Monday, February 8, 2010

The Varied Housing Market - Buying vs. Renting - Part 1 of 4

In a recent comment, an associate posed the following quandry:
I think many associates erroneously think that renting a place to live is always throwing money away, while buying a house is always good, not understanding that they're investing (or "investing") on borrowed money in an asset that may not appreciate it at all.
This is a question that I get asked a lot.  Although at first it seems like a simple question, there are actually several issues wrapped up in the comparison of renting vs. buying.  We will unpack and examine these issues and develop a formula for making a direct financial comparison in this 4-part series (it is just too big for one post).  In Part 1, I will review that the housing market varies widely geographically and that any determination of ownership vs. renting really relies on your local factors.  Part 1 starts below:

Many people talk about "real estate" or "housing" in the US as if there is one unitary market.  This impression is furthered when the media reports that "housing" in the US is down 10%, for example.  However:
  1. Real estate costs and values are truly a local market rather than a national market.  The press likes to talk about "real estate prices in the US plunging,"  but although that is true for the majority of cities, even now real estate prices are rising in several cities.  Consequently, the rising or falling of the "US real estate" may not really pertain to your local market.  Additionally, the "US" real estate numbers are usually based on a per-house-sold determination.  This means that states that have a lot of houses like NY and CA exert a disproportionate influence on the "US" numbers.
  2. A corrollary to this regional variance is that the cost differential between renting and owning varies widely in different cities.  For example, the general trend is that owning is more costly than renting per month in a pre-tax dollar out-of-pocket sense.  However, this trend is greatly exaggerated in certain expensive cities like New York and San Francisco  - but can actually be inverted in certain extremely low cost housing markets like several cities in Texas.
  3. Another corrollary is that changes in housing prices also vary widely geographically.  For example, California and New York often have large price swings, while the midwest typically does not.  In this regard, there have been several years when real estate in some costal cities rose or declined by 25% - it's no longer a surprise when this happens.  However, in the midwest, any movement of greater than 5%/year is uncommon.  Further, some cities in the midwest saw a "shocking" 10% decline in house prices last year, where 10% up or down in a year seems pretty common in LA - and maybe New York.
    With this in mind, whenever I hear an "expert" talking about how "it's always better to own" or "always better to rent," I take their advice with a grain of salt.  That is, the specific math on whether owning is better than renting can vary widely depending on where you are located.   Further, depending on your specific situation, it really could be either.

    Of course, in addition to the raw financial numbers, I recognize that there are a number of psychological factors at play here as well.  For example, many people find it appealing to "own" their house (although if the bank owns 80% of it, saying you "own" seems somewhat misleading.)  It gives them a sense of solidity, ownership and freedom that they might find appealing.  Conversely, some people find it more appealing to rent.  For some, it gives them a sense of freedom because they can move at any time and they don't have to waste their time fixing anything that goes wrong.  For those that were following closely - yes, it's true that people can make opposite choices and both can believe that their choice gives them more freedom.

    In this regard, people often want to compare the financial impact of renting vs. owning, but several comparisons break down.

    For example, just comparing the out-of-pocket costs of renting to the out-of-pocket coses of owning fails to consider any equity in the house, tax impact, and appreciation.

    Conversely, simply regarding owning as always superior may neglect to consider the actual ownership costs associated with a home which may actually cause the homeowner a greater financial impact than renting would

    In order to compare the true financial impact of owning vs renting, we will consider the Ownership costs, Equity Costs, Financing Costs, and Appreciation of the housing and compare the final value to rent.  We will discuss the determination of the Ownership costs in Part 2, the Equity and Financing Costs in Part 3, and the Appreciation and some calculation examples in Part 4.  The results may surprise you!

    1 comment:

    1. Interesting post, I look forward to the series.

      Someone once said to me that one of the perks of owning your home is that your landlord would never evict you. ha!

      I consider myself a homeowner even though I owe a mortgage. Just like I would never say that the bank owns my law degree just because I owe a lot of money on that. It's true that the bank could take possession of my home but not my brain (in theory). But I view both as the bank owning an income stream from me.

      Snow days are fun. Make sure regardless of whether you rent or own, you're not shoveling your own snow! :)