Sunday, February 25, 2007

Why Own When You Can Rent?

You see the ads everywhere, and the idea seems at the core of American culture. Talk to any Realtor and you’re bound to get a half dozen reasons why owning is better than renting. The Searchlight Crusade has a whole series of persuasive articles arguing that now is the best time to buy in San Diego. Implicit in his analysis is an estimate of future appreciation rates, which are anybody’s guess.

I used to own 4 houses. My parents have been part-time real estate investors since I was a young kid. I guess, at bottom, I buy into all this “buy versus rent” crap, myself, as I’ve recently been seriously thinking of buying something—anything—so that I’m not just “throwing my money away.”

But, really, is it true that owning is always and everywhere better than renting? It seems a foregone conclusion that buying a home in Phoenix in 2000 was a good idea (though at the time, of course, things were far from clear-cut). What about now? Sadly, certain knowledge about the future is impossible. Nonetheless, it seems unlikely that the price trends of the past 6 years are going to continue unabated.

There is, however, another way to look at the problem—one that doesn’t require gazing into crystal balls or reading tea leaves. It’s a “back of the envelope” technique that you’re also not likely to learn from your typical Realtor or real estate guru, either, even though it can tell you quickly and unequivocally whether a given property is a “good deal” or not.

In a nutshell, the idea is to take a property you are interested in and compare the monthly cost of renting it with the monthly cost of owning it at 80% LTV. If it’s cheaper to rent it then the house is overpriced. If it’s cheaper to own it, then buy it!

Let’s take a look at some actual Phoenix area properties and see what we find.

Here is a home in Avondale renting for $1,150/month. A substantially similar home down the street sold in January for $255,000. Monthly housing costs as an owner for this home, then, would be $1,583 ($1,263.00 principle and interest payments on a $204,000 loan at 6.3%, plus $55 HOA fees, plus $70, plus $195 taxes).

In other words, if you were to put 20% down on a house in that neighborhood with the intent to rent it out, you’d be subsidizing your renter to the tune of almost $5,200/year—and that’s before any expenses.

One hopes that the owner of the actual rental isn’t faced with such a situation. However, what can be said with certainty is that their return on equity is unacceptably low—unless the property’s value is appreciating a lot faster than $5,200 yearly. This was the case the last few years, but who can say it will continue that way much longer?

Here is a condo in Phoenix renting for $1,190/month that would cost you $1,462/month ($1,219 monthly payments on a $197,000 loan at 6.3%, plus $135 HOA, plus $108 taxes) to own. Were you maybe wondering why there were so many condo conversions recently? There’s your answer. What apartment building owner wants to lose $272/month on every unit they own? What could you do with an extra $3,300 a year?

Suzette wants to “make a deal” on a lease-to-own condo in Chandler—with a current asking price of $264,000. Let’s be generous and assume a market rent of $1,300/month. In that case, any “deal” that involved paying more than $220,750 would be a bad one (unless you’re Suzette, I mean).

Here is a 3 bedroom house in Scottsdale you can rent for $1950/month today. To buy it today, on the other hand, would cost you $2,602 a month ($2,352 principle and interest payment on a $380,000 loan at 6.3%, plus $100 insurance and $150 taxes). Whoever ends up renting that place should kiss their landlord’s feet, as they are basically being given a $7800/year gift.

What can we take away from this analysis? First off, I think it’s fairly clear that pretty much no one in Phoenix is making money as a landlord right now (I mean to say: specifically when calculating a return on equity). Secondly, people who say it’s a “buyer’s market” don’t know what they’re talking about. Thirdly, something’s gotta give! There’s no way real estate investors are going to continue to lose money hand over fist over the long term. Either housing prices have got to come down or rents have to go up. I imagine that the future is going to see some combination of those two things.

Meanwhile, I’m gonna keep renting—and putting the money I’ll be saving into something likely to provide a much higher return.

7 comments:

Anonymous said...

It really is hard to know when to buy in the real estate market.

The first single family home investment I bought (1980's) cost me over $100 each month when it was rented, and even more when it was vacant. It did start to make money after a few years, and, eventually, I made a good profit when it was sold.

A large inventory (more supply than demand), low interest rates, and a good rental market (here in Tucson) make it tempting to buy more single family homes. Two things keep me from buying - (1) purchase prices are too high. My mortgage payment would be higher than the rent even with a large down. And (2) I'm tired of tenants.

If I was younger, and if I could afford a negative income each month, I would be very tempted to buy, waiting a few more months to see if the country goes into a recession like some are predicting. If this happens, all the better to buy!

Dikkii said...

I crunched the numbers some years ago on this and worked out that rental yields were so low that for the first twenty years of a thirty year mortgage, assuming a fixed rate and that you were meeting minimum payments only, you would be paying more in interest alone than what you would to rent the equivalent property.

And people talk about renting as throwing money away!

Can't remember what my starting deposit assumption was though. I think it was 20%, but I'm not sure.

At about the same time, I compared rental yields to dividend yields on the stockmarket (yes, in Australia, companies pay dividends) and worked out that if you compared a blue-chip property with a blue-chip company, there would be absolutely no way that anyone in their right minds would consider a residential property as an income-generating investment.

Being a firm believer in portfolio theory, I prefer listed property trusts and property securities funds rather than individual residential properties. In Oz, rental yields are generally higher for commercial and industrial property than they are for residential ones, and you get a diversified portfolio of different properties to boot.

Einzige said...

Dikkii, I hear you!

I think I'm going to have to sit down and really work through some numbers myself, because this belief that real estate is a good investment is so friggin' pervasive!

I was just chatting with my mom about this tonight. She was insisting that the net rental income she's currently getting from her properties is higher than what she could get in the stocks/bonds markets. I didn't grill her on specifics, so while I am still somewhat incredulous, I admit that I don't really know.

Meanwhile, Dan Melson (as I mentioned in the post) over at the Searchlight Crusade is taking every opportunity to extoll the benefits of home ownership. I tend to respect the man's opinion - but only up to a point.

In the first place he's a Realtor and a mortgage broker, so of course he has a vested interest in convincing people to buy and sell real estate. That aside, his March 5th "Hot Bargain Property", I think, is a good example of why he shouldn't be given carte blanche.

He says the place is a "bargain" at $370K, but then says that it would only rent for around $1700/month. Given that principle and interest payments alone on an 80% loan at 6.3% interest would be $1832.16, I have to disagree with him.

He asserts that even if you were to put zero down on the property, in ten years you'll be $160,000 net ahead of the renter. Of course this assumes a 5% appreciation rate, but that's not entirely unreasonable. However, I don't know what other assumptions he's using.

Here's my BOE analysis:

Sales price: $600,000
Sales costs: $60,000
Loan bal: $312,000

Net to seller: $228,000 (not $290,000, like DM claimed)

The difference between the zero down loan payment and the $1700 rent is going to be somewhere in the range of $830, and that's not including taxes, insurance, any possible HOA fees, or home maintenance costs.

If we assume a fixed monthly cost of $3,000 to own this home for the next 10 years, and we assume that rents will increase by 5%/year during that same time, and we assume the renter invests the difference between those two numbers at 10%/year, tax free, then the benefits of owning that home instead of renting it are not $160,000 in ten years, like Dan claims.

Instead, you get a figure closer to $29,000. If you ask me, given the margin of error inherent in all these assumptions, I'd have to conclude it's a wash. The case for owning is nowhere near as clear-cut as Mr. Melson would have us believe.

Dikkii said...

That's a fairly significant difference you've calculated there.

I must admit, I'd like to know what Dan's assumption on inflation is - if it's also 5%, it would be patently unrealistic.

I meant to mention earlier, that in comparing the property market to the stockmarket, in Australia, dividend imputation makes it a no-brainer.

The bond market is more problematic, given its reliance on interest rates and its history of minimal capital growth.

Paul said...

The only comment I would have on these buy/rent analysis is that one should account for the ability to deduct the interest off of your taxes. This works for buying and living in the home. That would result in some of the differences being much smaller.

As to owning and renting out, I feel it would almost always be bad to have a negative cash flow. However, any negative cash flow and expense should be deductable against income and gains, and that might shift some of the considerations.

Other than that I see no issues with the thoughts presented.

Einzige said...

Tax laws can change (and have - sometimes significantly - witness the real estate crash of 1987). Including any supposed tax benefits in your profitability analysis is therefore as ill-advised as including estimates of future appreciation.

samlyons23 said...

I've been renting for a few years now and the benefits over owning a house are what maintained my interest in the market. You only have to answer to your landlord and so long as you pay rent on time each month then you have nothing to worry about.

However, my current landlord has decided to get a quick property sale and has left me in the lurch somewhat. I was wondering what the rules are surrounding these sell-and-rent-back schemes when selling with a sitting tenant.