Why do people rent rather than buy in high-yield markets?

Question

I'm an Aussie investor researching your markets. Our yields in cities vary approx 2-4%, so I'm trying to come to terms with some cultural differences regarding home ownership.

In a recent discussion on an Aussie property forum regarding forecast flat or falling property values, many local investors put the view that there is a natural floor on values caused by the rent/buy decisions of current tenants. In the current low-yield environment here, it is clearly cheaper every month to rent rather than buy. One only buys in anticipation of appreciation, and for the lifestyle benefits (stability of tenure, etc), and this is what 70% of the market does. (Even without the tax breaks that you are fortunate to have! Our mortgage interest isn't deductible on our own home; only on investment properties.)

I estimate that the cost of ownership of a property in the US each year, if 100% financed, is around 10% of purchase price (6% interest, 2.5% property taxes, 1.5% repairs). Now I know from investigating your markets that there are many, many cities in the USA where yields are 10% or more for SFRs. When you factor in anticipated appreciation, it seems to me that anything close to 10% would cause tenants to prefer to be owners. Factoring in some modest appreciation, it's hard (from our perspective) to understand why anybody would pay more than 5% yield! When you factor in time - and that your mortgage payment remains static whereas rents increase - the balance swings even further towards ownership.

So my question is: why do tenants pay such high yields rather than buy the property themselves?

My guesses are:

* they can't get finance
* it just doesn't occur to them - home ownership is outside their expectations
* they are concerned that they won't cope with the bills (eg repairs)

Tracey B. · Answer

Many contributors to an Australian property investing forum are currently arguing that as yields are now approaching 1/2% (from below), Australia must be getting set for another boom, because "why would people pay 1/2% to rent when they can buy for that?".  :lol: This is even more starkly contrasted with the US situation when you consider that we don't have tax deductibility of owner-occupied mortgages.  :mrgreen:

Mark Borderud · Answer

Hi Tracey,

1. they just don't want the complications/headaches...it seems simpler to rent
2. a feeling of freedom without the commitment of home ownership
3. a temporary situation making renting a better choice (ie. experiencing living in a market before buying

My Best,

Mark

Tracey B. · Answer

Sorry, yes: by yield I mean annual rent divided by purchase price (actually, market value).

Jon, I would think the "expenses being 50% of scheduled gross rental" rule would hold true where yields are 0.5% per month or less, but I don't think rules of thumb like this work when taken to areas where yields are extraordinary. Just because a property attracts twice as much rent per year, doesn't mean its expenses will be twice as much. Aussie investors tend to budget on about 2% of market value per year for repairs and maintenance, insurance, etc, regardless of the yield. Or 1/6% per month. My suspicion is that this is more valid than a percentage of income.

I agree that those very low yields in California and Florida, for example, were unsustainable. What is amazing is that Australia is like that EVERYWHERE, and there seem to be an incredibly small number of people who acknowledge that it's unsustainable and needs to change. We have a couple of generations of people alive now who've become accustomed to their house doubling in value every 10 years or less, and effectively funding their retirement with appreciation of their family home. Despite the recent turmoil - which of course has hit here as well - this mindset doesn't seem to have been dented; most people think that yields might go from 1/6% to 1/4%, for example, but very few seem to be suggesting that they'd go to 1/2%, let alone the 1% in your rule of thumb. I just wonder how much longer our bubble will continue. And I do think it's an unsustainable bubble, which is why I'm looking at high yielding properties in the USA, and not buying any more here in Australia.

It seems you agree that the reason why people don't buy rather than rent is a combination of 1) in many areas yields aren't high enough that renting is more expensive, and 2) many people can't get a loan.

Jon Holdman · Answer

Tracey,
What do you mean by "yield" in this situation?  Do you mean annual rent divided by purchase price?

A very old rule of thumb is that rents should be 1% of the property price.  The idea is that a landlord should make a decent profit at that price.  In reality, I don't see how you can,  if expenses really are 50% of gross scheduled rents, and interest rates are above 6%.

Nevertheless, there are many places, like my neighborhood, where rents are closer to 1/2% of purchase price.  There are many places in CA or FL where they were more like 1/4 or 1/6%.  With rents that low vs. purchase price, why would anyone own?  Many of these owners were really speculators, betting on continued appreciation.  Oops, they crapped out big time.

Many people can't swing a long.  Saving up a down payment is hard for many people.  It was hard for me, and I've had a steady job since getting out of college.  I seriously doubt we'll see the 100% loan programs we saw for the last 10 years anytime soon.

You need good credit, too.  Its really easy to make some mistakes and mess up your credit.

Some people move around frequently.  Renting makes it easy to move.  I actually think we may see more of that, not less.

Landlords take care of a lot of stuff.  Maintenance, insurance, taxes.  All that adds up.  And sometimes comes in big chunks.  Tenants rarely, if ever, have a big hit like that.  In your math, you're missing insurance, which can be quite high in some areas.

Most loans here are amortizing.  So, you'll also have principal payments, too.

There is no guarantee of appreciation.  In fact, of all the houses I've owned as residences or second homes, the three that I've sold showed trivial appreciation, or even value reductions.  Add on the outrageous transaction costs, and it would have been cheaper to rent.