Rent Versus Buy: The Calculation is More Complex than You Think

I want to continue with the line of thinking that I started to develop in yesterday’s post, which explored some of the options that exist between the gamut of renting and buying. Today, I want to directly examine these endpoints. Let’s face it- for most people, the decision is not whether to get a co-op or a timeshare or pay points (this one was new to me as well), but instead is simply whether to buy or rent.

The most basic (and perhaps the most sensible) calculation is the housing equivalent of a stock’s P/E ratio. As one columnist explains, “You find two similar houses, one for sale and the other for rent, and divide the sale price by the annual rent. You can call the result the rent ratio.” If the ratio is low, than it probably means the house is cheap (just like with a stock!). Depending on the terms of your mortgage, a ratio below 20 will favor buying.

While everything is relative, consider that “Throughout the 1970s, ’80s and ’90s, the average rent ratio nationwide hovered between 10 and 14″ whereas at the height of the real estate bubble, “In Boston, New York, Los Angeles and south Florida, it topped 25. In Northern California, it approached 35, higher than it had been in any city, at any point on record.”

The next step is to open a Rent-or-Buy calculator, which based on a set of parameters that you select, will determine that it makes financial sense to either buy a home or continue renting. The most sophisticated calculators will usually go one step further, and tell you how many years it will take for you to break even from buying (i.e. how many years before your closing costs and down payment or recouped in the form of equity in your home). This calculation hinges on two crucial variables: rent inflation and home price appreciation. Using the most optimistic assumptions, you will probably determine that even if you plan to stay on your current home for only five years, you will still come out ahead.

The problem of course is that these variables are ultimately unknowable. Even worse, you will probably overestimate how much your home will increase in value. While the precise figure depends on when you buy and sell (i.e. at what stages of the real estate cycle), historical data implies a long-term real appreciation rate of only .4% per year. Compare this to the 3% that you could earn from a savings account or the 7%+ that you could potentially earn from investing in the stock market.

This unfortunate truth reveals a flaw in the reasoning that real estate agents propagate and buyers accept: that owning a home is akin to making an investment. In the right set of circumstances (i.e. if you are lucky), you will end up earning a return on your investment. But as the chart above shows, this kind of reasoning is misguided at best, and blatantly harmful at worst. You have to consider that for the first few years of owning a home, most of your mortgage payments will go towards paying interest rather than towards building equity. While such interest is tax-deductible, it’s not tax-free, which means that the benefit is probably only about 30%. Then there are property taxes, maintenance costs, insurance, etc, such that in the end, it’s sometimes a complete wash between renting and buying.

Even if this is the case, people have been programmed to think that owning is inherently better than renting. “In a 2003 survey conducted by Fannie Mae, 74% of the respondents said they believe ‘owning something of your very own’ is a reason to buy a home.” According to a recent study, however, homeowners are no happier and generally more stressed than renters. The study concludes “that our perception that homeowners are better off than renters might be fueled only by casual observations. The conventional wisdom might not hold up so well when you look at the data carefully.”

This is not to say that it’s better to rent than to buy. Instead, think of it as an exhortation to really think critically before deciding whether to jump into home ownership, since it may ultimately prove more expensive and more stressful than renting. In the end, it should be a personal decision, based on your unique profile- NOT the advice of a mortgage broker or real estate agent.