One of the biggest financial decisions in your life will be the potential buying of a house.
Actually, this is a really severe decision, especially in big cities or other expensive places; a decision than will determine your cash flows, your freedom and even your way of life for decades to come.
Thus it is amazing how blue-eyed most people approach this decisions. At least in Munich, Germany, where Woodpecker’s live, and where real estate prices are sky rocketing currently, the only thought people seem to have is:
How can I quickly get in the market before prices rise even higher?!
Woodpecker kept on observing this for a while now and I speak to as many people as possible who are currently buying houses or are looking for some, and virtually nobody ever put forward real economic arguments, like return on investment, opportunity costs etc.
Instead it is always:
Prices will continue to rise, so we have to join now.
Plus the inevitable:
Real estate is the only asset that will protect me from the coming hyper-inflation.
Real estate markets in Germany have not been booming for a long time, thus Woodpecker has limited experience, but I strongly belief these are signs of a bubble formation.
However, let’s get away from speculating and let’s look at the economics:
Does it pay to buy a house?!
I will not go into deep details of the economics (there an endless tools in the internet for those interested), but start with a more general quick-scan approach – some questions, that, although basic, most potential buyers seem not to consider (at least in Germany today).
First question is your motivation to buy a house.
This question will determine the value the good “living in an own house” has to you.
- Is your motivation purely economical on the optimal provision of the good “living in a house”? I.e. your decision is only driven by efficiency: Will you pay more by renting over decades or by buying?
- Does your motivation include a speculative element? I.e. apart from receiving the good “living in a house”, you want to speculate on the price changes of your asset “house” (You do that automatically, when you assume “prices will continue to rise”, “my city will continue to boom” etc.!).
- Do emotional values play a role for buying a house? Like feeling better or more secure when owning. Do you value very much the freedom to change things at your house, that would be difficult in rental homes? How much is this emotional part worth to you?
Next question is your investment alteratives. This will define your opportunity costs, i.e. the the chances you are forgoing as your money will be tied up in the house.
- Do you have an idea where to invest your principal in, if not in a house?
- What is the return you’d expect from such an investment?
- Does investing and caring for your money (e.g. buying stocks) is fun for you? Or is it a bore and secretly you’d be happy to put all your money in your house, so you don’t have to care about it anymore?
The third question is your expectations of the future. This tells you how the price of your house will develop. (I’d not overrate this bullet though – as the future tends to be a difficult beast to predict 😉 ).
- Do you really think the price of your house will always go up? Why should it? And why hasn’t prices always gone up in the past? Why do markets crash here or elsewhere? Are you sure you can judge the market and all factors better than those poor guys that messed up in the past or elsewhere?
- Do you really know how inflation works and that it will sky-rocket in the future? Do you have arguments for that or are you simply repeating statements that are circulated by others? Could it be the majority is wrong here?
The last question is very important for a downshifter, as it targets at your freedom.
- How long will you have to pay down mortgage on your house? How heavy will this burden be? Will it significantly reduce your dimensions of freedom (e.g. rates are so high, you will not be able to reduce working hours or take sabbaticals for the next 20 years or so).
- Are you prepared for a shock-event? Are you flexible to handle such an event even with a lot of debt on your shoulders? Shock events could be: You lose your job, you get somehow disabled, you get divorced. Etc. All that things tha can severely distort your mortgage plans and force you to very costly decisions.
- Are you ready to settle down here? Or do you want to keep flexibility to move around or experience new areas in your city later?
- Do you belief you will be able to sell the house later to consume the proceeds of the sale? If not, you will simply save for your kids – this is noble, but would certainly cut you off from much of the potential returns the house would generate.
Typical example here: Woodpeckers elderly neighbours.
They have no kids, but live on a huge ground, that I’d estimate 1.000.000 EUR worth, in a ridiculously huge (but run-down) house of 200+ sqm.At the same time they have to live like poor people because their retirement rents seem low and they are not willing to let go of the house. They could have it all: Travelling, great vacations, services, fantastic food, entertainment or charity for the rest of their lifes, instead they cling to this very run down house and the huge garden, while complaining about all the work it implies. A very irrational decision, but very common too. The price they pay for this “emotional aspect” of their house is virtually 1.000.000 EUR! Are you sure you will not end up like this?
In Woodpeckers case, the decision (at current market prices) goes as follows:
- The decision on buying a house is to a great extend driven by economics.
- We do not want to speculate on house prices. Real estate is not an asset class that we know well and I think most of my ideas on its development will be pure speculation or linear extrapolation of the status quo. Thus I’ll assume prices to rise along with general inflation (2,5% p.a.) only, but not outperforming it. Same assumption on development of house rental prices.
- My asset class is stock trading. I am confident to generate a minimum return of 5% p.a. after taxes. This is confirmed by past trading success and by market statistics, showing that stock markets over the long run yield even around 7% p.a.
- Thus, I’ll expect a return of 5% p.a. for a house as well. Consequently I’ll take 20 times annual renting costs as a proxy for a “fair” house price. This is a good rule of thumb, there are some deviations to both sides as inflation, interests and change in rental fee, or renovations in the case of owning, but in general this factor has proven to work fine.
The renting cost to be applied is the “cold rent”, as it is called in Germany, thus the rent before additional costs (insurance, utilities, taxes, heating), as the latter will have to be paid even if you own the house.
- Woodpecker family’s current “cold rent” is 1.650 EUR p.month or 19.800 EUR per year for a 150 sqm house + garage + small garden.
- If buying we want something similar or larger, thus a fair price for a similar house would be 19.800*20 = 396.000 EUR. Subtract around 10% of broker, tax, moving costs, this yields a house price before costs of 356.400 EUR.
- Emotional value is existent, I’d value it at 2.000 EUR a year (…or even less, if you think about it in this way…), so let’s add 2.000*20 to the fair house price: 396.400 EUR.
- For shock events, I’d like to subtract 10%, as cash or a liquid stock portfolio will be more flexible in those cases. And I’ll subtract another 10% as freedom and flexibility (e.g. to reduce working hours, or to take sabbaticals, or to move somewhere else) are very important to us, and much easier achieved if you have a fair amount of liquidity.
- On the other side, I’ll add +20% to the fair price for potential security in an inflation scenario (although stocks should do ok in this case as well) and for securing against rental fee increases and potential hassles from having to leave the rental house.
- Over all, fair price comes in at roughly 400.000 EUR (before tax and broker).
4-5 years ago, this would indeed have been an somehow achievable price in Munich for Woodpeckers type of used house.
Today, prices unfortunately are way off, probably around 500.000 EUR for our size and location of a 20-year-old house and around 650.000 EUR for a similar new built house in the neighbourhood sold to a colleague 3 months ago (and his was a row house only).
Translating this example of a new built house back to monthly cold rent, we would end at (650.000+10% broker+tax)/20/12= 2.980 EUR per month!!!
And would you pay an equivalent of nearly 3.000 EUR per month for a 150 sqm row house in a Munich suburb?
Well thanks, we would rather not, so we will continue to rent our house and maybe recalculate in case prices come down…