Housing: Buy or Rent?

Buy or Rent? That is the question.

In a recent paper, three economists compared buying and renting as part of reaching a conclusion that there is no housing bubble: Assessing High House Prices: Bubbles, Fundamentals, and Misperceptions. Dr. Thoma presents a couple of rebuttals: Housing Bubble or Housing Froth?

And two recent articles gave specific examples of the buy vs. rent decision, from the New York Times: Is It Better to Buy or Rent? and the San Francisco Chronicle: Why own when you can rent?

Using one of the examples from the NY Times article, I’d like to illustrate the basic difficulty with this approach. The NYTimes article has an example of a home in the Bay Area that can be purchased for $1 Million and an equivalent home that could be rented for $2500 per month. The various costs of ownership are tallied, minus any tax benefits and compared to the cost of renting.

Assuming a 5 year ownership period, I repeated these calculations (my results differ slightly from the NYTimes). For the homebuyer, the Net Present Value (2005 dollars) of 5 years of shelter is: $254K. For the renter, the NPV of costs is $98K.

NOTE: The cost of renting is reduced by income from the retained downpayment, as per the NY Times example.

So why does anyone buy with a 5 year ownership horizon?

For homeownership to make financial sense, the difference between the cost of buying and renting (adjusted to 2010 values) is the amount the property must appreciate (plus the future transaction cost must be included in the appreciation). Without boring readers with all the details, I estimate the property must appreciate 29% to break even (The NY Times estimated 19%).

Now 29% might not sound too unreasonable for 5 years, especially since home prices in the Bay Area have increased 19% in just the last year! From Dataquick:

The median price paid for a Bay Area home was $619,000 last month, a new record. That was up … 19.0 percent from $520,000 for August a year ago.

But here is the problem with this approach (and why I repeated the calculations). Instead of a $1 Million home, I repeated the calculation with a purchase price of $2 Million. The house would still rent for $2500 per month. Adjusting the calculations using the higher purchase price, the house must appreciate 33% over the next 5 years for the homebuyer to break even.

The amount of appreciation required to break even, on a percentage basis, is only slightly higher, even though the price of the house doubled. So looking at the percentage appreciation required is not really useful.

Estimating the future value of the house is the basic difficulty with this approach. If anyone is doing this calculation, it is important to realize that prices might not appreciate at all over the next 5 years. In fact, home prices might decline and decline substantially. Dr. Leamer at UCLA offered this advice:

If you’ve been shopping for a home, Leamer says you “need to recognize the risk and do some hard-nosed thinking” … he suggests you add up all the monthly costs and benefits (such as tax deductions) of owning versus renting. If buying still makes sense, his advice is: “Think long term — seven to 10 years. Avoid adjustable rate mortgages. Lock in a low, fixed interest rate.” … “If you’re not sure you’re going to be living in the home in two to three years, don’t buy it.”

NOTE: On Monday, the National Association of Realtors will release Existing Home Sales for August. The number of transactions should still be near record levels, but it will be interesting to see if the recent trend of higher inventories continues. And on Tuesday, New Home Sales will be released and might show the first signs of a slowing market.

UPDATE: August New Homes Sales did show signs of weakness! (Here for graphs). Inventories of existing home sales continued to rise …

Best Regards, CR Calculated Risk