Rent is the price of housing accommodation
The home building industry often promotes to potential young home buyers that rent money is “dead money” i.e. money down the drain. It encourages them to stop paying rent and, instead, use the money to pay off the mortgage on their own new home.
I became very aware of the power of this self serving message when my 24 year old daughter proclaimed that she wanted to buy her own property as soon as possible, as rent was “just dead money”. Although impressed by her determination to take on such an obligation, I couldn’t resist the opportunity to give a basic economics lesson.
The reality is that rent is not dead money but the cost of purchasing housing accommodation. It is essentially the same as paying for a hotel room for an overnight stay or for a two week vacation in a luxury holiday resort.
We all pay the cost of housing accommodation, whether we rent from a third party or we own our home. And this is the case, regardless of whether or not we have a mortgage.
What is the real cost of home ownership?
For the home owner, an obvious cost of housing accommodation is what they could earn by renting their property i.e. it is the “notional rent”. This income foregone is a real cost. When viewed in this light, many are unwittingly “paying” a large amount for housing accommodation.
For example, the family with the $5 million residence is probably “paying” (i.e. foregoing) about $150,000 p.a. or roughly $3,000 a week in “notional rent”. Often, this notional rent is a very high percentage of total ongoing expenditure. And much greater than many home owners would be prepared to pay to rent a property from a third party, assuming they were to sell their home.
But notional rent is not the true cost of home ownership. The true cost is the best alternative you forego by committing funds to a home purchase i.e. the opportunity cost.
And this cost can be substantial. It explains why large supermarket chains and department stores generally rent/lease properties rather than own them. They consider they will get a better return by committing financial resources to the business of retailing rather than property ownership. And you don’t hear savvy investors suggesting that the rent Woolworths or David Jones pay to Westfield and others is “dead money”.
For many young people, home ownership may represent a poor alternative for their scarce financial resources. They may be better off at this stage of their lives committing funds to a business venture or maximising their career options by maintaining total flexibility with regard to where they live. Home purchase is a major commitment that may stifle the willingness to explore potentially higher risk but higher return opportunities.
Home purchase as forced saving
So rent money is not “dead money”. It’s the price you pay for something of value i.e. housing accommodation. And home purchase may not be the best use of a young person’s scarce financial resources.
Yet many baby boomer parents are encouraging their now adult children to get into the property market as soon as they can. They feel it worked well for them and proved a great “investment”, with the value of property always seemingly going up.
In our view, this thinking leaves a lot to be desired. A satisfactory outcome doesn’t mean the original decision was sound. The conclusions drawn by the baby boomers warrant some qualification:
A home purchase is primarily a lifestyle choice. It doesn’t exhibit the characteristics of what we think is good investing practice;
a major reason home purchase worked so well for baby boomers is that high inflation helped to ease mortgage pressure; and
borrowing to purchase a home is a form of forced saving. Money that might otherwise have been totally allocated to consumption, with nothing to show for it twenty years later, was used to repay mortgage debt. As a result, the baby boomers now have largely debt free homes that provide them with a sense of financial security that they would like their children to enjoy. But saving, rather than astute investment, was largely responsible for this desirable result.
Invalid clichés and dubious logic do not make for sound decision making, particularly when the decision is regarding such a major obligation as a home. Ideally, the home purchase option needs to be rigorously compared with alternative uses of limited financial resources.
Of course, for a young person who does not have great financial discipline and/or can’t identify better alternative uses for their funds, then borrowing to buy a home, with its inherent forced saving, may be a good choice. But the phrase “rent money is dead money” and its implication that renting never makes economic sense are dangerously misleading.
Wealth Foundations (ABN 95 965 896 114) is a corporate authorised representative of Wealth Leadership Services Pty Ltd (Corporate Authorised Representative No. 319641). Wealth Leadership Services Pty Limited (ABN 36 121 535 993) is a licensed Australian financial services firm (AFS Licence No. 317369).
The material contained in this article is for general purposes only and should not be used as a substitute for personal financial advice. This article does not take into account your specific objectives, financial situation or needs. No person should act or refrain from acting solely on the basis of this material. Before making a financial planning or investment decision, you should consider if it is appropriate for your circumstances. You should read and understand any relevant Product Disclosure Statements or any other associated documentation relevant to your individual situation.