There are two accepted topics of small talk when you live in London: the weather and house prices. House prices in London seem to be the equivalent of internet stocks at the turn of the millennium, where you cannot escape even a visit to the barber without a 15 minute segment on the topic. Being an immigrant to this country, the British obsession with property ownership does sometimes baffle me. Don’t get me wrong, at some point in my life I hope to own my own home, but what I always find fascinating is what seems to be this innate belief that you need to do whatever it takes to get on the property ladder. Owning a house may be a great idea for some, but I think many people don’t realize that its not always the optimal investment decision.
- A mortgage isn’t free money
People seem to forget that the interest cost you pay over the life of a mortgage is very substantial. When you buy the GBP 1m house with a 25% down payment, you end up paying closer to 1.8m for it in total if you add in the interest cost. This goes back to the fundamental idea of using leverage for making investments:
Leverage amplifies the differential between the investment return and the cost of the leverage
If you are paying a 4% mortgage rate and house prices rise by 4% per year, you are in effect only making money on the deposit portion of the house. Going back to 1991, the compounded annual growth rate (CAGR) of UK house prices has been 5.66%, and so once you add the costs of running a property (maintenance costs etc), there isn’t actually thatmuch return left. And if you look at returns in the equity markets, the CAGR over the same time period is 4.7% excluding dividends, which average roughly another 3% per year. People may argue that London property has experienced higher growth than this, and these same people love to extrapolate past returns. However, it is important to note inner London house prices to median income levels are now at 12x (with some boroughs above 20x), a historical high, and up from 7.8x in 2004. It is well known that London house prices are (and have been for a while) heavily supported by foreign inflows of money, and happily buying an asset at overinflated prices simply because you think someone will pay an even more overinflated price for it in the future is a game only fools play.
The important thing people should keep in mind is the differential between the rental yield and the mortgage cost. If we assume for a second that house prices don’t change, then when presented with a 4% mortgage cost and a 4% rental yield, an individual should prefer to rent, given the flexibility that renting affords. It is also not correct to assume rental yields move in line with house prices. This is especially true for cities like London, where house prices are heavily influenced by foreign inflows of money. While foreign money flows can push house prices to extremes relative to domestic incomes, rental yields naturally track domestic incomes much more closely. After all, the bulk of the people renting also work in the same area, and therefore there is a natural limit to what they can pay.
2. There is an opportunity cost to the deposit
The 25% deposit paid down is usually a substantial sum, and for the majority of people is the bulk of their savings at the time of purchasing their first house. What most people don’t realize is that there is a substantial opportunity cost to having this money tied up. Yes it will technically appreciate at the rate of the house price increase, but it also excludes that money from being used in other potential higher returning activities, whatever those may be for that individual (investing in businesses, stocks, education etc). In general, people underestimate the opportunities available to them to achieve higher investment returns (a subject for future posts).
3. Leverage presents a significant loss of freedom
No matter how you want to phrase it, having debt is akin to a chain on your neck. I was taught early to avoid debt of any kind, despite how attractive it might seem. Using debt can amplify returns, and is a useful tool once you are confident you have reached the stable part of your life, but if you are young and not even 100% sure you are on the career path you want to be on then whether you like it or not having a debt burden will restrict your decision making. The presence of a mortgage naturally makes people shift into risk averse mode with regards to most aspects of their life. Life slowly starts to rotate around the concept of getting out of debt, which is strangely something that was self-inflicted. The counter argument that I hear to this is that if need be you can always rent it out to cover the mortgage. Its a solid argument in theory, but rarely have I seen it used in practice. The shift in behavior is often subtle and unnoticeable. A person might not actually look for the exciting job change or new opportunity once they start heading down the road of stability. That person is simply a lot less likely to believe they can just get up and go travelling for a couple months.
4. It can be one of the most crowded trades there is
An asset is only as good as your ability to sell it when you need to. A huge portion of peoples wealth in the UK is locked up in their house. The problem with crowded trades is that chances are if you need to sell, then a lot of others need to sell as well. Its all good to say house prices are up 10% on some Foxton’s published house price index, but the actual return for you is based on where someone else is willing to buy your property. The counter argument to this is that because it is such a crowded trade, the government would never actually allow for the trade to become too painful, and I do agree its a somewhat valid argument, but despite that I know too many people who say their property is “up 20%, but I can’t find a buyer”. Unfortunately, if the second part of that phrase is true then by definition the first part is false.
5. You shouldn’t forget about conditional probabilities
What I mean by this is that you need to consider where you end up geographically based on what happens in your life in between now and then. Using myself as an example, I live in London, one of the most expensive cities in the world, because I believe that it provides extremely high earning and career potential that I wouldn’t find in other places. However, if in 5 years I haven’t “made it” professionally, then I wouldn’t plan on remaining here as the cost of living at that point isn’t worth it, and the quality of life is potentially much higher in other European cities. Therefore I look at rent as a premium I pay for the optionality that living in London provides. If in 5/10 years I am still here, then the rent I would have paid will be inconsequential. Therefore if things go well then the rent is minuscule in the grand scheme of things, and if things don’t go well then I have no business in taking out a mortgage to buy a property in London anyway.
Putting it all together: renting vs buying
So where is the equilibrium where a person looking to optimize their investment return should be indifferent between renting and buying? Essentially it boils down to the following equality:
(Investment opportunity cost) + (Value of freedom/flexibility) – (Rental cost) = (Gain from house price appreciation) – (House running costs) – (Cost of Leverage)
So there are tons of reasons why it makes sense to buy. If your mortgage costs are low versus what you would pay in rent, you expect house price returns to really be the highest investment return available to you, and you are generally happy with relative stability in your life, then buying a house can be a great saving product.
However, I believe that a lot of young people buying houses in their 20’s just to get on the property ladder are heavily underestimating the first two factors in that equality. It is now easier and cheaper than ever to start businesses, learn how to invest on your own across various asset classes, as well as travel and explore the world. Buying a house is the first road to locking yourself in to a certain life, and for now I would much rather leave the upside unknown and unlimited.