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Is it better to buy or rent a home? - Theory vs. reality-

Yuichiro Kawaguchi
Professor, Graduate School of Business and Finance, Waseda University

Buying and renting a home are financially the same, in theory

The average expense for a purchased home (e.g. loan payment, repair and maintenance costs, and property tax) is approximately 90,000 yen per month in Tokyo (survey by the Tokyo Metropolitan Government in 2010).

In addition to the housing expense mentioned above, depreciation (a monthly decline in the value of both property and equipment) and the monthly rate of change in housing value combined are known as capital cost. For example, let’s assume that an apartment was purchased in Tokyo. If the building depreciates 20,000 yen per month while the future housing price increases by a monthly increment of 15,000 yen, the capital cost of this purchased apartment is approximately 85,000 yen per month (90,000 yen – 20,000 yen + 15,000 yen).

Meanwhile, the cost of a rented apartment is rent only. In Tokyo, the average rent for an apartment leased by private housing companies is 85,000 yen (Housing Survey of Japan, 2008 and 2013). If the apartment described above is rented, the rent is equivalent of the capital cost (85,000 yen). Therefore, the financial cost of buying and renting housing essentially become the same.

According to the economic theory of investment, the capital cost for a rented home and a purchased home are the same. A purchased home does not require rent payments (marginal benefit of housing services) but requires cost payments (marginal cost in housing services). These two expenses become equal for a home buyer because, in economics, household economy is assumed to consume services where the marginal cost eventually matches the marginal benefit.

In reality, timing matters

In reality, timing determines whether buying a house is a better investment than renting one. This is because housing prices have large swings while rent remains steady most of the time. In the earlier example of the apartments, if the future housing price changes dramatically, the capital costs between the rented and purchased apartments are no longer the same. If the housing price drops, you could save more money by renting because the capital cost is higher. However, if the housing price increases, there is a greater economic advantage to purchasing a home.

In the 1990s, renting housing saved more money. The rent for homes in Tokyo leased by private housing companies had almost no change (+0.3% annually from 1993 to 2003) while housing prices sharply dropped. When the economic bubble burst (from 1990 to July 1995), for example, prices of used apartments in Tokyo dropped by 18 percent per year. During the deflation in housing prices that followed (from August 1995 to September 2003), housing prices decreased by 6 percent annually.

People in the process of buying a home during the housing price crash never expected for the price to drop as much as it did, but they proceeded with optimism that the price would recover. In the Tokyo metropolitan area, however, it was not until 2003 that the end of deflation in housing prices was confirmed. In areas where land and property values continue to decrease (33 prefectures), the capital cost of purchased houses remains high.

Now in a sideways market—using existing home prices as an indicator of asset value of purchased homes

Figure 1 shows the changes in new and used apartment price indices in the Tokyo metropolitan area (from June 1993 to April 2016). Between these two housing price indices, which one should we use to determine the changes in home asset value? The answer is used home prices. The reason is simple; a purchased home is no longer new. Needless to say, a premium is given to a newly-built home only once. In investment, information on prices of the same house/apartment (resale prices) at different points in time is crucial. The used apartment price index in Figure 1 is intended to capture such price changes.

Moreover, the used apartment price index is designed so that it can be compared with the stock price index (TOPIX). Figure 2 shows changes in used apartment values respectively to the TOPIX values, setting January 2003 as a reference point (100). This graph indicates a few interesting facts. The most obvious is that the bottom TOPIX prices were always nearly the same as the used home price index at that the time.

This may have something to do with the fact that the entire period shown in Figure 2 was in a sideways market. The TOPIX value moves between the ceiling and the bottom price, indicated by the used home price, on the chart. Although the deflation in housing prices in the Tokyo metropolitan area ended in 2003, prices have been in a (narrow-range) sideways market since then, similar to TOPIX.

As shown in Figure 2, the three points in time, 2004, 2009, and 2012, are at the bottom of the range. If the real estate market in the Tokyo metropolitan area remains in this range, the decisions made to buy a house at these times will prove to be the right choice because the future housing price will not become lower than the purchase price.

Figure 1: Changes in new and used apartment prices in the Tokyo metropolitan area Created by the author using the Japan Property Price Index and data from the Real Estate Economic Institute

Figure 2: Changes in used apartment and stock prices
Created by the author using the Japan Property Price Index and TOPIX (Quick Astra Manager)

Detailed investment decisions—hurdle rate for buying a home is 15%

Finally, let’s discuss the specific method for making an investment decision regarding a home purchase.

First, obtain the total profitability of the property under consideration. The total profitability comprises an income return and a capital return. The income return is calculated by dividing the saved rent by the amount of the down payment. The saved rent is calculated by subtracting housing expenses from the rent. The capital return is the future profit (or loss) generated by the sale of a purchased home.

Next, calculate the opportunity cost of the property. An opportunity cost is the profit that would have been generated if the down payment was invested in an alternative choice with equal risk level as purchasing a home (e.g. business or asset). The total profitability of Japan’s Real Estate Investment Trusts (J-REIT) is considered as one of the opportunity costs of investing in home purchases. For example, the total profitability of the J-REIT since 2010 (hurdle rate) has been approximately 15 percent per year on average (from March 2010 to June 2016).

Finally, compare the total profitability of the down payment and the hurdle rate. A home should be purchased instead if the total profitability of a purchased home exceeds 15 percent. This is because the net increase of the down payment means more wealth for the buyer.

In conclusion, growing wealth by buying a home is difficult in Japan. At least it seems safer to think this way for the time being.

Yuichiro Kawaguchi
Professor, Graduate School of Business and Finance, Waseda University

Yuichiro Kawaguchi is the Dean of the Graduate School of Finance, Accounting and Law, Waseda University. He received his Ph.D. in Engineering from the University of Tokyo and became a professor at the Graduate School of Finance, Accounting and Law, Waseda University in 2004. He is also the chairperson of the Japanese Association of Real Estate Financial Engineering, director of the Institute of International Real Estate Studies at Waseda University, director of the Asian Real Estate Society, and a temporary member of the National Property Subcommittee of the Financial System Council of the Ministry of Finance. His major publications include Fudosan Kinyu Kogaku (Real Estate Financial Engineering), Seibunsha, 2001, Riaru Opushon no Shiko to Gijutsu (Real Option Concepts and Techniques), Diamond, 2004, Fudosan Ekonomikusu—Shisan Kakaku no Nanatsu no Nazo to Jyutaku Kakaku Shisu (Real Estate Economics: The Seven Mysteries of Asset Prices and Housing Price Indices), Seibunsha, February 2013, and Fudosan Māketto no Asu wo Yomu—2020 Nen ni Mukete no Fudosan Jyutaku Toshi・Senryaku no Ronten (Reading Ahead of the Real Estate Market: Key Points on Real Estate and Housing Investment Strategy for 2020), co-authored, Nikkei BP, 2015.