken into account and, if necessary, estimated
- How reasonable assumptions can be made for these parameters and variables
- How to calculate the assets of the buyer, the tenant and the difference between them
- What should be taken into account when comparing the assets generated
In the 2nd part ( https://app.getquin.com/activity/evjQvBldso ) I will illustrate what I have learned with a real example. This part will help you to apply the considerations from Part 1 correctly in practice for your individual buy or rent decision:
- Detailed calculation of a real-life example
- Step-by-step adaptation of this example to make it gradually more realistic
As many parameters can only be estimated and the housing situation varies greatly from region to region, we will take a look at these aspects in the 3rd and final part of this series ( https://app.getquin.com/activity/GEBmMewkKS ):
- Effects of changed parameters on the result
- Sketching realistic scenarios that tilt the example from part 2 in the other direction
- Calculating further examples, which are welcome to come from the community
- Conclusion
Renting vs. buying - the basic idea
You often hear arguments such as "Everyone pays off a house in the course of their life - either their own or their landlord's" or "Buying is always worthwhile, I then pay the rent into my own pocket and live rent-free for the rest of my life once the financing is complete". At first, of course, this sounds logical. But it's worth taking a second look. Financing a property for owner-occupation usually requires a high level of equity, which cannot be invested on the capital markets, as well as a loan, the repayment of which incurs considerable interest. In addition, property owners have to reckon with costs for modernization and maintenance, which a landlord is not allowed to pass on to the tenant. The tenant therefore has a high starting capital compared to the owner, which generates a corresponding return and does not have to be used to avoid debt. In addition, the monthly rent is often - at least in the first few years of financing - lower than the amount that a buyer has to pay for repayments, interest and maintenance. This difference can also be invested profitably on the capital markets. Is this advantage sufficient for the tenant to build up assets that will later cover the monthly rent and perhaps even more? We take a look at this in this series of articles.
Costs, parameters and variables
For the tenant the following expenses must primarily be taken into account:
- basic rent
- Deposit (this cannot be used to generate capital income)
- If renting an apartment in an apartment building, additional operating costs such as elevator maintenance may be incurred
- Moving costs, if applicable
The tenant also depends on the following variables to be estimated:
- Yield on the capital market
- Development of the rent
A buyer has to reckon with these costs:
- Opportunity costs for the equity
- Purchase costs of the property
- Incidental purchase costs (land transfer tax, notary fees, land register entry, estate agent's commission)
- surveyor
- Interest on a loan
- Additional operating costs, if applicable, if an apartment is purchased in an apartment building. For example, costs for property management or elevator maintenance.
The buyer must also estimate these variables:
- Maintenance costs (carrying out necessary repairs, e.g. new roof to maintain the value of the property)
- Modernization costs (e.g. retrofitting the heating system or converting the attic to increase the value of the property)
- Conditions for follow-up financing
If the property is sold over the years, sales costs may still be incurred:
- Small items such as an energy certificate, extract from the land register, ...
- Costs for valuation
- estate agent's commission
- Cancellation of the land charge
- Early repayment fee if an existing loan is canceled
- Removal costs
If a sale is planned, the value of the purchased property must of course also be estimated.
For both tenants and buyers are relevant
- Inflation
- Legal changes, e.g. with regard to taxation
However, the latter in particular cannot really be estimated and are therefore ignored in this article.
What about costs such as waste disposal charges or insurance?
Costs that are passed on to the tenant by the landlord via the ancillary costs (e.g. garbage charges, insurance, property tax, heating costs, etc.) or costs that the tenant bears directly in most cases anyway (e.g. electricity and internet costs) are irrelevant. These are incurred when using a property yourself or are passed on to the tenant by the landlord, which is why they can be ignored.
Are there any other financial aspects?
Yes, but these are very individual, difficult to quantify and are therefore not taken into account in the calculations. However, they can be relevant in individual cases. These include the following
- Buyers often afford more living space than tenants. In this case, not only should the purchase and rental costs of two identical properties be compared, but also the purchase costs of a slightly larger property with the rental costs of a slightly smaller property.
- Buyers often invest in higher quality and therefore more expensive fixtures and fittings than tenants.
- Buyers often accept a longer commute to work, which results in higher transportation costs.
- Consequential costs of insurance claims that are not covered. For example, accommodation costs in the event of water damage.
- Relocation is not so easy for a buyer, which is why lucrative job offers that are not accessible from their own property may not be taken up.
- Depending on the buyer's manual skills, repair costs can be low or high - depending on how much the buyer can do themselves.
- Financial contributions from the family, which are only made in the event of the purchase of a property, represent a possible advantage for buyers. For example, the granting of an interest-free loan or gifts of money.
- As a property buyer, you are subject to a positive compulsory savings contract. You have to pay the monthly installment to the bank. Even in the event of unplanned unemployment, illness or other increased costs / reduced income. If there is no longer enough money to go to the movies, then there is no longer enough money. If you save monthly in a world portfolio, you may be tempted to reduce the savings rate in such cases and go to the movies after all.
- ...
How can plausible values for the variables be determined?
Many values can be easily determined, e.g. the amount of the rent or the purchase price, the expected ancillary costs per federal state, credit conditions, ... However, some aspects are not yet known, which is why assumptions have to be made for them.
About the developments on the capital market there is valid historical data. Even if future performance may deviate from this, it still gives an indication of how much return could be achieved with capital market investments. If we take the MSCI World, [1] suggests that an increase in value of approx. 5 - 7% per year is realistic. In [2], the annual, inflation-adjusted (!) increase in value of a global equity portfolio is put at 5.2% over the last 120 years and 7.6% from 2010 to 2019. Of course, you can also simply select the index of your choice on the website of your choice and have the performance displayed there.
The development of rents and purchase and sale prices of real estate is unfortunately very difficult to substantiate with historical data. One of the reasons for this is that real estate is more subject to local conditions and, unlike shares in the MSCI World, you cannot simply live in the global average. To make matters worse, there is a lack of independent statistics going back more than a few years. Unfortunately, this is particularly dangerous. Due to the recency bias phenomenon, we attach more importance to events in the recent past than to events that happened longer ago. In other words, we instinctively assume that rents and real estate prices will continue to rise at the same rate due to the high increase in recent years. This is where the regression to the mean catches us off guard, as it states that value trends converge in the medium and long term. Years with above-average returns are therefore followed by years with below-average returns and vice versa. [2] assumes inflation-adjusted (!) annual increases in the value of real estate in Germany of 0.6% between 1970 and 2020 and 5.3% between 2011 and 2020. A few lean years could therefore follow, especially in an environment of rising interest rates.
Let's take a look at the rental prices 3] assumes increases of between 2.1% (first occupancy) and 2.7% (re-letting) per year over the last 31 years. Only new lettings are considered here. Existing rents generally rise far less sharply [2]. In [2], the inflation-adjusted (!) rent increases for new and existing rents in Germany from 1998 to 2018, excluding modernizations, are estimated at less than 0.3% per year. According to [4], inflation averaged 1.37% per year during this period.
Let's stay directly with the inflation. Here, too, it helps to look at the past, which according to [4] has been 2.5% for Germany over the last 62 years. If we only look at the last 20 years, we arrive at a value of around 1.5%. At the same time, the ECB's target of 2% inflation in the medium term should also be taken into account when determining a sensible value [5].
Let's move on to maintenance. Opinions differ on the amount. There is often talk of a flat rate per square meter, which - depending on the age of the property and who you ask - is between 0.60 and 1.50 euros per square meter per month. However, many practitioners criticize the much too tight calculation here and instead refer to Peters' formula. This is based on 1.5 times the production costs of the property within 80 years. Note that production costs are different from the purchase price of a property + land. Assuming that the production costs are 2,000 euros per square meter, this results in monthly maintenance costs of 2,000 euros * 1.5 / 80 / 12 = 3.125 euros per square meter. What seems unrealistic in both approaches is the constant value, which does not increase over time in line with inflation / the current value of the property. In [2], Gerd Kommer considers an annual reserve of 1.5% - 2.5% of the current value of the building section to be sensible. If the property is very old, in a poor structural condition, has high-quality fittings or is detached, the maintenance costs are more likely to be higher and closer to 2.5%. If we continue to assume production costs of 2,000 euros per square meter, Kommer believes that reserves for maintenance of between 2,000 euros * 0.015 / 12 = 2.50 euros and 2,000 euros * 0.025 / 12 = 4.17 euros per square meter and month are appropriate. These should be adjusted for inflation and expressly do not include the costs of modernizations.
The conditions of follow-up financing are unfortunately impossible to predict today. In principle, every buyer should work out how high the interest rates can rise at most so that the budget is still sufficient. If the personal risk of sharply rising interest rates is considered critical, you can buy lower interest rates by locking in interest rates for a long period. Alternatively, there is also the option of a building society savings contract as a hedge.
How can the two investments be compared?
The calculation of whether renting or buying is worthwhile is made in several steps/parts.
Buying a property:
- Full purchase costs of the property = purchase costs of the property + ancillary purchase costs + surveyor
- Amount of the loan = Full purchase cost of the property - equity
- Initial monthly interest = amount of the loan * interest rate / 12
- Initial monthly repayment = Amount of the loan * Repayment rate / 12
- Monthly installment = Initial monthly repayment + Initial monthly interest
The loan is reduced with each installment, which is why the absolute interest to be paid must be recalculated again and again and falls in absolute terms over time. As the monthly installment remains unchanged at the same time, the monthly repayment increases.
- Monthly repayment = monthly installment - remaining loan amount * interest rate / 12
- Remaining debt = Amount of the loan - Total repayment over the term of the loan
To calculate the remaining debt, I recommend using an appropriate calculator on the Internet such as https://www.zinsen-berechnen.de/kreditrechner.php or Excel. If follow-up financing is required to settle the remaining debt, we start again at "Amount of the loan", select the remaining debt and repeat the calculations from there.
- Monthly provisions = maintenance costs according to Peters' formula or Gerd Kommer (annual adjustment of the provision to the estimated inflation) + provisions for modernization
- Monthly charge = monthly installment + monthly provisions
As soon as the loan has been paid off in full and follow-up financing is no longer necessary, the monthly charge corresponds to the monthly provisions. In the event that you want to sell your property in the meantime, you must of course calculate the sales price.
- Selling price = purchase cost of property + change in value since purchase + increase in value due to modernization - selling costs (brokerage fee, deletion of land charge, relocation costs, prepayment penalty, etc.)
After a sale, you will have to buy another property for your own use or opt for a tenancy with a global portfolio.
Renting a property:
- Available starting capital = equity - deposit
- Monthly savings installment = Monthly buyer charge - basic rent
The available starting capital is paid into the global portfolio, as is the monthly savings rate - provided this is positive. If the basic rent exceeds the buyer's monthly charge over time, the corresponding amount must be withdrawn from the world portfolio instead.
- Monthly withdrawal = basic rent - monthly buyer charge + taxes payable on profit
The important thing here is to take the correct tax into account, which is currently 26.375% on capital gains in Germany, provided there is no church tax liability. This calculation can be carried out with a little effort in Excel and will be made clearer in the second part of this series of articles with an example calculation.
As the value of our global portfolio increases over time, it must be recalculated annually.
- World portfolio value = (old world portfolio value + monthly savings rate * 12) * annual increase in value in percent
or in the withdrawal phase:
- Value world portfolio = (Old value world portfolio - Monthly withdrawal * 12) * Annual growth in value in percent
Strictly speaking, of course, the world portfolio does not suddenly generate the assumed return at the end of a year, as is the case here. However, this is only a minimal inaccuracy, as only a relatively small amount flows into or is withdrawn from the portfolio each year. This fact is ignored so as not to further complicate the calculations.
Of course, the rent must also be adjusted to the assumed rent increase at regular intervals in the calculation. More on this in part 2 of this series of articles.
Comparison of buying vs. renting:
When analyzing which makes more sense at the end of the period under consideration (e.g. until the tenant/owner passes away), three main factors play a role
1) Value of the buyer's property
2) Value of the tenant's deposit
3) Will the value of the tenant's deposit increase or decrease?
The easiest way is to compare 1) with 2). If 1) is higher, buying is the better financial decision. If 2) is higher, renting is the better financial decision.
In my opinion, however, it's not that simple. I buy/rent a property to live in. If I were to stay in my property until the end of my days if I were to buy, I am more interested in whether I would have more financial options as a tenant. And this brings 3) into focus. If my deposit value continues to rise steadily after deducting the rent, I can use the surplus for other consumer spending that I would not be able to afford as a buyer. In this case, the buyer could of course sell his property, buy/rent a smaller apartment and use the surplus for himself. But the question is: does the buyer want to do that? Selling a property is always associated with costs, effort and stress, just like moving to a new property. Depending on the market situation, a sale can take months or years and the property for sale may have personal memories attached to it that you don't want to "sell". And all this at an advanced age. A custody account is simply much more flexible than a property and avoids a high cluster risk. If the aim is not to preserve assets, but rather to reduce them, a tenancy may make more sense even if the value of the portfolio has fallen in recent years but is high overall.
I think it is more likely that I will treat myself to more in old age if my portfolio grows steadily - even if a property has a higher value than a portfolio. However, this is an individual decision and can/must be made by each individual. For me, however, it is only in the following constellations that the buyer "won":
- The value of the property is significantly (!) higher than the value of the deposit at the end of the period under consideration or
- The value of the property is at least as high as the value of the custody account and the custody account loses value
In all other cases, the tenant the comparison.
End part 1
That's enough theory for now. In the next part, we will put it into practice and calculate a real example!
Is there anything else missing in the analysis? I'm just a layman in this field and would be happy to receive suggestions for improvement => let me know in the comments!
Do you have an exciting scenario that you would like me to calculate for you? I'd love to hear about it in the comments too. I'll be happy to do the math for you in part 3 ( https://app.getquin.com/activity/GEBmMewkKS ) of this series of articles.
Are you facing the decision of whether or not to buy a property for your own use or have you already made this decision? Feel free to share your thoughts or reasons why you have made this decision in the comments.
You can find the 2nd part here: https://app.getquin.com/activity/evjQvBldso
Kudos also go to @Koenigmidas who reviewed the article as a real estate owner and provided valuable input.
Sources
[1] https://www.msci-world.de/kurs/
[2] Buying or renting? Gerd Kommer, 08/2021, 978-3593514765
[4] https://www.laenderdaten.info/Europa/Deutschland/inflationsraten.php
[5] https://www.ecb.europa.eu/press/pr/date/2021/html/ecb.pr210708~dc78cc4b0d.de.html
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