Buy vs. Rent Calculators

If you've read some of my other posts, you'll know that I hate financial truisms like "You need to be able to generate 80% of your pre-retirement income to live comfortably in retirement" or "Invest in stocks because you'll get 8% returns." Why do I hate these sayings? Because they purport to be true for all individuals when, in reality, financial planning is such an individual-specific exercise. And, as these sayings become accepted as truisms, people are effectively discouraged from challenging these ideas and thinking for themselves.

One of the most annoying financial truisms to me is the whole "renting is throwing away money" and "you should always buy instead of renting" line of thought. I accept that owning property is hardwired into our collective DNA as one of those quintessentially American ideals like mom and apple pie, but taking these truisms as the truth can result in some horribly bad financial decision-making. And, I'm not just talking about the people who took out sub-prime mortgages. The way to figure out whether this particular truism is, in fact, true for you is to sit down and crunch the numbers to accurately assess your situation. I realize for a lot of people, the joy of math probably ended somewhere in high school, if not before then, and putting a rent versus buy analysis together may be beyond the scope of their desire, ability and/or free time. One solution to this problem is to use one of the many online calculators that provide a rent versus buy analysis. The problem for me was that I found most of the online rent versus buy calculators to be overly simplistic - most contained too few variables for consideration, and as a result, I ended up spending way too many hours putting together my own rent vs buy spreadsheets.

However, just last week, the New York Times released its own online rent vs. buy calculator (registration may be required - but it's free!), and this is one of the first calculators that I've seen online that I think captures most of the major variables that should go into a rent versus buy analysis. In addition to accounting for many of the most basic variables that other calculators include (monthly rent, mortgage interest rate, etc.), it includes many other variables commonly ignored, such as annual HOA/assessment/maintenance/upkeep charges in owning and insurance/broker fees from renting. Most importantly, the calculator accounts for investment opportunity costs when you make a particular choice, and you can see the consequences of your choices depending on the rate of home price appreciation and rental price increases.

What the New York Times' calculator does is it puts you the consumer in the position of making an informed choice. That is, it doesn't just give you simplistic "buy" or "rent" answers, but rather it forces you to actively think about and consider your assumptions. The beauty of all this is that given the same set of facts for two individuals, one person might choose to buy and one person might choose to rent, and it would be the rational decision for both. For example, let's say you are looking to move to Irvine, California. Searching online, you find this beautiful new 2 bedroom, 2 bath apartment with a pool for $1850/month. You're also considering buying a home as well and find this beautiful new 2 bedroom, 2 bath townhouse for $479,900.

Going to the New York Times calculator, here are the other figures I will input (jump to the next paragraph if numbers are going to make your eyes glaze over): On the main page, I assume a 20% down payment, 6.25% mortgage rate, 1.5% annual property taxes, and annual rent increases of 2%. On the Renting tab, I assume 1 months deposit, 0% rental broker fee (this isn't New York City after all), and 1% renter's insurance. In the Buying tab, I assume $100 in condo fee/common charge with 0% deductibility, 4% buyer closing costs, 6% seller costs, 30 year mortgage, 0.5% annual renovation and maintenance costs, 0.46% homeowner's insurance, $500,000 in capital gains exclusion, and $100 in additional monthly utility charges. Finally, on the General tab, I assume 8% return on investments, a 31% effective income tax rate and 2.5% inflation rate.

So, what's the answer? Do I rent or buy? The answer is it depends because I still haven't entered in an assumed annual home appreciation rate yet! So, if I'm following all the doom and gloom in the news and think the housing bubble is upon us, I'll put in a lower home appreciation rate, say 2%, and the calculator tells me that buying is never better than renting over 30 years. Thus, I should rent. But, if I'm bullish and optimistic and believe that lots of people are going to keep moving to Southern California where the weather is perfect and there just isn't much room left to build houses, I might put in a more optimistic appreciation rate, say 6%, and the calculator tells me that buying is better than renting after just 4 years.

So, what's the lesson? The first lesson is that there is no easy buy versus rent answer and that not all renters are losers! The second lesson is that your assumptions and beliefs play a huge role in the analysis. If you're a young 30 year old couple looking to start out, you're probably also putting your investment funds into stocks expecting higher returns. If you're on the cusp of retirement, your funds may be in more conservative investments. Thus, the 30 year old and the retiree would have different assumptions to punch into the Times' calculator. So many different factors can impact the calculations.

And, all of this isn't to say that there aren't problems with the Times' calculator. A more robust calculator might take into account future effective tax rates (e.g. are you climbing the corporate ladder with annual salary raises and thus higher income tax brackets? Do you think a future President Hillary might increase taxes?), the impact of non-traditional mortgages like 80-10-10s or 80-15-5s, variable rate mortgages, expected growth in HOA/assessments as the property ages, etc. Also, more generally, who really knows what the inflation rate should be or what rate home prices will appreciate at? But, the bottom line is that going through the exercise of punching in some numbers into the buy vs. rent calculator will at least make you informed enough to know that renting isn't always throwing away money!

Real Estate: Information Overload and How to Think For Yourself

Is it me or has it been just about impossible for the past several years now to go through a day without hearing or reading something about the housing market? At first, it was all about how everyone was making boatloads of money in real estate (with the implicit message that anyone not in on the action, read: renters, would get passed by in the great economic rat race), and more recently, everything has centered around the fear of housing bubbles, rising interest rates and the subprime mortgage market. Truisms that seemed to make so much sense a couple years ago (e.g. "real estate is never a bad investment because prices always go up!") have been replaced by others (e.g. "there's a giant housing bubble in our country caused by an overheated run-up in housing prices!"). With so much information overload out there, how do you separate the wheat from the chaff to figure out what is and isn't important when you're looking to buy or sell property? Some thoughts below:

1. Reject all the truisms - personal finance is by nature "personal" which means that no one truism applies to all inviduals. So, no matter how many times you hear a pundit repeat mantras like "renting is for losers", just because the message is loud and persistent, it doesn't mean that it's necessarily true for you. Remember, there's no help like self-help, and by thinking about issues actively and critically rather than letting others tell you what to do, you're more likely to make better informed decisions.


2. Don't be afraid to do the math - a lot of truisms that you'll hear on the news or read about on the Internet can be verified (or disproved) by doing a little math. For those of you who are math-phobic, there are a bunch of tools and calculators on the Internet that can help you crunch numbers. Caveat: the only problem is that some of these calculators are more reliable than others, and I could dedicate entire posts to this topic.

So, all I've told you so far is to reject everything you read and hear along with some vague notion that you should be dusting off your old Algebra books to do some math. How is that supposed to help you? Well, I admit that I certainly haven't provided any magic answers, and that's partly on purpose - I don't think there are quick and easy answers. However, I do believe that popular notions about the real estate market are rife with unjustified and oftentimes incorrect myths, mantras and exaggerations, some of which I have tried to address here and here. For now, I'll leave you with this article "What Happens When the Boom Goes Bust" from the Motley Fool, one of the rare articles about housing that I have found to be informative and well thought out:

According to the National Association of Home Builders, the average price for a new home in 1980 was $76,400. In 2005, the average was $295,100.

That's incredible! $218,700 in caaash ...
Before you get too excited thinking about investing in real estate and flipping houses, ponder this: Over a 25-year period, that $218,700 gain comes out to a 5.6% annualized return.

Think about that. If your stock investments had grown at just 5.6% annually over the past 25 years, you'd be kicking yourself. And with good reason -- during that time, the S&P 500 earned 10.3% annually -- almost double the average gains in housing....

Treat investing like you treat homeownership
During the past eight years, home prices have grown at a much faster clip, so some of you are probably accusing us of cheating. We aren't.

Instead, we're taking a long-term view -- because that's the only view that can make you super-rich.

What's a mere million
Consider that cocktail-party story about Sal from Asbury Park who made a million a few years ago flipping condos in Miami. It's a great story, and we'll go ahead and bet that bits and pieces of it are true. In fact, it might all be true.

But for every Sal from Asbury Park, there was a Jimmy from Hackensack who got in over his head and lost everything. Yeah, that happened too. That's why the subprime lending market is collapsing around HSBC (NYSE: HBC), Washington Mutual (NYSE: WM), and New Century Financial (NYSE: NEW), among others.

And even if Sal did make a million in 2003, is he set for life? Certainly not. In order to make that nest egg last, Sal can only withdraw about $40,000 per year. Our guess is that Sal wants to live better than that. So he probably kept flipping houses. Flipping and flipping until the Miami condo market came down around him. Or, if he's still holding properties, the real estate boom cycle has ended, and Sal will be lucky to eke out 5% returns over the next decade or more -- all the while servicing the debt he needed to buy those condos in the first place.

A cautionary tale
Of course, Sal's a figment of our imagination, but we invented him to make a point. One great year will not set you up for life. Even a short-lived real estate boom won't make that happen. To set yourself up for life, you need decades of good years. And the stock market is the wealth-building enterprise that has demonstrated the ability to return 10% per year for decades. In other words, buy a house for the comfort, but buy stocks for the profits.

The Problem with HGTV

We're generally fans of HGTV (the Home and Garden Television Network for those of you who do not have cable or are visiting this blog from outside the U.S.), but that isn't to say that there aren't some major problems with the network.

• It's called "Home and Garden" but where is the "Garden"? Maybe the network has some garden-related shows, but I've never seen one. Residential real estate has been booming on a national scale for the past 5+ years, so I'm not surprised that the focus is currently on "Home". Maybe when the "housing bubble" pops or deflates, we'll start to see a whole lot more gardening shows.
• Is it me or does pretty much every show on HGTV (especially House Hunters, Designed to Sell and What You Get For the Money) brim with unbridled optimism and good cheer about the housing market? If you watch HGTV, it's almost like the good times are still rolling (and will keep rolling) in the residential real estate market across the entire country. I can think of two reasons for this: (1) the housing market in the U.S. boomed for so long creating widespread popular interest in real estate, and HGTV capitalized on that interest and created shows to meet its audience. Now that the housing market has cooled significantly in many regions of the country, many of the shows on HGTV seem outdated, probably because of the time it takes to produce television shows and the lag in time from filming to broadcast and (2) it's a whole lot easier to sell advertising to the Home Depots of the world when you present a cheery disposition of the housing market, as opposed to "the sky is falling" stop-investing-in-real-estate atmosphere that has gripped many a housing market.
• All that being said, I did stumble across a show on HGTV called "Buy Me" which appears to be produced by HGTV's Canadian operations, and it's a show that I highly recommend to all of you. Normally, I wouldn't recommend that you watch a TV show as generally TV, in my opinion, can really dull the brain. However, I make an exception for "Buy Me" because it does a great job of portraying the realities AND stresses of the home selling and home buying process. Maybe it's the Canadian sense of pragmatism and earnestness, as opposed to the American unblinding optimism, that connects with me, but I think anyone who has gone through or is thinking about buying or selling a home will really relate to the individuals in the Buy Me show. First of all, the show is realistic - along with showing the champagne celebrations when deals are closed, it shows the warts of the process, including the stress and psychology of negotiations between buyer and seller. Second, unlike the U.S. HGTV shows, gasp, deals actually fall through on Buy Me, and some shows end with unhappy buyers, sellers and real estate agents. Lastly, even when deals are consummated on the show, sometimes the camera catches seller's or buyer's remorse. For all these reasons, Buy Me is a fantastic program that really strives to depict the reality of buying and selling homes, both the good and the bad.
  

Real Estate: Myths and Exaggerations II

Myth: Buying a home is a great investment.
Reality: Maybe

One of the most common reasons given for buying a home is that owning property is a great investment. The correlations don't lie - the average net worth of a homeowner in our country is much higher than the average net worth of a renter. But, is correlation equal to causation here? Should we put all of our money into real estate?

Let's compare real estate with another asset class - stocks. According the U.S. Census Bureau, in 1990, the median price of a home in the U.S. was $122,900. By 2006, the median price was $245,300, an impressive gain of $122,400 or 99.6%. Contrast that with the S&P 500, which on January of 1990 was at 329.08 and by June 1, 2006 was at 1285.71. That's a 291% gain. Or put it another way, invest that same $245, 300 in the S&P 500 in January 1990, and your investment would be worth $713,083. What if we go back further in time? Thirty-one years ago in 1976, the median price of a home in the U.S. was $44,200, the equivalent of a 455% gain by 2006. The S&P 500 was at 90.9 on January 1, 1976. That's a 1314% gain.

Some of you will say - hey, wait a minute. Most homeowners didn't pay for their homes outright - most people make a down payment and take out a mortgage. When housing prices increase, their return on investment is much higher because they're using the bank's money to fund the purchase of the home. If I put a $10,000 down payment on a $100,000 home and the price of my home appreciates to $150,000, I've made $50K just off a $10K investment. Those suckers who invested in stock had to spend $100K of his (because suckers are usually men) own money to buy the stock, and when the value of his holdings go to $150K, he's made the same $50K but had to put up $100K to get there! Perhaps, but how is this really different than buying stock on margin?

Others of you will say - hey, what about all those people who made a killing off of real estate in California, Boston, Manhattan and DC - even better than stock market index returns? More power to anyone who can figure out which markets are hot and can time the market (or maybe they're just lucky that they picked the *right* place to live), but if you've really got those Nostradamus skills, why not use those prescient powers and pick some great stocks (and let me know your picks, please). Sure, you could have doubled, tripled, quadrupled or quintupled your money in your Bay Area condo over the past ten years, but you also could have put your money in Yahoo ten years ago and 20x your investment.

Real Estate: Myths and Exaggerations

Myth: Buying real estate will save you a lot of money on your income taxes.
Reality: Maybe

The interest that you pay on your mortgage and property taxes will save you money only to the extent that the interest, property taxes and your other itemized deductions exceeds the standard deduction you are eligible to take times your marginal income tax rate.

Example: Let's assume the Bush Cheney Average Joe family has a household income of $46,326 (median U.S. household income in 2005), putting them in the 15% marginal federal income tax bracket if they file married with a joint return. The Joes have their eye on a house like this 2500 sq. ft. beauty in Dallas listed on the market for $245,300 (median U.S. home price in 2006). The Joes put down a 20% down payment, leaving them with a $196,240 30-year mortgage and a total payment of $11,708.85 in interest in the first year of their mortgage. The Joes will pay another $4943.33 in property taxes. Assuming the Joes have no other deductions to itemize, their tax savings from buying this home is 15% x (11,708.85+4943.33-10,300) or $952.83. Not too shabby at all, but not exactly a bonanza either.

Some additional notes:

• If the Joes can itemize additional deductions, their tax savings will go up even higher. Of course, additional deductions also means a greater risk of running into AMT country.
• Another way the Joes can "save" more money on taxes is if they take out a bigger mortgage, allowing them to deduct the higher interest amounts. Of course, this begs the question of whether the Joes are actually saving any money if they are plowing their money into a bigger mortgage and, thus, bigger interest payments.
  
• As the Joes' mortgage amortizes over time, the interest component of the mortgage payments will decrease. Assuming (1) property taxes increase 1% a year to go along with Dallas home appreciation, (2) no other deductions are taken and (3) the standard deduction for those filing married with a joint return increases 3.8% per year (as it did from 2006 to 2007) , the tax savings of owning decreases by about one-half after just 5 years and becomes non-existant after an additional 5 years.