Rent vs. Buy Part 2 - The Rent vs. Buy Calculator

Last time we covered some of the misconceptions about renting and/or buying. Today I want to cover both the qualitative and quantitative benefits and drawbacks of renting vs. buying.

QUALITATIVE ADVANTAGES OF RENTING

Let's start with the qualitative advantages of renting or buying, starting with renting.

Renting has a number of advantages that many people often forget about:

1. Lower upfront costs
All you typically need to move into an apartment are 2 months rent and a security deposit. No closing costs, points, inspection fees, etc.

2. Lower switching costs
When you want to move, you give notice, hire movers (or bribe your friends and family) and move out. No Realtors to hire, no 6% commission to pay.

3. Flexibility
Choose a month to month lease which typically requires only 30 days to move out, or sign up for a year lease to protect your payment and provide security

4. Save time (or money)
Let your landlord fix that leaky toilet, mow the lawn, paint the house and clean the gutters. Spend your Sundays at the beach, not working on the house. Sure you can pay someone to do this work, but can you afford to?

5. Live in a nicer neighborhood
If you can't afford a house in a "better" neighborhood, or one with good schools, chances are you can afford to rent there

6. Free up your money for other uses, such as for investments, starting a business, paying for school, daycare, whatever else.

Don't forget that renting doesn't have to mean a small apartment in a big complex. You can rent an apartment, house, houseboat, in-law unit, duplex, whatever you can find.

QUALITATIVE ADVANTAGES OF OWNING

Now on to owning. The overwhelming opinion in the USA and many other places is that owning is better than renting, which is evident by the belief that "renting is throwing your money away." Owning has a number of benefits as well.

1. You can do anything you want to the house, without needing landlord or property management approval. Put that couch on the porch? Sure! Car doesn't run? Push it in the backyard! Want a purple house? Paint it! Want to knock out a wall and expand the living room? Bring on the sledgehammer!

2. Lock in your monthly payment, hedging against inflation.

3. Security. You don't have to worry about a landlord evicting you on a whim.

4. Pride of ownership. You're more likely to take good care of something you own, vs. something you rent.

5. Over the long term the costs for owning are typically lower than renting. And once you've paid off the mortgage all you have to worry about are taxes, insurance and maintenance.

6. You can borrow against your equity to start a business, pay for school, cover an emergency, and the loan payments are tax deductible.

6. The government will give you a tax break for your interest payments.

So that covers the qualitative advantages of both renting and owning. Obviously some of these are weighted more highly than others, and each person will have a different ranking of importance. But at the end of the day it's the supposed financial advantages of owning that convinces most people to plunk down their hard earned (or borrowed) cash for a house. So let's look at the qualitative advantages to both renting and owning.

QUANTITATIVE ANALYSIS - RENT VS BUY CALCULATOR


First off, here are a few guidelines that I believe when it comes to creating forecasts like this.

1. Your forecast is only as good as your assumptions. And this tool has a bunch.
2. Always triangulate your forecasts i.e. look at it from 2 or 3 different angles to confirm your assumptions and results
3. Does it pass the gut check? Does your gut say that the results is close, or way off?
4. Don't tweak the assumptions to get the outcome you want - that's my job!

OVER THE NEXT 5 YEARS, IS IT BETTER TO RENT OR TO BUY IN PORTLAND?

For my calculations I used the house we are renting, since I had both the sales price and real world rental rates. Knowing what a house will rent for is one of the major assumptions that can skew your results badly. The house we're renting sold for $350k just before we moved in, and we pay $1400 a month in rent.

I also assumed that the money you would have used for a down payment could be invested at a 6% rate of return.

The basic methodology behind my calculations is to take the equity or value you would have at the end of the forecast period (5 years) and subtract all the relevant expenses over the five years (this can also be used to decide if you should buy a new car, etc). For the house we'll take the equity paid in through the mortgage payments as well as from any positive appreciation at the end of 5 years minus all expenses including closing costs, maintenance, taxes and insurance. For the rental we'll take the cash you save by not needing a down payment and invest it, then subtract the total rent payments from the invested amount and accrued interest.

One notable exception that I have not included yet is the mortgage tax break. In my experience the tax break is not nearly as high as the online calculators would have you believe, mostly because they ignore your standard deduction ($5k for singles, $10k for married couples). You'll need a lot of interest to overcome the standard deduction, plus the deduction declines as you pay down the mortgage. The best way to estimate your deduction is to take the interest calculation from my spreadsheet, and plug this into your most recent tax return, then multiply by your tax rate. I will work to add this in to a future calculator.

ASSUMPTIONS:
There are 3 major assumptions that drive the calculations:

1. How long you will be in the house/apartment: For this case assume 5 years
2. Cost to rent vs buy the same property: (see below)
3. Overall home price appreciation rate

Other significant assumptions include:

Annual maintenance: 1% of purchase price
Annual taxes: 1% of purchase price
Closing costs: 2% of purchase price
Annual rent increases: 3%

So using the above assumptions, over are five scenarios, only changing the expected home price appreciation rate from -5% to 5% annual appreciation.

Over 5 years, we would need to see 4% annual home prices appreciation to be better off buying vs. renting. If the market stays flat we will be $65k better off by renting over the next 5 years.

Over the past few years with 5-10% increases on average it was a no-brainer that owning was better than renting, but as the above chart shows the high costs of owning and the effects of leverage also make any decreases potentially devastating.

If you would like a copy of the spreadsheet please click here and download it or send me an email (on right navigation bar) and I will send a copy over. (Edit - I changed where the file is hosted, you can now download it and play with it at will.)

But please take a copy and play with it to see what your situation looks like. My best guess for price appreciation in Portland is that we will be flat over the next 5 years, if not down 1-2% annually. If you have any suggestions for other features I will keep updating it and republish.

Portland Exisitng Home Prices Fall 5.8% in June - Case Shiller

We're taking a break from a great discussion on renting vs. buying today to highlight the latest Case Shiller data.

The median price of existing homes in the metro Portland area fell 5.8% year over year in June 2008 according to Case Shiller, continuing the trend that began in July 2007. This is down 6.2% from the peak in July 2007.

The slight month over month gains we saw in April and May have now reversed, and the price index is down 0.3% from May.


The chart above clearly shows that 1. there was a bubble in Portland, and 2. it is now deflating. The chart and also shows a bit of a plateau over the winter as sales slowed and seller's held out that prices would rebound in the spring.

We've also seen the rate of decline slow a bit as peak buying season is in effect, but look for the decline to accelerate later in the year.

I predict we'll be down at least 10% year over year by the end of December. Any other predictions?

The chart above shows the price index over the past few years. You can see a slight increase in the median price the past two months which corresponds with the seasonality seen in previous years.
The above chart shows Portland, Seattle, the San Francisco bay area (the other areas I consider as closest to Portland) as well as the 20-city composite index. Portland and Seattle are tracking each other nicely, still about a year behind the rest of the market. The San Francisco area has really fallen off the cliff and continues to plummet.

The above chart shows the price index over the past 8 years. Prices have now fallen back to the May 2006 level, but look to have stabilized through the summer buying season.

I've added one more chart, which shows the price changes for the past 20 years. We saw one previous bubble around 1990, and then the more recent bubble. Prices have not been negative in Portland since they started tracking the market until just recently.

ABOUT CASE SHILLER:
The Case Shiller data focuses on the change in price of existing homes, and tries to exclude the effects of remodeling, or major damage. It tries to exclude investment properties and foreclosures (which would make the data look worse) as well as transfers between family members. It's a much better indicator of how the price of the average or typical house has changed from year to year. For full details on their methodology see their factsheet.

When to Rent vs. Buy? Top 6 Misconceptions

One of our readers asked the question recently, when is it better to rent, or when is it better to buy? This is always a hot topic, one that Clint recently featured, and is the subject of numerous online calculators (typically designed to convince you to buy).

Here's part of Bill's email:

"Maybe this is common knowledge but I've been trying to figure it out. I see many happy renters, talking about the benefits of renting vs. owning at the moment. I feel similarly and I'm keeping my eyes open for the market shift which is likely more than a year out. Still, that last post about the place on [632 NE] Russell got me thinking."

Before I dive into my favorite part, the financial analysis, I want to start off by highlighting a number of misconceptions about buying and renting.

1. Renting is throwing your money away.

There are only three things you really need, right? Food, clothing and shelter. A house is fundamentally just shelter at the end of the day, but we've made it out to be much more than that. You can rent and let someone else deal with maintenance, taxes, etc. Or you can buy and manage all these things yourself.

Renting is not throwing money away, it's paying someone else for the benefit of shelter.

2. Owning is always financially superior to renting.

This assumes that real estate values are continuing to increase. This is certainly not true when the market is flat or declining, due to the increased expenses of owning. And is also not true for short periods of time due to high transaction costs. We'll cover this in extended detail in the next post.

Also, Robert Shiller has shown that real estate has basically kept pace with inflation over the long term, so while real estate on average has been a good (or bad) investment over short periods of time, over the long term you'll likely just keep up with inflation.

3. Everybody should own their own house

Frankly some people just don't have the financial maturity, common sense or ability to maintain a house. It's been said before, but most of the people that are currently facing foreclosure in areas like California would have been better off continuing to rent. Then there are the people who treated their houses like ATM's and have in effect already sold the house, and blown the money on "improvements" (granite countertops!) or vacations.

4. You'll save money on your taxes by having a mortgage.

This is what my wife likes to refer to as Spaving (Spending to save). Every online calculator I've ever seen over-estimates your tax benefit, mostly by ignoring the standard deduction that everybody already receives. Never mind that you're paying a bank $3 to save $1 on average, I hear this argument all the time.

5. You can't make a rental "your own".

Sure you can. Most people don't, but you can paint, plant a garden, pretty much everything short of major construction. In Germany we had to buy and install our own kitchen (and remove it later), which really allows for customization.

6. A rental will never feel like home.

This is one of my favorites. Every place I've lived has felt like home, but mostly because of other intangibles, not always the place itself. I never thought our little apartment in Germany would feel like home, but after our first trip back to the States it really did.

Next time I'll go into the qualitative benefits of renting or buying, and follow it up with the quantitative analysis. If I missed any misconceptions please let me know.

Open Thread

Hey, where'd summer go? I'm not ready for fall just yet. Can someone ask the powers to be to bring back the sun?

In the meantime, I know Clint is on vacation, so if you're looking for a place to chat here's an open thread to keep us busy while we wait for summer to return.

Update - 2815 NE 57th Ave Sold!

A reader sent in an update on 2815 NE 57th Ave. (see previous post).

Quick summary: The house sold for $485k in Dec 05, after only 2 days on the market. It was bought back by the bank at auction in August 2007 for $400k.

The bank initially listed the house at $339k in May this year, and it just sold for $285k in July, after 62 days on the market.

For those keeping score that's a 41% decrease from the previous (fishy) sale at $485k.

It's also a 16% reduction from the recent listing price of $339k.

That comes out to $96.54 per square foot of finished space, way below recent rates, which according to Trulia have been closer to $200 / square foot.

I'd say it's fairly priced, if not cheap. Granted it's not oozing charm, but it is over 3000 square feet and has been redone recently, hopefully properly.

Granted this is a foreclosure, but if that's the new going rate for price/square foot, a lot of people are in for a shock.

Thanks for the update James!

Please Take the 70's Back!

This poor house (RMLS #8080271) might have been cute once, but it's not now.

Can't you add a second story without making it so ugly? Houses aren't supposed to wear hats.

And does the addition on the side need to look like a giant wart?

Finally, it's never a good idea to remove a beautiful fireplace and install a wood stove in it's place. Never.
I can only assume these were decisions made during the 70's, when it seems like all things real estate related fell out of the ugly tree and hit every branch on the way down.

Poor house.