Should you rent or buy your next real estate property?

Stuart Wemyss of API Magazine (Feb 2007). Part 2 of 2 of this useful article that explains the differences in saving money for a real estate property purchase for primary residence versus one for investment purposes.

Cash flow and borrowing capacity difference

From a cash flow perspective, renting real estate may be a lot cheaper, especially for people with little equity or no deposit. Consider the example of two people who occupy a real estate property worth $500,000. The renter will probably pay a rental yield of say 3.5 per cent, depending on location. This amounts to an annual cash outflow of $17,500.

Assume the homeowner has a home loan of $400,000. Annual principal and interest repayments on this loan will be about $32,000. Therefore, the homeowner’s annual commitments are $14,500 higher than the renter ($32,000 less $17,500).

The renter can borrow over $220,000 more than the homebuyer because of this commitment difference (and also the fact that banks factor potential interest rate increases into their borrowing capacity calculations, which affects the homebuyer but not the renter). The homeowner’s loan would need to be less than $220,000 for the repayments to be less than the renter’s annual commitment of $17,500. The conclusion is, if you have little cash or equity, then you may be better off maximizing your borrowing capacity by renting rather than buying a home so that you can purchase more investment real estate properties.

Deposit Power

Real estate investors should understand that owning your home property may render some of your cash or equity to be unusable. Perhaps the best way to communicate this point is to consider an example. Consider two different investors in real estate property. One property investor has $200,000 in equity in his home (say a home worth $400,000 with an outstanding mortgage of $200,000) and another doesn’t own a home but has $200,000 in cash.

The real estate investor with $200,000 can buy about $800,000 of property (note, this figure will depend on the state the property is bought in as stamp duty charges vary), assuming a maximum loan to value ratio of 80 per cent is maintained (i.e. the $200,000 cash was used to pay for a 20 per cent deposit plus costs).

The real estate investor in property who owns his home can borrow up to 80 per cent of his home’s value in Australia (therefore, $320,000). He already has a $200,000 home loan secured by this property. Therefore, he can borrow an extra $120,000. This amount ($120,000) can be sued to pay for a 20 per cent deposit plus costs (eg. Stamp duty). Therfore, this investor in real estate can spend up to $480,000 on an investment property while maintaining a locan to value ratio of 80 per cent.

In these calculations, I’ve assumed that the investor in real estate borrows a maximum of 80 per cent of the property’s value. This is the maximum most lenders wil provide without charging Lender Mortgage Insurance, which can be a very costly upfront fee. However, it’s possible for the homeowner to bridge some of this gap between him and herself and the cash holder by borrowing more than 80 per cent (although as noted) this does come at a cost). This leads nicely into my next point about timing.

The Timing Issue

Most people intend to own a home or property some time in their life. Therefore, some investors in real estate are faced with the decision: “What do I buy first? A home or an investment property?” I would guess that there would be very few people who would decide never to purchase a home just because numbers don’t stack up.

Buying a Home and Then an Investment Property

The main advantage with this real estate investment strategy is that it allows you to balance your tax deductible and non-tax deductible debt more effectively. That is , you’re able to contribute all your cash towards your home purchase to minimize your non-tax deductible home loan. You can then utilize the home equity in your real estate property to borrow the total cost of your investment property, even if it means paying for mortgage insurance. The main practical downside to this strategy in real estate investing is that for many people, the subsequent investment property purchase may never eventuate. They may have every intention to purchase an investment property. However, due to constant distractions in life, time slips away and they may never actually complete the investment real estate property purchase. In this situation they would have been far better off purchasing the investment property before the home form a wealth building perspective. So, if you choose this strategy in real estate investments, make sure you follow through with your intentions and purchase investment properties.

Buying an Investment Property First and then a Home

Obviously the reverse of the pros and cons mentioned above apply to this strategy. Another benefit of this strategy is that buying an investment property a number of years before your buy a home may help you afford to purchase a more expensive home as you would have hopefully built up equity in your investment real estate portfolio.

Occupying an Investment Property

A really good “happy medium” is to purchase a property real estate purely on investment fundamentals (ie.e purchase the property as if you weren’t going to live in it) and then occupy the property as your home. Of course, this may involve you have to compromise on your personal lifestyle requirements. However, the main benefit in real estate is that you won’t compromise on the main reason for home investing in property. That is capital growth! You will, of course, be missing out on the income (i.e. rent). However, it’s capital growth that will increase your net wealth the most and allow you to continue to build your real estate property portfolio.

The biggest downside to buying a home is that home purchases are heavily influenced by personal, non-financial preferences (e.g. location, type of architecture etc.) This may result in someone purchasing a poor quality asset from an investment real estate perspective, whereas investment property purchases should be unemotional and only influenced by the question “which asset is going to perform the best?”.

Therefore, eliminating the “emotional” influences fro your home purchase in real estate should go a long way to helping you build wealth! This real estate strategy is particularly important for people who may only want to buy a home to occupy for a short period (say five years). Buying a good quality asset can help them tremendously after they decide not to occupy the home anymore and sell it or rent it out.

Buying: A Forced Savings Plan

One risk to taking the “rent a home and buy an investment property in real estate” option is procrastination. Buying a property, be it a home or an investment, is a bit like a forced savings plan. As discussed earlier, it’s cheaper to rent a property from a cash flow perspective (i.e. rent payments are lower than home loan repayments). That can be useful as long as you use the cash flow saving wisely (eg. Buying an investment property). However, some renters fall into the trap of spending the cash flow saving on their “lifestyle”. This is a common trap and is extremely “wealth destroying”.

By buying a real estate property, you’re essentially forced to contribute a greater proportion of your income towards buying an asset in real estate, rather than spending this money on your lifestyle. Therefore, if you’re not as disciplined with your money as you could be, make sure you have something in place to “force” you to buy an investment property (a good solution is to use a buyers agent to locate and purchase the investment property for you, because then you know it will definitely be done).

Focusing on Financials

I’ve written this article on the basis that people are focused solely on the financial pros and cons. I realize this isn’t realistic. I understand some people are mainly driven by personal preferences. For example, some people feel more secure if they own their home and would never want to rent. Some people prefer to rent near the city, because if they purchased, they could only afford to buy something in the outer suburbs and they aren’t prepared to compromise on location.

The only advice I have for people who are heavily influenced by their “personal preferences” is to be aware of the financial repercussions of your decisions and how they may affect your long-term wealth because they can be absolutely huge! The renting or buying real estate decision is not an easy choice to make.

Stuart Wemyss is a chartered accountant and director of mortgage broking firm ProSolution Private Clients. For more information, please contact API Magazine of Australia.