Rent vs. Buy – Where Did I Go Wrong?

[Daniel]

Mr Wrong,

You’re actually “wrong” in a very subtle way (this is leaving aside the obvious opportunity cost issue, which many others already pointed out). It all has to do with risk premiums.

The interesting thing is that a “buy vs. rent” analysis would – surprisingly for most on this board – conclude that the housing market is fairly priced, as you noticed.
However, the same analysis done at any point in the past decades would have shown buying to be a screaming deal when compared to renting. Simply put, buying a home has always assumed an implicit risk premium, which has now all but disappeared.

To better understand this, I recommend that you read a very, very good housing paper at:

http://neweconomist.blogs.com/new_economist/files/HSBC_frothfindingmission.pdf

The section “Using a zero-risk premium” precisely addresses your observation. I’ll cite from it:

“Could it be that house prices in the past 30 years that we have data for have always been ridiculously cheap and that it is only now that house prices are moving towards fair values?

Not likely. These calculations assume a zero housing risk premium. But who cares about a risk premium? After all, this is a home, not an investment.

Unfortunately, this is the equivalent of saying that if you hold stocks for a long enough time period (a few decades), and you are sufficiently diversified, then history shows that stocks have proven to be no riskier than bonds, and therefore one should apply a zero-risk premium to stocks.

On this basis, today’s Dow Jones should be north of 50,000 instead of 11,000, taking the PE ratio from 19 times to about 100 times or more. Of course, many did start to think that way in the late 1990s, with the publication of ‘Dow 36,000’, one of the more notable book titles of the tech-bubble era.”

Daniel

[PerryChase]

Rich Toscano, maybe somewhere on this site, you should have a “sticky” that will summarize all the items to consider in buy/rent decision.

Or perhaps a Voice of San Diego article in plain English for people who are considering buying now? I’m not suggesting telling people not to buy but simply to give them things to consider when buying such as liquidity, maintenance, taxes, etc…

[(former)FormerSanDiegan]

1996 Rent versus Buy

To put things in perspective…
At some point we will get to where the cost of purchasing is equal to or less than renting. An example, based on personal experience in San Diego: In early 1996 we reached a point where we could put 5% down, pay PMI, mortgage at 8.25% for about the cost of renting (after taxes). That was the most recent low point in the SD housing cycle.

Your example is well short of this.

[blahblahblah]

I rent a really nice SFH very close to downtown for $2400/mo. It is 2000sf and would probably list around $850-900K (not sure it would sell tho). Your rent should be no more than $2K/mo for a $600K condo, which is one place you may be going wrong. I’m guessing it’s probably about 1400sf, right?

[blahblahblah]

Oh, and one other thing. The last place I owned was a condo and our HOA went up from $222/mo to around $260/mo in the first two years. What services did we have? Trash collection and basic maintenance, nothing else. Many new buildings will start out with artificially low HOA fees to sell the units but as soon as the board starts dealing with all the issues the HOA has to increase.

[(former)FormerSanDiegan]

On the other hand … Opportunity Cost:

Not that I agree with the analysis of the original post, but I want to point out something about the opportunity cost of tying up the down payment ($120K in this example).

Consider the flip side: If rents increase by 5% per year: By choosing NOT to buy, the renter would face a cumulative INCREASE in rents of about 96,000 over a 10-year period. And $229,000 over a fifteen year period. So the TRUE opportunity cost is the difference between what was earned on the $120K investment outside a home and the $120 K down payment “invested” to avoid potential future rate increases.

I believe that the numbers still highly favor the renter in this (over-inflated) rent example. But someday they will not.

[mrwrong]

Thanks again for all the responses and comments. Instead of responding individually, let me again summarize:

1. Not taking closing costs into consideration.
Good point. I’ll update the numbers using 4% of purchase price as closing costs.

2. Real estate is not liquid. You may change job to a different city, etc.
This is all true, but if you are worried about liquidity or changing your jobs every few years, I’m not sure you should ever buy a house. The fact that we are participating on this forum indicates we plan to stay in San Diego and are considering buying a house at some point in the future. Otherwise, why would you even care? In other words, other people might be leaving San Diego due to high housing price, but we are staying. 🙂

3. You took the entire PITI in your tax deduction.
I may be Mr. Wrong, but I’m not that wrong. 🙂 I’ve only used the interest portion of the mortgage and the property tax for tax deduction. Principle, Insurance, and HOA are not included.

4. You made up the number on the rent. It is too high and your HOA is too low.
This is a condo in Carmel Valley. Actually, it’s a townhouse. It’s a 3br and 2.5ba and over 1500 sqft. This craiglist link suggests the rent number is reasonable. I know the HOA is $200. They have a pool and a gym. HOA includes insurance, water, and waste.

5. Landlord uses GRM of 8.
I agree that it’s a lousy investment for a rental property at this price. My original post states this purchase is for primary residence and not for investment purpose.

6. You are double counting (counting equity and deducting it from the monthly cost)
Several people raised this point. I have to think about this one a bit more. This could defnitely be one of the places I was wrong.

7. Risk premium
Very interesting point. I think I can buy this argument. Can you suggest a quatitive number so that I can incorporate this into the monthly cost for buying?

Thanks again for all the comments. I’ll post the updated numbers later.

Mr. Wrong

[an]

Why add extra variables like down payment and principal to this comparison. It would only give more room for error. How about we compare a $600k house/th/condo using I/O loan and 0 down.
On a $600k IO loan, the monthly interest would be around 3400 in the first 5-6 years of ownership.
$3400 Interest
+$625 Tax
—–
$4025 Before tax saving.
$2656 after tax saving.
+$200 HOA
+$100 Insurance
+$100 Repair, etc. (low estimate)
—–
$3056 After said and done.
$2350 Rent average.
—–
$700 Overpaid per month = 30% more than rent
With $700/month saving, if you invest it and get 7%, in 10 years, you’ll have $121k, @ 8.5%, you’ll have $132k, @ 10%, you’ll have $144k.

That mean your house has to increase by 20-25% over the next 10 years in order for you to break even.

[PerryChase]

Well said asianautica.
Plus as was mentioned earlier, there are other factors that would cause buying to cost even more. $700 overpayment per month is just the base.

Craigslist prices are all over the place. Take whatever they ask, cut 25% and negotiate from there. I’ve noticed that emotions plays a lot into online postings. Some people price it right, others are testing the market for ludicrous prices, yet others price below to get a deal done and out of their hair.

I’ve bought many things online and I’ve learned to never regret a deal because something else will always be ahead. Something like no matter how hard one works at it, there’ll always be someone better looking, smarter, thiner, richer.

[Daniel]

Is that the Airoso development, by any chance? I know that area fairly well. If so, I think you forgot to add the Mello Roos taxes (total tax rate is something like 1.8%, I think, rather than 1.25%). Also, the rent you’re using may be a bit high. $2,200 is possible, but $2,500 quite unlikely, I think.

You may also want to include realtor fees. When you sell, 3 to 6 percent of the selling price will go to agents (even if you do FSBO, you’ll probably have to offer a buyer’s agent commission, otherwise nobody will show up). There may also be carrying costs if your house stays empty on the market for several months until it is sold. If you decide to use a figure of 5% for “selling expenses”, and you plan to stay in the house for 10 years, that works out to about 0.5%/year.

As for the risk premium, this is very hard to estimate, as it depends on sentiment in the market. But now that I think about it, you may have taken it into account already, without realizing it. This is because you didn’t assume any price appreciation at all. A correct calculation would have assumed a historical price appreciation of, say, 4%/year, offset by the risk premium, which historically also runs at about 3-4%. Considering further price appreciation in these bubblicious times smacks of craziness, but a cold logical calculation would actually need to include it.

Your method (assume you buy the house at 600K and sell it at the same price later on) is probably as fair as it can be. But, if you assume that the selling price down the road is 500K or 700K, your results, as they say, will vary 🙂

And a personal perspective: I did a “buy vs rent” calculation for myself, and, like you, I found that the numbers were in the same ballpark (a bit cheaper to rent). But I judged, based on historical trends, that the risk of a price decline was substantially higher than the risk of a price increase, so I decided to wait for a few years.

Daniel

[Anonymous]

Continuing on qcomer’s analysis

qcomer has so far done the best job providing a *comprehensive* answer to the question, even sticking with mrwrong’s (conservative?) assumptions. qcomer’s posting is entitled: I am going to trust you on.

A few questions/comments following qcomer’s analysis:

A. qcomer is correct that HOA payments are not deductible. Search for the word association in http://www.irs.gov/publications/p530/index.html .

B. The $460 per month mrwrong would be building in equity will be his, so it seems fair to remove that from his monthly cost of buying. As with mrwrong and qcomer, this is an appreciation neutral analysis. For the sake of completeness, the amount is a little less than $500 a month for the first 36 months. If you’re following this thread, this point should address mrwrong’s follow-up posting number 2. Also, see the postings from lamoneyguy and no_such_reality for more on this.

C. mrwrong assumes that insurance is included in the HOA. HOA presumably includes insurance for the complex, but doesn’t each condo owner have to get individual insurance? How does that compare in price and benefit to renter’s insurance?

D. As PerryChase pointed out, the mortgage interest deduction only has a benefit for people who itemize. The standard deduction amounts, in most cases, are $5,000 for singles or married filing separately and $10,000 for married filing jointly. http://www.irs.gov/pub/irs-pdf/p17.pdf at page 133. In many cases, especially in California, the buyer will have state taxes and charitable contributions of more than this amount. However, for people whose income is below $75k for singles or married filing jointly or $97k for married filing jointly *in any year* in which they own, there’s less value to the mortgage interest deduction. See http://www.ftb.ca.gov/individuals/tax_table/index.asp .

E. Conversely, if your income is too high, you lose some of the benefit of the mortgage interest deduction, and other deductions for that matter. Above $145,950 ($72,975 if married filing separately), you lose $30 of deductions for every $1,000 above that amount. E.g. you lose $2,310 of deductions annually if you have $150k in income and are married filing separately. http://www.irs.gov/pub/irs-pdf/p17.pdf at page 196.

F. Comments D and E together suggest that for people whose income fluctuates a lot from year to year, the benefits of the home mortgage deduction could be greatly reduced. Example 1: a person who loses a job or takes a leave of absense for a year (maternity?, paternity?) might have less income to offset the itemized deduction amount for one or two tax years. Example 2: a self-employed person whose income fluctutates a lot from year to year. Example 3: an asset wealthy individual whose income is mostly capital gains based or only generates earned income from time-to-time.

G. I was going to say that mrwrong had some arithmetic errors in his original posting regarding the 34% tax deduction, but apparently mrwrong was skipping some steps in his analysis that others thought might have been mistakes. PerryChase’s idea of summarizing this (on a wiki?) is a good one.

H. A lot of people have caught the closing costs, but there’s also lost opportunity for money spent for those costs. Presumably, that’s not too big.

Summarizing, it looks like qcomer’s cost of ownership should be reduced by $500 per month from B., increased by some amount for C. and H, and increased in some (many?) cases for E., F. and G, but I haven’t figured out what would be fair for the latter amounts. Also the risk premium comment has merit, but quantifying it will be tough.

It’s clear from asianautica that there are alternate analyses worth pursuing, but that should be in addition to mrwrong’s and qcomer’s. I’d like to see another alternative analysis of a cash purchase versus renting and putting the money in the bank.

Enjoy (or should I say Bottoms-Up?)! 🙂

[DaCounselor]

Good input so far on ways to tweak the analysis. Since Mr. Wrong’s analysis is predicated on the fact that he intends to stay in SD for the long term, a fixed rental expense cannot be used. I’m quite sure a 3 bed/2.5 bath 1500 sq ft condo did not rent for $2200-$2500/mo 10-15-20 yrs ago. My old neighbor rented her very nice 3 bed/2.5 bath townhouse in PB for $1250/month in ’93. Rents will be up up up in SD over the long term, and that must be factored in to get an accurate picture. Also, Mr. Wrong don’t forget the income tax you will have to pay on your interest income if you invest your down payment money.

[an]

I agree, rent will go up and up. But tax write offs will go down and down. So that will add complexity to the comparison. Then you should then consider, if you’re a very good tenant, paying early every month, do your own minor repairs instead of bugging the landlord, keeping the place looking good, they might not raise the rent for many years. These are some variables that can affect some of the assumptions about the future of rent and cost of buying. Who knows, maybe we can go in a great depression and rent will drop or real estate price can copy Japan’s movement and drop for 18 years straight. It’s hard enough to estimate what will happen in the next year or 2, much less 10 years down the road.

[no_such_reality]

Million dollar question.

The buy or wait question is pretty simple with housing since it leverages you so much with current prices.

If housing is going up, you buy.

If it isn’t going up, you wait.

With 20% down, you’re leveraged 5X-to-1. Your gains and losses are magnified 5 times. With a stocks and margin, you’re leveraged 2X to 1. Without margin, it’s a straight 1 to 1.

So all we really have to do is decide if housing is still going to be going up faster than inflation. That’s at least 4% a year.

A flat market means you’re lossing the inflation rate x5.

Down… say 10% whoops, that’s $60K, 50% of your down payment.

So keep it simple, just decide, in ten years, will someone buy that condo for $1,000,000? Literally.

[VCJIM]

I understand this statement in terms of margin accounts and the stock market:

“With 20% down, you’re leveraged 5X-to-1. Your gains and losses are magnified 5 times. With a stocks and margin, you’re leveraged 2X to 1. Without margin, it’s a straight 1 to 1.”

I don’t understand how 20% down causes magnification in the housing market (5x). Could you please explain in more detail?

[Author]

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