Preview

The question of whether to own or rent a home is more relevant than ever as the housing market continues to decline. Each of us may have various opinions regarding what is in store for home prices, but what does this mean from a practical standpoint?

In this issue, I try to simplify the owning versus renting decision into its most important fundamental factors. Most of the analysis centers around the price to rent ratio, which provides the best single indication of whether owning will pay off economically.

In the end, I think that current prices still make renting a more attractive option in most U.S. markets. There are many good reasons to own a home, but the pure cost-benefit analysis tends to favor renting until home prices become more favorable.

Owning versus renting

The basic question is whether it makes more economic sense to own a home or to rent one. Individuals should be willing to do either depending on the relative prices. Contrary to popular belief, it is not always economically advantageous to own a home, even if you can afford it.

The common argument in favor of owning is that you don't "throw away" money in rent. Instead, you build equity in your home over the course of the mortgage. But what about the money you "throw away" in mortgage interest? Or taxes? Or maintenance? It's nearsighted to think that these expenses cannot be greater than rent if the home price is too high.

In addition, you have to think about the opportunity cost of your downpayment. Investing that money in the stock market may be a better alternative than parking it in home equity, which earns no rate of return. Finally, if renting is cheaper on a month-to-month basis, you can save and invest the monthly difference.

The complete own versus rent calculation is quite complicated and depends on many outcomes which are uncertain at the time of purchase, such as future rent growth or future home prices. In order to make a precise comparison, I've created a spreadsheet that projects the costs of owning and renting under various future scenarios. Another way to frame the problem is to figure out what you must believe about the future in order for owning to be the right decision.

Using the spreadsheet, you can enter in your exact estimates for taxes, insurance, maintenance, and so on, but ultimately the own versus rent decision can be boiled down into just a few factors, listed in order of importance:

1. Price to rent ratio - home price divided by the annual rental cost of a similar unit
2. Home price appreciation - future home value at the time of sale
3. Alternative investment return - the opportunity cost of your savings
4. Mortgage interest rate - the rate at which you can borrow money
5. Rent growth - the speed at which rents increase over time

The price to rent ratio is so fundamental because it gives you a quick sense for whether you're overpaying for the home. Consider a price to rent ratio of 20 - not uncommon in some of today's markets - where you would pay 5% (=1/20) of the home's value each year in rent. Compare this to owning, where you're probably paying 6% mortgage interest (or missing out on 5-10% investment returns on your home equity) and another 2-4% for taxes, insurance, dues, and maintenance. In most cases, it's tough to justify a price to rent ratio this high.

Home price appreciation is important because small percentage changes in home prices can translate into substantial dollar amounts. Even with a conservative price to rent ratio of 10, a 10% increase in the home value is equal to one year's worth of rent!

In order to make the own versus rent question more tractable, I've made a number of assumptions to simplify the analysis:

• 5-year length of ownership
• 3% annual rent growth
• 3% annual inflation rate
• 6% realtor commission
• 2.5% closing costs
• 20% downpayment
• 1% annual property tax
• 1% for annual insurance and maintenance
• 25% mortgage tax benefit
• 8% alternative investment opportunity cost of savings

The remaining factors are:

• Price to rent ratio
• Home price appreciation
• Mortgage interest rate

If you knew all of the above numbers with certainty, you could make an exact comparison between owning and renting. Obviously, the simplifications won't work for every situation. Taxes vary substantially across localities, and the length of home ownership has a non-trivial impact on the decision (although it almost never makes sense to own for less than 3 or 4 years). But for a general analysis, the estimates are quite informative.

I ask the following question: if you expect home prices to appreciate at X% per year for the next five years, under what conditions should you own instead of rent?

I begin with a market in decline, where prices are falling 2.5% each year. This isn't an unreasonable 5-year projection for some of the cities I reported on in the February Issue. You might consider this projection to provide a cushion if you are considering buying a home in such a market.

Click here for a more detailed analysis

I plot mortgage rates on the horizontal axis and price to rent ratios on the vertical axis. The black line indicates the break-even point between owning and renting a home. If you truly expect your market to fall by 10-15% over the next five years, you wouldn't want to buy a home unless the price to rent ratio was under 10. Unfortunately, almost no markets are pricing homes this cheaply.

Even in the non-bubble markets, I am not expecting much price appreciation in the next few years. The following graphic displays the own versus rent decision assuming no price appreciation over the time period.

Click here for a more detailed analysis

In a flat market, you would probably not want to buy a home for price to rent ratios much higher than the 12 to 13 range. Using this price rule in today's environment would tell you to rent in almost every U.S. market.

Over the long-run, home prices have demonstrated a remarkable consistency in growing at the rate of inflation, according to the research of Yale economist Robert Shiller, although it is less surprising once you consider that rents make up 30% of the consumer price index. In "normal" market conditions where home prices are increasing at roughly the rate of inflation, you are probably safe buying a home in the price to rent ratio range of 13-15:

Click here for a more detailed analysis

Finally, in a boom market with home prices growing at 5% per year, it can make sense to buy even in the price to rent ratio range of 15-20 since home price appreciation is such a dominating factor.

Click here for a more detailed analysis

However, the dangerous characteristic of these boom markets is that they do not last forever. As I argued in the May Issue, prices and rents are unlikely to diverge in the long-run. Expecting 5% price appreciation for any extended period of time seems overly optimistic to me in all but the highest growth markets. The 20% growth years we experienced in the last decade were anomalous, and we're now seeing the past appreciation vanish before our eyes.

Today's Markets

After running the numbers, it is amazing to me that price to rent ratios reached the 30s in more than a handful of cities. That would put the average home completely off the above graphics!

Part of the explanation for why the bubble continued as long as it did is that dramatic home price appreciation can compensate for high price to rent ratios, at least for a limited time period. The trouble is that home prices cannot grow indefinitely high without a foundation of rents to support them. And rents rarely increase by more than 5% per year for any extended period of time, even in the fastest growing cities.

Below is a chart from the May Issue that I have updated with the latest price to rent data:

Even after the most recent price declines, it still is hard to justify buying into most of these markets. Certainly the city averages do not perfectly reflect every single home, but in most instances I think it's worth waiting for prices to fall even more than they have already.

An alternative viewpoint

For a different perspective (although now that I'm re-reading it, the analysis is remarkably similar to what I've just written above) and a more user-friendly owning versus renting calculator, please see the following very smart NYTimes article, "As Home Prices Drop Low Enough, a Committed Renter Decides to Buy".

Key quote:

"For the last few years, I have been an evangelist for renting... Home prices almost certainly still have a way to fall, but they're now well below their peak. So my wife and I began our search with open minds, willing to consider renting or buying. We ended our search by signing a contract to buy a house. This is the story of my conversion.

...

All else being equal, owning seems far preferable to renting. Knowing all this, my wife and I were willing to buy a house even if it was ultimately going to cost us a bit more than renting. We just weren't willing to have it cost a lot more than renting.

...

Most of the time, the decision whether to rent or buy should be based above all on life circumstances. Do you expect to move again in a couple years? Or is there a good chance that you're ready to settle in - and stop worrying about real estate for a while?

The housing bubble, unfortunately, forced a reconsideration of this standard, because houses became so overvalued. But they're slowly coming back to reality, which means that buying has again started to make sense for more people. Apparently, I'm one of them."

Conclusion

Personally, I'd rather act cautiously until the downward pressure on home prices has fully run its course. At least for the next few years, I'd recommend owning only in cases where you won't depend on home price appreciation for owning to make sense. For most situations, this means trying to find homes that are selling in the price to rent ratio range of 10-12 or finding markets where home price appreciation was not unusually high in the last 5-10 years.

Economics aside, there are a few benefits to owning a home instead of renting. You may decide it's worth the extra premium for not having a landlord controlling your home life. As for me, I say there's nothing wrong with renting, especially when the economic savings can be substantial.