Here Is How To Decide Whether To Buy Or Rent A Home

Getting major financial decisions right makes up for a lot of little misfires. And one of the biggest decisions people face is deciding when to buy a home.

To make the right call, it’s important to avoid common misconceptions that surface when people try to compare the benefits of owning a property versus renting.

Is a Residence An Asset or Liability?

Many folks consider their home an ‘asset’ on their personal balance sheet, but that’s not automatically true. Here is a simple litmus test:

  • Assets put money into your pocket.
  • Liabilities take money out of your pocket.

It’s all about cash flow.

Your residence is a liability, because it costs money to live there.

An investment property that generates positive cash flow is an asset.

If the property is vacant and cash flow turns negative, it becomes a liability.

Real Estate Returns

Over the long run, real estate has generated mediocre returns.

Yale economist, Robert Shiller, found that from 1915 to 2015, U.S. home prices appreciated 0.6 percent per year net of inflation. By comparison, U.S. equities have delivered a 6.5% annualized real return.

Credit Suisse completed a separate study in 2018, comparing real estate returns across 11 countries since 1900. The average annualized return was 1.3%.

“House prices did not grow at a steady rate… over the first half of the 20th century, average house prices did not move at all in real terms,” according to the Credit Suisse report.

“Prices started to rise in the 1950s, with an even stronger showing in the 1960s. However, the highest period of growth was from the mid 1990s until the eve of the Global Financial Crisis, when real house prices rose by 6.2% per year.”

What caused home prices to rise faster?

Falling interest rates have been a major tailwind for property prices.

Government legislation also played a role. In 1930, the home ownership rate in the U.S. was 47%. Back then, most mortgage loans were balloons, the rates were variable, and down payment requirements were high.

The FHA and GI Bill resulted in subsidized mortgages. This helped the home ownership rate climb to 55% in 1950. And by 1970, it reached 63%.

A couple points worth noting:

  • Recency bias has inflated perceptions of what constitutes “normal” real estate appreciation.
  • Since interest rates are now at 100-year lows, this historical tailwind may no longer apply, which could hinder future appreciation potential.

It’s also easy to overlook the role leverage plays. The average retiree would never lever their stock portfolio five times. But if they have a mortgage on a home, that’s a levered investment. This means higher returns if a property appreciates, and higher risk if it doesn’t.

Benefits of Owning a Home

There are a variety of benefits associated with owning a home. Most obvious is the opportunity for price appreciation.

There are also tax deductions for mortgage interest, although this aspect is less appealing than it used to be. President Trump instituted changes that limit the amount of tax deductions available.

Another benefit is how a mortgage acts as an invisible, forced savings account. Amortizing mortgages were the primary form of wealth accumulation for America’s middle class over the past century. By steadily reducing principal, people built equity.

Of course, monetary factors aren’t the only consideration. For many, owning a home also has experiential perks. These include a feeling of stability, and the freedom to make property improvements.

Hidden Costs

If someone sells a house for $500,000 and originally paid $400,000, it may seem like a 25% return. But under the surface, there are costs taking a bite out of that return.

For instance, there are transaction costs. To overcome the typical 5% broker fee and moving costs, every prospective buyer should carefully consider their time horizon. As a general rule, you should only consider buying a property if you will be content living there for at least five years. That will give you time for appreciation to help offset the upfront costs.

Other hidden costs include:

  • Property taxes
  • Maintenance costs
  • Opportunity cost of not being able to invest a down payment

Once you’ve properly accounted for all the costs, you can more accurately compare the monthly cost of owning to renting. And when you run that analysis, you’ll find it varies a lot by region.

According to research from CJ Patrick Co., based on data from First American Data Tree, the nation’s top 50 metropolitan areas are about evenly split on the rent versus own calculation. Their study looked at median rent prices, median home sale prices, and taxes and insurance.

They found cities in the Midwest and South generally favored buying. For example, Memphis, Tennessee had a monthly rent cost of $914, which was almost double the cost of owning.

In California, where property prices are much higher, it is generally cheaper to rent than own.

Bottom-line: When it comes to real estate, each region has its own set of supply and demand variables.

Ultimately, buying a home isn’t something to fear. Nor is it something you should feel required to do. It’s a big step you should make when you’re ready—financially and based on your station in life.

Leave a reply

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <s> <strike> <strong>