| The classic Rent vs Buy Question |
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mlathe
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| The classic Rent vs Buy Question |
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I live in the San Francisco Bay Area (actually in the south bay in San Jose). As many people probably know by now the Bay is a very expensive place to buy, yet people still do it, and as a result it makes me think. Is this really a good thing to do?
Consider this math:
Cost of living in an apt:
-- $2000 will get you a pretty nice apt (see example)
-- $200 for a year of renters insurance
-- free maint!
-- That's $24,200 for an entire year!
Cost of a house
-- i'll consider a $500k house as about the same as the above apt (see example, note that it's 27 yrs old!)
--let's say you put down 20% (that's $100k!)
--mortgage interest=$400k loan * 6%=$24k in interest (this is tax deductible so really this probably only "feels" like $17k (very rough math))
--property taxes=1.25%*$500k=$6250 (I think the percent is about right)
--insurance=$500 (??? i really don't know)
--maintenance=$300HOA fee per month for outside maint. $100 for inside maint. That's $4,800 in maint per year.
--TOTAL: $28,550 per year in "fees". There is still no added equity in the house yet.
I think that i've been pretty fair in the prices and weighted things toward the house. Please correct me if my numbers are totally wrong, i haven't done any real research into the numbers.
But as you can see the home buyer is paying more for the basic living space, not the mention the fact that they but down a $100k which the renter could safely invest into a MM at 5% to make a $5000 per year. That makes the costs about $19k vs $28k!
So i think it's pretty clear that the renter wins here. Perhaps in the long term the home owner would do better since most of her costs (interest) don't get bigger each year. They should get smaller as the principle is paid down. Also the renter will have more expensive rent each year.
Does anyone disagree with my argument?
Does anyone know at what point renting vs buying makes more sense (ie a ratio of monthly rent vs house cost? here 2k/500k seems to show renting as the winner. What about 3k/500k?)
Thanks you guys
--mlathe
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Sun Dec 24, 2006 12:59 am |
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oldguy
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quote:
That makes the costs about $19k vs $28k!
So i think it's pretty clear that the renter wins here. Perhaps in the long term the home owner would do better since most of her costs (interest) don't get bigger each year. They should get smaller as the principle is paid down. Also the renter will have more expensive rent each year.
Your analysis considers only 'cash flow' - that's a lot different from total cost. As you suggested, after 20 years the owner will still be paying $28k but the renter's $19k will have risen to about $34k. But that's NOT the big factor. The big factor is appreciation - the house will be worth about $1.6M and the owner will owe about $220k - ie, he has an equity of $1.4M. So if you add up the $28k for 20 years and subtract it from the $1.4M, the owner was actually PAID to live there.
BTW, don't make a $100k down payment. As you can see, the amount that you add to princiapl affects the $220k - and it won't matter much if the $220k was $320k or $120k - the $1.6M is the important number. When I buy rental houses, I make the smallest down payment that I can and still get a prime rate. And no ARMs - you want a fixed rate loan so that you won't be forced into a refinance at a time when rates are high. IOs work great (you pay no principal for 10 years), but, again, FR only.
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Sun Dec 24, 2006 5:57 pm |
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mlathe
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quote:
Originally posted by oldguy
Your analysis considers only 'cash flow' - that's a lot different from total cost. As you suggested, after 20 years the owner will still be paying $28k but the renter's $19k will have risen to about $34k. But that's NOT the big factor. The big factor is appreciation - the house will be worth about $1.6M and the owner will owe about $220k - ie, he has an equity of $1.4M. So if you add up the $28k for 20 years and subtract it from the $1.4M, the owner was actually PAID to live there.
You should be careful when you only consider one side. In the real world everything gets more expensive including the house payments (e.g. maint is more expensive). Also you must consider that the renter is paid quite hansomly for his investments. It's like the renter was PAID for letting someone else use his money!
So let's do some math to consider the other part of the situation (the final profit to the person).
Here's my Math:
The renter pays between $19k-$34k per year in housing expenses during the 20 year period. That is an average of $26.5k per year, which is a total of $530k in expenses (wow!). i think that $34k is low (using this inflation calc, and the time period of 1980-2000 $19k=$43k which is a 20 year total of $620k in expenses).
Now the owner has been paying $28k per year without ever paying down the principle. As coaster said the insurance is low, and i'll also ignore the fact that certain items will get more expensive (ie maint should be affected by inflation. These allowances are both in the favor of the homeowner's position. Thus you can see here that they owner will have paid $560k.
These are the cash Flow calculations. Now let's get to the investment side:
renter has $100k invested in stocks. They can also invest $1500 extra, each year ($28k-$26.5 (avg for renter)). If i assume 10% return, i find that the renter will have $760k in liquid assets in 20 years ([ur=lhttp://www.moneychimp.com/calculator/compound_interest_calculator.htm]see calc[/url]).
The owner will have a 1.6M house (this looks like a 6% growth per year on the 500k which seems optimistic for a house (correct me!)). That 1.6M still has a 400k debt on it, and the owner paid $560k in fees. Which leaves the owner with about $640k in non liquid wealth.
At this point the renter has about $760k vs $640k for the owner. Looks like the renter wins here.
Let's take a moment for one last calc:
let's say the owner doesn't only pay $28k per year for each year.
--interest will be the same: $17k after tax deduction
--taxes in CA are the same: $6.3k (total for 20yrs is $126k)
--taxes outside of CA are about 1.25% * avgHouseValue=1.25%*((1.6M+500k)/2)=$13k avg per year ($260k in 20yrs)
--insurance=$500 (leave it constant to help owner)
--maint: $660 per month= $8k per year avg maint for the 20 years (i used the same inflation calculation).
--Total in CA=$31.8k per year, and $638k during 20yrs
--Total not in CA =$38k per year, and $760k during 20yrs
in this calc the owner doesn't get anything more they just pay more (and not for unreasonable reasons). The renter though would have access to more money for investing. In CA it would be 31.8k-26.5k=5.3k more, which when using the calc used before comes to a nest egg of about $1M. Outside of CA the renter would have 38k-26.5k=11k extra to invest(!) which adds up the about about $1.3M in assets.
It seems pretty clear that the renter does pretty well in this situation, as long (VERY IMPORTANT) she doesn't spend her savings. Houses work great as a "Pay yourself first" investment, however i'll argue that a renter (at least in the expensive prices of the Bay Area) can do very well for himself, as long as he invests heavily (ie at least 11k per year into 401k + IRA's + savings).
quote:
Originally posted by oldguy
BTW, don't make a $100k down payment...
Yes, good point. Paying 20% isn't always the right thing. It just made the numbers round. Perhaps this is the weakness in my argument? If the initial investment was only 50k it would dramatically affect the renter's calculations, but not so much the owner's.
Comments?
Thanks for this thought experiment.
--Matthias
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Mon Dec 25, 2006 9:15 pm |
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oldguy
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quote:
That 1.6M still has a 400k debt on it, and the owner paid $560k in fees. Which leaves the owner with about $640k in non liquid wealth.
At this point the renter has about $760k vs $640k for the owner. Looks like the renter wins here.
You double-dipped on the $560k, that has already been accounted for. The owner actually has $1.2M in cash if he were to sell out at this point.
quote:
--maint: $660 per month= $8k per year avg maint for the 20 years (i used the same inflation calculation).
If one of my houses was costing me $8k/y in maintenance I'd burn it to the ground for the insurance, lol - mine are closer to $600/yr.
quote:
Perhaps this is the weakness in my argument? If the initial investment was only 50k it would dramatically affect the renter's calculations, but not so much the owner's.
If the owner could buy with zero down, then he, also, would have the $100,000 to invest for 10% for 20 years - so he would have a $673k account in 20 years. And better yet, the owner should refi the house at $800k (about 8 years), take out $250k and invest it at 10% - that should grow to $785k in 12 years (at year20). So at Y20, the owner has the $1.6M house (w/ a $500k or $600k loan) PLUS $1.4M in investments. BTW, I have experience with this recipe - I've used it on each of my rental houses - ie, refi often and invest the equity in stock indices. It makes a good (ideal?) diversification - leveraged real estate and stocks, the 2 appreciating assets.
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Tue Dec 26, 2006 12:55 am |
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mlathe
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Thanks everyone,
oldguy, I stand corrected. Thanks for working through this with me.
For future readers I'll explain what is going on. The key is that when I consider the payments of the renter vs owner separate from their final wealth. I wasn't being fair here. The renter pays the same as the owner. The difference is where the money goes. For the owner all the money goes directly into fees (kind of a downer). For the renter most goes to fees but some is invested.
Thus when we compare the outcome we need to compare the totals with each other. So the owner we will assume ended the twenty years with a $1.6M house and a $400k debt, so $1.2M in wealth. The renter in the best case (ie when the owner had to pay inflation adjusted maint and taxes, and therefore the renter had more to invest), had $1.3M in investments with no debt. In the worst case the renter had a wealth of only $700k.
So it is now clear that the owner does pretty well. I would say this is b/c he takes on more risk (bank could foreclose on his loan and take his house), and also b/c he is leveraging his downpayment to make a $500k investment which should grow much faster than a $100k investment (stocks) that has a better return .
A few final statements:
--refinancing and investing the equity might seem like a good idea, and probably works pretty well, but you are clearly taking on more risks. The renter could do something similar (probably not at the such a goot rate though), if they margined their stock to get more purchasing power. So i don't think this should be considered in this thought experiment.
--I'm surprised that you can get by on $600 a year in maint costs, esp in a rental. Replacing a roof (every 20yrs?), repainting (every 5-10yrs), cleaning up after renters (every 1-2yrs), mowing the lawn (every 2 weeks), etc starts to add up. If you are doing this stuff yourself, then you might be right that $600 per year in materials might be enought. But when you start to add laybor, it gets expensive really fast. FYI the $8k is inflation adjusted (about $6k in 2006), and comes from $400 HOA + $100 internal maint which is about the going rate in the Bay Area.
oldguy,
just out of curiousity, where are your rentals, and what kind of rent are you charging at what outlay? or more general, do you invest in cheaper areas of the country? or more expensive?
Don't answer if you don't want to.
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Thu Dec 28, 2006 8:57 pm |
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oldguy
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quote:
--refinancing and investing the equity might seem like a good idea, and probably works pretty well, but you are clearly taking on more risks. The renter could do something similar (probably not at the such a goot rate though), if they margined their stock to get more purchasing power. So i don't think this should be considered in this thought experiment.
Yes, clearly more risk. And of course that is what you want. Risk is directly proportional to return. A low-risk investment (CD, MM) gets a 4% or 5% return, it is a mathematical certainty that you will not accumulate wealth, you will simply match inflation. High-risk investments (derivatives, futures, day trades) will most often result in a catastrophic loss of principal. So that leaves moderate risk - 12% or so. When I need to increase risk, ie return, I increase the leverage on houses (refi) and reinvest.
The renter could margin his stocks - that would get him 2:1 leverage. In a way, that is what I actually do. Think of it this way - if I put a $100k loan on a paid-for house and invest it and if I already had $100k in stocks, now I have $200k in stocks but half of it is borrowed. But here is the difference - a margin is a variable rate loan, short term, and subject to margin calls (there is that ARM again), it is an unstable money supply. Our society is geared toward promoting home ownership - cheap rates, long terms - you couldn't go to a bank and ask for $200k for 30 years to buy stocks - but that same bank will give it to you for a house. So make use of that cheap source of capital.
quote:
just out of curiousity, where are your rentals,
In the Phoenix area. I buy in nice new neighborhoods, try to avoid 'junk' and fixer-uppers. I like to find 1 to 4 year old single family houses - the first owner has hung the drapes and planted the lawn, all I need is a key & a renter. New water heater, new AC, new plumbing/toilets, new roof, new disposal, new paint - so almost no maintenance for the first few years. Small 3bdrm2ba houses, about 1100 or 1200 ft seem to rent best, as well as sell the best (they form a base for the RE market). And for some reason, folks want 3 bdrms - a 1200' 2 bdrm is way harder to sell/rent than a 1200' 3 bdrm, otherwise just alike.
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Fri Dec 29, 2006 12:09 am |
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mlathe
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hey oldguy,
Thanks for the info. I like doing these thought studies b/c they illustrate the basic principles behind something. In this case i realized that buying a house is like cheaply leveraging an investment to increase your gain.
As for margin, i agree. The renter is stuck without a way of "pulling out equity through a refi". the only way to do this is margin, which is really expensive (ie like 10%). Also the owner will never need to deal with a "margin call" if for some reason his house drops in value. This is a real boon to the owner.
So AZ, eh? There's a guy at my work that has a similar approach. He buys houses that are about 5yrs old in AZ and Indiana (he might start in Hawaii too). He seems to do pretty well with this formula. The one thing that i'm curious about though, is that he says he actually makes amonthly profit from renting after he paid the mortage (i'm not sure if he's counting taxes and other fees). I don't understand how this can happen. If renting cost more than the mortage, wouldn't everyone just buy? What is your experience? do you count on the leveraged value of the house for your profit, or do you actually experience positive cash flow month to month. I would assume that positive monthly cash flow is not the case for my thought experiment that started this thread.
What do you think?
Thanks
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Fri Dec 29, 2006 4:36 pm |
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oldguy
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quote:
he says he actually makes amonthly profit from renting after he paid the mortage (i'm not sure if he's counting taxes and other fees). I don't understand how this can happen. If renting cost more than the mortage, wouldn't everyone just buy? What is your experience? do you count on the leveraged value of the house for your profit, or do you actually experience positive cash flow month to month. I would assume that positive monthly cash flow is not the case for my thought experiment that started this thread.
You can set up cash flow to match your desired level of risk. If you have a paid-for $200k house, your income is $1200/m rent and $150/m for depreciation tax break. That's about a 14% ROE if appreciation is 6%. If you have a $100k loan on a $200k house, your payment is $800/m . You'll get $1200/m rent and the $150/m dep tax, so your profit will be about $550/m (ROE about 19%). Or, if you have a $200k loan, your payment will be $1400/m, rent $1200/m, dep tax $150/m for a negative cash flow of $50/m. The house appreciates at $12,000, your ROE is infinite while your equity is zero. I like to keep my loans above 50%, so I refi often - my cash flow is barely positive (don''t want extra taxable income) and my unrealized appreciation is where I make the money. (And, of course, the investing of the equity from the refi's)
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Sat Dec 30, 2006 8:11 pm |
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mlathe
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Great info.
I didn't really understand what "depreciation tax break" means but i found this:
http://www.southcoasttoday.com/daily/02-05/02-05-05/t24hh550.htm
I'm not sure how you got that $150 number. From the above article (who know's how right they are) i see that "Residential income property, must be depreciated on a straight-line basis over 27.5 years". That would imply 330 periods (27.5*12months) to depreciate the $200k value. That would mean $660/month.
Also I'm still interested in this Q: "If renting cost more than the mortage, wouldn't everyone just buy?". A few answers that i can think of are:
--bad credit, means the mortage would actually be higher.
--people don't realize this fact.
--people don't want to bother with the paperwork.
Thanks
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Mon Jan 01, 2007 1:59 am |
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oldguy
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quote:
That would mean $660/month.
OK, you would deduct $660/m from your gross income - if your marginal tax rate is 25%, then you would get a tax reduction of $165/m. You can get that immediately by updating your W4, no need to wait until the following April 15.
quote:
If renting cost more than the mortage, wouldn't everyone just buy?".
I think they do. About 70% of US families are home owners. But you need a time-horizon to buy a house, it costs 6% to get in and 6% to sell, and a bit of time to cover a flat year or two, ie, you don't buy if you can't be certain of 4 or 5 years minimum. And young people need to consider a new job, a promotion, a transfer - pretty hard to know where you're going to be for the first 5 or 10 years - so you have to pay the premium for portability/flexibility - at least that's how it worked when I was young. And then I worked for 33 years at the same company.
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Mon Jan 01, 2007 5:06 am |
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