Tuesday, October 1, 2013

Rent versus buy


Is now the time to buy this house?


One of the possible outcomes of the housing market debacle is that young people who once assumed that owning a home was a smart idea may now have come to a different conclusion. After seeing the precipitous decline in housing values brought about by the stupidity of banks and failed government oversight, many Millennials (those who have come of age in recent years) have concluded that a house is not a good long-term investment.  In fact, USA Today recently reported that from 2006 to 2011 the number of 25- to 34-year-old renters grew by more than one million while the number who owned homes fell by almost 1.4 million. If this and succeeding generations perpetuate this trend there will be inevitable consequences for the housing market. At a minimum, if many potential homebuyers opt out of the market, home values will not increase as rapidly as would otherwise have been the case and a higher proportion of total housing units will be rentals than has been true historically.

Renting can, in fact, be more cost effective (at least in the short run) than owning a home.  The situation is different, however, for each geographic market since the relationship between rental and ownership costs depends on the state of the local housing market.  Even well before the housing downturn, it was more cost effective to rent a home than to purchase a home in most major American cities. With the recovery of the housing sector, however, this situation seems to be reversing. But renting is still the more cost-effective option in many U.S. locales.

The real estate analysts at S&P/Case-Shiller report that for the top ten American cities, home ownership lost its position as the better value around the year 2000 and only recovered last year (see chart). According to many real estate experts most U.S. urban markets have now tilted in favor of buying versus renting.


As we discussed last month, many Madison Parkers are renters.  So for those who are renting with the intention of possibly buying a house or condo in the future, here’s a framework for thinking about the 'rent versus buy' decision.

First, start with your assumptions about how fast home values will increase versus how fast rent payments may go up. If the housing market is hot and values are anticipated to move up rapidly, home ownership will obviously be a more attractive option than if the situation is reversed.  Building equity is one of the historic advantages of home ownership, but that only happens in an up market.

The New York Times and several other websites offer online calculators that help make sense of the rent/buy conundrum. Using the NYT calculator in an example where rents are assumed to increase at only 3% per year but home prices are expected to increase by 5% annually, buying is the better option after only two years.


In another example, where rents increase at 2% and home values decrease by only 1%, renting is the better option for the first five years. If you want to live in the home for longer than that, perhaps purchasing it (or an equivalent property) is the better option. These examples both assume a $300,000 home price and a $2,500 monthly rent. The same process, however, holds for any comparison of purchase cost versus rental cost in a particular market.

When looking at costs, home ownership expenses are more difficult to calculate than rental expenses since there are more variables to ownership. Rent/buy calculators require inputs for initial purchase costs (such as down payment and closing costs), property taxes and insurance, utilities, and maintenance. So each of these factors must be correctly estimated for the ultimate output to be valid. It’s something that requires a bit of investigation and thought.  But the effort, at least for those who plan to live their new home for a long time, could well be worth the effort.

Right now in Seattle rental costs are rising at an annual rate of 6%, according to research firm Apartment Insights Washington.  But rents were up a full 3% in the most recent quarter (annualized), so there is definitely an acceleration of rental costs underway in the local market. While the large number of rental units coming on line in the next quarter and in 2014 might offset this trend, the rent option will almost certainly continue to be relatively expensive.

Real estate website Trulia reports that in Seattle it is now 31% cheaper to buy than to rent. The principal reason for the ownership advantage, says Trulia, continues to be historically low mortgage rates and house prices that remain well below their 2007 peak. In making its analysis Trulia assumes that a new homeowner will live in the dwelling for at least seven years and will itemize their mortgage cost to take advantage of tax savings.  SeattleBubble.com, which disputes the Trulia analysis of the Seattle market, reports that the average cost of home ownership here is $1,509 per month using Trulia’s methodology.  So in theory, for a home or condo in the Seattle area valued at $300,000, for example, any rent greater than $1,509 would cost the renter more than what ownership of the property would cost.

Seattle rents are up almost 50% since 2000, but house prices are up almost 60%

But it’s not all about relative costs. SeattleBubble.com last year provided some food for thought for those considering buying: renting has its advantages.  For one thing you don’t have to fix leaky plumbing or buy a new roof.  If you rent you are not tied down and can easily take a job in another town without concern.  Also if you rent, you don’t have to absorb the risk of declines in property values or suffer long term with such unpleasant circumstances as bad neighbors.  And for certain neighborhoods, renting will always be cheaper than owning.

That’s probably not the case for Madison Park, however, given our history of steady (though recently interrupted) price appreciation. Using the NYT calculator for a median-value Madison Park home, one worth about $800,000 and renting for $3,400 per month, the result shows that only if home prices increase by less than 3% annually is renting a better value than buying (assuming a similar level of annual rent increases).  At only a 2% annual growth rate in home values it would take 14 years to break even on a purchase.  But if the annual appreciation rate is assumed to be 4%, buying the home is a better value after only five years.  And at 6% annual home-price growth, buying makes sense for anyone planning to own the home for a minimum of only three years.

Just to put this all into context, real estate website Zillow recently reported that Madison Park home values are expected to rise 10.1% in the next year, compared to an 8.4% rise for Seattle as a whole. Good news, if proven true, for those who plan to buy soon.

[Photo above shows 2041 McGilvra Boulevard, currently for sale. Lowest chart by SeattleBubble.com]

2 comments:

  1. There are some presumptions here: reported rents usually apply to people moving at this time; it doesn't factor in actual rents, especially of tenants who have been in place for a few years. Additionally, markets do not exist on their own - for some, moving beyond Seattle might be a valid and good decision.

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  2. Housing stock needs change every 5-10 years. If you are investing in a house "for now" that will not suit your needs in the next phase of life you'd better hope these appreciation rates continue to ring true. The 8-10% selling cost to get out of one property and into the next can hold homeowners hostage.

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