Rent vs buy datapoint of the day

By Felix Salmon
July 20, 2011
wonderful paper, Eli Beracha and Ken Johnson went back and actually did the math on whether it would have been better to rent or buy over the past 30 years.

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It’s never possible to know for sure, at any given time, whether it’s a better idea to rent or to buy. If rents and prices both go up in the future, then buying’s likely to have been a good idea. And if they both go down, then renting is sure to have been the better idea.

But never mind the future — what about the past? In a wonderful paper, Eli Beracha and Ken Johnson went back and actually did the math on whether it would have been better to rent or buy over the past 30 years. And the answer is clear: it would have been better to rent.

This very strong result is expressed in this particularly ugly chart:

rentbuy.tiff

This needs a little bit of explanation. Basically, you consider two people, one of whom rents and the other of whom buys. If it costs more to buy than to rent, the renter takes the difference and invests it in the market — a mixture of stocks and bonds which has the same amount of risk as home equity. After eight years, the buyer sells. Then you see who’s worth more money.

The lines on the chart above are what you get when you take the amount of money that the renter has and subtract the amount of money that the buyer has. When the number is positive, the renter wins, when the number falls below zero, you would have been better off buying.

The chart looks at rolling eight-year periods, starting with people who bought in 1978 and ending with people who bought in 2001; while there are significant regional variations in the northeast, which had a nasty property slump in the 1990s, the big picture is that there are a hell of a lot more datapoints above zero than below it. And The only negative datapoints are the ones which involved selling during the bubble. Here’s how the paper describes the chart in English:

When the U.S. as a whole is considered, renting was preferred to buying 75% of the time. On average, the annual required appreciation return was 2.04% higher than the actual appreciation. In retrospect, the period spanning the mid 1990s to the early 2000s was the only time frame in which buying was preferred to renting. This narrow time period is associated with homeowners that purchased a home just before the recent boom and sold it shortly before its sequential bust. However, because most homeowners never transfer back to be renters, it seems unlikely that most homeowners, who benefitted from home appreciation during the boom period, avoided the subsequent housing collapse.

The authors go to great pains to make this as accurate a comparison as possible. Specifically, they do a lot of things which weight the scales toward owning rather than renting:

  • They assume a standard 30-year mortgage with 20% down and no nasty tricks.
  • They give the owner the option to refinance every year.
  • They give the owner the benefit of the mortgage-interest tax deduction.
  • They don’t allow homeowners to lose money on an underwater mortgage: the authors assume that you’re buying in a non-recourse state, and that the rational homeowner will strategically default rather than lose money on a sale if that’s the most lucrative option.

Even so, renting still comes out ahead. The people at e21 explain why:

Unless someone possesses the cash necessary to buy a residence, he or she will be renting one way or another. The choice is between renting the property directly or instead renting the capital necessary to buy the property…

The principal component of each mortgage payment – i.e. the portion of the mortgage payment that goes towards reducing the principal mortgage balance instead of interest – is an added expense renters don’t have. During the housing boom, the wealth created from housing was not principal amortization, but rather large price gains on a highly leveraged asset. A 20% increase in the price of a house purchased with 5% down results in a doubling of the homeowner’s equity. These wealth gains proved illusory and were a function of the leverage involved (20-to-1 in the case of a 5% down payment) rather than anything related to housing.

There is an important proviso to add to all this. Back to the paper:

Individuals, on average, were better off in economic terms to have rented for most of the years in the study period. This first result is strongly dependent upon fiscally disciplined individuals that, without fail, reinvest any residual savings from renting…

While this first finding might seem to fly in the face of the homeownership paradigm (specifically wealth creation), it is reasonable to find that most individuals still preferred homeownership during the sample period because ownership is in essence a self-imposed savings vehicle… while renting may have been wise, any extra savings from renting might be spent on non-wealth enhancing goods resulting in any benefits from renting versus owning disappearing in a cloud of consumption spending rather than savings.

To put it another way, a mortgage is a commitment device. You’re forced to spend all that money on your mortgage each month; if on the other hand you rent, you’re very likely to simply spend the excess, rather than save it. The e21 people reckon that only “myopic households” would not otherwise save the difference, but that’s just not realistic. People stretch to make their mortgage payments, and without the mortgage there there’s no need to stretch so hard, and you can enjoy your life more instead — go out, go on holidays, buy nicer clothes or extra iPads.

But the exercise in the paper is well worth running all the same. People get real value out of consumption, and so when you buy rather than rent you’re essentially denying yourself all that extra fun and pleasure. And if you both rent and deny yourself the extra fun and pleasure, then you’ll end up with more money than the buyer.

One other proviso: if you’re a super-long-term buyer who has no intention of ever selling your home, then this analysis starts to break down. The paper assumes you sell after 8 years; if you don’t sell, then you save a bunch of transaction costs for starters. And if you hold on to your house for more than 30 years, you get to live in it rent-free, which is wonderful. (Although if you do that then you lose out on the full refinancing opportunities built in to the model — they assume that you always refinance with a new 30-year mortgage.)

Finally, the authors note that we’re in a historically unusual point right now, with very low mortgage rates and historically reasonably low price-to-rent ratios. Which means that now might be one of those rare times when it actually makes sense to buy rather than rent. But these things are very contingent on local prices and rents. As a general rule, the more of a premium you pay to buy rather than rent, the better off you’re likely to be just renting.

Indeed, that seems to be what we’re seeing in the latest housing statistics: the rise in housing starts was concentrated in multiple-family homes, which are generally rental units, and a huge proportion of existing home sales were cash purchases, which also indicates that they might end up on the rental market. It’s hard for a professional landlord to take a single-family suburban home and turn it into a rental, but I am seeing hints that the US is moving back to renting rather than owning. Which is a great thing over the long term, especially for labor mobility. But it’s certainly bad for single-family house prices in the short term.

(via Salam)

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Comments
23 comments so far

To simplify, suppose one either bought for cash or rented and invested the available cash. The renter would have to withdraw her monthly rental cost from the investment. The buyer would simply live in the house.

Even if property values are flat, it would seem that unless the investment appreciated so fast that one could pay one’s rent on the monthly profits, then buying will win.

So it would seem that that’s the comparison. Was the rate of increase in equities large enough both to compensate for the monthly rental cost as well as to keep up with whatever property value increase the buyer enjoyed?

Posted by RussAbbott | Report as abusive

An interesting study…

Worth noting:
*You chose the “risk equal” graph to highlight, not the “risk free” graph. I’m not at all clear why you believe homeownership is risky for somebody who is adequately capitalized. If you intend to actually live in the property, not sell it for some imagined capital gain, then you know EXACTLY what it will produce: a steady supply of housing. That’s a heck of a lot less risky than US Treasury obligations.

* Assumed transaction costs of 8% (2% closing costs, 6% selling costs). For a short ownership period such as 8 years, this is a substantial negative bias.

* Their refinancing calculation is likely a money-waster. The rule of thumb that we’ve used is that a refinance should pay for itself in *one* year. If it takes 25 years for the refinance to pay for itself, then you’ve stepped down your interest rate without achieving any real benefit.

* Taxes, maintenance, and insurance at 3.5% annually is high, at least for our neighborhood.

* As always, this is necessarily an apples-vs-oranges comparison. There simply aren’t properties available for rental like the one we own (certainly not maintained to the same standard). I’m guessing that our house is being compared to a similarly sized rat-trap, outfitted with the cheapest line of cabinets and hardware from Building 19.

That said, I’ll note that we bought in one of the more expensive markets in the Northeast, in 2000. The chart affirms what was already obvious to anybody with personal experience in this market — buying has been better than renting for anybody purchasing here in the last fifteen years.

What I don’t understand is why you believe this wasn’t obvious up front, at the time we bought. Selling out of the tech bubble to buy a risk-free supply of housing that REDUCES our cash flow expense? C’mon, that’s a no-brainer!!!

Posted by TFF | Report as abusive

“So it would seem that that’s the comparison. Was the rate of increase in equities large enough both to compensate for the monthly rental cost as well as to keep up with whatever property value increase the buyer enjoyed?”

Yes, exactly! And the two decades for which renting beat owning capture the longest bull run in the history of the stock market.

Note, however, that even a cash buyer will still need to pay for taxes, insurance, and maintenance.

Posted by TFF | Report as abusive

Well there you go…all the more reason to tax capital gains at ordinary income rates. ;)

Posted by GRRR | Report as abusive

Now is a historically unusual point; so was 1980. Stocks and bonds did poorly from 1966 to 1982, and mortgage rates were rising with inflation through the seventies; I don’t know what house prices did in the seventies, but since “inflation hedge” is one of the advantages I hear to homebuying, I’m guess they went up a bit faster than inflation. This is all to say that I’d kind of like to see this chart extended back another ten years if the data are available.

The efficient markets hypothesis is a ridiculous idea in any strong sense, but is still my default working hypothesis when looking at things like large asset classes, and I don’t buy that housing in general is always or almost always a substantially worse as an investment than stocks, bonds, or the like, any more than I believe the claims that it’s always or almost always the best place to invest. I’m going to need fairly convincing evidence, with a few of the concerns raised by other commenters addressed, before I’m going to believe that it’s persistently out of line with other asset classes.

Posted by dWj | Report as abusive

In America, of course, many people buy houses so they can get their kids into better school districts. Essentially, this is an investment in the future earnings power of their children.
To capture that, you would have to compare the quality of school districts in areas with lots of rentals with the quality of schools where most people are homeowners.
You could also run the same exercise comparing crime rates where rental housing is common vs. where homeownership is common.
Your point seems to be that buying a home is a fundamentally irrational decision (unless one does it for forced savings). I think there are a lot more variables involved.

Posted by RZ0 | Report as abusive

There are benefits to home ownership over renting that are not captured by this economic analysis. Those include greater control over the premises, and increased ability to maintain a stable residence and avoid moving against one’s will. Also, bearing on a point TFF makes, the housing stocks available for rent and those available for purchase are far from identical. To assume that all or most buyers actually have an option to rent a property that meets their needs is not grounded in reality.

Posted by kenjd | Report as abusive

I rented apartments for a couple of years and then rented part of a house for a very short time. The inability to make it my own was a pretty good incentive to buy and I have had some pretty terrific homes that i would never have found to rent…

Besides TFFs usual excellent answer… here is my short list for what I want and need to make it my home and why I hated renting:

You can’t paint or change a rental without permission. Even when I got permission she made me change the kitchen.

You can’t build a playground in the backyard without permission. (Why would you anyway, as you have to leave it when you leave.)

You can’t plant a tree, dig a flowerbed or make a garden without permission.

Wiring the house for specialty items is virtually impossible due to rental/fire codes.

You can’t renovate … you need permission and it has to meet rental code… and you are lining the landlords pockets even if it is possible.

The landlord is responsible for the repairs which means they will delay it unless it is an emergency. They will do the very least and not care an iota if you have a problem as long as it isn’t their problem. Timeliness is for you paying the rent…

In this slump it is a lot more difficult to buy, but I would never have a 30 year mortgage and pay for a house 2 and a half times over! Amortization of 15 years max for me.

The reasons I would say to wait to buy would be that houses are not yet bottomed out and the AG’s are making a mistake being on the side of the banks. That is a huge setback for stability on the market and gives permission to continue to ripoff homeowners in the future… and to let banks bypass the law.

Property laws should be sacred and no one seems to care unless they are being foreclosed upon. BIG red light there … Also the mortgage interest credits will soon dry up and the interest rates will be creeping up soon. Renting may be safer during such a risky time and the chart might even be correct for some areas, but there really is no comparison to owning a home no matter how many charts you find saying otherwise.

Posted by hsvkitty | Report as abusive

“A 20% increase in the price of a house purchased with 5% down results in a doubling of the homeowner’s equity.” hmm, should be quintupling of the equity, no?

Posted by tiger4 | Report as abusive

Felix this was your best ever post on residential housing.

Put me down as a house lover even though I’m underwater after putting 20% down and making 6 years worth of payments.

As other posters have all noted, I don’t need anyone’s permission to put in hardwood floors. I can sleep at night even though I send my kids to public schools because we bought in a great district. And 10 years from now, god willing, we’ll still be here!

Posted by y2kurtus | Report as abusive

Felix,
Aren’t you the one encouraging young people to invest with leverage since it would maximise their lifetime returns etc…?
A house is by far and away the easiest way to do it.
IIRC house prices don’t appreciate anywhere near the 7% LT avg of stocks so without the leverage no one should be investing there.
But they DO offer leverage, so they should – according to… you.

Posted by TinyTim1 | Report as abusive

TFF and hsvkitty pretty much said it all. Felix, you’re still looking at renting versus buying as entirely an economic decision, and not a quality of life one. I do believe your bias comes from living in the one area of the country where there is fundamentally no difference between rental and purchase units. If you buy in Manhattan, you are almost certainly buying what the rest of the country would consider an apartment.

Posted by Curmudgeon | Report as abusive

““A 20% increase in the price of a house purchased with 5% down results in a doubling of the homeowner’s equity.” hmm, should be quintupling of the equity, no?”

Not after transaction costs… (They build in 2% and 6% respectively when buying and selling.)

Posted by TFF | Report as abusive

e21 “assume a standard 30-year mortgage with 20% down”. But no normal investor can borrow to invest in the stock market remotely on these terms, still less with a non-recourse loan. So if you believe in the economy or in inflation, a large property purchase and large mortgage give you something that rental plus stocks just cannot provide.

As I read it, this factor is not included in the e21 analysis or in yours. Have I missed something?

Posted by RogerS | Report as abusive

“As I read it, this factor is not included in the e21 analysis or in yours. Have I missed something?”

I believe it is included implicitly in the calculations. When you buy, a certain amount of capital is tied up in the home, even if the rest is leveraged. That is accounted for. When you rent, all of the capital comes from somebody else.

Leverage isn’t necessarily a good thing, either. It increases financial risk. Nor does it make any sense to be paying 4.5% interest on a mortgage at the same time you are collecting 3.0% interest on bonds. The rent/buy calculations I’ve seen do not properly account for the option value of paying down the mortgage early.

Posted by TFF | Report as abusive

I am not surprised at this result for the US as a whole or even for large areas. Where it really breaks down would be in metropolitan locales where rents increase with incomes making buying a no brainer when your income starts rising less than average, at least if you want to stay there.

Posted by MyLord | Report as abusive

I am not surprised at this result for the US as a whole or even for large areas. Where it really breaks down would be in metropolitan locales where rents increase with incomes making buying a no brainer when your income starts rising less than average, at least if you want to stay there.

Posted by MyLord | Report as abusive

All I can say is, most people are are neither canny nor stoic enough to leverage their savings and “come out ahead” by renting and taking the difference and investing in the stock market. Heck, they aren’t even canny enough to see that delta as savings to be invested rather than money to be spent on current goods and services. So once again, human nature punctures that abstract balloon blown up by economists.

You might also posit that “diversification” and hedging one’s bets would suggest buying a smaller house and then using the delta between what you bought and what, in theory, you could afford, to invest in the stock market as well. The truth is, you don’t have to go all in in either market.

Posted by rb6 | Report as abusive

I’ve rented m entire life and have invested the difference I would have paid in various things over the ears, from stocks and bonds to small businesses and collectibles. I presently rent a 2K sq ft home in one of the nicest areas of town for $2650 a month, and my rent has not gone up in the last three years. Meanwhile, the owner, who bought with a min down loan in 2007, has an annual property tax bill of just over 23K a year. You figure it out.

The ideas of owning real estate and land speculation in general is bred into our culture, and I think that makes it very hard for some people to be objective about the benefits of ownership.

Posted by Fifty-five | Report as abusive

“You can’t paint or change a rental without permission. Even when I got permission she made me change the kitchen.”

If you go to sell a place, you’re more than likely going to have to paint the walls to something neutral in order to make it more palatable to as broad a faction of the market as possible, so I’m not convinced there’s much difference.

“You can’t build a playground in the backyard without permission. (Why would you anyway, as you have to leave it when you leave.)”

Public Parks? I’ve rented places with public parks nearby. Less of a liability that way, too.

“You can’t plant a tree, dig a flowerbed or make a garden without permission.”

Asking permission isn’t so bad. Besides, some HOAs make these same things impossible.

“Wiring the house for specialty items is virtually impossible due to rental/fire codes.

You can’t renovate … you need permission and it has to meet rental code… and you are lining the landlords pockets even if it is possible.”

This might be one sticking point, but this alone shouldn’t be enough to make someone over-leverage themselves on a financial millstone like a house.

“The landlord is responsible for the repairs which means they will delay it unless it is an emergency.”

I pay for the repairs and deduct the total from my rent.

“They will do the very least and not care an iota if you have a problem as long as it isn’t their problem.”

This sounds like a slumlord; not like any experience I’ve had in thirty years as a renter.

“In this slump it is a lot more difficult to buy, but I would never have a 30 year mortgage and pay for a house 2 and a half times over! Amortization of 15 years max for me.”

It shouldn’t be more difficult to buy if you qualify and have the money. If I bought, and I doubt if I ever will, I would pay it off in five ~ seven years, max.

Posted by Fifty-five | Report as abusive

The problem is that the years in the range (79 – 2009) contain quite a few boom years for housing. The 80′s and 90′s were fairly consistent boom years, and 2000 to 2006 was very strong. During the boom years there was a strong buyers market and therefore less renters, less demand, and weaker prices. There were also many investors who bought with the intention of selling in 2 or 3 years for big capital gains…. they were less interested in cash flow, and would take a few years of losses to get the 30% or 40% investment gain. That isn’t the case today. Many renters will be trapped because of bad credit, insufficient down payments, etc. Investors will focus on cash flow, and there you have it. High rents for the forseeable future.

Posted by jc3 | Report as abusive

Home buying has two different aspects. The psychological (feel good)and the Financial aspect (monitory profit).
The first can’t be measured in Dollar value.
The latter is a gamble, which in most calculations have ended up short compared to renting. This is specifically true when home prices are higher as in the current market.
The methodology and data interpretation used in this study appears to be excellent.

Posted by commansense | Report as abusive

It amazes me how many people miss the flaw in this study. In one sentence the entire study is proven faulty. It is “The paper assumes you sell after 8 years;” Of course renting would be better than buying if you sell every 8 years due to amortization, selling fees, and financing fees on the new home. This study “assumes” that renters are smart enough to invest every penny saved vs buying, but the buyers are so dumb that they don’t understand the simple principal of amortization over the life of the loan. If you buy a home, never refinance, and live in it for 30 years, you will FAR outperform a person renting and investing the difference.

Posted by NateSt | Report as abusive
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