Homebuying Platitudes vs. Reality

This is a post that I originally wrote for the highly-recommended personal finance blog Get Rich Slowly. As such, the style of writing is more geared toward the audience of that site. However, I felt that the post would be of interest to the readers here as well, so I am re-posting it in its entirety.

It was posted at Get Rich Slowly on July 16th, where it rapidly became one of the “Most Discussed” and “Most Rated” posts. It was subsequently bookmarked by over 350 people at del.icio.us, featured on Consumerist, and posted to Digg. If you’re a Digg user, I encourage you to “Digg it,” so maybe it can finally make it to the front page there, and get a little more attention. Enough shameless self-promotion—on to the post!

Introduction

“If you rent, you’re throwing away your money.”
“Owning your own home is a forced savings plan.”
“Home ownership is an excellent path to build wealth.”

You’ve probably heard statements like these plenty of times. On television, radio, the internet, and in casual conversation. Such sentiments are common in any discussion that involves home-buying and personal finances. It’s common knowledge that buying a home is a better financial move than renting. After all, you’re building equity instead of throwing away your money, right? Well, maybe not quite… Rather than assuming the “common knowledge” on this subject is accurate, let’s take a look for ourselves at some of the financial differences between renting and home-buying.

A Real-World Example

For the purpose of comparing renting to owning in this post, I’ll be using real-world data gathered from my area (NE of Seattle). Although most first-time buyers tend to move from renting an apartment to buying a larger, stand-alone house, as much as I can I will compare apples to apples.

For rent, I located a 3-bed, 2.5-bath, 1,840 sqft house with an attached 2-car garage, on 0.2 acres. Monthly price: $1,495.

For purchase I found a 3-bed, 2.5-bath, 1,850 sqft house with an attached 2-car garage, on 0.22 acres. Price: $424,950.

The two homes are located within two miles of each other in similar neighborhoods, and neither is located on a busy road. We’ll assume that our hypothetical homebuyer is a married couple with $85,000 in the bank to make a 20% down payment. To calculate mortgage payments we will use a recent 30-year fixed interest rate of 6.25%.

Let’s look at how the monthly costs break down (approximately) for our hypothetical potential first-time homebuyer:

  Renting    Buying   
Rent/Mortgage:    $1,495 $2,093
Insurance: $20 $163
Property Tax: $407
Tax Savings*: ($327)
Maintenance: $354
Total: $1,515 $2,690

*: (less standard deduction)

Right off the bat, you see that simply trading straight across from renting to owning results in a 78% more expensive monthly bill. That’s not exactly chump change. With even a slight upgrade from renting to buying (which most first-time buyers are prone to do), you can easily see how the total monthly costs would be more than double.

“If you rent, you’re throwing away your money.”

Common knowledge says that despite today’s large premium, buying a home is a “good investment” anyway. Hey, at least you’re not “throwing away” your money, right? True, the renter in our scenario spends $1,515 every month that they will never see again. I wouldn’t exactly say it has been “thrown away” any more than money spent on any other good or service is “thrown away,” but granted, there is zero financial return on that money.

However, when you take a look at the breakdown of the homebuyer’s monthly expenses, a large amount is money that will never return, either. Insurance, property tax (less tax savings), and maintenance, add up to $517 every month that is being “thrown away.” Even worse is the amount spent on mortgage interest. Consider how much of a mortgage payment is applied toward loan interest throughout the life of a 30-year fixed loan:

Years    % toward interest
0-5 ~80%
6-10 ~70%
11-15 ~60%
16-20 ~50%
21-25 ~35%
26-30 ~10%

Homebuyers throw away lots of money, too.In the first five years, approximately 80% of the mortgage payment goes toward interest. That’s an additional $1,674, for a total of $2,191 being “thrown away” every single month by the homebuyer for the first five years. Ouch! In fact, not until the homebuyer has been paying down the mortgage for over 20 years will the amount they are “throwing away” be less than the renter.

“Owning your own home is a forced savings plan.”

As you can see above, if home buying is like a savings plan, it’s probably the worst savings plan on Earth. Would you voluntarily sign up for a savings plan where well over half of the money you deposit in the first 20 years simply vanishes, and from which you can only withdraw money by relocating and paying a 6-9% fee (not on the amount you have “saved” mind you, but on the total sale price of the home)? Of course not. That doesn’t sound anything like a savings plan.

If our potential homebuyer has that $85,000 saved up for a down payment and deposits it along with just half of the monthly savings over buying ($578 per month) into an account at 8% interest, the balance will be nearly $300,000 in just 10 years. That’s a liquid investment, that can be used for whatever you want, no relocation required. Buying a home is not a savings plan. Actually saving money every month is a savings plan.

“Home ownership is an excellent path to build wealth.”

If your goal is to build wealth, you will be much better off investing your money in the stock market than buying a home. While both stocks and housing are cyclical markets, long-term historic trends show that housing appreciates at a rate barely above inflation, while stocks tend to return an inflation-adjusted 7-10%. In our hypothetical scenario, a renter who invested in the stock market with the $85,000 down payment plus the monthly difference between the $1,515 rent and the $2,690 home-buying costs would be over $500,000 better off after 30 years than the homebuyer, assuming 4% average appreciation.

An important thing to consider is that home prices in the United States are just now beginning to correct from an enormous unprecedented run-up in recent years. Despite what those in the business of selling real estate may insist, the correction in housing is still in the early stages. Four percent is most likely overly optimistic for most areas in the next 5-10 years. The only thing we know for sure is that double-digit gains are gone and won’t be coming back any time soon.

Also keep in mind—I mentioned it above but it bears repeating—in order to cash in on any “wealth” you build through your home you will need to sell that home and move. No, “extracting equity” does not count, since that simply results in a larger debt. Debt != Wealth.

Conclusion

For most people buying a home will result in their largest monthly bill (by far), and because they believe that it will bring them wealth or that they are “throwing away their money” if they rent, they often take on a much larger home debt than a prudent budget would allow. It is a real shame when people are driven to get into the housing market because of misplaced notions of imagined financial benefits. Of course, everyone’s circumstances are different, and for some (particularly those that live away from the coasts) the numbers may actually work out in favor of buying.

Don’t misunderstand me here. I am not saying that no one should buy a home, or that my example scenario is a golden standard of truth for all. Don’t take my word for it. Run the numbers for yourself, check out other articles (a small collection is listed below), and do what works for you. I highly recommend the great graphical calculator from The New York Times for comparing the financial aspects of renting and buying. Many people will consider all of the consequences—financial, emotional, etc.—and conclude that buying a home is the best decision. Just don’t trick yourself into thinking it’s a good financial decision if it’s not.

I myself intend to buy a house some day. However when that day comes, I will be buying a house because I want a nice, “permanent” place to live where I’m the boss, not because I think it will help me get me rich.

Additional Resources:

Wall Street Journal: Your Home Isn’t the Nest Egg That You May Think It Is
New York Times: A Word of Advice During a Housing Slump: Rent
New York Times: Is it better to buy or rent? (graphical calculator)
The Motley Fool: The Worst Investment Ever
SmartMoney.com: Renting Makes More Financial Sense Than Homeownership
CNN Money: Stocks vs. Real Estate
Priced Out Forever: Renting vs. Purchasing


About The Tim

Tim Ellis is the founder of Seattle Bubble. His background in engineering and computer / internet technology, a fondness of data-based analysis of problems, and an addiction to spreadsheets all influence his perspective on the Seattle-area real estate market.

154 comments:

  1. 1

    GREAT ARTICLE TIM: HARD TO ARGUE WITH AND OPEN-MINDED TOO

    I’d add a caveat: if you do decide to buy something less expensive, look at the foreclosure listing prices in that neighborhood.

    If the foreclosure rates and prices are close to your purchase price of cheaper deals, you have less equity loss to worry about than the plummetting in foreclosure prices I’ve seen even in the $300K+ priced homes (lower priced…lol).

    The higher the home’s price, the bigger the foreclosure price plummetting effect I’ve noticed. Check it out yourself on RealtorTrak or other foreclosure websites. The more you pay (the higher they fly) the greater the forecloure plummetting recently (the harder they fall).

    And remember the old joke a Seattle Blogger stated, I’ll quote:

    “In the 1985-1990 Seattle Bubble a condo was harder to get rid of than Herpes”

  2. 2
    SunTzu says:

    I would say even for those who have enough cash on hand to afford a pricy house, putting all that cash into a house would be a bad choice.

    What I mean is say you’re lucky enough to have 300K so you figure you can buy a 700K house (without getting a jumbo loan) by putting in all that 300K. That cash is now tied down. If you want to use that money you’d have to borrow against your house and pay interests, whereas if you shoot for a 500K house and put in 200K then you have 100K to invest in other more liquid and better yielding securities (such as stocks).

    But the best choice now would be to rent, forget all the I must have a house to be worthy as a person, and invest all that 300K into gold or oil.

  3. 3
    Mark L says:

    I’ve done a similar analysis – I like to compare my 1000 sf Mukilteo 2Br/1.5 to a similar condo for $500K in Ballard. The only things I would change are the maintenance cost assumptions for a SFH (1% of purchase price per year seems a bit steep), and I would probably use a risk free rate (like 5%) on the invested down payment and invested cash flow. Even after tax savings (net of std deduction), and assuming 0.5% per year maintenance/HOD, that scenario turns out to provide $2000/mo in cash flow for renting versus buying, plus no $108,500 ante (including closing costs) up front. Plus my commute would get over 20 miles longer. It is tough to make those numbers palatable…

  4. 4
    jon says:

    Without even discussing interest deduction, repayment of principal, or inflation of rent it seems simplistic. While buying a house ahead of a down-turn in prices is risky, even appreciation due to inflation over the long term is quite significant.

  5. 5
    biliruben says:

    He did include interest deduction ($327), principal (~20% of the PITI) and inflation. They were central to his argument.

    It seems pretty clear to see we are going to see depreciation not appreciation due to inflation or speculation, if we are going to return to fundamentals over the short to medium term.

    Did you actually read the post, jon?

  6. 6
    The Tim says:

    jon said,

    Without even discussing interest deduction, repayment of principal, or inflation of rent it seems simplistic.

    Actually Jon, I did account for all those things.

    interest deduction – You’ll notice in the first table, there’s a row for “Tax Savings (less standard deduction)”

    repayment of principal – I didn’t lay out the full details behind the calculations, but this was factored into the comparison, including in statements such as “$500,000 better off after 30 years.”

    inflation of rent – Also factored in, but not explicitly laid out.

    The post was long enough as is that describing in detail the math behind every single statement would have made it into a novel. Besides, most of it was covered before in this post, which has a spreadsheet attached that you can download to check the math yourself.

    Thanks for the feedback.

  7. 7
    Angie says:

    Jon hits the nail on the head.

    I have the same criticisms of this article now that I did 2 months ago on GRS. $1500 for that rental is decidedly optimistic and depends heavily on the goodwill of the landlord. Just like in July, I looked at today’s 3 bedroom/1+ bedroom houses for rent in N. Seattle (according to the adverts in the Times online). 16 places fitting that bill, rents ranging from $1200 to $3950, with the median at $1850. Undoubtedly those will rise in time, too, whereas a fixed-rate mortgage won’t.

    Sun-Tzu, your comment made me think: if I had $300K floating around to spend on housing, I’d buy a $300K house in the outskirts or a $400K house in the city with a 10 year mortgage. Get the house paid off ASAP and have a big load off my mind. That’d buy you an OK house in an OK neighborhood, and having a house bought and paid for would be more than OK!

    Slaving away for another 30 years for a $700K McMansion is not my idea of fun.

  8. 8
    The Tim says:

    Angie said,

    $1500 for that rental is decidedly optimistic and depends heavily on the goodwill of the landlord.

    Angie, both the rental and the for-sale home were real-life examples that I found, on Craigslist and the MLS. They were both in the Finn HIll / Moorlands area (between Kirkland and Kenmore).

    The for sale house is still listed, for the same price, MLS# 27139905.

    The rental is off the market (presumably they found a financially savvy renter), but plenty of similar homes can be found with a cursory search.

  9. 9
    bob barker says:

    One of the issues that seems to get overlooked in these discussions is retirement savings. Most people are not in a position to handle a big mortgage AND max out their 401k. In my case, by renting, I’m able to put a significant amount extra into my tax deferred retirement account each month. Thus, while I don’t get a mortgage interest deduction, I do get the tax benefits of contributing more into my 401k. From what I’ve read there’s a looming crisis as the shift to defined contribution retirement plans–as opposed to defined benefits plans–has led to an enormous savings deficit. If I have to choose, I’d rather rent and have financial security in my golden years, than have to take out a reverse mortgage in order to buy groceries.

  10. 10
    biliruben says:

    $700K McMansion? $1500 unreasonable for Kenmore?

    It appears you are a bit out of touch with the market, Angie. I would have expected a bit more from a landlord.

    $700K buys you a 1050 sq ft 2 bedroom in a working class neighborhood:
    http://www.redfin.com/stingray/do/printable-listing?listing-id=1077893

    Not a McMansion.

    And there are plenty of 3 beds for reasonable prices in Kenmore.

    No wonder you are skeptical of a bubble!

  11. 11
    John says:

    One point people don’t consider is that property taxes almost always go up while landlords don’t raise rent every year, or even every few years.

    Look at all those condo conversions. Tenants used to pay $1000-$1200 a month rent. Now the developers are selling those things for $300k-$400k. It doesn’t take a genius to know in those cases, it is better to rent.

  12. 12
    Rob Dawg says:

    You need to credit the renter with an additional $350/mo ROI for their $85,000 left invested at 5%.

  13. 13
    deejayoh says:

    This reminds me of another conversation with no real answer…

  14. 14
    greater context says:

    i’d say the rent cost estimate is too high.

    when you rent, you rent for what you need today. when you buy, you buy what you think you’ll need within 10 years.

    i’m married and without child, so i don’t mind a decent 1 bed 1 bath apt for $1k/mo including wsg

    but if i were buying, the smallest i would consider would be a 2 bed 1.5 bath condo and i’d insist on a decent view. this puts you at $300k easily

    i think the same is true of houses. my parents choose to rent an apartment right now (for a bit less than me), but if they were to buy, they would only be looking at 3/2 houses. the rent they pay right now wouldn’t cover the tax, insurance, maint on the average 3/2 in Loyal Heights (where they happen to rent right now, b/c it is close to work). nevermind the mortgage and buying/selling fees

    so they’re in large cap stocks instead.

    i accept that you don’t account for this in your comparison, but i think it is a reasonable part of many people’s decision-making process

  15. 15
    deejayoh says:

    oops. lost the punchline.

    Preview made it look like I could embed the image.

  16. 16
    The Tim says:

    John said,

    One point people don’t consider is that property taxes almost always go up while landlords don’t raise rent every year, or even every few years.

    For the purposes of this post, I tried to account for as many factors as possible, but also keep it relatively simple. Yearly increasing taxes are factored in (with assessments lagging a few years behind value), and rents are assumed to increase yearly as well. Granted, it’s not perfect, but it does a fairly good job.

    Rob Dawg said,

    You need to credit the renter with an additional $350/mo ROI for their $85,000 left invested at 5%.

    ROI is definitely factored into the post. See the “forced savings plan” section. It’s not in the first table, since that discusses costs only.

  17. 17
    wageslave says:

    “Many people will consider all of the consequences—financial, emotional, etc.—and conclude that buying a home is the best decision. Just don’t trick yourself into thinking it’s a good financial decision if it’s not.” = well said!

    As for me, a first-time home owner that purchased in Seattle early Spring 2005 with 5% down to get 1200sq ft of living space for ~$430k, I…

    LIVE as if our only equity is what we’ve paid down and toward principle rather than some magical fairyland numbers that make believe it has appreciated 25%+ in 2.5yrs

    FEAR being upside down in the mortgage (this’d require an approx 25%+ depreciation from est. peak “value”), especially if there is a deep and/or prolonged recession that results in job loss

    HOPE that the home appreciates enough over time (we plan to expand eventually rather than move so are thinking long-term) to cover most of the costs of home ownership such as maintenance, taxes, etc.

    WANT it to also appreciate enough to help pay for any difference between savings and actual cost of that expansion

    DREAM of enough appreciation to cover the above plus the cost of upgrading to a larger/nicer/nicer location home upgrade in the future

  18. 18
    Joel says:

    Jon hits the nail on the head.

    No he doesn’t. He missed entirely and broke his thumb. Did you even read the article?

    I have the same criticisms of this article now that I did 2 months ago on GRS. $1500 for that rental is decidedly optimistic and depends heavily on the goodwill of the landlord.

    No it isn’t, back when I was looking for rental houses (in Belluvue) I found a few on craigslist that were listed in the $1400 – $1500 range and that had been recently sold for over $450k. But the whole point of the article isn’t to say “Your situation is exactly like this, therefore you should not buy!”, it’s more like “Here’s a real world example of why buying a house isn’t a good investment, you should check to see if you are in the same kind of situation.”

  19. 19
    The Tim says:

    Joel said,

    But the whole point of the article isn’t to say “Your situation is exactly like this, therefore you should not buy!”, it’s more like “Here’s a real world example of why buying a house isn’t a good investment, you should check to see if you are in the same kind of situation.”

    Exactly. That hits the nail on the head.

  20. 20
    Rob Dawg says:

    ROI is definitely factored into the post. See the “forced savings plan” section. It’s not in the first table, since that discusses costs only.

    No. You discuss it but you don’t credit it. Every month the renter keeps $85k in th bank they earn $350.

    That isn’t in your monthly costs comparison.

  21. 21
    plymster says:

    deejayoh, if that’s your real name, conventional wisdom suggests that a Superman would beat the web-slinging snot out of Spiderman. Unfortunately, the local citizenry has been loading up on toxic loans… er… kryptonite, so now Spidey is set to destroy Superman.

    Just like in the rent vs. own, Spidey vs. Superman is all about the environmental variables. Once again, nice post, DJO!

  22. 22
    rentalbliss says:

    Hi Tim,
    This home is in the same hood as your example any ideas what is going on? Less than 2 months after sale asking 25K less than purchase.

    http://redfin.com/stingray/do/printable-listing?listing-id=1041052

    This is the second home in this area I have found that is asking less than what was paid within a year.

  23. 23
    Angie says:

    $700K buys you a 1050 sq ft 2 bedroom in a working class neighborhood Flippity, flip, flip, flip. Lookit those gleaming granite counters. It’s the in-city equivalent to a McMansion. I will point out that even if the price of that house falls by half it still wouldn’t be “affordable” by the traditional borrow-3-times-your-income-30-year-fixed measure (last time I checked city of Seattle median income was $71K).

    You get a lot more house for that kind of money in my zip code, like :
    http://www.windermere.com/index.cfm?fuseaction=Listing.ListingDetail&ListingID=1830359
    or http://www.windermere.com/index.cfm?fuseaction=Listing.ListingDetail&ListingID=18303592

    (Forgive the ugly links, the HTML isn’t working the way it oughta.)

    And there are plenty of 3 beds for reasonable prices in Kenmore. More power to ’em. Enjoy that commute!

    “Here’s a real world example of why buying a house isn’t a good investment, you should check to see if you are in the same kind of situation.”

    Why not ask the real-world owner of that rental what the financial playing field was like when they acquired the property?

  24. 24

    For me in Albuquerque, you are completely right. I made up a spreadsheet just to double-check my net worth after buying versus renting, and it’s generally much cheaper to rent. If you’re interested you can get it here: http://tinyurl.com/2q9nc6

  25. 25
    UrbanArtist says:

    I think this is a great article. Just because everyone is saying owning a house is the goal doesn’t mean it is right for everyone at the same time.
    My husband and I rent in Ballard we have been here since the early 90’s. Houses were less expensive but we still did not make enough to buy.
    We both did not want to buy if we had to live paycheck to paycheck. We chose to rent and travel a lot. Don’t get me wrong I would love to own a house of our own so we could do solar etc….There have been times when we questioned if we were cowards not to take the plunge to buy a house but every time we ran the numbers it didn’t look good. So in 99 we thought lets get land insted and bought 5 acres in Port Townsend with a little tiny cabin on it. Many of our friends thought we were crazy not to buy a house. Now many of those same people envy us. We will have the land paid of very soon. We have not been able to save as much stated in the article but at least we aren’t living one paycheck from disaster.

  26. 26
    david losh says:

    The one factor not mentioned is future dollars. I buy a house at today’s price and mortgage then in five years I’m paing the same mortgage with inflated dollars. In fifteen years I have inflated dollars and a diminishing principle balance. At twenty years I owe what most people consider a bargain, and either pay it off or don’t.
    If I want I can throw money at the principle at any time to begin that diminishing principle balance. If I do that at the front end of the loan the back end becomes shorter.
    I’ve paid off two personal residences this way in my life time and am working on a third. I use the cash and the added tax benefit of selling a personal residence without paying Capital Gains then keep the money, or in my case, I squander it on what I consider good works.

  27. 27
    SunTzu says:

    “I buy a house at today’s price and mortgage then in five years I’m paing the same mortgage with inflated dollars. In fifteen years I have inflated dollars and a diminishing principle balance.”

    Yes, inflation will give you that (i.e. inflate out of debt/mortgage), but probably not all from general inflation. The assumption that housing prices will continue to increase (price increase = inflation for any tangible object) is future looking from past data.

  28. 28
    biliruben says:

    LOL, Angie. Good to see you haven’t lost your sense of humor.

    Pretty audacious flip, imho. Even your starry eyes picked it out. Drives me crazy when they tack on the basement as if it’s legit sq. feet.

    That second one’s

  29. 29
    biliruben says:

    … nice house. Pricey for the hood, but nice.

  30. 30
    Tsuru says:

    According to Aubrey Cohen, “homeowners generally earn far more than renters”. You hear that you filthy renters? Get a job!

    http://seattlepi.nwsource.com/local/331297_housing12.html

  31. 31
    explorer says:

    Excellent article and responses Tim.

    If you indeed get “inflated dollars” to lessen the burden of the mortgage payment, would that not be offset by “inflated taxes/assessments” and “inflated” maintenence, insurance, NO refis, lines of credit, food, clothing, etc.? That is also assuming everything else, e.g. job, wage growth exceeing inflation, health, disasters, etc. remains stable. Pretty big pink pony assumptions.

    I never clearly understood the “inflated” dollars argument applied to very large amounts of debt. Debt is debt, and it does not provide income, only takes it away…

  32. 32
    Steve says:

    One assumption from your post that I don’t understand is why someone would purchase a house, then rent it out for less than its monthly cost. For example, if you are paying $2,690 per month as an owner, why would you even consider renting for $1,515/ month?

  33. 33
    Alan says:

    Any debt or investment has an effective interest rate which is the actual interest rate minus the rate of inflation. If you take on debt with a fixed interest rate that is offered expecting low inflation (say 4%) and then inflation grows (to say 6%) then you are ‘earning’ 2% on that debt because inflation is shrinking it faster than the interest rate is making it grow.

    Similarly, if you invest money at 4% when inflation is 6% then you are losing 2% a year in real dollars.

    Tim’s calculations were all inflation neutral. His 7% growth was 10% minus an assumed 3% interest rate. Comparing inflation adjusted dollars to inflation adjusted dollars his comparison is accurate (because the investment ends up earning more while the debt decreases more quickly).

  34. 34
    jess says:

    Hello, I’ve been lurking for a few weeks and have found the information and comments very helpful — especially to help me keep my feet on the ground and head out of the clouds. We chose to go to grad school when all of our friends started buying small houses north of the cut in the mid-90s, which means we have been renters for over 15 years (except for a two-year stint of owning in a Kitsap community and trying to commute by ferry, didn’t work so well and got out as soon as we could, made a bit of equity, but no fortune by any means). As renters, we have had to leave every single house, and most of the apartments, because the owners decided to either sell or jack the rent up. We are lucky to have a nice landlord right now, but it’s still not our house (and we are starting to get the hint that he wants to sell now, too). I had a terrible time finding this rental house last summer — not only were landlords weary of us because we had a 10 year-old boy and a spaniel, but I was told over and over that they weren’t comfortable renting to us because we were the “buying type” rather than the “renting type” (because we have advanced degrees and incomes). I know that’s against the Fair Housing Act, but when there were so many renters and so few houses, well, there you go… I suppose the thought was in summer 2006 that anyone who can buy should, and those who don’t, well, what is it, bankruptcy? are you going to jail? do you have too much debt (why yes, thanks to student loans, but not crippling, thank you very much)? You get the point… While renting may be the smart economical decision, it is not very stable, convenient, or reassuring. Your shelter and your children’s shelter is always at the mercy of someone else’s whims.

    Now we are ready to buy again, just in time for the housing market to fall! We need to have easy access to son’s school in Wallingford, can go up to $650K (30-year fixed + cash), plan to own the home for at least 8-10 years, and we have jobs + 401Ks and do not see home-ownership as a way to get rich quick. With this information, what would you recommend? Would we be the foolish buyers, or will the length of time we are hoping to stay override any bubble-burst?

  35. 35
    UrbanArtist says:

    What Steve said is a good point. If a lot of these homes are bought as investment property and the monthy payments are 2k + per month they will ask that much or more for rent. Which is going to be a problem for renters.

  36. 36
    Joel says:

    Why not ask the real-world owner of that rental what the financial playing field was like when they acquired the property?

    If the owner bought 5 or more years ago, it’s likely that the difference in cost of renting vs. owning was much smaller. I’m not sure what that says about the here and now though. Actually, it would just go to show how inflated the market is right now.

  37. 37
    Dave0 says:

    Steve,
    I’ve wondered the same thing. Here are my two theories:
    1) The landlord bought the property so long ago, at a cheap enough price, that they are making a profit on current rents, even though if someone were to buy it now they would have to rent it out at a lose (I know my landlord falls in this category).
    2) They are speculative investors thinking they will make so much in equity that they can afford to rent it out at a lose.

  38. 38
    david losh says:

    Number one I never figure appreciation into my personal residence. Inflation is a fact of life. Gas is going up every day and will continue to do so.
    About the buying a house and renting it out for less than the payment; my guess is that the house payment is off setting other income. I don’t pay taxes. I pay social security. If my income excedes my expenses one way to not pay taxes is by taking on more debt. It’s complicated but one hypothetical scenario for having a mortgage larger than the rental income that I do not endorse or recommend is if you take your rental payment in cash or personal check and do not declare the income you have additional income and write off your mortgage against other income.
    This works for the self employed. A doctor may have a house in the Hamptons that he pays for and never uses. His tax liability is decreased while his investment increases. He pays for the house in added income from a variety of sources. Let’s not go there right now but some people make more money than they literally know what to do with.
    About stocks and Real Estate. I had a bet with a woman years ago who was great at stock picks. At the end of the year we both made about the same money but I won by the tax advantages the Real Estate system offers.
    One more thing that is Urban Legend and I’m sure you guys can straighten me out on is; if you are adding a tax savings to the mortgages paid column shouldn’t you also add money to the renters cost column for paying rent with after tax dollars?

  39. 39
    EconE says:

    Angie said…

    “Why not ask the real-world owner of that rental what the financial playing field was like when they acquired the property?”

    don’t need to. I already know in my case. The LL paid 508k…homeowners dues are approximately $450 a month.

    I have a 2 year lease at $1670…do the math Angie.

    And before you try to “poo-poo” Bothell by using “your zipcode” to try to outsmart Tim…I’ll tell you what…

    If I ever decide to become a crack addict or feel like joining a gang…maybe I’ll look into living in YOUR zipcode.

  40. 40
    Onlooker says:

    “For example, if you are paying $2,690 per month as an owner, why would you even consider renting for $1,515/ month?”

    Because even though a landlord would love to rent out their house for payment+profits, unfortunately, the rental market sets the rates, and as The Tim has posted numerous times, the rentals are out there and they are that cheap.

    I guess the landlord could just eat the costs entirely, but that doesn’t sound like fun either.

    From my 3+ years of Seattle renting experience rent is roughly 500+ per room in the Queen Anne, Magnolia, Ballard, Green Lake area. So this example doesn’t seem out of line with my anecdata.

  41. 41
    Alan says:

    if you are adding a tax savings to the mortgages paid column shouldn’t you also add money to the renters cost column for paying rent with after tax dollars?

    I am married and I rent. I get a $10k standard deduction. I do not have enough itemized deductions to make itemizing worth while. If I buy a house, I will be paying the same taxes on the first $10k of that interest mortgage. I could say that standard deduction is applied against my rent.

    My landlord presumably has a mortgage and gets to deduct his interest. We both get a deduction so you can’t count my lack of mortgage interest deduction against me.

    If I did have a housing mortgage then I might look for more ways to deduct income. That is something I lose by renting.

  42. 42
    mike2 says:

    Don’t most people deduct the $15,500 in 401K contributions? That’s significantly more than the standard deduction for a single dude, and it’s equivalent to interest on a $300K mortgage.

  43. 43
    Madrona, USA says:

    @mike2: Isn’t that an above-the-line deduction? To arrive at AGI?

  44. 44
    UrbanArtist says:

    As Jess mentioned renting is not super great either. You are at the whim of the landlord. We have been lucky but our landlady is old. If prices don’t drop we will never be able to buy a house in Seattle so in some way Priced out Forever does ring true. I keep thinking there are a lot of people in Seattle that make good money but not 100K+ that want to buy. It just stands to reason prices will drop or there are a lot of people who wont be able to buy and the market will tank. The area I live in Ballard does not seem to be affected very much yet, sales of SFH do not appear to be slowing or prices going down. We would be looking for a Town House maybe they will be more available for a good price in a year or so, we do have our land to fall back on anyway. A little off topic developers are going to be putting up condos and shops in place of the old Denny’s in Ballard. It is sad to see what is happening in Ballard.

  45. 45
    Angie says:

    Those of you who are wondering how owners can keep afloat renting for so little—remember that not all mortgages are necessarily ~100% of the sales price. If someone puts down a big fat down payment, their monthly obligation can be much less than it would seem at first blush.

    Biliruben, have you ever actually been in the Seward Park neighborhood? It’s been a moneyed enclave for decades and is about as different from the “hood” as you can imagine.

    That offhand characterization and EconE’s grang/crack bullshit are pretty typical for Seattle myopia about the south end, with not a little hometown racism thrown in for good measure. (My heavens! Actual black people in Seattle!) Go look at the crime stats on the SPD web site, it’s no worse here than in most of the city (and way better than in the U district where I lived for the first 6 years here).

    We’ve been down here for 8 years, have put down roots, are raising our kids here. It’s great and we love it. And—more relevant to the subject of real estate—the area has seen quite a renaissance, which has been reflected in home prices, but you can still get way more house for the money around here than in the north end or the burbs.

    Hey, I’m in a two-working-parent family w/2 kids. My husband and I are well-educated, and have jobs we love that don’t pay particularly well. Only in the past two years has our family income exceeded the city median, and even then not by a whole lot. And by taking some calculated risks and working hard we’ve been able to buy, and keep, not one but two houses in eight years. No stupid financing tricks, either; straight fixed-rate on both; we could pay both mortgages out of pocket every month if needed. We figure we’re on track to be able to buy the next one (enough saved for a good down payment, able to meet or exceed PITI+ upkeep with rent for what is now our residence) in the next 3-4 years. (If prices tank, great! I’d love another good deal, and we’d still be way ahead in our current houses.) A few years after that, house #1 is fully paid off.

    I don’t think it could have happened in any other part of town, where we are essentially priced out forever!

    Anyhoo—that’s my “real world example” of how owning turns out better than renting. Go ahead, make fun of my zip code all you want!

  46. 46
    Teacher Greg says:

    Hey, over 11,000…how about that. How long do you think to get to 12?

  47. 47
    Mark L says:

    A 401(k) is pre-tax, above the AGI line. Standard deduction (or itemize) comes off after AGI. Plus, most people – especially if we are talking the median local income – do not contribute the max ($15,500 for an individual in 2007) to the 401(k).

    In general, you add your mortgage interest and property taxes (and any deductible points for new buyers), subtract your applicable standard deduction (single or married/HoH), multiply by your marginal tax rate, and that is your interest deduction attributable to your home ownership (for owner-occupied).

    Also, as for the comment about inflation… Just work in monthly or yearly cash flow and nominal interest rates and it will all work out. You should assume a growth factor for rent, property taxes, etc. I typically use 3.5% or 4% anually. My spreadhseet for this goes out for 30 years – cash flow for eah month. A bigger factor for handling the investment income (for invested down payment you never made) is to properly account for the tax hit each year.

  48. 48
    Mark L says:

    Whoops – second paragraph paragraph above – I meant to say “that is your tax benefit” attributable to your home ownership – i.e. the net delta cash flow you will see in your monthly finances (you can see it through reduced withholding from your wages).

  49. 49
    deejayoh says:

    have you ever actually been in the Seward Park neighborhood? It’s been a moneyed enclave for decades and is about as different from the “hood” as you can imagine.

    If I could afford this place, I’d move to 98118 to be Angie’s neighbor in about 2 seconds.

  50. 50
    Alan says:

    401k contributions are pretax and are not considered ‘deductions’.

    I don’t think we will see 12k this year. I think inventory is going to max out around 11600 this month, drop to around 9250 at the end of December and then start climbing again. Who knows what will happen a year from now? If the current trends continue then we may see 16k next September, but honestly that is too far away to make any sort of prediction.

    Landlords can rent out for less than their mortgage/tax/insurance payment when houses appreciate 10% a year. Who cares if you are losing $16k up front when that $400k house goes to $440k?

    Landlords who have large equity stakes would have been better off pulling the equity out with a low interest rate refinancing and investing the cash equity in a vehicle that earns a higher rate than their loan — that is — if they believed the sales prices would continue to rise.

    Landlords who believe prices will drop would be best off selling the soon to depreciate asset and investing the equity in something that they did not expect to drop in value that also would return a nice rate of return.

    For example, say you own $700k house that you rent for $1500/month (after accounting for management fees and vacacy percentage). You bought the house for $400 and put $100k down on purchase. Your equity is $400k and your loan amount is $300k. Your PITI is around $1900/month. This is very close to the situation that my last landlord was in.

    Each year you pay close to $5k out of pocket, but if you see your 10% appreciation (like you have the past several years) then you gain another $70k in equity!

    But you are losing the opportunity to put that $400k in the stock market and earn a theoretical 7%. That comes out to $28k lost. That isn’t a problem when you are earning $70k in equity increases, but if the value stagnates then letting that equity sit dead doesn’t seem like such a good idea.

    Even if it is appreciating, you are still losing money by letting that equity sit in your house. Pretending you could borrow $300k of that equity at 6% and invest it at 7%, you are losing out on a net of $3k a year.

    If you think prices are going to drop, say 5%, then you stand to lose $35k in equity plus that $28k of investmet opportunity cost this year.

    Of course, nothing is certain and real estate is pretty easy to understand. Certainly more easy than the stock market. I think that is one of the reasons it attracts so many investors.

  51. 51
    Greenthum says:

    Angie:

    When you resort to accusations of racism to win your argument with Biliruben, your credibility goes right out the window. You’re lame comment makes me seriously doubt how well educated you really are!

  52. 52
    Sen says:

    Angie’s comment about racism was in response to EconE’s remark about crack addicts and gangs in Angie’s zipcode. It had nothing to do with her debate with Biliruben.

  53. 53
    Snake Plissken says:

    There are so many parameters that factor into the decision to buy a house (or not).

    Even taking only money into consideration, the comparison is not that simple. When I bought my house I thought my housing budget was going up slightly. As a matter of fact it ended up being a wash, because the old rental was a leaky cold house while the one I bought is well insulated. As a result my utility bills went down significantly.

    But there are also many aspects of home ownership that have nothing to do with money. What about the ability to have pets? The stability it provides kids? There could be a million non-financial reasons for buying a home and they’re important as well.

    The goal of life is not to end up the richest resident of the local cemetary.

  54. 54
    EconE says:

    I think that Angie was referring to me with her racism comment. Sure…I’ll admit that I went over the top a bit but my comment was tongue in cheek. Everybody loves to play the race/gender/etc. card however…pretty pathetic sign of our society.

    Seward Park is in fact a nice “pocket neighborhood in Seattle…one that is in essence surrounded by a bunch of crap that can tend to filter it’s way in. It’s no different than “moneyed” pocket areas of Los Angeles proper…surrounded by both crackheads and gangs. Murders too!

    You asked for real world equivalents with regards to what someone pays for a “home” and I gave you one. I can find those deals all day in the downtown condo scene. Your silence WRT my example speaks volumes.

    Are you willing to admit that there is a much greater potentiality of the SHTF in the condo market or are you just the new RE cheerleader here on SB?

    You assumed that everybody that lives in Bothell must have one hell of a commute. I have a funny feeling that Tims commute would be much longer if he lived in your Zip Code.

    Oh…and regarding Ballard…I expect to see a slight rise there in the cost of a single family home now that they have a bunch of flippers trying to off condos at prices that they most likely will never get. When a potential home purchaser compares the price per sf of the overpriced investor ridden condos to a SFR then the SFR will appear to be a much better value.

  55. 55
    Yawn says:

    Greenthum: are you serious? Angie is just telling it like it is. It took me only about 3 months of living here to absorb the Seattle mentality that the northside is where hicks live, the south is where brown people live, and the only “safe zones” are east and west (with the eastside being full of stuck up snobs of course). I give her all the credibility in the word for dispensing with the bullshit, perhaps you should take notes?

  56. 56
    stephen says:

    “While renting may be the smart economical decision, it is not very stable, convenient, or reassuring. Your shelter and your children’s shelter is always at the mercy of someone else’s whims”

    Well said. No matter how many times this point is made it’s generaly ignored. Just as folks will pay 60-70k for a car they want, many of us will willingly buy a house in spite of a crappy market.

    Spent months looking at crappy houses on CL, there are not any decent houses for rent today for $1500.

    If the example was real world and the buyer stayed in the house for a decade it would most likely be a wash financially, but so what. Renting sucks…

  57. 57
    John says:

    It took me only about 3 months of living here to absorb the Seattle mentality that the northside is where hicks live, the south is where brown people live, and the only “safe zones” are east and west (with the eastside being full of stuck up snobs of course).

    3 months? Did you draw your conclusion from the news? Sounds like you have a chip on your shoulder to begin with. Seattle is not much different from Chicago, LA, and many other cities when you are talking about where the ghetto is.

    Seward Park is nice. If it is close to Lake Washington, its home price already excludes certain elements.

  58. 58
    Affluent Bitter Renter says:

    stephen said,

    “Just as folks will pay 60-70k for a car they want, many of us will willingly buy a house in spite of a crappy market.”

    LOL! I completely agree with Stephen. The people who will willingly buy a house in spite of a crappy market are **exactly** the people who will pay 60-70k for a car they want. Good luck with that – but it is advantageous to think once in awhile.

  59. 59
    Buceri says:

    Bottom line: In the Puget Sound area TODAY, you are much better off renting. 10 years ago I bought a 1050 sq.ft. townhome in South Bothell (10 minutes from downtown Kirkland) for $110K, interest rate was 8% and my monthly payments were $1100 including HOA dues. My neighbor was renting the same unit for $1350. 10 years ago, it was better to own. Today that unit is going for $297K and I don’t think the rent is much higher.

  60. 60
    wreckingbull says:

    This is classic. Responses like Angie’s are just like the responses this article received the first time. Everyone starting yammering about their personal situations.

    They are missing the point. The point Tim makes is this: Evaluate the choice in a quantitative manner using a model, not in a qualitative manner using old, stupid mantras like ‘real estate always goes up’ and ‘you are throwing away your money by renting’.

    By the way, the 401K comment is interesting. Most people I know with recent mortgages have completely stopped contributing to their retirement accounts, as they have now have no money left after paying their mortgage and expenses. Not a good idea, especially if you are young, as that is the time to be maxing them out.

  61. 61
    george says:

    Urban Artist: It’s true: rents will probably go up a bit as the housing maket softens but for nenting is still an incredible bargain compared to buying.

    Many landlords owned the place for years so they’re still feeling generous due to YOY price increases. When that number drops, I’d expect a flood of houses on the market and rents to keep going up.

    I wonder how many people in Seattle will actually sell their overpriced homes and rent for 5 years? Seems like it could be a great move right now, but you never know of course.

  62. 62
    Steve says:

    The fundamental problem with those who think the “buy vs. rent” argument is always “buy” is that – as others have noted – they never take into account all the money that the renters have saved. The power of compound interest is stronger than many realize.

    The interest from my savings (from renting as opposed to buying) are now more than enough to pay for all my housing expenses – rent, utilities, the works – and will continue to do so. That compound interest allowed me to buy a car for cash. None of this impacted my core savings – looking at my “net worth over time” graph, you can barely notice the car purchase. And no, I’m not a millionaire, I don’t even make six figures.

    It’s also really nice to be able to pick up and move somewhere else if I want to. Job move? Want to live in another neighborhood? Move closer to work? End the lease and move. Housing owners have to sell their house, which may be easy in a hot market, but isn’t easy now.

  63. 63
    Kime says:

    “If someone puts down a big fat down payment, their monthly obligation can be much less than it would seem at first blush.”

    But then you have to deduct lost interest of the down payment from the cash flow. I am sure the person didn’t have that big fat down payment hiding in their mattress.

  64. 64
    david losh says:

    Some comments are assuming that a 401K or savings will help in retirement. The fact is you have to live somewhere. When you retire in a rental you don’t have the same security you have in your bought and paid for house.
    I don’t really see the discussion really. Your personal residence is a sound financial decision. The numbers work over the course of time.

  65. 65
    wreckingbull says:

    “Some comments are assuming that a 401K or savings will help in retirement.”

    Yes, what a terrible assumption.

    With T&I + maintenance it still takes close to $800/month to own outright a median home here.

    The national news story of the next decade will be boomers in deep doo-doo because their viewed they home equity as a primary retirement savings vehicle. It ain’t gonna be pretty.

  66. 66
    John says:

    I don’t really see the discussion really.

    Of course you don’t, you are a realtor. Buy, buy, buy. At least you are honest about it.

    Renting doesn’t provide security? I’d rather have $500k in the bank and rent than own a $500k house out right and no money in the bank.

  67. 67
    The Tim says:

    wreckingbull said,

    By the way, the 401K comment is interesting. Most people I know with recent mortgages have completely stopped contributing to their retirement accounts, as they have now have no money left after paying their mortgage and expenses. Not a good idea, especially if you are young, as that is the time to be maxing them out.

    Sounds pretty familiar. While I’m contributing more than enough to get the full company match, one of my home-buying friends (in his late 20s) only just recently began making $40/month contributions. He mentioned it to me when he was telling me how tight their monthly budget is.

    In other news, I need to install some sort of threaded comments.

  68. 68
    wageslave says:

    John, I know you were reacting to a previous comment, but financial flexibility does not equal “security” to everyone. People have different priorities and different definitions. While I think it’d be silly to own a house outright and have zero savings (unless maybe I had an employment contract and was making lots of cash such that I could save up a bundle in a short time), there really are a lot of perks to owning over renting… albeit financial not necessarily being one of them unless one is lucky!

    If disaster strikes and I lose my home, I would dream of buying another as, to me *personally*, having only been a home owner for 2.5 years after having rented for 7 before that, owning is better than renting… assuming one can reasonably afford it (hearkening back to The Tim’s sound advice to THINK and not assume, as a mortgage is a massive financial commitment).

  69. 69
    Blue says:

    I’d like to reiterate the point made above: rent goes up while the P&I portion of the mortgage remains constant.

    You don’t get around that situation by invoking property taxes and maintence only on the mortgage…the rental property also includes those expenses, which will be reflected in an overall increase in rent.

    Yes, renting when fundamentals are out of whack makes a LOT of sense. But FAILING to buy a house (if your situation calls for it) when rental cost is reasonably close to ownership cost is an equally dumb move.

  70. 70
    Blue says:

    People who are arguing that the fact homeowners in retirement are in a similar situation as renters in retirement because they have to pay T&I + maintance are forgetting that a renter of an equivilent property will ALSO be paying that same amount of T&I + maintence…it will just be included in their rent. TANSTAAFL.

    In addition, the retired homeowner T&I situation is better off in many states due to appraisal growth caps and specific protections for elderly homeowners.

    Buying when rents are far cheaper than purchasing is clearly foolish…but I’d argue that, for many people in circumstances where they are not going to be moving, NOT buying when rental costs and ownership costs are close is one of the most foolish financial decisions they can make.

  71. 71
    wreckingbull says:

    “People who are arguing that the fact homeowners in retirement are in a similar situation as renters in retirement because they have to pay T&I + maintance are forgetting that a renter of an equivilent property will ALSO be paying that same amount of T&I + maintence…it will just be included in their rent. TANSTAAFL.”

    No. You missed the point. The point was owning a home outright still takes money. If you don’t have said money saved (IN LIQUID FORM, NOT ON-PAPER EQUITY), you will have problems. If you are counting on SSI for that cash flow and are below the age of 45, you are in for a very, very rude awakening.

  72. 72
    bob barker says:

    Just to follow up on my original comment on 401k contributions. What really gets my goat is how the tax benefits of home ownership are endlessly repeated with absolutely no attempt to address the opportunity cost of not contributing to your tax-deferred 401k. Given how poorly prepared most Americans are for retirement, it seems downright irresponsible to be promoting homeownership without including a caveat about the importance of savings. Maybe the real estate gurus and the retirement gurus need to spend some time locked up together in a windowless room.

  73. 73
    Hyperbola says:

    Angie said: Anyhoo—that’s my “real world example” of how owning turns out better than renting.

    No, that is a common fallacy. This example does not show what you think it shows because you did not compare how you would have fared by renting instead. For all you know, you might have made even more money by renting and investing in the stock market. Also, your argument suffers from confirmation bias – you have not adjusted for risks you have taken. Actually, all you have shown here is how buying worked for you. Good for you for buying in a financially responsible and productive way.

    Now let’s reason out what I’ve just said using simple examples, so we don’t get bogged down in the complexities of housing expenses. Let’s assume you have a fixed pool of money, $80k. You must pick one of the following: “rent” a $400k asset for $1500 a month for 5 years, or pay $80k down for the same asset and $2500 expenses a month for 5 years, and earn unknown returns on it. You have disposable income of $2500 every month for this purpose. Any unused cash will be invested in stocks. Let’s say you decide to buy it. Assume there are no other expenses, taxes or deductions, etc.

    After 5 years, your asset is worth $550k. You spent all your initial cash and income, so you are left with $230k in net worth. You celebrate because you’ve built a lot of equity. You tell everyone how buying was better for you and you have no regrets about your decision to buy. Does this sound like a reasonable simplification of your story?

    Now to the flaws. The first problem is your asset increased in value at the same time as other assets were increasing in value. In fact, the stock market doubled in value over those 5 years. So if you had rented instead, your savings (after adding $1000 a month in leftover income) would have grown to $240,000. So you have actually “thrown away” money by buying.

    The second major problem is risk. Owners of houses have greater risk than renters/stock investors. There is depreciation risk, which can be caused by factors outside your control such as crime, traffic, noise, zoning, fashion, and so on. There is also diversification risk – the initial $80k investment is a single bet, versus stock index funds, which invest in hundreds of reputable companies. Random, even unlikely events are more likely to cause harm to non-diversified investors. There is also liquidity risk: what is the chance you will be forced to sell the house to raise cash or move? The cost of selling the house is at least $40k, versus a termination penalty of 1-2 months’ rent.

    How can we adjust for risk? Everything depends on the odds. If you flip a coin for $100 and bet on Heads, and it comes up Heads, did you just invest $100 for a 100% profit? No, because you ignored the risk of loss. Actually, your risk-adjusted profit in this case would be zero, since you should lose half the time.

    How can we quantify the risk of price declines in your asset? In theory, the answer is simple: what would it cost you to buy insurance against these risks? You could buy puts on housing-related investments to cover the general depreciation risks in your region, but this is cheaper than protecting against declines in your specific house. My guess is even this rudimentary form of hedging (which is difficult for small investors to do efficiently) would cost you at least 5% of your house’s value per year. After 5 years, the cost of making your house a truly “safe” investment is over $100,000!

    By choosing not to insure yourself against risks, you are essentially gambling that those risks will pass you by (or assuming that you will be able to ride them out, which is only true some of the time). Now typically, you will receive a higher expected return by assuming more risk, but insurance will cost more. The huge insurance expense I mentioned above is just proof that buying individual houses is truly risky. Stocks (specifically, indexes) have much less risk because the individual random events that happen to specific companies partially cancel each other out.

    Thoughts?

  74. 74
    OCInvestor says:

    I gave the exact analysis to my cousins in Seattle and still they went ahead and bought the same kinda house mentioned above for whopping $500,000 last month.

    Feel sorry for the guys. They are in their late 20s.

  75. 75
    Angie says:

    Deejayoh, that is a pretty amazing house, isn’t it? I bike past there sometimes, right on the water, totally gorgeous.
    You know, if you bought it as an investment property, you could get like $1500/month in rent. Think about it, man.

    Seattle is not much different from Chicago, LA, and many other cities when you are talking about where the ghetto is.

    This is the kind of comment that shows me the speaker has no clue whatsoever. Even the “scariest” places in Seattle are nothing, no way, not even close to the bone fide ghettoes of Chicago, NYC, LA. Ask your friends in law enforcement, Seattle has one of the lowest crime rates of any city in the US.

    It’s the “low income neighborhood with brown-skinned residents==crime infested ghetto” equation that is racist BS. I have a lot of good, hardworking, honorable neighbors who are hurt by this kind of thinking and I respect them too much to let it slide.

  76. 76
    Greg says:

    Here’s my numbers from 2006 (pro-rated):

    Total mortgage payments to-date: $19983

    Interest paid to-date: $16496

    Principal paid to-date: $3487

    Recovered tax savings = ~33% of $16496 = $5443

    Interest-to-principal ratio: 4.7:1

    Total net cost: $19983-$5443 = $14539

    Potential appreciation: 7% = $33250

    Net equity: $37000

    Profit: $37000 – $14539 = $22197

    Now, I know that’s unrealized profit, but I underestimated the appreciation. It’s still a pretty good deal.

    One more thing: RENTS GO UP. Fixed mortgage payments don’t. And you can get kicked out at the whim of the owner, ‘specially in this state.

    So, for me, it made sense to buy. I agree with diversification though, and have a lot of my cash in equities, commodities, etc. You have to spread it around.

    Gold and oil! Great stuff.

  77. 77
    johnnybigspenda says:

    question: median income vs. median house price. these two things don’t have to correlate. why? because it really just depends on what the ratio of renters to buyers is. the median house price may be $500K, but the bulk of homeowners are likely people with income above the median income. Therefore, who cares what the median is. There will always be people who work at McDonalds who rent. They will never buy a house.

    It would be interesting to know what the median income was for *homeowners*.

    I’d also like to see a breakdown of rent vs. buy. ie. where does everyone in king county live?

  78. 78
    david losh says:

    I read the articles used for research for the post only after I had commented. Sorry. These articles are flawed in many respects. Most of these arguments for stock market investing are very tired and old.
    When I commented I think I was clear in referring to my personal residences. Real Estate investing is a totally different thing. When I buy a house for investment I pay a price based on making a profit on the property that day. I have an associate and his partner who are buying and selling four properties a month right now from pre foreclosure short sales.
    I agree that real Estate investing is very high risk and not for ametuers. All the get rich quick schemes are full of BS. There are systems that are sold that boil down to buy low, sell high. Many stock market gurus are selling the same schemes.
    It is also true you can diversify in the stock market and your home is a single big ticket purchase. I won’t call it an investment, it’s not for that. It’s for having a home that you control.

  79. 79
    John says:

    Angie, your reading comprehension is lacking. I was talking about the location of the ghetto in a city, not which city’s ghetto is more hardcore.

    Since you are so good at talking about your personal experience, here’s one for you. My friend grew up in the ghe…southside of the city, started a small business, got rich. Where do you think he moved his family to? “Snobby” eastside where they have better schools for his kids.

  80. 80
    deejayoh says:

    greg –
    you need to take off 7.8% of the gross value of your house from your profit if you are gonna do that math. That’s the transaction cost, which eats up all your 7% gain

  81. 81
    biliruben says:

    It would be interesting to know what the median income was for *homeowners*.

    I’d also like to see a breakdown of rent vs. buy. ie. where does everyone in king county live? – Johnny BS

    All this info is available, though I’m generally more interested in the total distribution than the median. I posted much if the interesting info here:

    http://seattlebubble.com/forum/viewtopic.php?t=623

    The median for homeowners looks like about 73K for homeowners.

    You can break it down by city and county in the links from the survey, but iirc it’s pretty close to 50/50 owner/renter in Seattle and 65/35 for the region.

  82. 82
    Alan says:

    If you invested your money in real estate or anywhere else other than World Water & Power Corp last year then you are just plain dumb.

    You could have purchased WWAT for $0.14/share and sold it less than a year later for $2.52/share. That $300k you put down on your rental to make it cash flow? It would have been worth $5.4M. You lost millions!

  83. 83
    Onlooker says:

    Well clearly renting is always better than buying because I invested the down payment and difference saved in a perfectly safe index fund that has gained 23% per year for the past five years. It even beat the gains of Seattle real estate! I bet this will continue on FOREVER!

    The fund name? EMPPF.
    The Emerging Market Pink Pony Fund.
    The EMPPF seeks to track performance of a benchmark index through diversified investment in pink pony ranches, feed, and rainbow production.

    Let’s just say the sector has been booming!
    Sure the long term trend only beats inflation by a few bps, but heck, I was right 5 years ago, so I am right now!

    Everyone who missed this train is simply poor and bitter. Have fun being priced out of ponies forever.

  84. 84
    Joel says:

    Anyhoo—that’s my “real world example” of how owning turns out better than renting. Go ahead, make fun of my zip code all you want!

    So you did the math like the article suggests and it made sense to buy, I don’t see what the problem is. If I could find a house around here that I could buy with monthly PITI roughly equal to equivalent rent I’d look into buying (once I had a downpayment).

  85. 85
    B&W NIkes says:

    “…the average monthly rent is $483 in King County, …according to the Cain & Scott Apartment Vacancy Report.” Seattle Times Living: Tuesday, January 16, 1990

    “…overall, King County’s average rent is $619, up from $600 six months ago.” Seattle Times Living: Sunday, April 28, 1996

    “…additionally, [Rose] Curran found that to afford the rent on the average two-bedroom apartment – some $732 on average county-wide – an income approaching $30,000 is necessary.” Seattle Times Living: Sunday, November 21, 1999

    “The Seattle area’s apartment-vacancy rate is 4.3 percent, its lowest level since the 2001 recession. Rents have increased 7 percent in the past year, to an average $893 monthly for all sizes of apartments, and are expected to keep rising.” Seattle Times Business & Technology: Thursday, April 05, 2007

    Though the figures aren’t precisely apples to apples, anyone can see a recurring problem with renting that doesn’t get factored into rent v. own calculations. There is no law in the region that prevents a landlord from setting an impossible price increase that a tenant won’t be able to plan for and will end up suffering through or relocating to escape. I agree with the principle that high debt ≠ wise investment, but anyone that’s lived through a high demand rental period and had to pay for it has to be equally skeptical. Where is this lack of predictability in monthly living cost expressed in fixed rate mortgages?

  86. 86
    mike2 says:

    B&W – an 84% rent increase over 17 years works out to about 3.6%/yr.

  87. 87
    Onlooker says:

    mike2,
    I don’t think anyone ever actually reads the articles.

  88. 88
    B&W Nikes says:

    mike2 – sure it’s about keeping with the magic rate for planning for inflation if you crunch numbers for historical average. The thumb in the eye is that it is usually a spike and and a leveling to a plateau. The spike can be unpredictable and traumatic. You still won’t find a +/- 4% annual increase happening to a fixed rate mortgage, though you may or may not have other equally traumatic unplanned expenses associated with ownership. You can guarantee that rents will rise and fall with market demand. Not true for a 30 year agreement.

  89. 89
    Blue says:

    Excellent post, Nikes. In essence, owning your dwelling functions as an important inflation hedge…and inflation is the bane of retirees.

    I think owning your dwelling outright is a key element of a comfortable retirement. If my grandmother wouldn’t, for example, she would have been totally screwed in the late 1970s/early 1980s.

  90. 90
    Mike2 says:

    B&W: The thumb in the eye is that it is usually a spike and and a leveling to a plateau.

    Geez, how young do you think I am? I rented in a hot Seattle neighborhood in the late 90’s. Remember that whole dot com thingy?

    Still, if you’re spending under 15% of your income on rent, even a 50% YOY hike keeps you well under the ~30% county average. Even 84% (17 years worth of rent hikes) keeps you under the county average.

    I fail to see how a few bumps above and below the mean increase matter to anyone that isn’t living paycheck to paycheck.

    And I

  91. 91
    B&W NIkes says:

    Mike2 – me too. But what is this business about spending under 15% of monthly inc. on rent? If the average rent is approx $900/mo that means someone makes around $6000 a month to have it represent 15% of the monthly expense. Money wisely spent, but not really the norm. And for what $900 buys these days you had better be single and not have a problem living in a racquetball court with a kitchenette.

    These bumps can be catastrophes for anyone making service industry wages, or who is on a fixed income, or in an otherwise economically fragile position. There are a lot of people living in the area that fit that description who would be helped immensely by modest long term housing arrangements.

  92. 92
    B&W NIkes says:

    Thx Blue. Though I wasn’t implying that actually owning a house was the benefit. I’m thinking more along the lines of taking out an initially overpriced 30yr lease as a hedge. Very few people own their houses outright anymore, most just have mortgages for long stretches of their lives.

  93. 93
    Cringe says:

    A $425,000 house appreciating at 4% per year for 30 years will be worth $1,378,000.

    The $85,000 down payment plus $14,100 rent “savings” is $99,100.

    $99,100 appreciating at 4% per year for 30 years will be worth $322,000. At 8%, it would be $998,000.

    At the end of 30 years, the home owner is approx. $400,000 ahead of the renter/investor. And its likely more than that due to the home owner’s tax deductions from the mortgate interest. And if the home owner also rents part of their house, that’s even more income.

    I don’t see how your math adds up Tim. Perhaps you can throw up a graph so we can see how you came up with your numbers.

    By the way, I love this site. Rubber-knecking the constant drama and “the world’s going to end any day now” dialog is profoundly entertaining.

  94. 94
    gregory wharton says:

    Tim,

    You’ve way over-simplified the math here by not taking time into account. That’s why, despite your case study, you don’t see many rich renters, but you’ll see lots of rich homeowners.

    Even assuming that home values don’t appreciate faster than inflation, a renter will be paying more than a mortgage payment after 8 years of normal rent escalation (about 5% per year). Assuming the renter has been saving all of the money he or she would have otherwise spent on mortgage interest, insurance, property tax, etc. and investing it with compound returns at the opportunity cost rate, the renter’s equity will start trending downward in year 15. At the end of 30 years, the home owner will have equity on average 14.4 times greater than the renter, even after factoring in cost of sale on the home.

    All of that assumes no appreciation of the home above inflation. If the home does better than inflation, these numbers become even more divergent.

    Interestingly, if we assume that the home does not appreciate at all (i.e. its value never increases over 30 years), the home owner still beats the renter’s equity build-up by twice.

    I can send you a spreadsheet that illustrates all of this if you’re interested.

  95. 95
    TJ_98370 says:

    Mr. Wharton,

    I’m not answering for Tim, but perhaps an error in your logic is assuming home purchasers stay in their homes for 30 years.

    Depending on the source, the average turnover rate of a house / condo in the U.S. appears to be seven to twelve years. So maybe for the average homeowner, renting is still a better option?

    ——————————-

    Cringe,

    Are you forgetting to add the $14,100 annual rent savings in your calculations? The annual “rent savings” are cumulative, get added every year, and will also earn interest (assuming it is invested at stated interest rate).

  96. 96
    gregory wharton says:

    TJ,

    Even if people switch their homes over every 12 years, the renter goes negative after 8, so the renter’s still behind. The math is inescapable.

    But aside from that, the renter’s equity never catches up with the home owner even if the home owner switches every five years. And that’s even assuming no appreciation above inflation. Time is what kills the renter, not first cost.

  97. 97
    TJ_98370 says:

    Mr. Wharton,

    I’m at a disadvantage without having seen your spreadsheet and / or having run the numbers myself.

    However, it is obvious that another assumption that you are making in your calculations is a given appreciation of home value and rent. A major point of Tim’s post is the “….enormous unprecendented run-up in recent years….” of real estate market value and that the recent appreciation is unsustainable. In fact there is a good probability that we will be seeing depreciation in the next several months. How can you assume a 5% annual appreciation of home values or rent given the current conditions of the national market? Or are you one of those who are going to retort that “Seattle is special”.

    It is interesting to note that we do seem to agree on one thing — that buying a home for the short term (less than seven years) is generally not good financial strategy.

  98. 98
    The Tim says:

    Hi Gregory, good to see you again. I think the simplified nature of the post itself seems to have led you to believe that the underlying math behind the statements in the post are equally simple. However, this is not the case. As I stated in a couple of comments above, the post was intentionally kept simple, so as not to become a boring lesson in mathematics.

    If you want to see the math I used to come up with all of these figures, you can download the spreadsheet that I created, which takes into account the following factors:

    • renter
      • insurance
      • utilities
      • initial investment amount
      • monthly savings continually invested
      • yearly rent increases
    • buyer
      • principal paid down
      • interest paid
      • property taxes & tax savings
      • insurance
      • down payment amount
      • utilities
      • maintenance
      • PMI (if applicable)
      • HOA (if applicable)
      • home appreciation
      • capital gains tax (when applicable)
      • RE fees upon sale
      • excise tax upon sale

    Suffice it to say, getting into all the details would have made a pretty boring post.

    You can find the spreadsheet attached to this post.

  99. 99
    Hyperbola says:

    gregory wharton said: …a renter will be paying more than a mortgage payment after 8 years of normal rent escalation (about 5% per year).

    No. This is just skewed data again. Long term rents rise at the same rate as wages, which lately have been growing at less than inflation, but historically beat inflation by about 1% per year. It’s true that your rent will eventually rise above the mortgage payment, but at the same time, other owner expenses like taxes, insurance, and maintenance rise too.

    Assuming the renter has been saving all of the money he or she would have otherwise spent on mortgage interest, insurance, property tax, etc. and investing it with compound returns at the opportunity cost rate, the renter’s equity will start trending downward in year 15.

    No. This only happens if rent rises faster than wages. Otherwise, the additional rent gets paid out of increased wages and the renter keeps putting money in the bank every month.

    At the end of 30 years, the home owner will have equity on average 14.4 times greater than the renter, even after factoring in cost of sale on the home.

    No. There are some major errors in your math here. Given what I said above (that the renter is always saving, so doesn’t need to draw down on previously saved equity), there is a really simple mathematical law in place here: whoever has the best rate of return eventually wins.

    Even a renter who has saved only $100 and continually earns 8% returns after taxes will eventually eclipse the owner whose house grows at 4% (~inflation), regardless of the loan terms or amount the renter saves per month.

    So your assertions that the owner’s equity spirals upward, leaving the bitter renter behind, is completely bunk. :)

  100. 100
    TJ_98370 says:

    Wow!

    Tim, I had forgotten about that post. Excellent job on rent vs purchase analysis.

  101. 101
    gregory wharton says:

    Hyperbola,

    I’m not skewing the rent escalation data. I’ve been in this business for many, many years and 5% per year average rent escalation is historically accurate. Rents tend to outpace inflation by a little bit, though the model I used for my calculations assumes rent escalation and inflation at par (along with home appreciation — all three set equally).

    Part of the false assumption you are making is that the opportunity cost for the homeowner is 8% after-tax annual returns in the stock market. That’s a gross misrepresentation of how opportunity cost and risk calculations work. The opportunity cost of the home owner’s decision is the 30-year long bond rate, since that’s the equivalent low-risk alternative for the time horizon. If the time horizon is shorter, it would shorter bonds, T-bills, or something like that. The stock market has a much higher risk profile than either bonds or owning a home, so you can’t use it for opportunity cost without skewing the result. You’d have to discount the stock returns so much for risk that the numbers wouldn’t make a lot of sense.

    The other thing you’re failing to take into account is the divergent nature of mortgage interest versus escalating rent over time. The mortgagee is paying less and less interest every year, while the renter is paying more and more rent every year. After a few years, that divergence gets rather extreme, to the point where the amount of rent paid out by the renter over thirty years far exceeds the amount the home owner paid in both principal and interest.

    If we assume 5% inflation, 5% rent escalation, 5% capital appreciation, and 6% opportunity cost (so that the home and rents are keeping exact pace with inflation with no real increases in value, and opportunity cost is slightly outpacing all of them just as it does in real life), the monthly rental rate will exceed the home owners cost of ownership (interest, taxes, maintenance, and all that other stuff) by the end of year 8 as I said earlier. The rent keeps going up, while the home owner’s cost of ownership declines. The differential is serious enough that even with compounding of interest on the renter’s initial savings, the renter’s equity peaks out in year 15 and starts declining to the point where by the end of year thirty it’s right back to where it started in year zero, while at the same time the renter has paid rent in excess of twice the amount the home owner has paid in ownership costs. Yet, the home owner also has the built-up equity of the home at the end of that period, while the renter does not.

    I even give the renter the benefit of the doubt in all that by assuming he doesn’t have to move every two to four years.

    It also looks like you’re treating principal payments on a mortgage as negative cash flow, when in fact they’re positive cash flow to equity. That’s an easy accounting mistake to make, but it can mess up your results by a lot.

    Again, that’s why you’ll see lots of rich homeowners and very few rich renters. If what you were saying was true, it would be the other way around. The math and reality both back up what I’m saying here.

    And, just for background, I used to believe exactly what you all are saying about renting vs. owning and lived by that belief. I rented for many years and banked the difference in investment accounts (which is the key part of the strategy…and the part most people don’t do). I noticed the differentials I’m talking about not just in the numbers but in practice. After 8 years or so, I fell behind. So I analyzed the situation in more detail and changed strategies when I discovered how wrong I was. I’m not saying that changing conditions might not get me to change my mind again, but for that to happen opportunity cost would have to go much higher than it is, capital appreciation rates would have to go negative for a decade, and rents would have to stagnate or decline. Right now, opportunity cost and interest rates are low, capital appreciation is stagnant or rising only slightly, and rents are escalating rapidly (get ready for rental rates upwards of $2 per square foot, coming soon to a neighborhood near you). This is my business. I know how the math works.

  102. 102
    gregory wharton says:

    So Tim,

    I’ve looked at your spreadsheet, and you’ve made two errors:

    1) Your assumption of 11% opportunity cost is way out of whack with standard financial practice for calculating same. I don’t know how you came up with that number, but opportunity cost / risk premiums for the purpose of discounting should always be based on the lowest-risk investment of similar term. In the case of real estate, that’s always the US Treasury instrument of similar period…usually the long bond. So, actually, your renter’s returns are going to be compounding at a much lower rate than you’ve assumed for the purposes of analysis.

    2) You neglected to factor the additional cost of rent back into the renter’s tabulation of value. In your spreadsheet, the home owner paid out about $667K over the period of analysis. The Renter paid out $1,876K over the same period. The difference has to be factored back in. Either the home owner gets an equity credit to his own compounding savings account for having saved the extra $1.2 million not paid in rent, or the renter has to pay the extra out of his compounding equity as it comes due (that’s the way I calculated it). Either way, the home owner is going to way outstrip the renter again when you aren’t giving the renter a free pass on his negative cash flows.

  103. 103
    John says:

    Again, that’s why you’ll see lots of rich homeowners and very few rich renters.

    The only thing that proves is home owners generally have better paying jobs than renters.

    I’m not saying that changing conditions might not get me to change my mind again, but for that to happen opportunity cost would have to go much higher than it is, capital appreciation rates would have to go negative for a decade, and rents would have to stagnate or decline.

    That’s what happened in Japan after their housing bust. Years of declining home prices. They decreased their rates to 0%.

    Many people in other parts of the country are finding out their homes are worth 20%, 30% less than a year or two before. The math is not working out for them.

  104. 104
    evildoc says:

    Worthy article with caveat that onen cannot take his “downpayment” or any percentage of it, and pop it into an 8% account. No such thing. Maybe… 5%. 8% doubles every 9 years. 5% doubles every 14. Not counting for now the substantial hit of paying taxes on all that interest during a 30 year run up, the 80k deposit placed instead in the bank at 5% will grow to about $350k- way less after taxes paid each year of run up. At 8% 80k will grown in 30 years to 700k or so, save that lots will be lost to taxes along the way. I suppose a tax free Muni Bond could help with the taxes, but i fear that Municipalities will be going BK due to the bubble effect, so they are not wholly safe.

    Still, the principles you outline are sound and worth hearing.

    e.d.

  105. 105
    Mark L says:

    I just looked at Tim’s spreadsheet and have to agree that the 11% return on the rental cash flow would defy almost any conventional analysis norm. Personally,I would use about 5% (risk free) for short-term considerations, and maybe 7% for longer term projections. Maybe 8%. Most finance minds would not project an equity risk premium beyond 3%, despite the roughly 4-5% of the last century, At the same time, I would put rent and home appreciation at he same growth rate. Except for anomalous times like now, both home ownership (prices being set by ability of these homes to change hands) and renting will inevitably be tied to income growth. One might assume that higher income people will see bigger % increases than lower income people, and that higher income people are the home buyers.

  106. 106
    Mark L says:

    Another way of looking at 11% assuned returns – this assumption would make any investment analysis nearly unbeatable in the long term. It just overwhelms all the other numbers in the analysis. The good thing is that anyone can input their own assumptions and look at the result, But the 11% would have to be a stated KEY assumption if the net result of the analysis was published.

    The only thing that seems like a fixed, good assumption in this could is that tuition at our public universities will rise an average of 7% annually in the long run.

  107. 107
    Mark L says:

    I need to put my contact lenses in – sorry for the typos. Also, “in this world” not “in this could”

  108. 108
    Hyperbola says:

    gregory wharton said: the monthly rental rate will exceed the home owners cost of ownership (interest, taxes, maintenance, and all that other stuff) by the end of year 8 as I said earlier. The rent keeps going up, while the home owner’s cost of ownership declines.

    I did not dispute this. It’s true – the interest cost declines over time to zero. This effect is partially offset by rising tax, insurance, and maintenance costs.

    The differential is serious enough that even with compounding of interest on the renter’s initial savings, the renter’s equity peaks out in year 15 and starts declining to the point where by the end of year thirty it’s right back to where it started in year zero…

    No, here is where your calculations are completely wrong. Both the renter and owner are taking in income every month, and in general this income rises at the same rate as rent (and, in the longer term, house prices).

    Your assertion that the renter’s equity would ever decline in this scenario is wrong. The renter is NOT paying the rent out of his investment gains – he’s paying rent from his wages. So he gets the full stock market return, in addition to depositing excess wages every month. This does not change as prices rise, even though it’s true the owner’s costs may be declining.

    I think you are getting confused between absolute savings and the relative comparison of savings between owners and renters. You cannot simply say, “the renter’s costs are more, so his equity is declining relative to the owner” because you are ignoring investment gains on the rest of the money the renter previously saved. Try caluating everything in absolute terms “renter saves $1000, owner saves $1400” instead of “renter loses $1400”.

    … while at the same time the renter has paid rent in excess of twice the amount the home owner has paid in ownership costs. Yet, the home owner also has the built-up equity of the home at the end of that period, while the renter does not.

    As I have shown above, this is false. Both the renter and owner are building equity using different means.

    It sounds like you are claiming that it is impossible (given the numbers in above) to build any wealth without buying a house. This kind of claim is ridiculous, and if you think it’s true in your life experience, either you’re getting a raw deal or you miscalculated.

    To summarize, here are my claims:

    a) In the current price environment, renters will initially be saving money each month by renting instead of buying the same house.

    b) If rents, houses, and income all increase in price at the same rate (inflation or slightly above), both the owner and renter will have more money left over each year for savings. Neither will ever have to draw down this savings. This is easy to prove – if my rent goes up 5% from $1000 to $1050, and my income goes up 5% from $3000 to $3150, and all my other expenses go up 5%, then my amount of income left over for savings will also rise 5%. I will not be REDUCING my equity, ever. And that equity I have been saving all this time is still growing (whether it’s 6%, or 7%, or 8% is not important, as long as it’s higher than house price growth).

    c) Whoever has the highest rate of return on their assets will eventually end up with the most equity. What the proper return rates are is completely debatable – though I would argue it is not proper to assume anything less than 6-7% for stocks.

  109. 109
    Hyperbola says:

    Typo.. “renter loses $1400” —> “renter loses $400”

  110. 110
    deejayoh says:

    Here’s a scenario to run through all your calculators:

    – Run the the rent vs. own calculation through with whatever set of assumptions you want.

    – Now run it through again, but change one thing: Instead of assuming a constant average appreciation for a home, run a scenario where the value of the home goes down for the first three years (by say – 10%) and then goes up by the same average.

    Now see if in the second case, you aren’t better off renting for the first three years and buying the home for a lower price.

    The general case is about as solvable as the superman vs. spiderman argument I joked about earlier. You can tweak a model just about any way you want with your assumptions. But I never thought this blog was about owning a home being a bad investment. I bet most of the people who are arguing on the side of renting are planning to buy at some point (even Tim)

    I think the more relevant question is, should I buy now, or should I buy later? Everything else held constant in whatever model one chooses, with whatever set of assumptions one chooses – I don’t think there’d be too many scenarios where a few years of 2-5% per annum declines at the front end wouldn’t mean spending those years renting makes it a better outcome.

    Of course, if one spent 2002-2006 renting and waiting for prices to come down, then I also doubt one will ever do as well as if they’d bought at the front end. But that’s because I don’t think the market will ever give back all the gains of the bubble. I know others do – and those opinions are equally valid. I just don’t happen to share the view. But overall I think the arguments about the general case of buying vs. renting comparisions are a pretty tiresome theoretical exercise.

  111. 111
    gregory wharton says:

    deejoyah,

    Certainly, if you can time the market accurately enough to rent for three years, buy at a trough in prices, and then start on the equity train, you’d do better than someone who buys now. Both of them would beat the person who rents for the next 15 years, though. Even the buyer who takes three years of price depreciation before the market returns to historic trends. Personally, I don’t know anybody who’s any good at timing real estate markets. Not even my clients who have made hundreds of millions of dollars doing real estate investment will claim that.

  112. 112
    gregory wharton says:

    Hyperbola,

    Now you’re willfully ignoring some basic requirements of financial math. If the income figures stay equivalent as you claim (and which I’ve assumed), the home owner is still paying way less than the renter every period starting in about year four or five. That money saved should be compounded in the same equity savings you’re computing for the renter. You can either create an account in your model for the home owner to bank and compound that saved equity (in which case, he gains all the same benefits you are currently accruing one-sidedly to the renter), or it has to be deducted from the renter’s equity every period to cover the difference. That’s the only way to truly compare the cost of one decision vs. the other. If you leave that out, your model doesn’t compare anything to anything.

  113. 113
    The Tim says:

    gregory wharton said,

    Again, that’s why you’ll see lots of rich homeowners and very few rich renters. If what you were saying was true, it would be the other way around.

    Correlation is not the same as causation, Gregory.

    1) Your assumption of 11% opportunity cost is way out of whack with standard financial practice for calculating same.

    11% was not used for this post. That’s just the value that happened to be in the spreadsheet, since it was originally created using Rhonda’s numbers, quoted in the post I referenced. You’ll notice the house price and rent are not the same as what’s in this post either. I used that spreadsheet to calculate this post, but I didn’t use the values that are uploaded in it at the moment.

    2) You neglected to factor the additional cost of rent back into the renter’s tabulation of value.

    I’ve read this a couple of times, and I can’t figure out what you’re trying to get at here. The “cumulative cost” for the renter is the total amount they have paid out that they will never get back. Rent, insurance, utilities, and tax on the interest building in their investment. For the owner it is Interest + Taxes + Insurance + Utilities + Maintenance + PMI + HOA – Principal – Tax Savings. How does this not account for the difference in amount paid out? I don’t see the “negative cash flows.”

    Please elaborate.

  114. 114
    gregory wharton says:

    Tim,

    During the period you analyzed, the home owner paid out $667,000. The Renter paid out $1,876,000 for the same thing (putting a roof over his head. That extra money (about $1.2 million) had come from somewhere. There are two ways to figure that difference in expense. One, both of their salaries kept increasing and they paid it out of income. If that’s the case, then the home owner had LOTS of extra disposable income that the renter didn’t have, and to be fair in the analysis, we’d have to assume that he invested it in exactly the same way the renter invested his initial savings on rent.

    Two, you could simply take the extra expense of rent out of the renter’s equity in every period that the renter’s housing cost exceeded the home owner’s housing cost (which will be nearly every monthly period after about year 8).

    Either way, the net effect is the same. The analysis you’re using is shorting the home owner $1.2 million plus interest that they ought to have, or crediting the renter with $1.2 million plus interest that they shouldn’t have. In both cases, since the difference in their equity at the end of the analysis you linked me to is about $1 million, the difference is enough to push the home owner ahead if you counted it, which you should.

  115. 115
    Hyperbola says:

    gregory wharton said: You can either create an account in your model for the home owner to bank and compound that saved equity (in which case, he gains all the same benefits you are currently accruing one-sidedly to the renter), or it has to be deducted from the renter’s equity every period to cover the difference.

    Yes. We’re actually arguing for the same thing. I believe you’ve misinterpreted the results you get by doing this. Hence my suggestion that you use the absolute method (creating accounts for both owner and renter and compounding separately) rather than the relative method (creating one account representing the renter’s savings edge).

    Here is my interpretation of your calculations and what I believe it means:

    The initial own/rent decision is made using the assumption of initial savings as just enough to cover a 20% down payment. This is important because the debt ratio for the owner is really what controls whether buying or renting is cheaper, and this ratio goes down over time for the owner. If the renter’s savings grows fast enough, his debt ratio (if he bought later) would also decline. If the renter’s equity grows faster than the owner’s (as we all know it does in the beginning), then by waiting some amount of time, the renter can get a smaller debt ratio on the same house.

    You said the cash flow advantage turns to the owner after 8 years. I think it’s likely to be longer than this, but it will happen eventually. Let’s assume this is a good number.

    You said the renter’s equity advantage over the owner starts shrinking after 15 years. Again, I think this is reasonable, but it depends greatly on your individual situation.

    Your futher claims about what happens after that are more suspect but I am not interested in debating those right now.

    Now I will claim that really what you have shown here is that, using these numbers, the renter wins by buying the house from its current owner at the point of maximum equity advantage, which occurs around 15 years after having the 20% down saved.

    I don’t actually need more specific data to claim this, but it would be helpful to run the numbers and see how much saved equity both sides have after 15 years (in absolute terms). Then we would know what the renter’s ownership cost would be by buying at that time. But even without this, we know the cost will be less than the person who bought the same house with the same savings 15 years earlier, because the renter has more equity!

    So, from a common sense standpoint, the best approach here is to pick the house you want to purchase, then save to the point of maximum equity advantage, and then buy once the debt costs for that house are so cheap that you increase your equity faster by buying. This is a perfectly rational way of justifying the purchase of a house, and it sounds like you have personally done something like this (it sounds like you waited 8 years, not 15, but you still did the right thing by waiting, assuming you bought the house you could have bought at the beginning with 20% down!)

    Now the final monkey wrench: as we renters wait, we tend to set our sights on bigger houses. We tend NOT to buy down our debt in the smaller house over those first 15 years while we still have an advantage – instead, we end up saving for a 20% or less down payment on a bigger house, which sends this math exercise around all over again, since we are now at 80% debt all over again!

    To paraphrase: in the current environment, buying a house with 20% down is a poor financial decision compared to renting the same house. Buying a house with a large (TBD) down payment is a good financial decision compared to renting the same house. Are we in agreement now?

  116. 116
    Alan says:

    Gregory,

    Maybe you could send Tim the spreadsheet you used for your calculations. I am sure he would be happy to post it. Then we can all either learn from it or pick it into shreds.

  117. 117
    deejayoh says:

    Personally, I don’t know anybody who’s any good at timing real estate markets.

    I think that the point of this blog, isn’t it? a discussion of whether real estate prices will continue to rise or bust?
    I’d agree that normally it’s a fools game to time the RE market – but it seems its pretty blatantly obvious to most at this point that we are headed for depreciation, isn’t it? Lets look at the facts. The rest of the country is already going depreciating. Odds of a recessionare increasing and unemployment is rising. YoY appreciation in seattle is down every month, following the same pattern as every other market in the nation (95% of which have gone negative). Loose financing has disappeared. Inventory is up 50% and sales are off 25%. Personally, I see a pattern that makes the timing decision pretty easy. The only question is how long and how deep

  118. 118
    gregory wharton says:

    I’ve cleaned up and uploaded the spreadsheet I’ve been using here (http://files-upload.com/files/507074/rent vs own.xls). You can take a look at it yourself. To make the calculation it’s doing a bit more transparent, I’ve changed it so that it’s not deducting the renter’s increased housing costs from the renters equity, but saving the difference to a compounding investment account just like the renter has.

    As you look at this spreadsheet, notice that at the baseline case of no appreciation or rent escalation above inflation, and an investment rate in line with real opportunity cost and not some pie-in-the-sky wish about infinite low-risk returns on savings, the renter never is ahead of the owner on equity. Not even in year 1.

  119. 119
    gregory wharton says:

    For some reason, this didn’t show up the first time I posted it. Here it is again.

    This is the spreadsheet I’ve been working off of, modified so that it is now crediting savings on rent to the homeowner’s own investment account, rather than deducting them from the renter’s equity.

    http://files-upload.com/files/507074/rent vs own.xls

    If you play around with this, you’ll find that the only way the renter gets ahead of the owner in equity, even in year 1, is if the renter is getting real rates of return more than five percentage points higher than historical averages or standard financial accounting practice allows you to assume and the homeowner is getting no capital appreciation at all.

  120. 120
    John says:

    Greg, what do you think about the NYTimes buy vs. rent calculator? What kind of numbers do you plug in?

  121. 121
    Alan says:

    Gregory,

    I think I am misunderstanding you. Are you taking the rent I pay as a renter and adding it to your interest earning account as an owner even though I’m not paying the money to you?

  122. 122
    Hyperbola says:

    I can’t seem to download this file… Excel (2000) claims there is a problem with it.

    In any case, I think the spreadsheet itself is suspect based on your last comment, but I am waiting to see the details. :)

  123. 123
    Hyperbola says:

    Okay, got the file open on my Vista machine. :)

    Some issues I found:

    1) Principal is added to net equity without being included as a cost. The renter is not paying principal, but the owner is. That’s a $350 error per month right there.

    2) Property tax around here is more like 1.25% APR.

    3) Income tax should be 28% for most people. This is the marginal tax rate for most middle-class homebuyers.

    4) You haven’t given the renter a standard deduction. For married couples, this is over $10k per year off taxable income, which results in a tax savings of about $233 per month in favor of the renter (depends on circumstances).

    5) Renter’s insurance is too high. For me, it is 0.01 times my rent.

    6) Maintenance is too low. A good figure is 0.01. Should be $400-500 a month instead of $200.

    7) Property tax is too low for this location. Should be 1.25-1.3%.

    8) You haven’t calculated post-sale equity. Whether this is appropriate or not just depends. If you want to know who wins after the owner buys and then sells, you need to take 7% (more, actually) off the sale price. If you want to know who wins after the renter buys several years later, it’s probably okay to ignore this.

    I believe the collective sum of these errors swings the balance quite significantly.

  124. 124
    gregory wharton says:

    Alan,

    No. I’m doing a true comparison. That means that in any period in which the renter pays less than the homeowner in housing costs, the renter banks the difference in an interest-bearing account. In any period in which the homeowner pays less than the renter, the homeowner banks the difference in an interest-bearing account. That’s pretty simple, and that’s how it ought to be calculated.

  125. 125
    gregory wharton says:

    Hyperbola,

    Now your just yanking my chain rather than making substantive critiques. To address your “issues”, let take a shot:

    1) The principal payment part of your mortgage is not an expense. That’s accounting 101. It’s a payment direct to equity, just as any savings the renter makes to an interest-bearing account are direct-to-equity payments. You have to treat them exactly the same because they are the same.

    2) The property tax difference you’re citing isn’t large enough to make a difference. Change the figures and you’ll see what I mean. You could make the property tax 3% and it still wouldn’t make any difference.

    3) The income tax figure is also largely irrelevant. If you increase the tax rate, the owner’s advantage only grows. Go ahead.

    4) The standard deduction is generally a wash for itemized deductions not including mortgage interest for many (most) homeowners (it is for me). Again, standard accounting practice is to count cash flows from tax shelter as a positive payment to equity. That’s exactly what I’m doing here.

    5) Go ahead and change the renter’s insurance rate. In either case, it’s so small that it’s just chump change. It doesn’t modify the analysis in any substantive way.

    6) 1% of value for maintenance costs is way too high. I don’t know any homeowner who pays anything close to that amount in maintenance costs, even if you amortize out things like unblocking a sewer pipe every five to ten years. From you comment about this, I have to wonder if you’ve ever actually owned a home or if you’re just punting on this one.

    7) Again, the property tax rate difference you’re talking about is so small as to be negligible. Go ahead and change it. It won’t make much difference at all.

    At the bottom of the spreadsheet, you will clearly see where cost-of-sale is subtracted from the home equity value before tabulating net equity. You must have missed that part when you were looking at it. Go ahead and change the cost-of-sale to 10% if you want to. It’s doesn’t make much difference.

    Just for laughs, I went and put the changed figures you suggested into the model to look at them. I’m not going to change things that would be directly contrary to standard financial practice, so you’ll have to keep counting equity as expense on your own time.

    The results are as follows:

    Renter – Net Equity at End of Year 30: $826,708.34
    Owner – Net Equity at End of Year 30: $1,928,437.18

    The renter is still underwater by more than a million bucks.

  126. 126
    Hyperbola says:

    I agree that everything except (1) and (4) are minor points. I included them for completeness’ sake.

    (1) You are wrong on this one. The actual cost you are paying is interest AND principal, and in return for that your equity in the property goes up. You have factored in the second part (adding principal paid to net equity), but not the first. You are effectively paying yourself, but you still have to shell out the principal amount every month, while the renter doesn’t. So in effect your spreadsheet has double-counted the benefit of principal pay-downs.

    Here is the issue: your actual (approximate) costs total $2100 plus $350 for principal, plus $400 for maintenance. The renter only pays $1600. The net effect of this is the owner pays $1250 more per month in cash flows, and at the same time, the owner’s equity in the property goes up $350.

    (4) You’re missing the point. The owner gets to itemize the interest he pays, which provides a tax benefit (if done correctly on his W4’s, he gets this back every month, not once a year). The renter gets to use the standard deduction, which you haven’t included here. You’ve effectively assumed that the renter gets no tax benefit when this is usually wrong.

  127. 127
    gregory wharton says:

    Hyperbola,

    It’s not my job to teach you the fundamentals of real estate finance. If you’re really interested, go and find some books on the subject. In them, you’ll find that they treat payments of principal EXACTLY the way I have treated them: as equity build-up. The layperson only looks at the amount of the monthly payment and doesn’t understand the accounting principles behind what goes where and how it should all be tracked. I am not a layperson on this subject, so you’re not going to convince me to treat an equity transfer as anything except an equity transfer.

    Now, on the tax subject, I acknowledge that the handling of tax deductions is a complex subject. In fact, there’s really not any good way to handle it beyond looking at each individual person’s situation. What I did was a work-around: there is definitely a direct net positive cash flow from tax shelter due to mortgage interest and property tax deductions. The home owner has benefit of that, and the renter doesn’t. Apart from that, the renter can claim the standard deduction, but the home owner can also claim lots of other itemized deductions that in practice often come out roughly equal to the standard deduction not even counting mortgage interest and property tax deductions (last year, my non-home-related itemized deductions were well in excess of the standard deduction, for which I thank my accountant and his voodoo-working machinations). There’s no good way to really allot them in a generic model. You can’t just say that the renter gets the standard deduction and the homeowner gets only the mortgage interest and property tax deduction. That’s just silly. Does the renter’s standard deduction mean in practice that the home owner’s tax shelter value is less by comparison in some cases? Probably. However, like with the other items, the difference is so small we can ignore it without worrying about skewing the model over-much. You’ll notice that to account for that, I’ve also pushed the tax issues related to the renter’s investment activity out to the end of 30 years as a tax-deferred account. In practice, it really wouldn’t work that way, but it’s to the renter’s benefit to simplify it in this manner so it all balances out.

  128. 128
    The Tim says:

    gregory wharton said,

    During the period you analyzed, the home owner paid out $667,000. The Renter paid out $1,876,000 for the same thing (putting a roof over his head. That extra money (about $1.2 million) had come from somewhere. There are two ways to figure that difference in expense.

    Okay, I think I see the problem here. Part me, part you.

    My problem is that the “Cumulative Cost” columns took some things into account that they shouldn’t have. For the renter, it doesn’t make sense to add the tax on their interest earned to the cumulative cost, since that is more like unrealized gain, coming directly out of the interest earned. For the owner, it doesn’t make sense to subtract principal paid from the cumulative cost, since that is accounted for separately in the ongoing calculation of equity in the house. When I make these corrections in the spreadsheet (with the values as downloaded, which we both agree aren’t necessarily reflective of a realistic scenario) the difference is much more minor, with a cumulative cost of $1.21 million for the renter, and $1.07 for the buyer.

    Your problem is that you’re misinterpreting what the “cumulative cost” field is telling you. It’s really just included as a point of interest. What you should be looking at is the “monthly cost” columns. You’ll notice that even in year 30, the home buyer is paying $5,340 to the renter’s $4,988, resulting in a monthly savings of $352 that the renter is able to add to their investment.

    If the values in the top section are changed such that the renter’s monthly costs begin to exceed the buyer’s at some point (for instance, change “inflation” to 5%, and it happens in year 16), the spreadsheet begins to take this monthly difference out of the renter’s investment. The basic assumption is that the renter and buyer are both making their monthly payments out of income at the start, and their incomes grow equally at whatever rate would be necessary to make the buyer’s payments on the house. Therefore, if the renter’s costs begin to exceed the buyer, they start to deplete their investment.

    Hope that clears things up.

  129. 129
    Layperson says:

    I’m looking at the spreadsheet and I don’t know what an “escalation rate” is. Could someone explain this to me?

  130. 130
    Hyperbola says:

    I see Tim agrees with me on the principal payment issue. I didn’t even notice the issue with tax on interest.

    I agree that taxes are complex. However, in my experience, MOST people do not have $10k in itemized deductions before interest. So you have an advantage over many people because you get the full value from deducting your interest.

    I respectfully ask that you stick to the facts at hand instead of bashing me. I am not an accountant, but you are still wrong on this one. Effectively what you have done is to have the owner’s principal paid by the renter in your calculations, but the relative way you account for things makes this difficult to see.

    Let’s use a simpler example: assume the only expense is the owner’s principal payment (there is no rent, interest, or appreciation, so “net costs” for everybody are zero). Both owner and renter have $1000 income and the owner has a $10000 loan on a $10000 asset. Both start with zero equity.

    The renter has no costs and $1000 net savings, resulting in $1000 equity.

    The owner takes his income and writes a $1000 check to the bank for principal. The loan balance declines by $1000. So the owner has total costs of $1000, no savings, and a resulting equity of $1000.

    Here is how your spreadsheet accounts for this (try it and see): you show a net cost of $0 for the owner, since he paid himself. Since both sides have a net cost of zero, you show no cash flow advantage for the renter. You show a savings deposit of $0 for the renter. You calculate the owner’s equity as $1000 and the renter’s equity as $0.

    Do you see the error now? You need to compare actual payments, not “net” costs. You’ve taken the owner’s principal payment out of what should be the renter’s savings! Even though principal isn’t a “net cost” to the owner, it is still a $1000 cost the renter doesn’t pay. This is why I recommended using absolute savings figures instead of a relative savings account for the renter. These kinds of errors are much easier to spot.

  131. 131
    gregory wharton says:

    Okay. I think I see where the misunderstanding is here, and the answer is that we’re both right. On the one hand, payments to principal really are equity transfers and should never be counted as equivalent to rent. They’re not an expense in an accounting sense, while both rent and interest payments are expenses, and that’s what should be compared when looking at rent vs. mortgage payments.

    On the other hand, you are looking specifically at the case where all capital flows are coming from personal income rather than holistically at a personal total balance sheet. That’s fair. So, I’ve re-calculated the spreadsheet to include principal payments as costs of housing from income. You can find the revised spreadsheet here:

    http://files-upload.com/files/508508/rentvsown2.xls

    Now, by including the principal as a direct housing expense and crediting the renter for that amount in savings, the renter’s equity certainly goes up. However, you will notice that in the case where we assume that home appreciation and rental escalation stay at the inflation rate and opportunity cost is at the long bond rate, the home owner still comes out ahead. With a home value of $490,000, rent of $1600, inflation-appreciation-escalation at 4% (equivalent, so a wash), and opportunity cost (the investment return rate) at 5% (the long bond), we get the following at the end of 30 years:

    Renter (Net Equity): $978,577.90
    Owner (Net Equity): $1,687,186.08

    So, after ALL that, the home owner still comes out ahead.

    If we look at the more realistic case where real appreciation on the home is 1.5% over inflation and rent escalation is more like 1% over inflation, the divergence grows:

    Renter: $1,016,352.55
    Owner: $2,545,378.96

    Conversely, let’s assume that the home is not keeping pace with inflation (appreciating at 2%, rather than our assumed 4% inflation rate). If rent escalation stays at the inflation rate (which is typical historically), then the owner STILL comes out ahead:

    Renter: $865,629.26
    Owner: $1,177,139.85

    Now, as a final case, let’s assume that real estate values plateau for thirty years and the owner gets no home appreciation at all. If rents continue to escalate at the inflation rate, the home owner wins:

    Renter: $802,089.51
    Owner: $919,712.52

    If rents don’t escalate at all, then the renter comes out ahead:

    Renter: $1,304,720.92
    Owner: $657,834.24

    Now, since housing costs are typically 30% of gross salary, that means in all these cases we are assuming one of two things for the renter:

    A) The renter is saving something on the order of 22.5% of their gross pay every month (is there anybody reading this who even comes close to saving that much of their gross salary?), or,

    B) The renter is living way, way, way below their means.

    People make all kinds of lifestyle choices, and I’m very much in favor of living below my means myself. That’s the only way to really build wealth, regardless of whether you own a home or rent. But let’s be honest about this: a $1,600 rental house is not directly equivalent to a $490,000 owned house. I’ve done both, and even the nicest rental is still not up the level of quality of a house you own and keep up. Rentals take a real beating and wear out fast. You’re not going to find a nice one with that much of a price differential from a mortgage payment.

    Plus, rents are jumping up right now. It’s not that unusual to find rental rates over $2.30 per square foot for apartments in the city now, and the analysts are projecting $3.00-plus rates coming in the next two years. Rents in Seattle have been stagnant for six or seven years now because all the housing demand has been focused on buying. Now that mortgage money isn’t cheap any more, rental rates are accelerating upward. Add to this the lack of rental unit supply, and you’ve got a difficult situation for renters, no matter what happens with housing prices.

    None of which really constitutes a recommendation for one course of action or another. What it does mean, however, is that the issue is nowhere near as straightforward as the anti-ownership crowd has been making it out to be here. On the one hand, if you run the numbers using realistic figures and historic norms, the home owner will almost always come out ahead of the renter over time. In fact, the renter never gets ahead of the home owner even in year 1. However, if housing prices fall, renting could be a very good idea for a few years. On the other hand, if you’re going to try and time the markets that way, make sure you get a long-term lease (and get it notarized–leases over one year term aren’t valid unless notarized). That way, at least, you won’t get whipsawed by the major rent escalation that looks imminent.

  132. 132
    Hyperbola says:

    Okay, good, now we appear to be on the same page! Without poring over the spreadsheet some more, I can’t articulate exactly what Tim was objecting to regarding interest and taxes, but that might be something that needs fixing too.

    Regarding some of your numbers: you have to be really careful about assumptions here. When analyzing short-term horizons (who wins after 1 year? 5 years?), adjusting for risk is difficult. Sure, you can use riskless (or nearly riskless) bonds for investments, but I’m not sure that’s appropriate – the annual log-normal implied volatility of indexes is usually 15% or more, which drowns any short-term profit you may receive. So for short horizons, it’s not even reasonable to put this money in stocks. Also, as I commented a long time ago, you also need to adjust for risk on the house, which is impractical.

    It’s more practical to use a long-term horizon, like 30 years. In that case, short-term variations don’t matter and you should be using established historical norms. (Whether you should assume reversion to the mean given current departure from those norms is debatable.) House prices, historically, go up at the same rate as wages, about 1% over inflation. (Same for rent.) I don’t think it’s proper to assume prices will go up faster than rent long term – economic forces create arbitrages (like the rent vs. own discussion we’re having right now) when things temporarily diverge.

    Historically, stocks gain 5% per year after inflation. (About 7-8% before.) The fact that this carries more short-term risk is irrelevant because both the owner and renter are holding on for 30 years no matter what. Of course, you should discount this a little due to the fact that most people don’t park their savings all in stocks – even people my age (24) should have 10% in bonds, depending. Now, if you still claim this needs to be discounted for risk, then fine, tell me what the risk (standard deviation or other measure) over a 30-year period is for stock indexes and an individual (nondiversified!) house and discount both.

    My quick and dirty estimate says for stocks: e^(0.15 * sqrt(30)) = factor of 2.26 of risk over 30 years, which amounts to a risk adjustment of ~2.75% per year. So that means we can assume at least 5-2.75=2.25% per year appreciation for stocks after inflation. Now see if you can perform a similar risk adjustment for nondiversified house prices (I have no data for this. All I know is indexes have much lower implied volatility than individual stocks.)

    I can offer some insight into my own circumstances as a renter. I live in a really nice apartment building downtown. The building is 6 years old, and here the rent/own cash flow discrepancies are even more out of whack than for single-family homes. My apartment would probably sell for total costs (as calculated above) 2.5 times the rent or more.

    My household is upper middle class. We spend 17% of gross income on rent and parking. Including retirement accounts, we save over 25% of our gross pay. Sometimes 35% of gross.

    We just got out of college 2 years ago, so from my perspective, it makes sense for us to wait to buy. Our savings is (for now) accumulating faster than the price changes in houses we plan to buy in a few years, even at 10% per year appreciation (which Seattle is not sustaining anymore). Eventually, this will no longer be true – either we will raise our price range to the point that the same appreciation rate starts to outgrow our savings, or the borrowing cost of the house we want will be lowered by having a big down payment saved. At that point, it will make sense for us to buy.

  133. 133
    The Tim says:

    Hyperbola said,

    I can’t articulate exactly what Tim was objecting to regarding interest and taxes, but that might be something that needs fixing too.

    I was referring to my own spreadsheet, and the “cumulative cost” column on it. There was however no effect on the month-to-month cash outlay.

    Gregory,

    I am curious, as a poster above asked, what you think of the New York Times Rent-vs-Buy calculator. When I punch in the same set of assumptions into their calculator as my own, I get similar results. Would you care to comment on that tool?

  134. 134
    gregory wharton says:

    Hyperbola,

    As a younger person, you certainly have a higher risk tolerance, but for the purposes of financial analysis, you can’t use the stock market as your opportunity cost rate without crediting the home owner for having a much lower risk profile, both long- and short-term.

    Volatility in the stock market tends to be a lot higher than in the housing market, even over 30 years, and even index funds can’t really protect you from that. If, for example, you bought into the stock market in, say, 1929 and held on for 30 years, you wouldn’t even beat inflation. With stocks, timing is everything. That’s why they’re a lot more risky than houses or bonds and no financial analyst would consider the risk factors associated with stocks to be equivalent to real estate. For one thing, the stock market is a lot more prone to Black Swans than the real estate market is.

  135. 135
    gregory wharton says:

    Tim,

    Since that calculator is a black box, I can’t really comment on the sorts of results it generates. It’s not at all clear how they’re calculating those numbers.

    I do know from looking at the spreadsheet you were using vs. the one I am using that your comparison is one-sided in favor of the renter since monthly cost-plus-savings is not equal for the owner and renter in every period. My spreadsheet adjust the numbers so that the total of housing cost plus savings is equal for the owner and renter in every period, regardless of who has the higher housing cost. That seems to me to be the only way to reasonably compare the two. The spreadsheet you showed me equalizes them for the renter so long as the rent is less than the housing costs of the owner, but doesn’t reverse when it goes the other way (which it does in later years).

  136. 136
    Alan says:

    a $1,600 rental house is not directly equivalent to a $490,000 owned house

    The last rental I was in was $1800/month and would have sold for $700k easily.

    I’m not anti-home-ownership. Before moving the the Puget Sound I owner my own home for 9 years. Looking back at my calculations I broke even owning versus renting, but I really do like the fixed payments a mortgage gives me. I also like the security of controlling when I move. Taking into account emotional factors I came out ahead even though financially I broke even.

    I am anti-home-owning in this location at this time. I’m expecting a 30% drop in home values over the next few years. I can’t make the ownership vs rental calculations work. My wife and I sometimes talk about “what if” we had bought here three or four years ago. Would we see this bubble as it is, sell our house, invest the equity and rent until prices dropped? We say that we hope we would, but we also acknowledge that we might be blinded by the appreciation.

    We also run scenarios where I had made large profits in the two homes I have owned. Had I purchased in a different neighborhood in Raleigh, I could have made a $100k profit instead of $10k. I could have taken that to Austin and used it to purchase a larger home in a nicer neighborhood there and turned it into $250k (instead of selling for $3k above the purchase 5 years previous — and that is before real estate commission). Then I could have moved here with the expectation that real estate always goes up and dumped my equity train money into a $500k house which would be worth close to $550k today.

    If prices do drop 30% that would take my hypothetical purchase back down to $385 and my equity train balance to $135k. But maybe I would get unlucky here and choose a neighborhood that drops more than 30% or I leverage myself more into a more expensive house (because that is how you make money I would have learned) and lose it all. Easy come, easy go.

  137. 137
    The Tim says:

    gregory wharton said,

    I do know from looking at the spreadsheet you were using vs. the one I am using that your comparison is one-sided in favor of the renter since monthly cost-plus-savings is not equal for the owner and renter in every period.

    I don’t know what you’re talking about, Gregory, because this statement is just flat-out incorrect. Monthly cost plus savings most definitely is the same for the owner and renter in every period. Just look at “Monthly Cost” plus “Saved/Mo.” for the renter, compared to “Monthly Cost” for the buyer. They’re equal every year.

    If you plug in numbers such that the owner’s monthly costs are less than the renter, the “Saved/Mo.” figure for the renter turns negative (meaning the renter is now tapping into their investment), which still results in the figures being equal.

  138. 138
    anonymous by request says:

    I can’t say that I follow every accounting detail in this thread. Is it accurate to conclude that it is not good financial planning to buy real estate in a stagnant or declining market, especially for the short term? If so, I believe that was one of Tim’s points in his original post.
    ..
    I am not anti-home ownership. I want to buy my own place some day. However, I am not going to buy real estate at the top / near the top of the market, as I believe that Seattle is lagging national trends and observable market correction is due. Even Mr. Greenspan said “…home prices have further to fall…” very recently, so there is a good chance that this ride isn’t nearly over.
    ..
    Also, as DJO alluded to, with this kind of analysis it appears that there are so many variables / assumptions involved that any predictions that actually come close to reality are a result of luck more than anything else IMO.
    ..
    Gregory Wharton said:
    The renter is saving something on the order of 22.5% of their gross pay every month (is there anybody reading this who even comes close to saving that much of their gross salary?),

    ..
    For what it’s worth, I save 29.0% of my gross income, excluding a mandatory 7.0% deduction for my retirement pension. I do live simply.

  139. 139
    gregory wharton says:

    Tim,

    Take a close look at the spreadsheet I linked to. You’ll see what I’m talking about.

  140. 140
    gregory wharton says:

    anonymous,

    1) If you’re going to live in a house for less than four years, it almost never makes sense to buy it. I’d consider that a “temporary” living arrangement, and much better suited to renting unless the market and location were in great shape.

    2) People who get in the habit of trying to predict the future only wind up humiliating themselves over time. It’s a bad habit that I tried to give up many years ago. I don’t know what the housing market is going to do. Could prices drop 30%? Sure. More likely (based on previous RE cycles in this area), prices will remain stable but liquidity will vanish for a few years (which makes selling a bit dicey if you need to get out). Could prices continue to go up? Yes, that’s also possible. If you’re going to base all your decision-making on a prediction of the future, particularly with respect to financial markets, the only thing that is for sure is you will be disappointed. I’ve learned that the hard way.

    3) I congratulate you on your ability to live beneath your means and save a substantial portion of your income. Most people can’t even muster 10% of their gross income in savings each year, let alone 29%.

  141. 141
    EconE says:

    GREGORY WHARTON SAID….

    “But let’s be honest about this: a $1,600 rental house is not directly equivalent to a $490,000 owned house.”

    How about brand spanking new “luxury” downtown condos?

  142. 142
    RottedOak says:

    A lot depends on the time horizon. If you look a 30 year time horizon, it is much harder to come up with a scenario that favors renting. On the other hand, if you assume that we are entering a period with below average home price appreciation — which seems a reasonable assumption — then it is very easy to construct a scenario where it is better to rent for the next several years. If prices appreciate at just 2% per year (not negative, just below average positive appreciation), then for the better part of a decade a renter will be ahead of an owner who needs/wants to sell, even if you assume rent increases of 7% per year. If they both continue to hold after that, then the owner eventually gets ahead, but the typical “bubble sitter” is looking at buying within 5-10 years, not renting forever.

  143. 143
    Hyperbola says:

    I agree that the stock indexes have higher long-term volatility than housing markets as a whole, but that’s not what we’re comparing here. We’re comparing the volatility of stock indexes to the volatility of a particular house. Not the same thing. But I think we already briefly discussed the benefits of diversification above – without specific data it’s hard to argue this one way or the other.

    I’m not sure I agree a diversified stock portfolio is more vulnerable to Black Swans than real estate. All asset classes have unpredictable disruptions that cause losses, especially after adjusting for inflation.

    According to http://w4.stern.nyu.edu/salomon/docs/Shiller_NYU2007.pdf, which may or may not be adjusted for inflation, if you bought a house in 1895 and held for 30 years, you would be even more screwed (down almost 50% in 1925) than stockholders who bought in 1929. I’m not sure where the data in that chart comes from, though.

    All it would really take in any medium to large city for lots of people to lose everything is for the largest business in town to pull an Enron and go under due to massive “accounting irregularities”. The same risks apply to stocks. Presumably, most people think Seattle is very unlikely to experience such a disruption, but that’s why they call them Black Swans. :)

    So the question of risk is not merely “how plausible is it bad things might happen?”, but also “how many bad things does it take before I panic and change my strategy?”.

  144. 144
    takenroad says:

    Here’s my real-world example. Wife and I bought a typical small Greenwood house in 1993 for $141k with a fixed rate 30 year mortgage. In 2002, we re-financed to 15 year loan, lower rate, and pulled out $20k for kitchen remodel. We made some extra principal payments along the way, mostly in the early years. Today, September 2007, we think Zillow is about right on the estimated sale price – $470k. Our principal balance is ~ $80k. With 9% cost of sale, we would net $348k. Our mortgage payments started at $1000 a month, and have risen to $1375/mo with increasing taxes and insurance, plus move to 15 year mortgage. In total, we’ve paid $225k over the years. Add to that about $55k in maintenance and improvements for total outflow of $280k. (Haven’t bothered to figure the tax deduction on the mortgage interest here, which would reduce the total payments.) If we sold today (if we were able…), we would get back every penny we’ve put into the house plus about $70k. In other words we would net out rent free for 14 years plus $70k in pocket.

    In the early days of our mortgage, rent would have been cheaper than mortgage. We crossed over somewhere around 10 years into the deal. Now we think it would cost about $1800 /mo to rent this house.

    Would we have been better off renting and investing the “savings”? Maybe. But remember that money in the stock market in 2000 didn’t recover its value until around 2005. Don’t completely dismiss the “forced savings plan” idea. Would a rental house have been in the same condition as we’ve kept our house? Doubtful.

    Owning our house likely kept us from moving closer to my work, but ties to church and kids’ school now exert the same restraint. I live in and work out, so my reverse commute isn’t too bad.

    It might not be this home, but one of these days, we will own our home and our monthly payment will be down to taxes (Ugghhh) and insurance, which today amount to about $380/mo. As “rent” goes, that’s a stellar deal.

    An observation about appreciation: In 1938, when our house was built, the tax appraisal was $1200. In 1963, the tax appraisal was $2500. In 2006, the tax appraisal was $347000. In the early years of our mortgage, the house seemed to appreciate at about the mortgage interest rate (6 to 7%). Recently the numbers were much larger (17%). My own theory is that the tax change on exemption from capital gains tax on housing appreciation was nearly as important as low interest rates in causing the current bubble.

    All for now.

  145. 145
    James says:

    As a landlord and a current real estate investor (foreclosures @ 70% aquisition cost to current value) I agree that the value of rentals vs. purchase is the little known or believed secret. This is if you measure in economics only. A few examples that I can give are my own. We usually sell everything we buy rather than put it into our rental inventory because in a market that rose as fast as this market did it can decline with equal enthusiasm. We kept two $400K+ homes (one was $500K and one was $400K) because of tax purposes. The $400K home was advertized for $1695 per month but the renter opted for a lease purchase plan for more but the $500K (now worth $400K) is renting for $1795 per month. These are bargains compared to owning. Both of these homes had minor problems with the heating systems this year and guess who they called. While it may give you a warm feeling to own your own house it doesn’t give me a warm feeling to lose money. In the second example I gave you, I can assure you that $1795 was all the market would bare because it was not easy to get a renter. If they put the difference in cost of ownership and renting in a decent investment they can achieve wealth without buying a home beyond their means.

    It used to be that a landlord could expect a rental to provide 1% per month rental compared to current value of the asset and if that rule of investment applied either home would bring $4000 a month. Those days disappeared a long time ago. If the landlord has lost this advantage who do you think now has this advantage? I did say “if measured in economics only”. We have a home that we purchased that we love and our children think of it as home. There is a value to that and it cannot be measured economically. I wish that for everyone.

  146. 146

    […] mortgage to get. Personally, I would look into renting a nice house for at least a few years (see this post for a strictly financial comparison between renting and buying similar homes in the Seattle area). […]

  147. 147

    […] say you’re a prudent person who has compared the financial realities of buying vs. renting and made the decision to rent for now. However, with the frequent news reports about increasing […]

  148. 148
    Swing Ninja says:

    There is a mistake that rent-vs-buy articles make all the time. Including yours. In your rent vs buy cost table you said: Rent costs $1,495, while mortgage costs $2,093. Some of that $2,093 should be money that goes into your pocket since it is equity + interest. And the saving that goes to your pocket should increase through time not to mention the increase in property value

    On the other hand, rent costs $1,495 only for the first year. If you decided to renew the lease, most likely it will increase.

  149. 149
    The Tim says:

    Swing Ninja, you did not read the post very carefully, because all those things were indeed considered.

  150. 150
    Bill says:

    They were considered? Where? Is it that 20-year statement? What rate of rent increase are you using and what rate of inflation? Are my monthly contributions to this 8% account going down as my rent goes up? I’d like to see the calculations on that. But I would tend to think that the inflation-adjusted price of renting remains relatively the same over time while the mortgage goes down, down, down. Not to mention I’d LOVE to find that financial instrument you mention which guarantees an 8% return. The stock market? Well since we’re using historical averages, then from an admittedly cursory search, home prices around Seattle increase 7% historically. I’d much rather get a 7% return on $425,000 than 8% on this $85,000 (plus deposits) I have for a down payment. You’d have $300,000 in 10 years, I’d have about $425,000 in 10 years in just appreciation, not to mention my $85,000 downpayment and added equity from payments (which is admittedly small). Let’s just say I have $525,000 in net worth to use a semi-round number. Yes, yours is liquid, mine is not. But it’s my estimation that that’s always the problem in the U.S. Why does the government want to charge you a penalty for withdrawing funds from your 401k or IRA early? To make it relatively illiquid. If it’s all free and easy, why not just buy that boat, or those fancy trips every year. You’re describing a “perfect saver” which there are very few of in this world. I’m kinda anxious to run these numbers myself.

  151. 151
    The Tim says:

    Hi Bill,

    As I said previously in this comment thread, the math behind this post was actually quite in-depth, I just kept the explanations to a minimum to avoid it becoming excessively boring and dry.

    You can play with the numbers yourself by using either the spreadsheet I made (posted here), or for a more graphical and less tedious method, the New York Times calculator I mention in the post is quite useful and I’ve found it to be pretty accurate as well.

    Best of luck to you.

  152. 152
    Bill says:

    Hi Tim,
    Well, your spreadsheet is very well done. I prefer things like spreadsheets to “black box” calculators. But I think we’re going down the route of having to agree to disagree. I think the assumptions you make of 11% return on the stock market and 4% appreciation are way out of whack. You’ve taken the most optimistic view of the stock market return and the least optimistic view of home appreciation. Simply ticking up the house appreciation 1 percentage point, from 4% to 5%, doesn’t make renting a good option until year 13. Even one more point and it skews completely in favor of owning.

    And that article the spreadsheet is part of is laughable. Absolutely nothing is sourced and it uses the highest level of hyperbole. No matter how right or wrong it may be it simply cannot be taken as credible. Who the heck is this person? Why should I believe anything s/he has to say? Why is s/he writing this article? For all I know s/he is a landlord. Hmmm…negotiating 15% off my rent? Yeah, that’s common. Especially since renters have almost no rights in Seattle. And apparently home appreciation is not in the constitution, but the return on the stock market is. The “Bottom-Line” section shows this bias pretty easily. The only numbers that change are house appreciation percentages. I guess 11% return IS in the constitution! How about also comparing various returns from investing to the various returns on the stock market. People in their 40s or 50s that are much closer to retirement need to be more conservative in their investments than a 25 year old. The investment return should also go down over time because of the need to preserve capital at a certain age. The best part of the article is your spreadsheet as it allows folks to change the assumptions based on their personal situation and how averse they may or may not be to risk. The article itself is no better than any RE Agent saying it is ALWAYS better to buy. Never say always or never.

    But I’ll just keep paying my mortgage and when it comes time to move on to a bigger and better place I’ll rent my old place out and get some nice positive cash flow out of the property. So keep on renting!! After all, I’ll need someone to occupy it.

  153. 153
    The Tim says:

    Bill, you seem to be fixed on the 11% thing. That number is in the spreadsheet by default only because it was the number thrown out there by Rhonda Porter, the lady who wrote the original article that the article on POF is responding to.

    For the purposes of this post, I used a more conservative 8%, which is closer to the historic long-term average of stock indices. However, there’s a reason that it’s a configurable variable in the spreadsheet. The purpose of the spreadsheet isn’t to shove a particular set of numbers down anybody’s throat, but to provide a tool that people can use to compare their own unique situation.

  154. 154

    […] at some Seattle-area rent vs. buy comparisons to see if the situation has improved at all since we analyized it last summer. Back then, the real-world example I used compared two similar homes in Kirkland. Total monthly […]

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