Article: Renting is better than owning in the long run.

[TheChaz]

An article from MSN details why renting will build wealth and owning won’t. I’m curious what the community has to say about this viewpoint.

http://articles.moneycentral.msn.com/Banking/HomebuyingGuide/WhyRentToGetRicher.aspx

Why rent? To get richer

A contrarian’s view: Houses don’t appreciate any faster than the level of inflation over the long term, so forget about buying a home and put your savings into stocks.

—–

I have something un-American to confess: I rent an apartment despite having enough money to buy a house. I plan to keep renting for as long as I can. I’m not just holding out for better prices. Renting will make me richer.

I normally write about stocks for SmartMoney.com, but the boss asked me to explain to readers my reason for renting. Here goes: Businesses are great investments while houses are poor ones, so I’d rather rent the latter and own the former.
Stocks versus houses: Returns
Shares of businesses return 7% a year over long periods. I’m subtracting for inflation, gradual price increases for everything from a can of beer to an ear exam. (After-inflation, or “real,” returns are the only ones that matter. The point of increasing wealth is to increase buying power, not numbers on an account statement.)

Shares have been remarkably consistent over the past two centuries in their 7% real returns. In Jeremy Siegel’s book “Stocks for the Long Run,” he finds that real returns averaged 7% over nearly seven decades ending in 1870, then 6.6% through 1925 and then 6.9% through 2004.

The average real return for houses over long periods might surprise you: It’s virtually zero.

Shares return 7% a year after inflation because that’s how fast companies tend to increase their profits. Houses have their own version of profits: rents. Tenant-occupied houses generate actual rents, while owner-occupied houses generate ones that are implied but no less real: the rents their owners don’t have to pay each year.

House prices and rents have been closely linked throughout history, with both increasing at the rate of inflation, or about 3% a year since 1900. A house, after all, is an ordinary good. It can’t think up ways to drive profits like a company’s managers can. Absent artificial boosts to demand, house prices will increase over long periods at the rate of inflation, for a real return of zero.

Robert Shiller, a Yale economist and the author of “Irrational Exuberance,” which predicted the stock-price collapse in 2000, has recently turned his eye to house prices. Between 1890 and 2004, he says, real house returns would’ve been zero if not for two brief periods: one immediately after World War II and another since about 2000. (More on them in a moment.) Even if we include these periods, houses returned just 0.4% a year, he says.

The average pundit, planner, lender or broker making the case for ownership doesn’t look at returns since 1890. Sometimes they reduce the matter to maxims about “building equity” and “paying yourself” instead of “throwing money down the drain.” If they do look at returns, they focus on recent ones. Those tell a different story.

Between World War II and 2000, house prices beat inflation by about 2 percentage points a year. (Stocks during that time beat inflation by their usual 7 percentage points a year.) Since 2000, houses have outpaced inflation by 6 percentage points a year. (Stocks have merely matched inflation.)

Stocks versus houses: Valuations

But though stock returns have come from increased earnings, house returns have come from ballooning valuations, not increased rents. The ratio of share prices to company earnings (the price-earnings ratio) has remained relatively steady. It’s about 16 today, close to both its 1940 value of 17 and to its 130-year average of about 15. Not so the ratio of house prices to rents. In 1940, the median single-family house price was $2,938, according to the U.S. Census Bureau, while the median rent was $27 a month, including utilities. That means the ratio of prices to annual rents was 9. By 2000, the ratio had swelled to 17. In 2005, it hit 20. We can adjust for the size of dwellings, but it doesn’t make much difference. The ratio of single-family house prices to three-bedroom apartments is 19. In SmartMoney’s hometown of Manhattan, where more detailed data is available, the ratio of condo prices per square foot to apartment rents per square foot is 22.

Two main events have caused house valuations to inflate since World War II. First, the government subsidized housing by relaxing borrowing standards. Before the creation of the Federal Housing Authority (FHA) in 1934, homebuyers who borrowed typically put up 40% of the purchase price in cash for a five- to 15-year loan.

By insuring mortgages, the FHA permitted terms of up to 20 years and down payments of just 20%. It later expanded the repayment periods to 30 years and reduced down payments to 5%. Today, down payments for FHA loans are as low as 3%. Aggressive lenders offer loans with no down payments or even negative ones so that homebuyers can borrow the full purchase price plus closing costs. Some require little documentation of income, assets or ability to pay.

That means more Americans can win loans for homes, and they can win them for far more expensive homes than their incomes had previously allowed. Two-thirds of American households own homes today, up from 44% in 1940, even though the percentage of Americans living alone has tripled during that time. The ratio of house values to incomes has risen 260% in just under four decades.

A second event helped boost house demand in recent years. Share prices plunged in 2000. The Federal Reserve, fearing that the decline in stock wealth would cause consumers to stop spending, reduced the federal-funds rate, the core interest rate that determines the cost of everything from credit cards to mortgages, to 1% by summer 2003 from 6.5% at the start of 2001. Since most of the cost of financing a house over 30 years is interest, monthly house payments shrank and demand for houses soared. In some markets a string of big yearly increases in house prices led to panic buying.

Stocks versus houses: Conclusion

For house returns over the next 20 years to match those over the past 20, the government and private lenders would have to “up the ante” by relaxing borrowing standards further. Given the recent attention paid to swelling foreclosures, that seems unlikely. I suspect real returns will turn negative over most of the next two decades, but that house prices won’t necessarily dip. Since 1963, they’ve done so in only two years versus 18 for stocks.

That’s because homeowners mostly just stick it out rather than sell during soft markets. But if house prices remain flat, they produce negative real returns due to the creep of inflation. According to calculations made by The Economist in summer 2005, house prices would have to stay flat for 12 years with annual inflation at 2.5% for the ratio of prices to rents to fall from its 2005 perch to merely its 1975-to-2000 average.

So to sum up why I rent: Shares right now cost 16 times earnings and over long periods return 7% a year after inflation. Houses right now cost 19 times their “earnings” and over long periods return zero after inflation. And they look likely to return less than that for a while.

Questions and objections

In what follows I’ve tried to anticipate and address questions and objections:

“You can’t live in your stocks” or “Renters throw money down the drain.”

Rent is the cost of owning shares with money you would otherwise spend on a house. Houses have ownership costs, too: taxes, insurance and maintenance. Rent costs about 5% of house prices each year if we apply the price-rent ratio of 19. House incidentals often cost around 2%.

If you have $300,000 and a choice between spending it on a house or shares, you’ll pay $6,000 a year in incidentals if you buy the house or about $15,000 a year ($1,250 a month) in rent if you buy the shares. But the shares will return $21,000 a year after inflation while the house will return zero. (My numbers work out even better than these. I pay a smidgen less than $1,250 a month for rent, while house prices in my neighborhood are far higher than $300,000.)

Note that houses and shares have transaction costs, too. Homebuyers pay around 1% in closing costs when they buy and 6% in broker commissions when they sell. Share buyers pay $10 trading commissions, which are negligible for buy-and-hold investors.

“Homebuyers get tax breaks.”

So do share buyers, but both are a bad deal. The interest on loans for houses (mortgages) and shares (margin balances) is tax-deductible. But the rates are almost always too high. A big house loan presently costs 6.1% interest, while a big stock loan costs about 9%. For the returns, we can forget about inflation because it helps debtors while hurting investors, making it a wash for those who borrow to invest. Still, nominal returns of 3% for houses and 10% for stocks aren’t high enough to justify those rates. The tax breaks aren’t really breaks at all. Moreover, a majority of homeowners don’t claim them. Their incomes are low enough to make the standard deduction a better deal.

“What about the pride of homeownership?”

It’s not for me. I define ownership as no longer having to pay for something and being able to do as I please with it. I own my coffee maker. Homeowners must pay taxes each year even when their mortgage payments are done. In certain markets they can’t even make changes to the houses they’ve paid for without seeking the approval of others. Personally, I feel the pride of ownership for shares of businesses, and I’m proud to occupy a nice place while leaving the burden and poor returns and maintenance to someone else.

“You seem to knock government housing subsidies, but they’ve helped many Americans afford homes.”

My inner socialist agrees. My other inner socialist worries that the government has effectively raised prices to the point where the middle class can’t afford houses or buries itself in debt to own them. My inner capitalist is too busy watching shares to care about house prices. My inner conspiracy theorist notes that while politicians tout the social benefits of homeownership, none mentions its tax benefits to the government. I pay no taxes on the overall value of my stock portfolio, just on my cashed-in gains and collected dividends. But Americans pay taxes on the full $11 trillion worth of housing they own plus the $10 trillion worth of it they’re still paying off.

“Houses are bigger than apartments.”

True, and both can be rented. A third of renters live in single-family houses. I prefer an apartment for now. I like not having to fill it with stuff. I like using a fifth of the energy of the average American. I like being 20 minutes from work and not having owned a car in 10 years. I like not stressing over whether to get the marble countertops or the imported tiles or the 52-inch flat screen. I’m not especially frugal; I spend a teacher’s salary each year on restaurants and travel. But I guess I’m too busy or lazy right now to bother with a big house and its innards.

“Are you saying I should sell my big house and rent an apartment instead?”

No, unless you have more space than you need and moving wouldn’t be disruptive to your family, and you want to cash in on recent housing gains, make more money over the next couple of decades, use less energy while simplifying your life, and you don’t mind seeming odd to friends. In which case, yes. But really, I’m not trying to win anyone over. Strong demand for houses keeps my rent cheap.

“Renting is for poor people.”

True. But it’s for rich people, too. The average renter makes about $34,000 a year, but while the percentage of renters declines after incomes exceed $20,000 and rents exceed $600 a month, it jumps again once incomes top $150,000 and rents top $1,200 a month. In other words, poor people rent modest apartments for lack of choice. Middle-income people buy houses. High-income people, presumably with a dose of financial savvy, often rent nice apartments instead of buying.

“You say houses return zero. But I’ve made a fortune on my house in recent years.”

I’m referring to inflation-adjusted returns over long periods, absent external boosts to demand. You’re referring to gross returns over a short time period that combined lax borrowing standards and ultra-low interest rates. Over the next 20 years I believe houses will return zero or slightly less after inflation, and that stocks will return 7%.

“So you’re never going to buy a house? What about raising a family?”

I might buy one eventually, but the longer I can put it off the more I’ll get out of the shares I’ll have to sell to afford it. I’m 34 now with a fiancée and a fish. I’m going to try to rent for at least 10 more years. If I have kids I’ll probably move into a big apartment or a house once they reach running-around age. I’ll rent, most likely.

This article was reported and written by Jack Hough for SmartMoney.

[no_such_reality]

This was covered a couple weeks ago when the original smartmoney article came out.

The real benefit of renting is it keeps you from over-consuming housing. You don’t get a three bedroom until you need a three bedroom. People are content renting a one bedroom but typically want to buy a 3/2.

You change jobs, you change rentals and still have a 7 minute commute. Big house filled with stuff? Nope. A small kitchen set, living set and bedroom set. No dining room collecting dust. No need for four TVs in the living room, family room, kitchen counter and bedroom. etc. & so on.

Transaction costs in buying RE makes it like signing a 3 or 4 year lease. ( how many people willingly sell multi-year leases without significant discounts?). Unless you need a 3/2, 4/2+ with yard, there’s little reason to get one everything else, is simply more available as a rental.

[PerryChase]

It used to be that the rule of thumb was $1000/month carrying cost (including taxes & maintenance) for each $100,000 borrowed. Exotic loans and teaser rates changed that.

Interest rate resets and high overall interest rates will make that come true again. I’m amazed at how many of my peers have forgotten the early 90s. Over this past weekend, a friend visiting from Orange County was asking me about investing in San Diego where prices are lower.

[PD]

On Saturday I was talking to a woman who told me that she was looking into buying a condo. I cautioned her and advised that she do some research as the market was probably going to be heading south for some time. She told me at least three times, “I just really want to INVEST in something.” I wanted to tell her that she was about to invest her way into financial destruction.
People just don’t get it yet. It isn’t going to sink in until they start seeing their friends and neighbors in trouble.

[no_such_reality]

It used to be that the rule of thumb was $1000/month carrying cost (including taxes & maintenance) for each $100,000 borrowed. Exotic loans and teaser rates changed that.

PC I think you’re confusing the 1% rule. When the monthly rent collected get’s to 1% of the purchase price of the home(SFR), you can expect to get cash flow positive. Anything less and you are cashflow negative draining money from yourself.

For condos, high mello-roos and HOA areas that is slightly higher due to the extra fees. (Some argue that it cancels in slightly less maintenance).

[surveyor]

N/A

This article is only applicable to certain areas of the country where it is cheaper to rent than to own. For those places where rent is about equal to ownership, his argument starts breaking down.

For San Diego, New York, and other bubble areas, yes what he is saying applies.

[kewp]

“This article is only applicable to certain areas of the country where it is cheaper to rent than to own.”

Well thats the thing, its supposed to be cheaper to rent than to own. How are you supposed to make money renting new properties, otherwise?

As an aside, I think the one factor more than anything else that is going to put the brakes on the inevitable crash in San Diego is all the savvy RE investors that dumped properties in 2005 and are eager to buy back in.

[NeetaT]

The article further corroborates the fact that property tax is the worm in the apple of home ownership.

[kewp]

oops, make that ‘it should be cheaper to own than to rent’.

[davelj]

The author is a clown. He completely omits the positive impact of leverage over long periods of time. For example, if I purchase a property that is “fairly valued,” with a 20% down payment and it increases at 3%/year (that is, zero real return after 3% inflation), my nominal return is 15%/year on my invested capital (and 12%/year after inflation) assuming I relever the property every few years to maintain 20% equity.

Omitting the impact of leverage when looking at buying a house or evaluating a real estate investment is like omitting the impact of earnings when valuing a company. It completely discredits the author.

Furthermore, his 7% real return assumption from owning businesses is largely dependent on his starting points for calculating such returns (when valuations were relatively low). There have been plenty of one- to two-decade periods for which the return from owning businesses was in the low single digits. It’s probably best to assume a “real return” of about 4% over the long term. That’s 2% productivity growth plus 2% growth in the population – and I’m being VERY generous.

It’s hard to believe that articles this fallacious actually get published. Who edits this stuff?

[blahblahblah]

The author is a clown. He completely omits the positive impact of leverage over long periods of time. For example, if I purchase a property that is “fairly valued,” with a 20% down payment and it increases at 3%/year (that is, zero real return after 3% inflation), my nominal return is 15%/year on my invested capital (and 12%/year after inflation) assuming I relever the property every few years to maintain 20% equity.

Sounds like you’ve invented the financial perpetual motion machine. Why are you wasting your time posting here on Piggington when you should be frolicking in the Mediterranean on your 100ft yacht?

[surveyor]

leveraging

It doesn’t take overnight and it won’t make you a bazillionaire, but you can get rich using real estate through what davelj says.

Don’t let your ideology blind you to the fact that there are ways to make money in this real estate market, bubble or no.

[PerryChase]

I concur that money can and is always being made in real estate, bubble or not.

However, purchasing a personal residence as a investment is not the way to do so, as correctly pointed out in the article. Since you live in the house, you forgo any potential rental income. Plus, by purchasing you’re likely to be consuming more than you would otherwise be if you were renting.

[blahblahblah]

I don’t buy the 12% year after year inflation returns in the general case. If you were really able to get real estate returns like that with such a simple method, no one would even bother with stocks or bonds. A very savvy investor might be able to do this with selected properties, but he’d have to be really sharp to beat the market by such a wide margin. It is true that there will always be money to be made in real estate, it just rubs me the wrong way when people post about their 15% annual returns and say that everyone else is a clown for not being able to achieve the same thing.

[TheChaz]

Regarding the leverage point, doesn’t he counter that by saying that you can borrow to by stocks as well? A margin balance will allow you to leverage stock purchases, right?

[Author]

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