Buy vs Rent: Homes

Since so many people lost their homes, their down payments, and all of their home equity in the 2007 mortgage derivatives crisis, many of them have been reluctant to venture back into home ownership.  Real estate prices in many cities have recovered, but buyers have not.  Homeownership rates in the US peaked shortly before the crisis and began a long steady decline from which they have never recovered.

Homeownership Rates

Even as home prices plummeted during the Great Recession of 2007/2008, rents kept climbing.

Although homeownership used to be the cornerstone of the American dream, these changes in housing economics have called into question the conventional wisdom. Now, many people are asking, “Should I buy, or should I rent?

Typical analyses draw attention to the difference is who pays what expenses, such as maintenance, taxes, utilities, mortgage principal, and interest.  What these analyses fail to realize is that these expenses, normally associated with home ownership, must be built into rent as well.  That is landlords expect to be able to pay all of the expenses they are responsible for from the proceeds of the rent they collect.  Aside form the convenience of being able to remodel, redecorate (for home owners) or not having to worry about surprise repair expenses (for renters), the principal financial difference in the decision to rent or buy depends on three things (in declining order):

  1. Changes in the market value of the home,
  2. The creditworthiness of the buyer/renter, as expressed in terms of the interest rate at which they can borrow funds (i.e, obtain a mortgage), and
  3. The frequency of transaction costs, such as real estate commissions.

By far, the most important of these, the most uncertain of these, and the most difficult of these to get good guidance or advice on, is the change in the market value of the home.

To establish the current market value of any particular home, professional appraisers typically look for comparable homes that have sold recently.  Using a database of home sales available from the Multiple Listing Service (MLS), appraisers will establish the value of an uncertain property by comparing it to those of similar size, condition, and locations, making adjustments for inevitable dissimilarities.  Because only licensed professionals have access to the MLS data, buyers, renters, landlords or home owners doing their own research must rely on alternative sites such as zillow.com or realtor.com, which glean sales data from public records and provide updated estimates or home value.  Because these estimates are not informed by an inspection of the property in its current condition, they are often understood to be less reliable than a professional appraisal or a real estate market analysis.  Nonetheless, they are widely available.

Home owners take all of the risk of declining home prices, and all of the gain of increasing.  Moreover, except in the case of adjustable rate mortgages (ARMs), homeowners enjoy certainty in fixed mortgage principal and interest payments.  Only their taxes and maintenance expenses can go up.  By contrast, renters may be subject to price increases when market conditions result in low vacancy rates.

Thus, the decision to Buy vs Rent will depend on the net present value of the expected future cash flow forecasts.  Home owners should forecast constant payments for several years, with only modest increases for taxes or home owners association fees, while renters might use the data in Figure 2 above to forecast slowly increasing rents.  At purchase, a homeowner may incur large one-time transactions fees and pay a down payment, whereas a renter will only be required to post a security deposit (and sometimes the first and last month of rent). At the end of the ownership or rental period, the homeowner will sell the property and have the proceeds of the sales, less any transaction fees (such as a real estate commission, typically 5%-7% of the sale price) and the payment of the remaining mortgage principal.  Thus, the homeowner might recover cash from the sale, or have to pay additional cash if their sale price is insufficient to fund payment of the remaining mortgage principal.  By contrast, the rent typically expects only return of their security deposit, with no market risk from the sale and fewer transactions costs.

The best way to answer the Buy vs Rent question is to draw the expected cash flow diagrams for each alternative, compute the net present value, and then conduct a sensitivity analysis that explores different eventual sale prices.  The alternative with the least net present cost (or value) will be the preferred option… but, the answer is likely to depend entirely on the final sales prices.  Those buyers optimistic about market appreciation will have a preference for buying, while pessimistic buyers will prefer to rent.

 

 

2 thoughts on “Buy vs Rent: Homes

  1. Millie Hue

    I really like that you mentioned that buying a house can give the person a chance to gain back their money if they plan to sell the property again in the future. This is great information since my sister is planning to invest in property this year. They wanted to have their own house since they have been renting ever since they got married. This will give her all the more reason to buy a house since they can sell it in the future if they plan to upgrade or downsize depending on their situation. Thanks!

    Reply
    1. Thomas P Seager Post author

      I’m glad you enjoyed it, Millie!
      Home ownership also comes with the risk of losing money, as a lot of people found out 10 years ago.
      I hope your sister is in a good market for investing!

      Reply

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

w

Connecting to %s