Rent … unless you want to buy :)

Experts have been arguing for a while that real estate is over-valued by looking at a number of metrics; e.g., housing prices relative to household income, historical trends of house price increases.

However, very few people connect with those arguments and reiterate: “when I buy a house I am building equity” or “rent payments go down the drain, at least when I buy I am paying towards ownership of the house.” I will explain why those assertions are wrong.

Fundamentally, a house is just another asset. Its value should be determined by the present value of the cash flows you can obtain from it. Those cash flows are the present value of the rent payments you can collect from it over time and the present value of the price you will sell the house for in the end.

In other words:

House value = present value of potential rent payments during the ownership period + present value of selling price

Unfortunately, it is very unwieldy for people to calculate house values that way. Not that many people know how to calculate present value, but more importantly there are too many variables that would be up for debate. People might know their discount rate and current rental values, but how can they reasonably estimate annual increases in rent and in the value of the house over the long run? Polling experts would give you a wide range in the annual price increase of the house – some give you a negative rate in light of the current high prices, some would grow prices with GDP and some would grow house prices faster than that in light of historical housing price increases.

If the present value of cash flow method is unwieldy, the easiest way is to look at the rental yield of the property. In other words, how much of the property value can you obtain in rental income yearly, based on current market prices.

Rental yield = annual rent income / current market price

For instance the current yield on the house I am renting in Long Island is 1.6%. Given that you can get 5.5% risk free in a money market at your bank, renting is clearly the best option by far! I can more than pay for the rent just with the interest of the money I would have had to spend to buy the house. My landlord (who I hope does not read this blog) would be much better off selling the house and investing the money in something else.

In a less exact way, you can also look at monthly costs of renting versus ownership. In other words you can compare monthly rent versus the mortgage cost plus the monthly maintenance cost plus the monthly property tax minus the monthly interest expense tax deduction. It’s not an economically exact representation of the two cash flows over time because you don’t know by how much rents will increase relative to changes in property taxes and maintenance. Not to mention the interest deduction varies, given that over time the amount of interest expense decreases as a share of the overall mortgage payment – but it gives you a sense of the respective costs. Note that you have to assume you are taking a 100% mortgage for the comparison to be correct, otherwise you would have to subtract from the rental cost the monthly income from funds that could have been put towards the house and have been invested elsewhere.

For my Manhattan 2 bedroom apartment, the monthly rent is $3,965. To buy the apartment would cost $2,000,000 which is $11,671 per month on a 30 year mortgage at 5.75%. My marginal tax rate is 40% and almost all of the payments are interest at this point, so I would get a $4,668 monthly tax break. The maintenance on the apartment is $1,249 per month and the monthly property tax is $1,039. In other words, I would pay $9,291 per month for the privilege of owning the apartment versus $3,965 to rent it – a $5,326 monthly difference. Again it makes much more sense to rent.

So what about “when I buy a house I am building equity” or “rent payments go down the drain, at least when I buy I am paying towards ownership of the house.” Well, yes ownership builds your equity stake, but consider that you could have been saving and investing the $5,326 in something else and letting it compound every month. In light of the current yield on real estate chances are you would be much better off in the long run – even if you place the savings in relatively safe asset classes.

So from a financial perspective it makes more sense to rent in New York right now than to own. However, life is not about maximizing your financial outcomes, it’s about maximizing your utility, economist speak for happiness 🙂 . Some people want the ability to remodel and change a house. Many people love having a place that is their’s and that they call “home.” In other words, if you get more happiness out of owning the house than the differential in cost between renting and owning, you should own!

In my case, I actually like not being tied down by financial assets and having the flexibility to go anywhere at a moment’s notice. So even at equivalent financial costs, I would probably choose to rent.

  • Good comment from a friend of mine:

    Spot on as usual. One factor though you forgot was the negative impact of alternative minimum tax (AMT) which takes away or greatly reduces the mortgage interest tax deduction for those with over approx $250k in income and in states like ny with high state/local taxes that get deducted from federal taxes. The AMT hit me hard and further supported my decision to sell last year in addition to all the reasons below. I am now a happy renter! Cheers

  • hey fabrice all of this is fine for new york, but over here in europe or more specifically Nissa la Bella, a town you probably remember, the figures are a little different.
    Real estate has been going up by an average of 15%/ annum since at least 5 years and at the bank you might get 3% on your deposits unless you want to block them for a long time.Currently one can obtain financing for an apartment at about4% without too much trouble. On top of this the family home is one of the only things that can be sold at a profit in france without getting hit with a large tax bill.
    With figures like these you have to be really attached to your flexibility to go anywhere at a moment’s notice
    Hope you’re having fun in the states

  • I do remember Nice, I am in Nice right now 🙂

    Real estate is local – my recommendation to rent is valid in New York, but more importantly the post described how to evaluate the rent vs buy decision.

    I have not looked at rental yield, income relative to housing values and rental vs. purchase prices in Nice. I will let you do the analysis for yourself. However, the fact that real estate has increased by 15% per annum for the past 5 years is not a valid argument. As they say “past performance is not a guarantor of future performance” if anything it might suggest prices have appreciated too much already.

  • Great article, Fabrice! I have always attributed value to the flexibility that renting affords. Incidentally, a similar analysis could be made regarding owning versus leasing a car. For me, leasing is an easy choice. The advantages include (i) being able to drive a brand new car every 2 or 3 years; (ii) always having the car covered by its initial warranty; (iii) in many cases, having free maintenance service over the entire lease term; and (iv) having smaller monthly payments (because you are paying only for 2 or 3 years of the car’s use, instead of its entire life over the term of the car loan).

    With respect to housing, I think there are other factors that come into play. For example, the “liquidity” of the housing market could be important. In other words, if the housing market collapses, or there is a deep recession, I would think that the risks associated with owning would be greater. Housing prices have generally been rising for the last decade or two, but historically there have been periods when they have stagnated or fallen. Perhaps this historical “volatility” should be factored into the analysis, maybe using option pricing models? Additionally, the length of one’s lease, and the financial penalties associated with breaking the lease early, have an impact on the value of a renting decision, since they define the parameters of one’s “flexibility”.

    But what do I know, I only studied economics in college, while you are an economics whiz!

  • I agree with what you are saying entirely.
    However, housing prices are sticky, but volumes sag when prices are stagnant or declining. So you might be better off renting for the next five years, but when your dream house has returned to ‘fair value’, it might not be for sale.

  • I agree entirely with the choice to rent instead of buying,
    more free cash flow and choices for investing in high yield
    In Australia where I live most people have no idea that
    property is overpriced, and consequently has a low yield.

  • Can you explain how in your NY example 2,000,000 devided by 360 (12 months x 30 years) equals a monthly payment over $11 thousand dollars? My calculator says that’s about $5555.56. Even if you add the 5.75% interest it’s only another $319ish dollars.

  • Fabrice, as far as I can tell you’ve proven only that has mortgage estimates that are terribly in favor of the lender. Why on earth would anyone take out a loan that only had you paying approximately $10 in principal every month? That’s a HORRIBLE loan (less than .1% principal paid in the first year). Find a better lender.

  • Fabrice, a big factor in some parts of the country/world (but not New York) is whether the loans are non-recourse. California for example is non-recourse so you need to add in the value of a de facto put option when you take a mortgage.