## Sunday, February 14, 2010

### Buying Vs. Renting - Followup

In our recent four-part series (Part 1, Part 2, Part 3, Part 4) we discussed calculating the total cost of buying vs. renting in order to determine which was the better financial decision.

I have had several great comments and suggestions both on the site and via e-mail.  These comments focused on 1) clarifying the tax deductibility of real estate taxes and mortgage interest, 2) including rental increases, and 3) identifying the ultimate online calculator for the buying vs. renting comparison.  We will discuss these further below:

Tax Deductibility Clarification
The general principle here is that real estate taxes and mortgage interest are tax deductible.  Consequently, you MAY be entitled to discount their cost in your calculations.  However, you need to take the standard deduction into account and compare it to the total of your deductions - your mortgage interest and real estate taxes are only deductible to the extent that they exceed your standard deduction.

For example, for a married couple, the standard deduction in 2009 is \$11,400 (for singles, it's \$5,700).  Let's assume that you and your wife together pay about make about \$150K and pay about 3% of that in state taxes (\$4500).  Let's also assume that you paid \$15K in mortgage interest and \$6K in real estate taxes last year. Let's also assume that you have no other deductions, but are in the 33% tax bracket.  Let's also assume that you are not impacted by the AMT.

In this situation, you would transition from taking the standard deduction at \$11,400 to taking an itemized deduction of \$4,500 +\$15,000 + \$6,000 = \$25,500.  Compared to the standard deduction, that provides you with an additional \$14,100 worth of deduction.  At the 33% tax bracket, this reduces your total cost for real estate taxes and mortgage interest by \$4,653.  That's a reduction of (4653/21000)= 22%

Note that the 22% reduction is not the same as the 33% of your tax bracket.  That's because some of the deduction is lost by switching from the standard deduction to itemizing.  Additionally, if you are impacted by other deductions or by the AMT, you should take them into account and use your actual values.  Additionally, note that some states have higher or lower state taxes - or no state income taxes at all.

Rental Increases
When I started answering this question, I was thinking more of a system for determining the price differential between renting and owning at any one specific point in time - rather than a system for determining the financial impact over the lifecycle of your decision.  However, then I realized that appreciation really needed to be included - and then I realized that the transaction costs also really needed to be included.  Finally, when it came to potentially including rental increases, I drew the line.  Part of the reason for this is that the rental market where I live has been substantially flat since about 2002.  Yep - We really have not seen much of a rental increase at all over the last 8 years.

Additionally, with the economy the way it is - and unlikely to recover anytime soon - it doesn't seem like there will really be much in the way of rental increases in the next five-or-so years.  Further, what about rental reductions? Do we include them in the consideration as well?  For example, it seems more likely that next year will lead to a reduction in rent rather than an increase.

Further, while your average person will probably know the rate of return of bonds and the current inflation rate, it was my belief that most people were pretty unfamiliar with the fluctuations in the rental market - and it really does fluctuate quite a bit.  For example, in Illinois, according to this Census publication, rents varied like this:

`Adjusted to 2000 dollars`
```2000    1990    1980    1970    1960    1950    1940
Illinois  \$605    \$569    \$487    \$476    \$419    \$286    \$339```

As you can see, rents declined significantly from 1940-1950, but generally rose in other timeframes.  The adjustment here appears to be an adjustment in light of the CPI (which may not be completely accurate), but considering this adjustment to be "the rate of inflation".  We find that rents from 1990 to 2000 exceed the rate of inflation by only about 0.6% - a very small amount.  Further, rents from 1940 to 2000 exceeded the rate of inflation by less than 1%.

However, a number of commenters and people sending me e-mail were viewing the housing situation in a much more long-term view and I agree with them that over the long term - say 20 years or so - rents will certainly be increasing and even small rental increases will be felt.

Overall, my general feel is that rent increases are going to be flat for the next 4-5 years.  However, after that I would expect them to rise at about the rate of inflation or a little higher.  If you are looking 40-50 years out, I would think that the average rate of increase over that time period would be about the same as the rate of inflation - or maybe half a point higher.

Consequently, if I am running an owning vs. rental comparison for the next 5 years, I personally would not include rental appreciation - this is why I left it out of the original calculation.  However, if I am running a comparison for a longer period, I would use rental increases as I discussed above.

Ultimate Online Calculator
One commenter alerted us to this online calculator.  When I saw it, I was immediately jealous - it is very inclusive and exhaustive and just the thing for a quant-minded, semi-control-freak like me.  I recommend that anyone who is trying to get a handle on these costs try out this calculator.  However I had a few issues that I brought up to the author of the calculator.  Here are my questions and the author's responses in red.

1) [This is with regard to a specific example of a 300K purchase with 20% down] At the end of the first year, your calculation puts the paid equity at 60364. However, the initial cost was 300K and the loan balance is 236459 - shouldn't the paid equity then be the difference of 63541?  A difference of 3177 from your number? One thing that you may be doing is (assuming a 5% sales commission) reducing the 63541 equity be 5% (which then gives you your number of 60364).  However, that does not seem to make sense because the fee is 5% of the appreciated value, not 5% of the paid equity.  Similarly, the appreciation numbers seem like you might be reducing them to 95% -which does not seem to make sense.

(1) The paid equity calculation is explained in both the "Explanation and Discussion" as well as the "Mega Data Table results explained".  Your Total Value is the \$300k, x 1.03 for 3% appreciation, x 0.95 for 5% sales commission.  The commission is paid on the sale price, not the amount the house appreciated.

Note: I agree with the author's comments in that the "Total Value" seems right, but I am still not sure what he is doing with the "Paid Equity" and "Appreciation".  Just be aware of the differences in those two columns.

2) Real estate tax payments are tax deductible (if they exceed the standard deduction), but it doesn't seem like that is taken into account in your calculator.  (Insurance payments are not tax deductible.)

I was unaware of this, thank you for letting me know.  I upgraded the calculator to take that into account, and linked to your site in an acknowledgement at the bottom of the page.

Note: Thanks for the link, Michael!

3) When renting, the landlord often pays some of the utilities.  However, when owning they are typically all the responsibility of the owner.  Should there be some entry for an increase in utilities?  Similarly, owners often have to pay condo or homowner association fees - should there be some place to add these?  Additionally, for people moving from an apartment to a house, there will be a cost in time and money for the upkeep to the house that was previously performed by the landlord - shoveling snow, mozing grass, etc.  Recognize that for someone moving from an apartment where the landlord pays water and heat to a house in a townhome association, the cost difference for the utilities could be \$1500 for the year - and the town home association could be anywhere from \$1000-\$3000.  These are big numbers that don't appear in your calculator.

There are any number of variables I could add to make the calculator more accurate, more cumbersome, and more confusing.  I already just added to the complexity by separating out Taxes and Insurance, which used to be combined.  The calculator is already more detailed than anything else out there.  I'm not interested in bogging it down any further at this point.  Anyone who *really* needs to account for extra expenses on the buying side will be clever enough to just add that amount to the maintenance, taxes, or insurance fields (as I now point out in the intro).

Note:  The author is certainly right - his calculator is far more complex and accurate than anything else that I have seen.  I highly recommend that you use it.  Just go ahead and ass the values into the maintenance filed as he recommends!

1. Even if rent goes up every year at exactly the rate of inflation and no more, that still has a big impact on the calculation.

Compare it to the situation where buy a house using a traditional 30 year fixed mortgage and your monthly payment can be expected to drop every month in real terms.

Here's another way to look at it: How much would you be willing to pay your landlord for a clause in the rental contract saying your rent cannot be raised any time in the next 30 years?

Seems to me such a clause would be worth a lot.

Also, I would be wary of using statewide average rents for the calculation since individual rents tend to be stickier downward and it averages changes in all markets.

If the rental market is down, it's unlikely that the landlord will reduce your rent. He knows you are settled where you are. On the other hand, if the rental market starts heating up there's a pretty good chance he will start jacking up your rent.

Also, statewide rent averages include rentals in undesirable locations. I think it's pretty likely that if you looked at average rents in desirable locations, those rents regularly outpace the state average.

2. nycsolo - Yep. If rent tracks inflation and inflation is at 3%, then the rent doubles in about 24 years. Also, I agree that there are several rent markets - both geographically, by property type, and by income level.

With regard to your comments about a landlords, I have owned a multi-unit property since 2002. The property is in a good, desirable area in Chicago and typically rents to young professionals. From 2002 to about 2004, rents declined about 20% - primarily because the "market" that I was renting to was going straight into buying condos. Rents are back up now, but really only slightly above 2002 levels - 8 years later. If the rents had been increasing at 3%/year, I would be much happier about my purchase.

With regard to stickyness, tenants are not shy about asking for rent reductions - and you are really at the whim of the supply/demand marketplace. For example, in 2002 I had an open house and about 30 interested parties came by. In 2004, same open house, same space, same advertising - and only 3. Frankly, I had to get the space filled if I was going to pay the mortgage, so I had to bow to the market.

Now, fortunately, demand is strong. Mostly, I think it is strong because the young professionals can no longer qualify for the crazy, zero-interest loans. With strong demand, the rental rates can go back up.

My point? The building is in one of the most desirable areas in Chicago and the average rents in that area certainly did NOT regularly outpace inflation - at least since 2002.

3. "With regard to stickyness, tenants are not shy about asking for rent reductions -"

They may not be shy, but as the landlord you have a bit of an edge in the discussions, particularly if the tenant is an old person or a family with small children. Because it's a pain in the (*^% to move and everyone knows it.

"The building is in one of the most desirable areas in Chicago and the average rents in that area certainly did NOT regularly outpace inflation - at least since 2002."

Well my experiences have been different. But let me ask you this:

Suppose your next potential tenant asks for a written guarantee that his rent will not be raised for the next 30 years. How much (if anything) would you charge for such a guarantee?

4. nycsolo - You are certainly right - it is a pain in the butt to move. However, it's also a pain to get the unit cleaned, paint it, and then be losing rent while you are trying to fill it. Also, my tenant base is pretty mobile. Also, I would feel pretty bad about making a family with kids or old people pay above-market rent.

With regard to the written quarantee, I would not go for it. As I mentioned above, I think that over 30 years you are going to see appreciation at about the rate of inflation. However, I don't think that is going to be the case over the next 5 years, so your question becomes more interesting if the guarantee was limited to 5 years. If the person definitely had the means to pay, then the cost for a 5 year lease might be pretty reasonable.

5. MP, great series. I think one major problem with U.S. consumers is that many purchase houses where they think they can pay it off in 30 years. (If either parent loses their job - a very real possibility - and they can't meet their monthly payment.) Well, at an interest rate of 5%, a person will pay roughly \$400K+ to pay off a \$200K mortgage.

People need to buy houses that they can reasonably expect to pay off in 10-15 years, as opposed to 30. This can be done with frugal living; not purchasing (unnecessary) large items, such as boats or luxury cars; and making double payments, making an extra payment 3-4 times a year, or simply paying an extra \$100-\$300 a month on the house.

Too many Americans - including the professional classes - insist on buying nice houses in the suburbs with 5 bedrooms and a 3 car garage. Well, this increases the amount of money one will need to spend on gas, car repairs and maintenance. It will also increase a non-economic cost of stress - as 40 minute commutes each way take their toll on one's sanity. (This also takes time away from one's family, chores, and enjoyable activities.)

Thank you for posting this here, MP. We live in a very prestige-driven society. "Oh, your husband is an attorney. Why do you both own 8 year old cars? Why don't you buy a house in suburb X?"

My mother's father had 8 daughters and they lived in a house that only had 4 bedrooms. My father's parents lived in a nice, 3 bedroom house - with five children. This was common for the time. Houses also had front porches, and people KNEW their neighbors. Today, houses are built with porches on the back - so you can avoid your neighbors. We have lost our way.

I know I am going off-topic (forgive me). I also see a dangerous trend of parents buying their kids 20 gifts for Xmas. They also tell their kids that they can accomplish anything they set their minds to. And they seldom say "No" to their kids - or punish them. (Well, playing video games and watching 5 hours of TV a day does not necessarily prepare one for success in the real world.) Such kids will be in for some MAJOR DISAPPOINTMENT, when they realize that it is damn tough to find a good-paying job or career.

6. MP, how about some new insight? I'm experiencing withdrawal!

7. come back to the blogging circuit, buddy! We miss your perspective.

8. Where have you been? Are you ok?

9. Hi Angel,
It's nice to be wanted! I am OK, but practicing law has been very busy for the last few months. It was actually pretty deceptive - I was thinking that I would have more slow time, but then there's a project/case - and it gets interrupted for another emergency - and then another one on top of that - and then before you can even get back to the original one, another one jumps up. Time passes pretty strangely for me when I am busy, like now. It seems like I blink my eyes and it is 6 months later!

Actually, while that is true, it is no excuse. I should have been posting more regularly. I have analyzed my thinking and I recognize that I have been somewhat fixated on the idea of providing long, detailed posts with in-depth analysis. However, because I did not have time to do that style of posting, I declined to post. Instead, I should have been more flexible with my thinking and provided some periodic mini-(at least for me) posts.

I have put in 13+ hours today (it has been similar for the last 6 months), but your concern has inspired me to post at least a little something immediately. You and JDUnderdog should feel free to continue to kick my butt if I slack!

Thanks again!

10. Nando - I was just going through some old comments and I realized that I had never responded to yours. That's unfortunate because I really agree with you. I think that you kit the nail on the head with regard to people taking for granted that they will always have great paying jobs and nothing will go wrong - and that this somehow justifies their leveraging their entire working lives to pay for grander and grander hosues.

I think that you are also right with regard to the pursuit of prestige being the cause of ruin for so many great houses. I have an interest in medieval history and you can see the same thing happening time and again - the nobles overspend, end up trading income-producing resources to their lenders to pay tehir debts, but then keep spending to "keep up appearances" - and the lenders end up owning the castle!

I also agree with you that it has become fashionable to present a distorted and unrealistic view of the world to children in the hope that the parents are somehow doing the children a favor. Nothing could be further from the truth. They are just setting up their children for a bigger fall and a greater disappointment. Parents should work with their children to explain and demonstrate how the real world works - and to prepare their children for reality rather than just cast them into a world that they are not prepared for.

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