Friday, April 21, 2017

Rent Versus Buy - How to decide which one is best for you?

People usually get emotional when the topic of rent versus buy is brought up. One group swears by owning a home, and believes that it is a good decision. The second group believes in renting for life, and brings a lot of arguments to support their decision. I have personally stayed in the "undecided" camp, right in the middle of it all.

We are rational people however, so we want to avoid emotions, and make the best decisions for our own situations. Owning a home is one part a lifestyle decision, and another part a financial decision.

There are pros and cons to buying and renting a home.

I believe that some people who rent may be wasting their money away if house prices in their areas are low. If home prices are high however, people who buy a home may be the ones wasting their money away. Home prices are low, if they are selling at a low multiple of home cost divided by annual rent expense. Home prices are high, if they are selling at a high multiple of home cost dividend by annual rent expense. I find a ratio about 15 or lower to be attractive. If that ratio is over 20, it may be a little bit too high.

Based on my research, if you manage to purchase a comparable unit to what you are currently renting, and you are mindful of costs, you may do better than renting over long periods of time ( exceeding ten years). On the other hand, if you pay a high price to rent multiple, and your monthly payment absorbs most of the funds you would have otherwise used to save to retirement,  you may not do as well with buying a home.

I do realize that owning is not for everyone.

You should rent if you:

1) Cannot afford the 20% downpayment for a home
2) Move every 5 – 10 years due to personal or work reasons
3) Simply do not like being tied down to a single location for an extended periods of time
4) Do not want to/cannot afford to spend time maintaining a home
5) Realize that the price to buy is too high
6) May end up buying too much house,
7) Are not ready to settle
8) Are not very handy, and do not want to learn new skills

If you plan to stay at a place for at least a decade, buying might be cheaper, assuming that home cost values are not outrageous. The focus on valuation is similar to the evaluation we use when considering dividend stocks for long-term investment.

For someone staying at a place for a decade, owning could turn out to be cheaper than renting. When you rent you pay the landlords:

- Mortgage
- Property Taxes
- Maintenance
- Administrative Costs
- Depreciation on the property

But most importantly, you pay a profit to the landlord, who risked their capital and wants to earn an attractive rate of return on it. Your friendly landlord usually increases rent at the pace of inflation over time, in order to pay for the upkeep, taxes and insurance of the unit. When you own, your mortgage cost is fixed for the length of your mortgage. Due to inflation, your end up paying less in real dollars for that mortgage expenses. The other components of the monthly cost like taxes, insurance, and upkeep do go up with inflation, although not consistently.

The government has provided certain advantages for owning a home. For example, you can get a 30 year fixed rate mortgage in the US, which is at something like 3% - 4%. This is very low. You are essentially purchasing an asset with 20% down (and in some instances as low as 3% - 5% down). This is a large amount of leverage. If you put 20% down in an asset, and the asset increases in value by 20%, you have essentially doubled your original investment. If the home price declines however, you can lose money on paper. If you can afford the monthly payments however, any short-term fluctuations in home prices should not matter to you.

You also get to deduct that mortgage interest on your taxes. However, if you didn’t have the mortgage interest deduction, you would have been using the standard deduction, so this is a moot point in my opinion ( unless of course you are buying too much house).

If you live in a home for 2 out of 5 years, and you sell that home, any gains up to $250,000/individual or $500,000/couple are exempt from federal income taxes. This is a pretty neat advantage to consider. On the other hand, houses usually appreciate at the rate of inflation, according to research by Prof Schiller.

Source: Robert Schiller

Perhaps the property markets of San Francisco and New York are an exception to the rule. I would think that prices in the Midwest would likely follow the rate of inflation. So in other words, if you buy a house in Kansas City for $250,000, and you hold for 24 years at a time when inflation is at 3%/year, your house may be worth $500,000 later. If you decide to sell the house, you would have a “gain” of $250,000. However, in real dollars, you would not be any better off than before. At least you won’t have to pay a tax on capital gains, which could make you poorer at a rate of 23.80%. (plus state tax)

All of this of course assumes comparable units of buying versus renting comparisons. I have often seen someone in the pro-rent camp compare the costs of renting a 1,000 square feet house/apartment to the costs of owning a 2,000 square foot house in an effort to justify their opinion. If you do not compare apples to apples, your decision will not be the most optimal one.

It also assumes that you do not fit one of the criteria I listed at the beginning of the article, which would make renting more advisable. If you overpay for a home, and your expenses are higher than what you would get by renting this equivalent unit, then you are not making a smart choice.

There is the argument is that the real prices of homes in the US have remained pretty flat/stable over the past 120 years. This means that the price of a home barely goes up to match inflation. This is a reason why home ownership is viewed as a bad idea. However, those statistics usually ignore what I call the “housing dividend”. If you own your home, you can essentially live in it rent-free (minus maintenance costs, property taxes, and insurance). Therefore, the benefit of owning a home is the shelter it provides. I view this shelter as a home dividend. You can call it a house dividend as well. As a homeowner, you are essentially paying rent to yourself, building equity. Rent goes up with inflation. The mortgage does not. Components of the monthly cost like taxes, insurance, etc do go up with inflation, although not consistently.

On a side note, people regularly forget about the impact of dividends on returns when they look at stock charts. This is why I find stock charts to be misleading.

As a hidden bonus, owning may be better than renting, because as an owner, you are more likely to care about choosing energy efficient appliances, energy efficient heating and cooling, as well as making sure that insulation is good. As an owner, you have control over your home. This is one of the factors that pushes many into home ownership.  If you are handy like my friend Carl however, you may also manage to increase the value of your home by renovating it completely.

Owning is not a slam dunk decision however. There are many risks associated with it.

In general, you need a place to live either way. I know that I need a place to live for next 10 – 20 – 30 years. As such, I need to think of the rent vs ownership decision in a similar fashion that I do with owning equities for the long-term. If you hold an ownership position in a company, simply because you want to flip it in a couple of years, you are speculating and should not be buying. If you do not believe you will be in a location for at least a decade, renting may be a better decision. If I have to sell a house within a few years of buying it, I may lose money in the process. If I have to sell my house, because I lost my job in a recession that affected most employers in my area, I would be in a real pickle. These are all risks that are important to evaluate when purchasing a home. Some of the factors, like whether you will be staying in one place for 10 years, cannot be known when the decision to buy/rent is made.

I know that I should look at valuation, and opportunity cost when making an investment decision. The valuation tool to use when evaluating whether homes are attractively priced is the Price to rent ratio. The lower, the better. The opportunity cost is that money spent on owning a house above the cost to rent could be invested in dividend paying stocks instead. Of course, if my investments do not deliver on their expected returns, the opportunity cost would have been owning my home free and clear and earning a house dividend ( this is the ability to live rent free in my house, net of any maintenance costs).

Another risk to consider is home obsolescence. The home you purchase today might be difficult to sell in 20 – 30 years, if tastes change and you do not do a good upkeep. It may also be difficult to sell if your neighborhood deteriorates. You may need to invest heavily on upgrades and remodeling after a couple of decades of ownership, in order to keep your home current.

As a home owner, there are annual fees such as property taxes, insurance and maintenance, which guarantee cash outflows for you at unpredictable intervals. If the local government is cash strapped, it knows that it can easily hike the property taxes on homeowners, because they are “stuck” there. If they hike taxes for businesses, they will likely move across state borders. In terms of unpredictable expenses, most of my friends who own houses have routinely complained about the cost of roof replacements. They have also complained about the heating/cooling unit replacement as another major expense. I am certain that a $10,000 roof replacement would sink almost anyone’s budget, unless you have built an emergency fund to cover that. If amortized over a ten year period however, a roof replacement doesn’t seem like a big cost. However you do need to have the discipline to cover this expense somehow with a larger emergency fund. Most people do not think this way.

Another risk you are facing is liquidity risk. Houses are not liquid investments. You cannot simply buy it one day, and sell it on the next day if you change your mind. A house takes time to sell. You pay a steep price to buy and to sell a house. There are long wait periods to qualify for a mortgage, have an inspection, and close the deal. Buying and selling is costly – and can take up to 6% of the price. It may take a lot of time to sell a house, particularly since the real estate market is very local and demand by buyers/sellers will change. If you need to sell quickly, you may be in for a little bit of trouble. However, you may get a home equity line of credit, at a decent interest rate cost. This is why housing is a great idea only if you plan to stay in a certain area for a decade.

With stocks, I can buy a share in a company I like, and then have the luxury of changing my mind and selling a second later. My commissions to buy and sell are approximately 35 cents/trade. As you know however, frequent trading is usually a dumb move due to costs, taxes, bid/ask spreads, and missed opportunity costs. I subscribe to the belief that long-term wealth is built by patiently sitting on a collection of assets for decades. But it is nice to know that if I have the need, I can liquidate everything.

The big risk that I do not like is that houses/homes cost a lot of money ( as in hundreds of thousands of dollars). For example, the average home in the US sells for close to a quarter of a million dollars. This is much more than the average retirement savings for Americans. As a result, homes end up taking a very large percentage of net worth for the average person out there. This poses risks, because you have a large portion of net worth concentrated in an asset that is very local in nature, and which is illiquid.. Since you already live and earn money in this particular area, your risk is increased when you also own a large piece of real estate there. For example, the whole country may do very well, but if your areas largest employer has troubles, this may affect your ability to maintain a good paying job, and it may also depress housing values. Hopefully you do not hold a large position in your employer stock as well.

Many in the anti-rent camp fail to understand the opportunity cost of tying up capital in a home, versus investing in the stock market. In many cases, when comparable units are evaluated, a person may have ended up with more money if they rented, and invested anything left over in the stock market instead. If you manage to purchase stocks at attractive valuations, which then compound your capital and income,you may do pretty well over time. Stocks have delivered annual total returns of 10%/year over the past century. With housing, the expectation is that prices would keep up with inflation over time. Inflation has been at 3%/year over the past century. The housing dividend or the right to live in your home net of any maintenance fees may or may not be enough provide a 7% yield on that purchase price. That housing dividend does not compound however, and you cannot reinvest it. If you manage to buy that house at a low price to rent multiple however, or if you are skilled at home renovation, homeownership may provide you with superior returns to stock market investing over time.

Unfortunately, most forecasters today expect that equities will deliver below average returns over the next decade. This is driven by the high valuations today, coupled with sluggish earnings growth.

On the other hand, owning your home provides you with a “guaranteed” return on investment – the ability to live in that unit ( minus the maintenance, property tax and insurance). Stock market returns are not guaranteed. For example, your capital gains may turn into losses, and your dividends may get cut or eliminated. For a retired investor in certain areas with a normal real estate market, it may make sense to purchase a home to live in it, rather than invest the money and live off that dividend income. The higher my net worth and dividend income, and the older I get, the lower my willingness to take risks becomes. It simply makes sense to take some money out of the vagaries of the stock market.

I personally believe that:

A) Owning a $200,000 home to save on an annual rent of $12,000 (even if you have to pay $4,000/year on maintenance, property taxes and insurance)

is a safer option to

B) Investing $200,000 in a portfolio of REITs yielding 4%, and spending that money on rent.

I wrote this article, because for the first time ever, I believe I am at a point in life where I am seriously considering buying a home. I used to be firmly against owning. However, as I gather more years around my belt, I have realized that things are more subtle.

I view my household rent expenses as one of the major items on the budget that I need to attack. With $1,000/month between my better half and myself, it feels like I am simply throwing money down the drain, with nothing to show for it. The inner capitalist at me is thinking of ways to reduce this expense as much as possible. I was intrigued that by buying, I am essentially capitalizing my housing expenses and turning that expense into an asset on my balance sheet.

I know a lot of bloggers out there are firmly against owning a home. Certain qualitative factors have caused me to consider doing the opposite of what they preach. For example, all my landlords in the past have always provided some older appliances such as washer, drier, oven, heating/cooling unit. All of this has resulted in higher than average electric bills. The landlords simply didn’t have an incentive to provide tenants with newer, energy efficient appliances. Worst of all, those apartments were in good areas to live in, not some sort of dumps.

The past two or three landlords I have had, have not been very good. There was the absolute bare-minimum amount of maintenance done on rental units. Most maintenance was done to make the apartments look great. Unfortunately, things broke down easily. My favorite part was when I hung a towel on a towel rack, which subsequently managed to crumble to pieces on the bathroom floor.

The insulation has not been that good either, which has resulted in loss of heat during winter time, and higher than average electric bills. Asking landlords to fix things results in cosmetic changes that are just a waste of time usually. When you rent, you are at the unit temporarily, and there are chances that a stranger will be at your house, maintaining things on a regular basis. Worst of all, I have had to call management about the same issue several times in a row, until it finally gets resolved after weeks of painful waiting and inconvenience to me. I do not like that one bit. When you are renting, you have limited control over the home you are paying for every month. With buying, you have more control, albeit at the cost of your time.

The final straw occurred when my current landlord decided to remodel their units in the middle of the rental agreement. This has been an ongoing hassle for quite some time. It is not fun living in a construction site, where you get random people coming into your unit at a moment’s notice. Unfortunately, there seem to be little protections for renters living in a construction site.

Last but not least, many of you know that I look at entry valuations before committing my hard earned money. I find it much harder to have the same level of confidence in deploying my money in stocks today, versus putting money to work between 2008 – 2014. In addition, the local market where I live seems to offer decent properties where the monthly cost of ownership is similar to the monthly cost of renting. It seems to me that an investment in a home today would provide me good returns on my money, and I can use a large portion of the money I “spend” on rent to actually “save” and build some home equity instead. Long-time readers remember my excitement in 2013, when I optimized my investments by maxing out retirement accounts. As a result of this move, I was able to save and invest more money than before, and therefore reached my goals faster. Today, I believe that by owning my home, I would be able to further streamline my expenditures, which would allow me to increase my networth every single month, since I would be paying rent to myself.

Of course, the monthly costs to buy and to rent would be equivalent. The only difference is the need to put 20% of the purchase price down, and the fact that after the mortgage is paid off, the buyer will own the house free and clear. Luckily, there will still be money left over to invest in equities for the long run.

In addition, I am trying to get some diversification from the stock market out of my net worth. Back in 2015, I shared with you that I was entering wealth preservation mode. I have built some fixed income exposure since then, and now I am considering adding some home equity exposure that will provide me with a safer return than investing in the stock market. When I buy a home, I will only end up buying as much house as I need. This would be in a fairly close range to the amount of space I would have otherwise rented at the time.

Relevant Articles:

My Dividend Goals for 2015 and after
Entering Wealth Preservation Mode

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