To Buy or Rent?
A Tale of Two Cities
In these times of inflated everything, to ask the question whether it is time to buy or rent a home may seem a bit like asking “Would you like a snail or a juicy hamburger?” You’re probably thinking, “Of course he’s going to say renting is what you should do now.”
And you’d be right. And wrong. It all depends on who is asking the question and where. Even in an age that has managed to blend features of the Roaring 20’s excesses with the stagflation of the Oil Embargoed 70’s - it just depends what economic strata you reside in - there are good deals to be found in the housing market.
I’ll repeat my very first principle of investing: fantastic opportunities exist in every economic and market condition.
I posed the following two questions in my last post:
Question 1 - If you buy a house to live in, do you have a productive asset or an expense?
Question 2 - If it is an expense, how would you determine if buying a house would still be a good alternative to renting?
If you answered “Expense” to the first question, you would most likely be correct. The home you live in is an expense. There are millions upon millions of Baby Boomers and maybe even some Gen-X types who would swear on a stack of bibles that their house has been a stellar “investment.” But alas, they have short memories and haven’t really worked out the math in 95%+ of their respective investments’ performance.
Allow me to give the example of our humble home.
We purchased it in 1997 for just under $200,000. Roughly 25 years later, if Zillow is to be believed, our home would sell for somewhere in the $950,000 range. On the surface that appears to be a nearly five-fold increase in value. If we were to calculate the return on that basis, it works out to roughly 6.5% per annum. A solid return for a 25 year period, right?
Except we’re forgetting a few expenses along the way. Let’s start with $300,000 in remodeling, maintenance and repair expenses over those 25 years. Sound excessive? Divided by 25 years, it works out to $12,000 per year…trust me, that’s fairly typical for keeping a home in good and current condition.
Then add the cost of property taxes - roughly $75,000 over 25 years - and insurance, another $75,000 over 25 years.
In order to unlock the value of our home, we’d then have to sell it. These fees are typically 6%, but let’s presume we found a good low fee agent who only takes a 4% commission. That’s another $38,000 taken out before we get our final investment return. I haven’t even added other costs, like gardening, trash, water and sewer costs (which renters don’t normally pay), but let’s just add up what we have and see how that investment really looks:
$950,000 - ($200,000 + $300,000 + $75,000 + $75,000 + $38,000) = $262,000.
Now when we look at the return over those 25 years, we’re seeing a $262,000 gain over all that time. If we calculate the annualized return over the 25 year period, we now get a paltry 3.4%. Not so stellar.
But you might correctly argue that I’ve saved rent all those years and to come out ahead at all after all that time is a win. And I would agree, except we owned this home during one of the most spectacular home value increases in one of the hottest housing markets in American history.
Had I invested $200,000 in 1997 in a low fee S&P 500 Index fund, the result would have been roughly similar to the S&P 500 Index itself. The S&P 500 grew from around 760 to 3,947 as of yesterday’s market close, a 5.2x increase (let’s say 5x after fees) for my invested money. That means I’d have $1,000,000 now, a 6.65% annualized return over that 25 years. That, by the way is only slightly higher than the longer term 6.2% return of the S&P 500 when it is projected back to 1928.
For a fair comparison we must deduct our rental costs over that time. To have rented the same type of home over the past 25 year period, I would estimate an average monthly cost of $2,100 per month (it is higher now, but was a good bit lower than that in 1997). Over 25 years, that works out to $2,100 x 12 x 25 = $630,000, so I’d have increased my net money from $200,000 to $370,000. The annualized return of our stock market investment would have been about 2.5%, after accounting for rental costs. Still not stellar, and in this case only 65% of the return on our home if we’d paid $200,000 cash for it (we didn’t) and which we owned in a hot market during a period of record increases. So, the house wins under optimal housing market conditions.
Owning and renting are two different experiences, and my goal is not to dissuade you from buying a home forever, but rather to look at the market in which you live and make the decision that doesn’t jeopardize reaching financial independence.
With this backdrop in mind, let’s look at today and what it would take to buy a home in two cities and how that compares to renting in those same cities: Pasadena, CA and Pasadena, Texas. My sources for this analysis will be Zillow.com (using comparable sized homes listed for sale) and Rentometer.com, a handy site I’ve used to get an accurate read on rental prices by the number of bedrooms and bathrooms for a rental.
Pasadena vs. Pasadena
Pasadena, CA: 1273 N Dominion Ave, Pasadena, CA 91104
This single family home built in 1928 has three bedrooms, two baths is 1,518 sq. feet and is listed for $1,300,000.
The median rent for a three bedroom home at this location is $3,988.
To buy this home with 20% down, a 5.5% mortgage interest rate, 1.2% annual property tax and $2,000 annual insurance, works out to $7,317 per month.
If we add 2% per year to maintenance costs for this 1928 home, the annual outlay not including water and sewer fees (usually paid by the landlord in a rental situation) would be an additional $26,000, adding another $2,167 per month to an owner’s tab. Renters are not obligated to pay any of this cost.
Pasadena, TX: 4210 Heathfield Dr, Pasadena, TX 77505
This single family home built in 1983 has three bedrooms, two baths is 1,596 sq. feet and is listed for $290,000.
The median rent for a three bedroom home at this location is $1,890.
To buy this home with 20% down, a 5.5% mortgage interest rate, 2.35% annual property tax (Texas has high property taxes but no income tax) and $1,000 annual insurance, works out to $1,968 per month.
If we add 2% per year to maintenance costs for this 1983 home, the annual outlay before water and sewer (usually paid by the landlord in a rental situation) would be an additional $5,800, adding another $483 per month to an owner’s tab, which renters are not obligated to pay.
What you might notice in these two scenarios is that the California home is not nearly as good a deal for the buyer as it is for the renter.
An Investor’s Take on These Homes
Let’s look at them from the perspective of an investor buying the home to lease to someone else.
If I buy the California home, I can expect a total revenue of $47,856 per year (12 x $3,988). If I deduct my maintenance costs of 2%, being $26,000, property taxes of $15,600 and landlord’s insurance of $2,000, I’ll have a net profit of $4,256. On my $1,300,000 investment, that works out to a rate of return of 3 tenths of one percent. That assumes I paid cash and I’m not paying mortgage interest on top of that! No investor would buy this home for any purpose other than speculation on the market continuing to go up (a topic I’ll cover in-depth in a future post).
If I buy the Texas home, I can expect total revenue of $22,680 per year (12 x $1,890). If I deduct my maintenance costs of $5,800, Taxes of $6,815 and landlord’s insurance of $1,000, I’ll have a net profit of $9,065. On my $290,000 investment, that works out to a rate of return of 3.12 percent. Still a historically abysmal return that assumes no vacancy, property management fees or water and sewer utility costs, but at least it surpasses the return you might get from a standard savings account (albeit with much greater risk).
Would I do either of these deals as an investor? No. However, as a potential owner, I would consider purchasing the Texas home if I was committed to staying in that community. While it is 30% more expensive than renting (if I resist the urge to remodel!) it provides a good deal more certainty of where I will be and locks in my base cost for shelter for the foreseeable future.
A solid case can be made that the Pasadena, Texas home - using analysis by substitution - would only slow your financial independence trajectory for so long as owning costs more than renting…not more than 10 years at 3% rent inflation per year…and then becomes a legitimate lower cost substitution to renting thereafter.
The Pasadena, California home, on the other hand, could put financial independence out of reach indefinitely.
A Little Historical Perspective
If I’m being honest, where housing is concerned, things are pretty bad for the prospective home buyer today. There are still pockets where the above analysis can be done and renting makes less sense than buying on the basis of substitution, but they are mostly in places where jobs are less plentiful and the economy is in bad shape.
In 2009, after the housing market collapse that started in 2007 reached bottom, it was a completely different story. There were countless markets, places where people wanted to live (although jobs were a challenge everywhere at the time) where a similar but more conservative return on investment analysis to the one completed above worked out to 10% or better. That being on a cashflow basis alone (speculators need not apply).
While I cannot promise anyone that housing prices will collapse to that degree again - barring a wholesale collapse of the US economy - I will say I am confident the recent sellers market has begun to roll over and will become a buyers market once again.
Housing market changes happen slowly, so when you start to see markdowns on homes for sale, don’t be too quick to jump unless you can show yourself it is a clear win from a substitution for renting standpoint.
It can take two years or longer for a peak housing market to reach a bottom. This is because home sellers don’t get serious about lowering their prices until they are forced to do so. Once a recession takes hold, and job losses force the need to sell, the market is flooded with homes and the only way to sell one’s home in a sea of listings is to lower the price more than the competition.
The bottom of a housing market is ultimately only known in hindsight. But for the prudent investor, the time to invest is not when the bottom has been reached, but rather, when their target returns can be achieved.
This is my fourth investing principle: Don’t try to time the top or bottom of an investment opportunity. Establish an achievable, beneficial return target and enter (or exit) the investment when you’ve reached that target.
Until next time, may peace and prosperity be with you.
The Natural Economist
Next up, I’ll demonstrate how buying your first home to rent to others (yes, even while you are still a renter yourself!) can shorten your path to financial independence.
A note to my readers: I realized after the post above that I'd worked through that there was an error in my analysis of our own home ownership experience. I deducted $200,000 from the net gains of a hypothetical sale when that had already been done in the math above. The outcomes are reversed between our home ownership and potential alternative outcome of stock investing. The online version has been corrected.