Is it Better to Remain a Renter or Buy a House? 27 comments
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Reader's Question: My husband and I are 40 years old, live in Australia, and have no kids. We own a small business and have annual income between $80k and $100k. We live within our means, have no debt, and save about $30k to $50k per year. We do not contribute to superannuation (tax-advantaged retirement plan) because we prefer to manage our investments on our own.
Our savings and investments (mostly common stock) are currently worth about $400k. Instead of buying a house, we have chosen to rent, since local real estate prices are very inflated, making renting much cheaper than buying. However, I am wondering if we should invest in real estate so as to diversify and have some place to live further down the line. How do you see renting vs. buying? Do you think we are on the right track to a comfortable retirement in about 15-20 years?
Rent vs. Buy Analysis
As with many financial decisions (e.g., invest in stocks or bonds?, whether or not to use leverage?, whether to continue to hold a stock or sell it now?), much can be said about the choice between renting and buying a house, although we only really find out tomorrow if we truly are making the right decision today. I'll go through an example using the U.S. real estate market, and then return the discussion to a broader perspective.
Back in 2000, just after the stock market had peaked and the dot-com crash was beginning, my family and I arrived in the city we currently live in. At that time, the local residential real estate market was firm with median-priced homes around $400k, and prices were rising at a solid though moderate mid-single digit annual rate. Being new to the area, we initially rented, paying $1,700 per month for an average-size house on a quiet street in a good school district. While renting, I occasionally would run through a quick rent vs. buy analysis, similar to the one I imagine you are now doing. Assuming no mortgage, the pre-tax calculation is simple, at least in principle (income taxes and a mortgage complicate matters but the main variable remains the relative investment performance outlined below):
Renting:
As renters, we were paying 12 x $1,700 = $20,400 per year in rent, and the owner was responsible for all property tax, homeowner's insurance and necessary repairs on the house. Since the $20,400 annual rent was about 5% of the estimated $400k price of a comparable house at that time (in the year 2000), we can write:
- Annual cost of renting = 5% of price of house.
Buying:
If we were to buy a comparable house, we would need to sell $400k worth of investments (mostly stock), foregoing whatever future return we might realize, and use this money to buy the house, which itself would show some rate of price appreciation. The financial burden of 1) paying property tax and insurance (about $4,000 annually on a $400k house) and 2) performing repairs or at least putting money aside into a reserve account for major repairs (e.g., roof replacement or painting) to be performed at some point in the future (estimated at another $4,000 annually), together add up to $8,000 per year. So, in approximate percentage terms, we have:
- Annual cost of buying = 2% for property tax, insurance & repairs + (S - R),
[where S is the estimated future annual percentage return on investments (mostly stocks) to be sold in order to buy the house, and R is the anticipated future annual percentage price appreciation of the house (real estate).]
From an investment point of view, renting should be preferred over buying when the annual cost of renting is less than the annual cost of buying, i.e., when 5% <> R + 3%. In other words, as a rough rule of thumb:
If stock market returns exceed house price appreciation by more than 3% (i.e., 300 b.p.) per annum, one can expect be better off renting a house (and owning stock) instead of (selling the stock and) buying a house.
The graph below shows how stock market returns (S&P 500) have compared to house price appreciation (for the Seattle area where I live) for the eight years between 2000 and today.
During 2000-2002, when the stock market fell sharply, I expected the sell-off in equities to exert noticeable downward pressure on local real estate prices, but the correlation between the stock and real estate markets was weak. When the stock market turned around in late 2002, initiating an extended five-year bull run, real estate price appreciation accelerated as well. Currently, amidst fallout from the subprime crisis here in the U.S., the housing market seems softer than the stock market, which itself is largely moving sideways as the economy flirts with recession.
In my family's case, after an extended house search, encompassing a few years but focussed on a small neighborhood with very little available inventory, we finally found the right house, liquidated other investments and closed escrow, switching from being renters to homeowners in early 2005. in retrospect, we managed to capture the bulk of the rapid price appreciation our local real estate saw in 2004-2006, and have ended up being on the correct side of the rent-vs.-buy dichotomy for each of the past three years.
Assessing the Future
Like you and everyone else, I wish I had a crystal ball to predict the future. If I could correctly forecast the relative performance of the S&P 500 versus my local real estate market, I would always know whether to be a renter or homeowner. Short of knowing the future, however, I look to "softer," more qualitative factors such as - being partially "hedged" through having exposure to both the stock and real estate markets, the freedom to replant a garden or repaint a room without consulting a landlord, peace of mind from having neither rent nor a mortgage to pay, and so on - for assurance that owning a house and allocating much of the balance of our investment portfolio to the stock market is the right decision, at least for now.
For a comparison to other markets, you might wish to read the Global Property Guide article here. It covers the state of housing markets around the world, and gives both price appreciation and rent figures for many countries. Some highlights, with emphasis on the Pacific Rim (including both Australia and the U.S.), are:
House Price Appreciation (2007, in local currency):
- Shanghai 28%
- Singapore 28%
- Hong Kong 11%
- Australia 11%
- U.K. 10%
- South Korea 9%
- Japan (6 major cities) 8%
- New Zealand 7%
- Canada 6%
- Japan (nationwide) -1%
- U.S. (average of indices) -2%.
Rental Yield (gross rent as percent of house price):
- Shanghai 7.8%
- Sydney 5.9%
- London 5.4%
- New York 5.0%
- Tokyo 4.7%
- Hong Kong 4.2%
- Singapore 2.8%
Offhand, I would guess that at some point during the next couple of years a few of the hotter real estate markets around the Pacific Rim will see declines similar to what the U.S. (particularly the submarkets like California, Florida and Las Vegas, Nevada, which rose fastest on the way up) is now experiencing. How your neighborhood real estate market in Australia is impacted is really something you, being local, should have a better handle on than I do.
When making your decision, keep in mind that:
- The future is hardly ever crystal clear.
- It is the relative future performance between whatever particular investments you will sell (the "S" above) and the specific house you will buy (the "R"), that will allow you (and only retroactively!) to determine conclusively if you made the correct rent vs. buy decision in prior years.
Overall, seeing that you and your husband are entrepreneurial, hardworking, persistent in your saving habits, self-directed in your investing, and debt-free, I am optimistic that either path you choose, whether it is renting or buying, will lead you to the comfortable retirement you are targeting.
Best of luck in the years ahead!
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This article has 27 comments:
Also of interest, you may enjoy the analysis of whether it's actually that risky to do an interest only mortgage, which has been villified by the press.
everydayfinance.blogsp...
If considering the Ufirst Money Merge to decrease the life of your mortgage, you should be aware of all the downsides and risks:
everydayfinance.blogsp...
Further, for someone buying a $400k house with a loan, likely paying 20% down, the interest paid per year on the $320k loaned does not exceed the standard deduction - given to ALL taxpayers, even renters - by much at all.
that's like going to the store and buying a bunch of stuff you don't need because it's on sale and then telling friends how much you "saved".
(FWIW, my comment was specific to this example - ie a ~$320k loan -- the deduction is important in more expensive homes, but it's not in itself a reason to get a larger loan...)
I don't advocate spending money you don't have or spending just to save (like people that carry credit card debt but love cash back rewards cards-kind of defeats the purpose), but the point of my article is that by putting more down than you need to or choosing to invest in principal rather than the market, you're essentially getting a 0% return on principal to a bank rather than investing it at a higher rate elsewhere WHILE forgoing a tax deduction. Your initial question was whether you'd even get the deduction. When adding the mortgage deduction and taxes this year, it was well over 20K off my income, which far exceeds the standard deduction even when filing jointly. It all comes down to net present value and you decrease your NPV when pre-paying more than is necessary.
Here's another example where there's great debate over the merits/benefits: The UFirst money merge account purports to reduce your mortgage from say, 30 years to 10 years, but with many strings attached. I've performed a full analysis to highlight that this is totally unnecessary and costly compared to either investing elsewhere or simply paying it down yourself. Anyone considering options related to pre-paying or using this system should read, since most articles on the internet are positive affiliate-related propoganda ads: everydayfinance.blogsp...
As far as the debate between everyday finance and jswede is concerned, I am of the opinion that jswede is on the money as far as the precise moot point is concerned. Since the author did not mention amortization or a mortgage, the tax break is out of the scope of the article and the argument. However, everyday finance does bring that as a valuable point and I think the author should have addressed the example with a mortgage example assuming standard interest rates, time to maturity etc. Please Mr. Sakazaki, add that piece when you can. Thanks.
I'd respond, yes give me infinite leverage so I can lever my investment money many fold and measly use real estate value increase to make boatloads of money - today's market excepting, of course.
But finally, if you have never built your own home with things exactly the way you want them, you are living at a level below someone who has/is even if your homes cost the same amount. They have exactly what they want and you have the Salvation Army version.
They get to plant the trees right where they want them, add the pool they wanted 5 yrs in, get granite counters when the want to, and basically actually have what they want...you get to use the coupon and buy the store brand.
I hope to spend my last dime on the day I die. You can't take it with you.
I LEARNED THIS LESSON IN 1932 WHEN MY PARENTS WITH FIVE CHILDREN LOST A TWO STORY HOUSE THEY WERE BUYING AND HAD TO MOVE BACK INTO A TWO BEDROOM HOUSE THEY OWNED. MY MOTHER DIED IN THAT HOUSE.
very astute observation you've made there. i was also wondering, when the issue of mortgage interest deductability came up, whether they even have that in australia.
jcrash,
i took the other side of that bet. i saved and worked 60-80 hour weeks, bought a smaller home and lived in it for 20 years, evn though i could have stretched and had a much more comfortable one. i sent my wife and son on vacations, but i stayed home and worked. now, i'm 55, we moved to a larger home, i'm retired and i write to people like you on the internet because i have time to do whatever i want. good luck with your plan.
cisco kid, was a friend of mine.
It sounds like this mystery couple from Australia has stayed committed to two virtue in life "freedom",i.e., the ability to pick up and change your lifes direction at any point in time and disciplined investing. Understanding that psychology, and only because of that, do I point out that "Kotika 98" has a point about the REIT's, which are essentially moderately to highly liquid equity positions in various forms of real estate, including mortgages.
However, neither REIT nor Company Stock certificates provide what what this family is looking for - a home. You get absolutely no utility out of certificates. Ooops, I take that back, you may be able to use them as fuel for a fire or scrap paper. This couple really needs to take the plunge and buy a home and here's why (based on US tax laws):
1. Real estate has a preferential tax treatment vs. Stocks
-Aside from the very important yearly tax deductions, mortgage interest and local property tax, many people forget that on your primary residence in the US, tax laws allow you to forgo up to $250K ($500K if married filing jointly) in gains, if you lived in and considered your property your "primary residence" for two of the last 5 years (they don't even have to run concurrent). Capital gains on stocks are either 15% (long term) to 20% (short term) currently.
2. Control over the Investment, You're at the Mercy of Others
-How many times as investors have you listend in on a conference call and been so upset at the things you heard coming from the other end of the line. CEO's getting paid handsomly while the company is losing money, BOD's not approving take-overs that would benefit the shareholder's, mismanagement of funds, etc. The same applies to rentals. You don't get to decide what how the toilet gets fixed, your landlord does, and if that means bringing in a used one from another complex that's what you get! With the real estate you own you get to decide how the money is spent and how the asset is utilized.
3. Utility and Pride of Owenrship
-By far the most undervalued variable in considering homeownership is utility. You gotta have somewhere live right? How do you calculate the value of utility or pride of ownership? It's virtually impossible. Owning 1/100,000,000 of General Electric is not going to give you the same feeling as owning 100% of your home, I can almost guarantee it!
4. Leveragble Asset
-Leverage is by far one of the best reasons real estate makes such a valuable investment. There is really no other investment that makes such use of high leverage as real estate does. Even in todays market (I've seen it done with seller financing) you could finance 100% of your home. Alternatively, you could be someone who dosen't like to be highly levered; in that case, when it's your daughters wedding, when you want to start up a new business, when you'd like some cash but don't want to sell your property, you can take out a loan against your property. Real estate improves your "personal balance sheet". It gives you a foundation to build from and lever from if you choose too. Go into Wachovia tomorrow and tell them you want a loan against your stocks payable in 30 years at 6% interest! Good luck.
5. Dividends, adding value to increas Cash Flow
-Not all stocks pay dividends, but most real estate does. Even a single family residence pays you the dividend of "Utility" and even there with a little work you can have your real estate pay you. Here are some of the things you can do to increase the "Dividend" on your home (1.) Plant a garden - With food prices going up you could easily save yourself 500$ to $1,000 annually on simple garden of tomatoes, avocadoes, strawberries, carrots, etc. (2.) Rent parking space - your neighbor may have an RV, truck, etc that doesn't fit on his lot rent him space. (3.) Extra rooms, Units, Storage - Rent it out.
You read why, no here's how and what to get!
WHAT:The ideal home for this couple is a 2 - 3 unit building with an adjoing, but not abuting SFR. This will give them the privacy and space for gardening, entertaing, etc., but also provide additional income from the rental untis. It must be under 4 units to qualify for favorble financing and tax treatment.
HOW: They should take a portion of their cash and put that as minimal a down payment as possible, most likely 10% to 20%, while weighing the considerations of interest rates and the tax deduction (lower down, usually means higher interest rate, no sense in getting a higher interst rate if it doesn't benefit you). They should go for a 30 to 40 year loan, but act like its a 15 year loan. What! 30 to 40 year, but act like it's 15! Yes. They should figure the loan payments based on a 15 year amortization (most definitely higher) and put the differrence between that and the 30 or 40 year payments in to local muni bonds. Local muni bonds are not taxed at the local, state nor federal level. Think about it. They are essentially paying there house off in 15 years, but only if they decide. The money they put aside will begin to accrue over the next 15 years and if on the 15 year the decide they'd like to pay the mortgage off then they can do it. If they decide they'd rather keep the money the money for current use they can. Paying down your house is old school and the equity is never there when you need it! Think about it, when would you most definitely need to tap the equity in your home, when you've lost your job, when you gotten ill, you think any bank in there right mind is going to lend you money when you're down and out? No. That's why it's better to keep your cash where you can use if you need it! Hope this helps. Know go by a house!
Well, for people in my scenario we barely spend $1,000 on food per year to begin with! On top of that, gardens cost more money to build and maintain than it does to buy the produce straight from a shelf. Any person who says otherwise hasn't built a garden in their backyard. Its a hobby, not a source of income and savings.
"Leverage is by far one of the best reasons real estate makes such a valuable investment. There is really no other investment that makes such use of high leverage as real estate does."
Thats because if you go bad on your loan, the bank takes your house. The bank is in a win-win situation (not the person who takes out the loan). This is a *bad* use of leverage. A good use of leverage over someone is to have your leverage and eat it too. In other words, to make leveraging your house a *good* option you would have to get money for the loan and if you go bad on your loan....you still don't lose your house. And what bank is going to do that? The only way the *bad* leveraging of a house is "acceptable" is if you already have the cash on hand to pay back the loan at any time, aka having your butt covered to begin with. A bank can call a loan at any time for any reason or no reason.
The rest of your comments about utility were pretty decent though. All of which, of course, take effort, committment, and preparation to achieve.
I'm single with no kids and I have owned all kinds of real estate including single family residences, but I have never owned the home in which I've lived. My rule has been to always rent and rent wisely. I even rented out the SFRs I owned. Typically, the landlord pays the property taxes and maintenance expenses. But, one can really get an edge when the owner also pays the utilities! Nice older apartments built without individual utility meters are out there. The utilities are included in the rent. Over the years, I have saved a lot of dough renting my home. It may not work for everyone, but one should look at it, especially now that there's a glut of property out there. Banks with large REO lists may be a good start to either buy or rent. One thing I've learned in life is that if one doesn't ask, one doesn't get.
I think you are on the dole.
As for leveraging, I do agree for investment terms that one can make good use of others' money. However, buying a personal use house is never one of those investment opportunities. Ever. Either invest to make a rental, or else invest somewhere else and rent. Buy if you have the spare money to do it and really *desire* a house. But don't do it as an investment opportunity. That was my point about leveraging.
It's really interesting to read comments from across the pond regarding the whole ownership/rental debate. I'm from Bonnie Scotland and my company specialises in helping people who find themselves in very distressing financial situations. Because they own their own home, they have some leverage ( as long as they are not in negative equity) and many of them choose to sell their home and rent it back. The funny thing is, that once the sale is over, they just get up the next day and everything is pretty much the same - with more money in their pockets.