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Financial Life Advisor
Buy or Rent?
How is owning a home a good investment, when I can rent a comfortable apartment for about what I would pay in property taxes, insurance and association fees on a home - not to mention the maintenance costs and other work necessary to maintain a home? Sure my mortgage itself is less than rent...but what about all the other costs? Once it is all said and done, won't I end up paying in interest on the note almost three or four times the original amount of the house. A house is not guaranteed to appreciate is it? Even if it was guaranteed to appreciate, would the appreciation rate even beat inflation?
A.M. from Laredo, TX A, you bring up some very valuable points of consideration when thinking about owning a home. A central part of “The American Dream” has historically included home ownership. It almost seems instinctual to own your home instead of paying rent, but on the front end, renting is generally less expensive and certainly has much less risk.
When I talk about a personal residence with clients, I encourage them to not think about it as an investment. I think it is better to look at your home as your sanctuary and place you live, rather than an asset which is making you money. If you think of your house as an investment, you are less likely to pour money into a diversified investment portfolio and will instead buy a bigger and better house or make costly improvements (which generally return less than what was spent on them). If you think of your home as something you consume, like a car or meal, then you are less likely to justify spending more than you can comfortably afford because psychologically, you are recognizing your house as a cost and not an investment. It is true that many homeowners have made a handsome gain when they have sold their property, but homeownership does not always work out so well. Let us look at some of the reasons you would want to own versus renting.
Real estate is often touted as great inflation hedge. In fact, the best indicator for housing values is the level of income of people in the geographic location where the real estate is located. As incomes usually rise with inflation, what people can afford to spend on a home has also increased. This is why I believe real estate has historically been about what inflation has been. This is perfectly illustrated by what has happened in urban Detroit. Because of the contraction in manufacturing, particularly in the US auto industry, Detroit incomes have been decimated. While the rest of the country saw rises in real estate values, Detroit saw a decline. There are numerous neighborhoods in Detroit right now which have housing selling for under $10,000. Outside of income levels, housing values can be affected by other factors such as:
Property Tax – In states like Texas where property tax is higher, property values are kept down because higher values mean higher annual tax. In a states like California, property tax valuations do not increase with the market values every year, so the lower tax rate on holding long-term real estate in California, among other things, has helped drive up prices.
Change in Lending Rules – As has been made painfully obvious in the recent real estate bubble, how houses are financed can affect real estate values. When the lending rules were loosened, buyers could get loans with little or nothing down and no proof of income. This effectively released a wave of new buyers into the market driving up home values. Appreciation was so quick that more people dived into the market, thus pushing up home prices further. We all know what happened next…….
Building Costs – As the cost of raw building materials and/or labor to build a new house go up, the value of existing structures goes up as well. This also works in reverse.
Zoning Laws – Many municipalities put restrictions on development. It may not be permitted to tear down a small house and build a bigger one or a multi-family unit. Additionally, there may be only so much land available for development. If zoning is tightly controlled, it can create scarcity of land and drive up values for desirable areas.
History has shown us over long periods of time housing has appreciated at approximately the same rate as inflation. The best web resource I have found to support this can be found here. Now that we have established that real estate generally only appreciates at or near inflation, let us look at the cash flow for purchasing a home.
When someone is looking to buy their first home, they generally have little to no savings. For this exercise, we will assume the potential purchaser is going to finance almost the whole home purchase price with a FHA mortgage. Also, because each housing market is different, I will use Laredo, TX as the subject of this comparison. In order to compare apples to apples, we will assume that instead of living in an apartment the purchaser would buy a condo in a multi-unit building. It is not fair to compare a 3 bedroom house to a 2 bedroom apartment. According to city-data.com the average cost of a multi-unit condo in Laredo was $91,789 in 2007 and the median gross rent was $632/month. The prevailing interest rate on a 30 year mortgage on 10/2/09 according to bankrate.com is 5.1%. We will estimate a property tax rate of 3%, homeowners insurance at .5%, and annual dues and maintenance at 1 % per year. We will assume a 3.5% annual inflation/appreciation rate.
If this person rents the apartment, they need to put one month’s rent down ($632) as a security deposit. They do not have any repairs or other expenses, as that is the responsibility of the landlord. We will exclude utilities, as they should be roughly equivalent in both properties. If a condo is purchased, they will need to put a 3.5% down payment on the FHA mortgage ($3,212). The 30 year mortgage payment will be roughly $498.37 per month. After closing costs, they will have no equity in the property (the down payment roughly equals the loan costs). When you add in tax, insurance and maintenance it bumps the total monthly cost of ownership to $842.58 per month. This illustrates clearly that up front, the cost of home ownership requires more cash up-front and more cash on a monthly basis. Even though we assume a monthly maintenance cost, those expenses usually come in large chunks. Those large chunks represent more risk to ownership. So for the first year, it is clear that renting definitely wins over owning.
Let us take this illustration out eight years past the date of purchase. At this point of time the rent has crept up over time to about $804 per month. Although the mortgage is exactly the same ($498.37), insurance, tax, and dues and maintenance have increased with both the value of the home and inflation. The total monthly costs have increased to $936.30 per month on the condo. So the apartment is still cheaper on an absolute cash flow basis, but the renter does not own their property. The condo owner does. Over the first eight years, they have paid off about $13,000 dollars of their mortgage, and the property has appreciated about $25,000. This means the condo owner has about $38,000 in equity. The renter has been saving money each month, but the owner would get some serious cash if they were to sell their home. It is close, but I would argue the owner is better off.
Now we will fast forward to thirty years later. The renter is now paying $1,713.91 per month. The homeowner is still paying the same mortgage payment ($498.37). The value of the property has zoomed up to $248,920.57 so the tax, insurance, and maintenance and dues drive the total monthly cost up to $1,431.82. The mortgage is virtually paid off, so the owner could receive a quarter million dollars if they sell. The renter would get their $632 deposit back. The owner clearly has the better deal at this point in time. They not only pay less per month but also have equity in their home. In year 31, the monthly payments would drop to $966.12 with no mortgage at all.
Here is a summary of numbers discussed:
Total Monthly Cost Monthly Rent Home Equity
Year 1 $842.58 $632.00 $1,390.98
Year 8 $936.30 $804.08 $38,134.83
Year 30 $1,431.82 $1,713.91 $248,716.96
Year 31 $966.12 $1,773.89 $257,418.96
The key to why homeownership wins in the long run is that you are benefiting from inflation ($160,000 in the example). By owning the property instead of leasing it, you are getting to keep the appreciation/inflation each year, versus the renter who just faces higher rent the next year. The place that most homeowners shoot themselves in the foot is buying more house than they need, buying more than they can afford, and/or by trading houses often. Each time you go through the process of buying or selling a home, you generally spend about 10% of the purchase price on sales commissions, movers, and loan origination, so the general rule of thumb is that if you think there is a good chance you will need to sell the home within 5 years, you shouldn’t buy it.
I have not mentioned it up to this point, but interest on a mortgage is generally tax deductible. This pushes the numbers increasingly towards ownership as in the beginning of home ownership most of the mortgage payments are interest. In the waning years of the mortgage interest is generally a much lower portion of the payment, but rental rate inflation has helped tip the balance in favor of home ownership. There are also certain legal protections that owning a home provides. If you file for bankruptcy, most states have a homestead exemption which allows you to keep your house, assuming you own it outright or stay current on the mortgage. Secondly, a landlord does have some limited access to your apartment. With your own home the buck and permission to enter the property always stops with you. I would argue that is one of the best reasons to own over rent.
Hope this helps explain the buy versus rent decision for you.
Posted by Ben Gurwitz on 12th October, 2009 | Comments | Trackbacks
Tags: Financial Planning, Oct 09
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