Calculated: Own a home or remain a tenant?
Part 1
There are many reasons to decide for or against a property for owner-occupancy. Owning a property is often also a question of preferred lifestyle. This series of articles, however, is all about the financial aspect of the decision. You will learn how to make a financially sensible decision to rent or buy in your individual situation and how to calculate it yourself. This 1st part is about the basics. It shows you what should be considered in your decision:
- The alternative investment to owning a home (spoiler: you're on GetQuin and should know them).
- What costs are involved in buying a property or renting and are relevant for a comparison
- Which parameters and variables need to be considered and estimated if necessary
- How to make reasonable assumptions for these parameters and variables
- How to calculate the assets of the buyer, the renter and their difference
- What should be considered 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 the 1st part correctly in practice for your individual buy or rent decision:
- Detailed calculation of a real-life example.
- Step-by-step adjustment of this example to make it gradually more realistic
Since many parameters can only be estimated and the housing situation differs greatly from region to region, we take a look at these aspects in the 3rd and last part of this series ( https://app.getquin.com/activity/GEBmMewkKS ):
- Effects of changed parameters on the result
- Sketching of 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
Rent vs. buy - the basic idea
You often hear arguments like "Everyone pays off a house in the course of their life - either their own or the 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. However, it is worth taking a second look. Financing a property for owner-occupancy usually requires a high level of equity, which cannot be invested in the capital markets, as well as a loan, the repayment of which incurs not inconsiderable interest. In addition, property owners must expect costs for modernization and maintenance, which a landlord may not pass on to the tenant. The tenant therefore has a high initial capital compared to the owner, which generates corresponding returns and does not have to be used to avoid debts. In addition, the monthly rent is often - at least in the first few years of financing - lower than the amount a buyer must pay for repayment, interest and maintenance. This difference can also be invested profitably in the capital markets. Is this head start enough for the tenant to build up assets that will later cover the monthly rent and perhaps even more? That's what we'll look at in this series of articles.
Costs, parameters and variables
For the tenant primarily the following expenses are to be considered:
- Cold rent
- Security 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 expenses, 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, broker commission)
- Surveyor
- Interest on a loan
- If applicable, additional operating costs if an apartment is purchased in an apartment building. For example, costs for property management or maintenance of an elevator.
The buyer must also estimate these variables:
- Maintenance costs (carrying out necessary repairs, e.g. new roof to maintain the value of the property).
- Costs for modernization (e.g. conversion of the heating system or conversion of the attic to increase the value of the property)
- Conditions of follow-up financing
If the property is sold in the course of the years, sales costs may still be incurred:
- Small things like energy certificate, extract from the land register, ...
- Costs for valuation
- Broker commission
- Cancellation of the land charge
- Early repayment fee, if an existing loan is terminated
- Relocation costs
If a sale is planned, the value of the purchased property must of course also be estimated.
For both tenants and buyers relevant are
- Inflation
- Legal changes, e.g. with regard to taxation
Especially the latter cannot really be estimated and will therefore be ignored in this article.
What about costs like garbage fees or insurances?
Costs that are apportioned by a landlord to the tenant via the ancillary costs (e.g. garbage charges, insurance, property tax, heating costs, ...), or costs that the tenant bears directly in most cases anyway (e.g. electricity and Internet costs), do not play a role. These are incurred when a property is used by the tenant 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 accordingly not taken into account in the calculations. However, they can certainly be relevant in individual cases. The following should be mentioned here, among others
- Buyers often afford more living space than tenants. In this case, not only the purchase and rental costs of two identical properties would have to be compared, but also the purchase costs of a somewhat larger property with the rental costs of a somewhat smaller property.
- Buyers often invest in higher quality, and therefore more expensive, equipment than renters.
- 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 as easy for a buyer, which is why lucrative job offers that are not accessible from the buyer's own property may not be taken up.
- Repair costs can be low or high, depending on the buyer's craftsmanship and how much the buyer can do themselves.
- Financial contributions from the family, which only occur 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 cash gifts.
- As a real estate buyer, one is subject to a positive forced savings contract. One must pay the monthly installment to the bank. Even in the case of unplanned unemployment, illness or other increased costs / reduced income. If it is no longer enough to go to the cinema, then it is no longer enough. If you save monthly in a world portfolio, you may be tempted to reduce the savings rate in such cases and go to the cinema after all.
- ...
How can plausible values for the variables be determined?
Many values can be easily determined, e.g. the amount of rent or the purchase price, the expected incidental costs per state, credit conditions, ... However, some aspects are not yet fixed today, which is why assumptions have to be made for them.
About the developments on the capital market there are valid historical data. Even if future performance may deviate from this, they still give 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 around 5 - 7% per year is realistic. In [2], the annual, inflation-adjusted (!) increase in value of a global stock portfolio is put at 5.2% over the last 120 years and at 7.6% from 2010 to 2019. You can, of course, simply select the index of your choice on the website of your choice and have the performance displayed there.
The development of the rents, as well as the purchase or sales prices of real estate, is unfortunately very difficult to substantiate with historical data. This is partly due to the fact that real estate is more subject to local conditions and you can't simply live in the global average - unlike stocks in the MSCI World. Complicating matters is the lack of independent statistics going back more than a few years. Unfortunately, this is particularly dangerous. Because of the recency bias phenomenon, we attach more importance to events in the recent past than to events that happened longer ago. This means that we instinctively assume that rents and real estate prices will continue to rise at the same pace due to the high increase in recent years. This is where the regression to the mean catches us cold, stating that value developments 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. So, especially in the environment of now rising interest rates, a few lean years could now follow.
Let's take a look at the rental prices [3] assumes increases of between 2.1% (first-time occupancy) and 2.7% (reletting) per year over the past 31 years. Only new leases are considered. Existing rents generally increase much less [2]. In [2], the inflation-adjusted (!) rent increases of new and existing rents in Germany from 1998 to 2018, excluding modernizations, are put at less than 0.3% per year. According to [4], inflation averaged 1.37% per year during this period.
Let's stay directly with Inflation. Here, too, it is helpful to look at the past, which according to [4] has been 2.5% for Germany over the last 62 years. If we look only at the last 20 years, we get a value of about 1.5%. In parallel, 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 about the amount. There is often talk of a flat rate per square meter, which - depending on the age of the property and whom you ask - ranges between 0.60 and 1.50 euros per square meter and month. Many practitioners criticize here however the much too scarce calculation and refer instead to the Peters formula. This assumes the 1.5-fold production costs of the real estate within 80 years. Attention, production costs are something else than the purchase price of a real estate + property. Assuming 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 grow over time with inflation / the current value of the property. Gerd Kommer in [2] considers an annual reserve of 1.5% - 2.5% on the current value of the building part as reasonable. A high age of the property, a poor structural condition, high quality equipment or a detached building rather provide for higher maintenance costs closer to the 2.5%. If we continue to assume 2,000 euros in construction costs per square meter, Kommer considers reserves for maintenance 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 to be appropriate. These should be adjusted for inflation and explicitly do not include the costs of modernizations.
The conditions of a follow-up financing are unfortunately impossible to predict today. In principle, every buyer should calculate how high interest rates can rise so that the budget is still sufficient. If the personal risk of a sharp rise in interest rates is considered critical, it is possible to buy lower interest rates by fixing the interest rate for a long time. Alternatively, there is also the possibility of a building 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.
Purchase of a property:
- Full purchase cost of the property = purchase cost object + ancillary purchase costs + appraiser.
- Amount of the loan = full purchase cost of the property - equity capital
- Initial monthly interest = amount of loan * interest rate / 12
- Initial monthly repayment = Amount of loan * Repayment rate / 12
- Monthly installment = Initial monthly amortization + Initial monthly interest
The loan is reduced with each installment, which is why the absolute interest payable must also be recalculated over and over again and falls in absolute terms over time. Since the monthly installment remains unchanged at the same time, the monthly repayment increases.
- Monthly repayment = Monthly installment - Remaining loan amount * Interest rate / 12
- Residual 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 needed to pay off the remaining debt, we start again at "Amount of loan", select the remaining debt for this and repeat the calculations from there.
- Monthly accruals = Maintenance costs according to Peters' formula or Gerd Kommer (annual adjustment of accruals to estimated inflation) + accruals for modernization
- Monthly charge = monthly installment + monthly accruals
Once the loan has been fully paid off and no follow-on financing is required, the monthly charge equals the monthly accruals. In case you want to sell your property in the meantime, you still have to calculate the selling price.
- Selling price = purchase costs of the property + value development since purchase + value increase due to modernization - selling costs (if applicable, broker's fee, cancellation of the land charge, moving costs, prepayment penalty, ...)
After a sale you will have to buy another property for your own use or decide for a tenancy with world portfolio.
Rent of a property:
- Available initial capital = Equity - Deposit
- Monthly savings rate = Monthly load buyer - cold rent
The available start-up capital is paid into the world portfolio, as is the monthly savings rate - provided it is positive. If the cold rent exceeds the monthly burden of the buyer over time, the corresponding amount must be withdrawn from the world portfolio instead.
- Monthly withdrawal = cold rent - monthly burden buyer + taxes payable on profit
What is actually important here is the correct consideration of the tax, which is currently 26.375% on capital gains in Germany, provided there is no church tax liability. This calculation can be implemented in Excel with a little effort and will be made clearer again in the second part of this series of articles with an example calculation.
Since the value of our world portfolio increases over time, it must be recalculated annually.
- Value world portfolio = (Old value world portfolio + 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 Value Growth in Percent
Strictly speaking, of course, the world portfolio does not suddenly generate the assumed return at the end of a year, as it does here. However, this is only a minimal inaccuracy, since only a relatively small portion flows into or is withdrawn from the portfolio each year. This circumstance is ignored - in order not to complicate the calculations even further.
Of course, the calculation must also adjust the rent at regular intervals to the assumed rent increase. More on this in the 2nd part of the series of articles.
Comparison of buying vs. renting:
At the end of the period under consideration (e.g., until the tenant/owner passes away), three primary factors play a role in analyzing which makes more sense
1) Value of the buyer's property
2) Value of the tenant's deposit
3) Is the value of the tenant's deposit rising or falling?
The easiest way now 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 is not that simple. I buy / rent a property to live. If I would stay in my property until the end of my days in case of a purchase, I am more interested in whether I would have more financial possibilities as a tenant. And that brings 3) into focus. If my deposit value, after deducting rent, nevertheless continues to rise unceasingly, I can use the surplus for other consumer expenditures that I would not be able to afford as a buyer. Of course, in this case the buyer could sell his property, buy / rent a smaller apartment and use the surplus for himself. The question is, however, does the buyer want to do that? Selling a property always involves cost, effort and stress, just like moving to a new property. A sale can drag on for months or years, depending on the state of the market, and there may be personal memories attached to the property being sold that you don't want to "sell." And all this at an advanced age. The portfolio is simply much more flexible here than real estate and avoids a high cluster risk. If the goal is not asset preservation but asset depletion, a rental relationship may even make more sense 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 my old age if my portfolio grows steadily - even if a property would have a higher value than a portfolio. But that is an individual decision and can / must be made by everyone. For me, however, only in the following constellations does the buyer "won":
- The value of the property at the end of the period under consideration is significantly (!) above the value of the deposit or
- The value of the property is at least as high as the value of the deposit and the deposit loses value
In all other cases the tenant the settlement.
End part 1
That should be enough theory now. In the next part we will transfer this into practice and calculate a real example!
Are you still missing something in the consideration? I am also only a layman in the field and am happy about suggestions for improvement => send them into the comments!
You have an exciting scenario that you want me to calculate? I am also happy about it in the comments. I will gladly calculate it for you in the 3rd part ( https://app.getquin.com/activity/GEBmMewkKS ) of this series of posts.
Are you facing a decision yourself about whether or not to buy a property for owner-occupancy, or have you already made that decision? Feel free to share your thoughts or reasons why you made that 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] Buy or rent? 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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