I Like Smashed Avocado
Family Christmas lunches provide a range of entertainment. This year was no exception. From eccentric aunties discussing their timeshare purchase, to the excitement of a 3-month old baby cousin being introduced to their extended family for the first time. Then there was that nice glass of Penfolds that spilt on the new couch and wayward tennis balls from the backyard cricket grudge match that landed in the potato salad. And my brother showing off his new tattoo to grandma – her reaction another highlight. It’s a day that is seldom uneventful.
The rather exhilarating (?) topic of conversation that I found myself engaged with this year was about interest rates, property and renting. I don’t know whether my family is actually interested or whether they were just trying to find something to talk to me about. Whatever, it ended up quite heated with the predictable dismissal of my generation which left me defending my millennial demographic from the generalisations and slander cast by some of the senior members of my family.
They think they had it hard and we have it easy. Rubbish. In their day the government paid for students to go to university. I struggle to actually wrap my head around that. And before the decades of 80’s inflation, the cost of property and the ratio of wages to property prices was two or three to one rather than the current ten or twenty to one. No wonder they are all millionaires. It didn’t require brains, it just required owning a property before 1980 or even 1990.
Parents paying for everything forever was their reply. Food, accommodation, school fees, phones, phone bills, cars, car insurance, speeding tickets, parking tickets, the insurance policy excess after an accident, overseas holidays, even beer money. You can add festival tickets to my list. Plus we have a sense of entitlement apparently, only shave once a week, haven’t got a suit, don’t ‘dress’ properly, want to be the CEO on day one, expect to start work later and leave when we like, think our sick day allowance is extra holiday to be taken on a whim, and, most contentious of all, think a $16 smashed avocado on toast is a birthright, not a luxury.
Can’t argue, I had a smashed avocado in a cafe for breakfast last weekend. Think it cost more than $16 (!)
Both sides have good points but let me tell you our biggest bugbear. You lot have enjoyed four glorious decades of property market appreciation and from these prices we think we are coming too late into the cycle. Short of a momentary property market collapse that allows us to get into the market on the cheap, and we certainly wouldn’t wish that on anyone, especially not Mum and Dad, the only way we are going to build the asset base that the senior generation have gloriously amassed is by earning it hard because we are in no mind to follow the same formula as the ‘property’ generation before us. To buy property at these ratios is now a ‘bet’. It’s speculative. It’s not what it was any more, it’s not a cheap necessity, it’s not a cheaper alternative to renting, it’s not guaranteed and at these prices it’s not even low risk. It’s a gamble.
To follow the same path requires me to borrow a lot on and outrageous income to lending ratio. It costs close to a million dollars to buy a block in my current suburb. Twice that if I want a house on it. And if I did that and the property market permanently drops 30% (it recently fell 20%) I’m going to be left owing the Commonwealth Bank $300,000 after-tax money on top of the $40,000 a year in interest. It just doesn’t make sense for us. Imagine having debt up to your eyeballs, only for your house (or unit in my case) to fall in value below what your loan was worth where even if I sold the property (would they let me sell the property at a loss?), I’d still have to pay the bank back tens of thousands of dollars. I’d be financially ruined at this age. And its after-tax dollars. Now I’m working full-time for the Commonwealth Bank.
And there are other issues, the loss of mobility, the daily negative psyche of taking the financial risk, and being a stock market observer, being on the other end of the Commonwealth Bank’s compounding return. Compounding returns are what the mortgage lender enjoys, they are the eighth wonder of the world for them, you don’t want to be the person funding that for them. For them (me) its a life inhibiting financial responsibility and if the property market corrects, a financial catastrophe.
Don’t buy a house then, they said. If its that hard do something else.
Don’t buy a house. I always assumed, I have been indoctrinated to believe, that I would always buy a house and that I too would be a multi-millionaire with little effort by the time I was their age. But what if I didn’t. What if I rented. Does it cost less, is it less risky, should I build my retirement asset another way?
Lets run some numbers and figure it out.
What I want to know first up is the economics of renting versus borrowing and buying.
Here are the numbers I came away with. First up, here are the boring assumptions, you can skip over the dot points below if you want to stay on the story:
- Working off the last 30-years of data from the RBA website I was able to calculate an average variable interest rate of 7.76%. They may be around 4% now, but what if they go up. 7.76% is conservative.
- In terms of house prices, CoreLogic has already done the hard work for me and estimated property prices will increase at a rate of 6.8% per year over the next 25-years. Really? This is the risky bit.
- Vanguard has also figured out that despite the stock market crashes, terrorist attacks and natural disasters the Australian stock market over the last 30 years has achieved an average return of 9.4% including dividends.
- Ernst & Young has calculated it could take around 9 to 10 years to save for a deposit if you wanted to live in Sydney, that might be something closer to 9 years if you wanted to live in Melbourne. Let’s take that assumption as well.
Now, I know interest rates, stock market returns and house prices go up and down but it doesn’t much matter. We are calculating a benchmark number from which we can make other assumptions. So let’s just go with it.
In the first scenario, let’s pretend I’m 9-years down the track, have finally saved $200,000 ($22,222 a year after tax not spent on beer!) which is a 20% deposit, enough to get an $800,000 loan from one of the big four banks. Now let’s say I have successfully ‘won’ (ha!) on auction day and am buying a house/unit/apartment for $1,000,000. And let’s compare that with renting an apartment with friends for $300 per week. A pretty standard situation.
According to the ANZ’s online mortgage calculator an $800,000, 30-year mortgage will cost me $1,324 per week to service. Umm, What? I actually had to check the calculator twice. That’s $5737 per month! Marcus, if you’re reading this, I might need a raise!
Assuming it has three bedrooms and I lie in one, I then have two bedrooms to rent out. According to SQM Research, I can rent the property out at the average rate of a 3-bedroom place in Melbourne at $900 per week. In which case I’d be taking $300 a room, $600 a week and would be $724 out of pocket per week for the pleasure of owning rather than renting for $300 a week. ($1,324 – $900 = $724). Basically it’s cheaper to rent.
Plugging some numbers into excel, after 30-years of compounding price appreciation at 6.8%pa that 3-bedroom property in Melbourne bought for $1,000,000 is now worth around $7,196,769.
Now according to the big bank repayments calculator at the end of the 30 years, I will have paid off the $800,000 and my total payments of $1324 a week have only cost me $2,065,258.
I sell my property (principal residence, so no capital gains tax) and I now have a profit on the whole deal of $5,131,511 and having sold the house I have $7,196,769 to retire on and I am only 64 (9 years saving plus 30 years of mortgage paying and I am 25 now).
Or is it?
Other factors that may have slipped my attention:
- If I stay in my own home at the end of 39 years I have nothing to retire on.
- I have to downsize to release any funds to retire on (nothing changes!). If I want to stay in my own home I can’t.
- What sort of house am I going to get at 2059 prices if I downsize to $4m – will I have to move suburb, City?
- Inflation – how much will I need to live in comfortable retirement. After downsizing to a $4m is $3,176,769 enough to fund me from 64 to 100 years old in 2059 (39 years from now).
- I have not factored in any renovations. No house goes for 39 years without one.
- I have had to save $22,222 a year for nine years before all this starts. Not sure that will happen without my parents continuing to pay for everything for nine years (Love you Mum and Dad).
- The $1,000,000 purchase of a house in nine years time may not get me that three-bedroom house in Melbourne. If house prices go up 6.8% per annum for the next nine years prior to me buying then that $1,000,000 house is going to cost $1,807,762. I may be able to afford a one bedroom apartment by then but a three bedroom house may be beyond reach.
- Offsetting the mortgage cost with $600 a week in rent is not a realistic assumption. OK when I’m 25 but when I ‘grow up’, get married, have kids, or even when I just get sick of living with Liam (next month) I’m wearing the whole cost of the house on my own. Please tell me I don’t have to live with two other f’wits for thirty years in nine years time (not happening Liam!).
- If I don’t rent our rooms I have had to pay a big bank $68,844 a year for 20 years AFTER TAX. At current tax rates that means I will have to earn a salary of $92,000 a year. I will have to earn $92,000 a year before I eat or can buy a Lite Beer.
- Whilst the actual payout to the bank over the 30 years is $2,065,258 (all the $1324 payments each week for 30 years) the truth is that the opportunity cost of paying $1,324 a month to the bank rather than investing it in the stock market at 9.4% is another $8,048,472 (money I could have earned in the stock market). The bank don’t tell you that when they show you their graphs.
- Then there is the core assumption. Will house prices go up? What if somewhere in the next 39 years there is a seismic/permanent shift down in property values. I don’t want to be the unlucky generation that got caught out trying to emulate the ‘property lucky’ generation (our parents) and getting it wrong.
- And there are some more positive assumptions – interest rates go to zero is the big one and the mortgage is paid off faster. But if rates go to zero it is probably because house price rises are going to zero as well.
- All in all, it is fraught with risk and even if it doesn’t go wrong, even if the assumptions are right, even if house prices behave, to service and pay off a loan big enough to buy a liveable house for a family in a City suburb now demands you earn a LOT of money. This formula worked when a house in Brighton cost $80,000 in 1970, but not now.
- Then there are other things. Being desperate for a salary (inhibits your risk-taking ability).
- Being owned by a bank.
- Losing geographic mobility.
- Having to watch what I spend for 39 years.
So let’s look at another scenario, the one I suggested to my family at lunch.
Renting with mates for $300 a week – my living circumstances will change but the point is, let’s assume I rent the rest of my life. In which case I’m not paying the bank $1324 a month, not taking a risk on the property market, I’m not losing my mobility, I am not beholden to my employer because I have to have the job (sorry Marcus), and, instead of paying $1324 a week to the bank I invest all that into my Super which is invested in a low-cost low risk (low return) industry fund (or the Marcus Today SMA!).
Now, with no bank standing over me, I have my freedom and I am not on the wrong end of the CBA’s compounding miracle. Quite the opposite. Now I am utilising the compounding miracle to my own advantage in the stock market.
If I am disciplined enough to partition and invest the same $1324 a week for thirty years starting now (no nine-year waiting period) then by 2050 I’ll have the $8,048,472 opportunity cost I was missing out on by paying the mortgage. Of course, the key to this is being disciplined enough. Discipline, being obligated to make your repayments, is why mortgages and property has worked. But if you aren’t going to be financially disciplined because you don’t have a mortgage you will doom yourself to poverty. So the flip side of not having a mortgage responsibility is to also realise you still need to save and you still need to do what our parents did, ‘put aside’, to invest. But for me, to invest in Super not property.
RENTING VERSUS BUYING CONCLUSION
For now, before the pressure of a family appears (things will change) my conclusions are these:
- Renting and investing is the way to go! You heard it here first.
- I need to be on the right not wrong end of the compounding miracle.
- I don’t want to take the property market risk.
- I don’t want to borrow.
- I want to retain my mobility.
- I want to live a few more years without too many responsibilities.
- I am now mature enough to know that to build the same wealth as my parents I need some of their financial discipline, and budget to save, and I will.
The other message I want to convey to my senior family members, is not about buying property being right or wrong, but the idea that I, that young people, may not want to emulate their parents and follow them into the property market. It looks like a big risk to us – buying a falling down Californian bungalow in Bentleigh for $1m of debt is not an attractive deal for us. Instead it is clearly very possible, especially because we have a much longer runway in Super than you did (you only started Super in 1991), to build an asset and a future income stream by saving and investing and without property.
Our job is to earn as much as we can, be as successful as we can, and to collect wealth not show off spending it. For us, showing off with fancy cars and shouting the bar is not cool as it was for you. It’s uncool. We are the ‘tight’ generation. We have to be.
The bottom line is that we’re smarter than you think and if you don’t believe me consider this…we’ve managed to get you to pay for everything for 25 years!
I’d like to finish on a clever point Marcus shared the other day. A BHP share trades hundreds if not thousands of times a day, its value is out there all day for everyone to see. The average house trades once every 5 to 10 years. No one really knows what its value is until the gavel sounds on auction day. If the value of that house was shown live time on a neon counter on the mailbox rotating up and down every day for the world to see, fluctuating the same way stocks do, property wouldn’t be nearly so popular.
*This research does not predict future performance and nor is it intended to represent financial advice.*