Never-ending capital growth

In my recent post, "Rent money is dead money", I highlighted that fact that there is lot more dead money when owning a house in comparison to renting. In the ‘Comments’ section, some people acknowledged this extra cost, but argued that house-price growth would more than offset this.

Anonymous, for example, said:

“Either way, a gap of $17,000 or $7,200 is a far cry from the appreciating gains a $500,000 property on average will give you. You do the maths!”

and… 

“If you want a good cost analysis of rent vs. buy, check out http://www.yourmortgage.com.au/calculators/rent_vs_buy/
Even in as little as a 7 year period, you will have a higher net wealth buy investing/buying a property compared to putting those savings into the bank.”

So I plugged some figures into the calculator and sure enough after just 7 years, I’d be better off owning, even after buying at these inflated prices.

Suspecting that a site called ‘Your Mortgage’ might be biased towards buying, I massaged the figures and still couldn’t find a scenario where renting was better. Getting desperate, I entered $0 as the rent amount. The result: “You need to buy a house now!!” – or wording to that effect. So even if I could get free accommodation for the rest of my life, apparently I’d still be better off paying for it!

Just as I was about to delete my internet browsing history so that my better half would never find this calculator to use against me, I scrolled down to the “assumptions” area.  And sure enough, they make the same mistake that Anonymous made, and that is to assume that house prices always go up – and not just at the rate of inflation (as occurs over the long term) but at a rate higher than both inflation and wages.  The website says:

“The appreciation rate on residential property is assumed to be 8%.”

You’ll often hear a similar claim from property spruikers – that house prices double every 10 years (which works out to 7.2% growth per year). And over the last couple of decades, this has been true. 

But is it reasonable to assume that this will continue indefinitely?

Well, let’s see what would happen to affordability if house prices continue to rise by 7.2% per year, while wages continue to rise by their long-term average of 5%. Here’s a spread sheet I whipped up.

You can see in the first row that the average wage is currently $60,000, and the average house price is $500,000. This means that you’ll need to work for 8 years in the average job to pay for an average house (up from the long-term average of 3 years). Of course, after first paying income tax on your salary and then adding all other costs associated with home ownership (and living), it would be about 3 times longer than that. But let’s keep this example simple.

Now let’s fast forward 100 years (the next highlighted row).  You can see that the average wage has grown to $4.8 million, while the average house price is $512 million – 106 times the average wage of the time. We will need some major medical advances to allow our great grandchildren to live long enough to pay back their home loan!

Fast forward another 100 years, and if house prices continue to outstrip wages growth by just 2.2% per year, the average wage will be $484 million, while the average house price will be $524 billion – or 1,363 times the average wage!

Of course that's ridiculous - but continual growth along the lines of the last 20 years is exactly what property spruikers are predicting and what the YourMortgage calculator is assuming.

Over the long term, house prices cannot rise faster than inflation and wages. True, they have over the last 20 years – resulting in house prices increasing to 8 times the average wage. But as the above example indicates, to assume that gap will continue to grow indefinitely when calculating whether it’s better to rent or buy is simply ludicrous.

Comments welcome.

Cheers,
Andy.