Economics #7: Rent vs Buy

Lately and frequently, the topic of homeownership has been popping up in my life. I don’t know if this is a result of my age or current economic trends, but I figured I might as well organize my thoughts on the subject.

Generally, the renting vs buying debate goes something like this: renting is essentially throwing money down the drain, while buying builds equity and sets you on the path to financial freedom. Throw in some narratives about the American dream and some wishful thinking about home price appreciation, and owning is just always better.

This post will explore this argument through the economics of renting vs buying. Of course, there are non-economic factors that come into play. For example, buying a house might just make you happier or vice versa. Buying can provide the stability of knowing you can’t be kicked out by a landlord or have your rents raised dramatically. Buying allows you to customize your house the way you want it. Renting can provide the freedom and flexibility to change your life up at a moments notice. Renting can be less stressful, no headaches from repairing a roof or a water heater. These factors might even be more important than the by-the-numbers analysis. To each their own.

The simple example

I’m going to use numbers for my area (Southern California) to illustrate a simple example of renting vs buying a house. Let’s say that I can rent a two bedroom apartment for about $1,600/month (currently do). Buying a similar property would cost about $400,000 (from Zillow). Let’s also assume an interest only loan to make the calculation easier.

Rent Buy
Monthly payment $1,600 Purchase price $400,000
Yearly payment $19,200 Down payment $100,000
Savings account $100,000 Interest only loan @ 5% $300,000
Savings income @ 2% $2,000 Yearly interest $15,000
Yearly property tax @ 1.25% $5,000
Yearly maintenance @ 1% $4,000
Tax savings @ 25% $5,000
Total money burn $17,200 Total money burn $19,000

This example leaves out a lot of important variables, but it still displays a key point: Renting and buying are both a form of consumption and as such both burn money. In some cases, renting burns less money.

The complicated example

Readers should rightfully take issue with the previous example. Most loans aren’t interest only and the analysis completely leaves out the price appreciation of the house. If you ask a realtor, a house is going to appreciate around 3% per year, making up for any cash burn and then some. If you ask Robert Shiller, the Nobel prize winning economist, a house is going to appreciate 0.37% (after inflation) per year. It turns out that the amount of appreciation that we build into our analysis makes a huge impact on the economic results.

To illustrate this point, consider this linked spreadsheet that takes into account all the factors that go into the renting vs buying analysis. You can make a copy and play around with the numbers. At an assumed 3% house price appreciation, we would be better off renting up until year 6. If we stayed in the house longer than 6 years, we would be better off buying. At an assumed 2.37% (2% inflation) house price appreciation, we would be better off renting far past year 15.

How long will we stay in the house? According to the National Association of Home Builders, the average homeowner owns a condo for 6 years and a single family home for 15 years. Taking this information into account and a by-the-numbers approach, there really is no right answer to the rent vs buy debate. It all depends on the assumptions made.

What about real estate as an investment?

Doesn’t a homeowner have the additional option of renting out their property? When we get into investment property analysis, what we really care about is our return on the investment in relation to our opportunity cost, capital preservation, or diversification. If we can make more money buying and renting out a property than we could elsewhere, it make all the sense in the world to buy. The factors that determine this are vast and change from location to location.

Consider this spreadsheet which breaks down a few of the factors that go into real estate investment analysis.

Conclusion

Rent or Buy? It depends. The main economic factors that go into the analysis are the assumed price appreciation of the house and the length of ownership. If we plan on living in the house forever, buying almost always makes sense. Anything less than forever, and we have some thinking to do.

References:
https://www.nytimes.com/2016/04/02/your-money/to-buy-or-rent-a-home-weighing-which-is-better.html
https://www.khanacademy.org/economics-finance-domain/core-finance/housing/renting-v-buying/v/renting-versus-buying-a-home
http://www.econ.yale.edu/~shiller/data.htm
https://www.nahb.org/en/research/housing-economics/special-studies/archives/how-long-buyers-remain-in-their-homes-2009.aspx

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Author: David Shahrestani

"I have the strength of a bear, that has the strength of TWO bears."

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