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Saturday, March 17, 2007

Rent vs Purchase: Help Me Compare Costs

A few days ago, Rhonda over at RCG made a post titled The Great Rent vs. Own Debate in which she attempted to prove that even in today's totally out-of-whack housing market, purchasing a home is still a better financial decision than renting. Obviously I disagree with her assessment.

The main problem I have with Rhonda's post is the overly simplistic nature of the comparison. Chief among her oversights were the omission of maintenance cost of the purchased property, overestimation of the purchaser's tax benefits, and not adding the renter's monthly savings to their investment.

In order to properly respond to her post, I have begun to put together a spreadsheet that will compare the financial situations of renting vs. purchasing (I won't say "owning" since you don't actually own it until you've paid off the mortgage). However, before I get my Excel on in a post of its own, I want to get some feedback about what factors should go into the calculation. Here's what I've got so far:

    Renting

    Costs
  • rent
  • insurance
  • utilities
    Savings
  • cost difference
    Returns
  • investment interest
    Purchasing

    Costs
  • interest
  • insurance
  • utilities
  • taxes
  • maintenance
  • HOA Dues
    Savings
  • principal payment
  • tax deduction
    Returns
  • appreciation
My spreadsheet accounts for a yearly increase in rent, as well as increasing maintenance costs, utilities, insurance rates, and property taxes (since we don't live in California). I also have a field where the individual or family standard deduction can be entered in order to calculate the true financial benefit of the mortgage interest tax deduction.

So what am I leaving out? I'd like to make this financial comparison as complete as possible, and I'd appreciate any help you all have to offer. Thanks!

Update: Wow, thanks for all the feedback, everyone! I received more emails about this post than any post yet. It will take me a little while to update my spreadsheet to incorporate your ideas. I doubt I will be able to account for every suggestion, but I will do my best to make it as comprehensive as possible.

46 comments:

Richard said...

The most important optimistic assumption made by the RCG analysis was that the house would appreciate 7% per year. If you do that on an investment leveraged with 80% debt, there is no question you come out ahead owning. But that is a huge assumption to make.

waiting_for_a_cooldown said...

I have been following the greater Seattle market for some time waiting for the market to cool as much of the nation already has.

Here is a listing that gives me little hope of a slowdown anytime soon. The property located at 5579 152nd Pl SE Bellevue, WA 98006 was on the market for about six months last year at $1.07M before it expired.

The sellers relisted yesterday at $1.265M (yes almost $200k increase). Today the property is under contract.

There are many other examples in this zip code of properties that continue to escalate in value beyond belief.

No relief in sight for buyers hoping for a slowdown (including myself)

MisterBubble said...

I just love the way her expert advice was to borrow more money (even though it's assumed that the buyer can afford 20% down), in order to maximize "profits". Makes you wonder how we got into this mess, doesn't it?

Tim, I think you've included everything that I would. The RCG "analysis" missed the obvious things that you have already noticed (i.e. maintenance, standard deduction, opportunity cost), and their assumptions were wildly optimistic, too.

matt said...

Don't forget taxes on the savings in the "rent" equation. Sure, I'm earning 5%, but it's adding to my income and I'm paying about 30% on it.

Also, in comparing deductions you should (obviously) compare standard deduction against itemized mortgage deduction. Just because I *don't* have a mortgage doesn't mean I can't use the standard deduction!

Finally, the old formula of 1% of costs for maintenance has to be crap. After all, have maintenance costs doubled over the past five years along with the value of the house? Something to keep in mind.

Finally finally, with renting you tend to move more (I know *I* have!) so perhaps add more in moving costs.

Towelie McTowel said...

I'd include closing costs on both ends (points, excise tax, title ins, etc.) adjusted for the predicted sale from (some tax benefit as well) vs. credit check for renters.

Also, standard deduction adjusts yearly and interest benefit is reduced yearly as the loan is paid off. That is, the first year yields the biggest benefit for purchasers.

Rob Dawg said...

Initial purchase (~8%) and ultimate sales costs (~3%) of owning.

And the renter invests the 20% downpayment at 10yr treasury rates.

Remember the annual tax increases.

dan said...

A few other thoughts:

1. My property taxes do not go up year-over-year due to prop 747 madness.

2. When you sell, in addition to paying realtor's fees, the excise tax is substantial here (in lots of King County, 1.78% of the sale)

SeattleMoose said...

Maintenance is a big category that heavily favors renters (for houses anyway)
1) Yard maintenance - mowing, fertilizing, weeds, mulching, pruning, tree service, etc.
2) Applicance maintenance - furnace, fridge, washer, etc.
3) Accident maintenance - if a tree hits your house you have to pay for it (at least the insurance deductible)
4) Time maintenance - hard to put a value on the time you spend mowing your lawn, cleaning the gutters, replacing bulbs while on wiggly ladders, etc.
5) Property structural maintenance - driveways and fences breakdown over time and need repair/paint/touchup, etc.
6) House structural maintenance - roof repairs, dry rot, termites, painting, plumbing, electrial, cleaning siding/gutters, etc.

Just wanted to elaborate on maintenance because having had a 5 acre place in TX for 10 years I am very aware of what can go wrong and to include maintenance as a "one liner" like "taxes" is comparing a mosquito to an elephant.

Other than this fine point the list looks pretty good.

SeattleMoose said...

One more thing...don't forget the costs to buy (points/fees/etc.) and sell (commission/fees/etc.) a house. These are not chicken feed and need to be factored into the equation.

prusakolep said...

You should also assume the 25% tax bracket, which tops out at 128K AGI. AGI is the W-2 income for most folks, which is income AFTER all the payroll deductions. So a couple earning up to 150K could still be in the 25% tax bracket if they do their payroll deductions right, especially 401(k). I'm new to Washington, but I understand there are no state income taxes here?

Also, the renters money should be assumed to be invested in the stock market and not in treasuries, so that the risk of the investment would be comparable to real estate.

meshugy said...

Maintenance is a big category that heavily favors renters (for houses anyway)

Yes, you can really spend a lot on maintenance. However, this varies widely and is really hard to predict. If you don't want to deal with maintenance, try and buy a house that has been well kept and is completely updated.

The previous owners of my house updated updated absolutely EVERYTHING. New roof, new gas heating system, new kitchen, remodeled nearly every room, new wiring, new plumbing, etc.

As a result, in the nearly two years I've been here the only thing I've fixed is the doorbell ($12.99)

Good for me, since I hate fixing things. Rather be playing guitar...

But I've been lucky, I agree you need to keep maintenance in mind.

Regarding 7% appreciation, I don't think that's unrealistic at all. My house has appreciated 35% in two years, about 18% a year. 7% is far, far below that.

Also, it's worth mentioning that eventually you actually do pay the house off. So in 20 or so years (when I'm in my 50s) all I'll have to pay is taxes and maintenance which would be a fraction of what it would cost to rent the same house. Assuming I live a long life, I could have 20 or more years of outright ownership which is a lot of saved rent.

Roman said...

Hi Timothy,
I built such a calculator in Execel in the past and used the same logic.

The blog explains the approach and you can use the excel in any desired form. The only thing is not accurate there to my knowledge is the constant rent price over the years. The rest is configurable.

EconE said...

but how is anybody going to come up with that 20% down?

After all wasn't it the loan we couldn't afford and not the house?

Sometimes I wonder if you guys toy with their lack of mental acuity just for fun.

EconE said...

The house example was cherry picked also.

Try the same numbers using a condo from the 2200 complex. All the numbers are a given with the exception of unforseen assessments. Not to mention...it will be an apples to apples comparison as houses can be hit or miss. Whos to say that one of the chosen houses...if not both...will require a new roof etc etc etc. Use the condo example and it will be too obvious.

They will ALWAYS find a reason that renting is better than owning...ooops...other way around.

Chris said...

PMI is an important consideration for those less than 20% down. So if you decide to purchase verse rent with less than 20% down you lose out even more on the equation. PMI generally runs $50 per $100,000 in loan, per month, but is also heavily dependent on your % down (0 versus 10%, let's say), though with all of these defaults it is probably starting to increase dramatically. I think PMI is tax deductible starting this year.

In terms of taxes when I would run a similar calculation I took into account the standard deduction which is a non-trivial $5200 or so (double for married). So the first $5200 in interest/tax you write off you would've already gotten from the standard deduction and that should figure somewhat into the tax calc. Of course, there are other benefits to consider because once you have breached the standard deduction threshold, other deductions like charity may become a factor that otherwise wouldn't have been if you didn't have the huge mortgage. Another thing to consider is if you did make a big gain on the house you would owe capital gains tax (over $250/500k in gain for single/married). Also if you don't live in your house at least 2 of the last 5 years you owned it you owe cap gains on any gain. I'm not sure if you can take a cap loss if you lost money (maybe some tax prof here would know that one).

The fees and taxes on selling is important as well and other folks have mentioned this. I would assume getting 91.5% of the final sales price in actual payment (6% commission, 2.5% in taxes and fees). You could maybe get that up to 95% if you tried really really hard but that's about the top line. If you bought a $500k house now in Seattle, or anywhere for that matter, you would already be $42,500 underwater as soon as you signed for it.

Someone else mentioned this but I definitely cannot stress enough that the appreciation number is the big wild card. If housing prices go down even 1-2% annum you are totally hosed. You are also exposed to a substantial drop and if this occurred you would be beyond hosed. At 0% appreciation life sucks but can be managed, 1-2 % life could be better, at 3-4% as long as you there long enough it starts to break even at 5-6% you're probably looking at a gain eventually and things are great and 7%+ it's pretty much Xmas as you cash in on an asset that appreciates for no real reason.

TO that end I think must readers who come to this site know the 10%+ year over year days are long gone. What you're looking at now if you 'buy' is very little upside potential and massive risk exposure . Probably the best you could hope for is slow deflating for the rest of the country, Seattle truly is "different" for some reason, and 3-5% annual gains over the next 5-10 years.

That's a lot of risk for a pretty blue "best case" scenario.

meshugy said...

PMI is an important consideration for those less than 20% down.

Any mortgage broker worth their salt knows that if you split the mortgage into two you can get around paying for PMI. It's standard procedure...

Amit said...

Another thing that would be useful for the spreadsheet is the interplay between income, the mortgage interest deduction and AMT. The mortgage interest deduction only goes so far due to the AMT.

KC said...

Is it just me, or does anyone else think that both you and the poster over at RCG should know the difference between the words principle and principal? You write about real estate, she claims to be a mortgage planner!!!

Nitpicking aside, I'll be interested to see your calculations. I feel like I've done fairly well in the housing market, but I've also been very conservative in my approach. I bought a house as a home, not just as an investment; bought in an in-city neighborhood at a price point that I could live with quite comfortably (in other words, WELL below what I was approved for); and refinanced and did not take any money out based on "paper profits."

The Tim said...

KC,

Thanks for pointing that out. I had it in my head that "principal" only referred to a school administrator, and all other forms of the word were "principle." It has been corrected.

Dove said...

Not that this is true for everyone, and not that it's worth putting in a calculator, but maybe it's worth mentioning, as it's a non-negligable factor in my decision to rent vs. own.

Renting means you can pull up the stakes and move at any time, for the cost of breaking your lease (around a month's rent), the cost of a U-Haul, and the cost of a weekend's worth of elbow grease.

Why is that a good thing?

I can maintain my five minute commute, no matter what my job situation.

This has the following effects -

- Saves me car mileage/etc. I haven't calculated it out, but I'd guess I'm saving some $100 a month just in gas costs alone.

- Gives me more time.

- An unexpected consequence of the last one: since I have more time in the day, I have more flexibility to volunteer to work overtime, without really spending any more time on work than I was when I was commuting. The net result of this has been that my income's gone up--way more than enough to cover the moving costs at any rate.

I'd move with my job again in a heartbeat, something I as a renter have the freedom to do.

WTF said...

The Dove's got a point. Be tough to assign a value to that, but I agree that the ability to live near work (not having to commute) is a significant cost savings. And that renting better facilitates this situation.

Currently, I can rent for less than half of what it would cost to buy a comparable residence.

Matt said...

Tim, have you checked out www.housemath.us?

Wanderer said...

So this will *sound like a fine point, but the timing of the cash flows is very significant. An accurate comparison MUST place every single monthly cash flow into present value terms (or future value if you wish).
Example: If you appreciate a $450K house at a (completely debatable) 5% it will sell for $1.9M in 30 years. If your cost of capital is 10% for an alternative use of your money (completely debatable) then that $1.9M is only worth $111K today. You have to treat every monthly cash flow the same way. Since the timing of rent and purchase cash flows are significantly different, this has a big effect.
Tim, you may have this completely under control but I will email you a spreadsheet that shows how I think it should be structured. My monthly cash flows of rent/mortgage are much too simple for all of the reasons you list. Refining those should be easy and then the spreadsheet automatically calculates the present value of each.
Besides the assumptions for the detailed monthly cash flows, I think the following percentages need to go into the model:
Annual rent increase
Annual appreciation of the house
Mortgage APR
Personal investment discount rate

Assumptions on these 4 rates drive the outcome in the model.

**** The assumptions shift the rent/own calculations to different conclusions. That debate is completely separate from what one thinks is going to happen in the near term. You can believe in 5% appreciation over 30 years and still think that flat or negative appreciation makes it stupid to buy in the next 1-3 years.

0x029A said...

Meshugy, I think you're a victime of bad math. You said

Regarding 7% appreciation, I don't think that's unrealistic at all. My house has appreciated 35% in two years, about 18% a year.

35% appreciation over two years equals about 16.2% yearly appreciation.

The way you calculate the average yearly appreciation is by calculating the square root of 1.35, not by dividing 35 by 2!

Wanderer said...

I didn't check out other posts before I sent. I absolutely agree that using treasuries for a comparable investment is an error. If you had 450,000 cash to invest today for 30 years, assuming treasury rates would be a poor use of (all) the money... though in the near term it ain't bad. If you have that cash and only expect to make 5.15%, thn get a financial advisor. 7-10% should be the range for discussion.

Alan said...

If you are going to include the buyer tax savings then you should at least include the standard deduction savings for the renter.

You may also want do rent vs buy for married couples who get a higher deduction and single people who might get a roommate to cut costs.

Alan said...

7% is high historically. You should use a comparatively historically high stock market return rate for the renter.

The stock market only goes up, right?

Rob Dawg said...

the 7-10% expected investment return represents a survivors' bias and an unrealisticly long time horizon. The average home is owned for 7-8 years. What would your 1999 investment in the NASDQ look like today? 7-10% compounded? Instead of 10yr treasuries call it inflation plus 2.5% or anything similar.

Ownership and renting will always have intangilbles and personal preference bias. Let's ignore the people who don't mind the yard work or like to move around a lot. Keep it simple. If I could set the wayback to 1995 and back test rent versus own the answer would be to buy two houses with the absolute cheapest monthly payments rather than 1 house with normal financing. Always recall; "past performance..."

No, going forward housing asset appreciation pacing inflation seems optimistic.

Frankly I'm too stupid to do all this. Rent in California if monthly rent is more than 150x sales price; 120x most other places. How tough is that? Try it and tell me if it doesn't yield the same answer.

Wanderer said...

rob,
Survivor's bias is certainly an interesting concept, but it does not significantly change the discussion of long term historic returns. The Nasdaq boom years are a great example of unsustainable short term gains... just like the ensuing crash was an example of extraordinary declines. The generally accepted method to look at risk for a WELL-DIVERSIFIED portfolio over the long term.

I personally think we are headed for a sustained period of below average returns in the stock market... but that doesn't change the historic long term expectation. See some (poorly formatted) data here:
http://tinyurl.com/3xfdk5

As I said before, none of that matters if you are convinced that your local housing market is ridiculously overpriced. If you expect 15%+ reduction in home prices in the near term, historic portfolio returns have little to do with your decision.

Peckhammer said...

"And the renter invests the 20% downpayment at 10yr treasury rates."

Why? My portfolio returns range from 15% to 20%. A conservative long term return might be 12%. Why would anyone put anything other than beer money in treasuries?

Rob Dawg said...

Everybody who gets 15%-20% is in the wrong business, they should be investment advisers. Phone in your strategy every Tueday and collect tens of millions in annual bonuses from whomsoever GS or BS or UBS outbids the others for your services.

Wanderer said...

15-20% return in the long term requires risk and/or speculation. It turns out that money obtained through such an investment strategy spends just as well as that gained from treasuries. It can totally be done in any market... you just stand the greater chances of losing more if you are wrong.

Peckhammer said...

"Everybody who gets 15%-20% is in the wrong business, they should be investment advisers.

I have an investment adviser. And he didn't suggest buying Seattle real estate.

Vickie said...

Accepted historical averge home appreciation is 4%, Accepted Hisotrical averge for stock is 10% over and average of 10 years to 20 years. these and only these should be used when doing any comparison. RCG is stoned using 7% appreication numbers.

GetMeTheHellOutOfCA said...

I just did an interesting spreadsheet calculation that compared my current take home pay post taxes and rent (rent is $2050 / month - yes it's California) in California (where I currently live) versus buying an $840k home in Seattle. I assumed 6% mortgage rate and 1% property taxes. CA state tax tops out at close to 9% and I am in high fed tax bracket.

If I did my math right it turns out that buying the $840k seattle home would leave me $928 more take home pay per month than my current rental situation in California.

Looks like you are going to get one more California transplant driving up prices in SEattle! Now if I could just find a $840k home in Seattle that is liveable I am set.

Wanderer said...

Getme,
I don't follow. 80% financing on that 840,000 house would give you a payment of just over 4,000/mo. Add 700/mo for taxes at your stated 1% and you are at 4,700.
Even if you are bringing 400K up from Cali, your monthly payment is 2,700/mo.

Your rent (hopefully a nice place) is 2,050/mo. Add 1,125/mo for your state taxes takes you to 3,175/mo. What am I missing here?

And don't get distracted about WA state tax. You don't see it on your W-2, but we are in the top third for taxes paid in the country.

Tom said...

Tim, I just emailed you a couple of spreadsheets, along with some comments. I'm including my comments here, for the record.

My wife and I discussed the whole rent vs. buy analysis recently, and to do a proper analysis, you wouldn't just put in a single set of assumptions. Some factors are that things like assuming a single appreciation rate is misleading if you're not going to be there for a very long time. This effect ties in with what people were saying in the comments on your post - it depends on whether you'll be in the house for 5 years or 30 years. Even if houses historically appreciate at the rate of inflation, they fluctuate from year to year, and with a small data set, those fluctuations will impact the net rate significantly. Because losing 10% is not exactly the opposite of gaining 10% (0.9 * 1.1 = 0.99, not 1.0), a drop in one year may not be offset by small gains in future years. And since many people are expecting prices to drop in the next couple of years, the net appreciation over 10 years might average to zero. But if you're looking at 30 years, the net appreciation would likely be higher.

So we think the most thorough way to do the analysis would be to a Monte Carlo simulation that produces not a single answer, but instead gives an answer like "in 25% of the likely situations, owning would be better, and in 75% renting would be better, and here's what the spread looks like." You could give it a statistical spread on expected inflation rates, house appreciation rates, etc. over a defined time period. For example: within the next 5 years, every year there's a 10% chance of going up 2%, a 30% chance of going up 1%, a 30% chance of being flat, and a 30% chance of going down 2% (in reality, you'd have more, better-defined intervals). Then the simulation would generate outcomes based on a random picking through those probabilities for each year, and re-doing the random simulation a bunch of times to build up a model of what is likely to happen.

Such a model may be overkill for most people, but could help give a better idea of what options and likelihoods are. As I've played with our spreadsheet and looked at housemath.us, it's obvious that small changes in your assumptions about inflation rates etc. have a huge impact on the results.

Good luck!

Wasichu said...

Here are some links I've collected over time in reference to the Buy vs. Rent topic. Perhaps they contain additional considerations for your spreadsheet.

http://www.mortgagefaq.com/tools/calculators/rvb_cl.asp

http://biz.yahoo.com/pfg/e10buyrent/

http://echang.freeshell.net/buyrent.html

http://echang.freeshell.net/buyrent2.html

Jazon123 said...

All, check out this blog/article. If you are in it, get out and stop hoping to turn the tide of a huge domino effect already underway. We are sick of the BS. We are not stupid.
http://money.cnn.com/blogs/generationrisk/2007/03/real-estate-can-only-fall-10-to-20.html

GetMeTheHellOutOfCA said...

Wanderer you may not be missing anything I may have made spreadsheet error.

The difference is I pay 43% of my income in taxes between feds and CA then I deduct the $2050 rent and pay with post tax dollars. In WA, the mortgage is $4030 monthly of which $3360 is interest and is deductible, then you add in $700 property tax which is also deductible. So in WA ,y tax rate is 33% so approximately $1551 monthly tax savings so payment is effectively $4700 - $1551= $3149. Now since I was looking at take home pay, my net take home pay in WA will be approx 9% higher than CA. The 9% is what makes the take home bigger in WA even owning hellishly expensive home. This really is not an Apples to Apples comparison as I wanted to see how better / worse off I would be moving from CA to WA

GetMeTheHellOutOfCA said...

I refined my analysis looking at owning a home in WA versus renting in California. Assumptions were $2050 month CA rent, 42% tax bracket - 33% federal tax. 6% mortgage.

The breakeven house price at which my take home pay is the same owning and living in WA versus renting in CA is $787,000. Any home value below this, my take home is greater buying and living in WA versus renting in CA. I only looked at monthly take home. I made no assumptions about down payment opportunity cost or return on my housing investment.

and you guys think Seattle living is expensive!

Alan said...

getmethehelloutofca,

You should do the same analysis for Texas and see what $800k will buy you there.

melonleftcoast said...

Hi! I have a suggestion for the maintenance section:

As a former owner of a 100 yr old home, one thing my husband and I did not properly account for was the TIME required to do house projects. The time it took to figure out how to do things, get supplies and then the time it took to do the project. Also, for the projects we hired out, it took A LOT of time to research contractors, get bids, and make sure contractors were doing what they were suppose to do.

I imagine one could quantify this by figuring out one's hourly rate at one's job, and then keep track of all the hours one spent doing house projects.

Does that sound reasonable?

Lukasz said...

Tim,

I would also present the results of the comparison in terms of absolute and relative difference. It is quite different to see that renting gives (in example) 95% of returns of buying than to see that renting gives (in example) $100k less than buying.

Thanks,

Lukasz

Ben said...

As a total layman to real estate who's in a long evaluation of the Rent vs. Purchase measurement I'd like to thank you for the post and everyone for all the comments. I've been given a lot of conflicting advice to my quandary.

One thing I don't see often taken into account when the local market is discussed is our unique geography, expected growth patterns, and closer relationship to Californian scenarios than national scenarios. We are hemmed by geographic obstacles which should perpetually drive prices with demand unless everyone flees the area. I don't see evidence of exodus just yet.

The calculators are interesting, but I find myself wondering how our limited amount of physical space to develop properties drives the long term outlook? I'm thinking of San Francisco or Hawaii as I write this. They were both, once upon a time, affordable places that are now out of reach except for the top earners. As people talk about cooling in Seattle what does that likely mean in prices here over ten years, even if there are national institutional corrections?

To buy what we currently rent is out of the question as it would cost us monthly nearly 300% what we now pay (we have a sweet deal and earn less than average), so it is hard to find a motivation to overextend ourselves now with the black cloud rhetoric on the issue. Any suggestions?

scott said...

You might wantto check out this real estate calculator:

http://www.realorganized.com/realtyjuggler/calculator_info.html

It is amazingly thorough and includes every aspect of the comparison that you might want to include.

The cost is $9