Should I buy or rent?
Should I buy or rent?
A mental framework for thinking about a house or apartment
It is a personal choice that depends on you and your family’s unique situation. More important is the mental framework you use to analyze and make a decision.
Let’s talk about how buying and renting are different and where they are similar and then let’s talk about how your personal needs and unique situation play a role in determining which one is right for you.
First, the main difference between renting and owning is flexibility and stability:
Renting gives you more flexibility
When you rent, you are only locked into the property for the term of your lease, which typically run from 1-2 years. After the lease expires, you are free to either negotiate a new lease or find another place to live.
The hassle and cost (more on this below) involved with selling your property effectively gives you less flexibility when you own a home.
This can best be illustrated by thinking about the downside case in a situation where you are forced to move. For example, the economy is bad and you lose your job and need to move to a new city. As a renter, the worst-case scenario is that you are out several months of lease payments. As a homeowner, you might be forced to sell at a major loss, potentially wiping out your entire equity investment if your mortgage is too high.
There is value in flexibility – and it varies by individual.
Owning provides more stability
The flipside to having less flexibility is the greater stability achieved from owning a home. Renters only have a right to live in their home for the term of the lease – whenever the lease expires, they can be legally forced to leave, or see their rent prices increase egregiously. Homeowners have effectively locked in their shelter costs “forever”. This extra stability manifests itself in a number of tangible ways.
Some homeowners can attest to the value of being able to build memories over a long period of time in your home and for many people, memories are priceless.
Because of this stability, homeowners typically put more work into their home to maintain it, customize it to their unique tastes and invest themselves emotionally in their homes.
There is value in stability – and again it varies by individual.
The other big difference between renting and owning is the fact that when you own, you need to come up with a decent-sized chunk of money to purchase the property. The opportunity cost of having to put down a downpayment and take on a mortgage is not being able to invest that capital into other assets, like stocks and bonds. So one must understand the key differences between owning real estate vs. stocks and bonds and factor that into the buy vs. rent equation:
Houses/apartments are not “pure” investments but in some ways they are ...
Some people view homes as pure investments while others will shout at you that “homes aren’t investments!” I think both are incorrect.
Homes/apartments are one part depreciable asset and another part land (with investment characteristics). Depending on where you live, it may be more investment-like (e.g. cities, urban areas), and in other places (like rural areas and suburbs), most of the value is trapped in a depreciable asset (the physical structure). I talk more about this concept here: Do economists consider a house/apartment to be an investment?
Transaction costs are extremely high
Factoring in broker fees, specific taxes, mortgage costs, legal and documentation etc. it costs around 1-2% to purchase a home and another 6-7% when it comes time to sell it (using New York City, where I live, as an example).
For a $1 million piece of real estate, that comes out to around $70,000 to $90,000. If you use a mortgage to cover 75% of the purchase price, these transaction costs could amount to over 30% of the equity downpayment! Compare this to purchasing $1 million of a liquid stock like Apple, which might cost a retail investor around $1,000 (less the trading fees and more the implied cost of the bid-ask spread).
The value of real estate is relatively easy for most people to understand
A house or apartment that one lives in is a relatively simple product that all people have used before, and can understand on a fairly intuitive level. Yes, “location matters” and there are many nuances to real estate that I do not mean to gloss over, but it is a much lower level of complexity compared to when you invest in stocks, where you need to understand an underlying business and industry and typically require more specialized skill and experience.
There are significant expenses/time involved with owning real estate ...
Homes are expensive. You need to pay property taxes, condo/HOA fees, insurance costs etc. In addition, a home is a depreciating asset in which you need to spend money to maintain. Again using New York City as an example, this annual expense is typically around 2-3% of the market value of a home. So for a $1 million apartment, expect to spend $20,000 to $30,000 per year on top of the cost of capital (interest on debt, opportunity cost of your downpayment/equity, more on this below) you used to purchase the property.
If you are trying to be frugal on costs by taking a DIY approach, then you need to factor in the time involved. If you are a renter and your pipes burst, the owner is responsible for spending money to fix the problem. If you own real estate and are renting it out to a third-party, you need to spend time (and money) to find tenants, deal with problems and collect rent.
With stocks, you do not need to invest any time into the underlying asset – that’s what you are indirectly paying management to do.
... but at least you can live in it!
You have to live somewhere right? Shelter is a basic human need, so whether you are using your real estate as a home, or renting it out to somebody else, you should be able to derive some amount of real-world value out of the asset.
How do you calculate this value? If you are renting it out, this is easy to calculate – it is the the rent that you collect. If you are a homeowner, there is a concept called “owner’s equivalent rent” which is the estimated rent that you would pay on an equivalent home.
Here in New York City, rents are currently running at around 4-5% of market value, which means that it would cost $40,000 to $50,000 per year to rent a $1 million apartment. Subtract 2% for expenses and you get to a “net yield” of 2-3%, which is analogous to a dividend yield for stocks. Real estate “net yield” has historically been higher than the dividend yield for stocks in the United States.
Like stocks, you also benefit from any increase in the value of the real estate. Historically, real estate has generally kept up with inflation in the United States. Contrast this with stocks, which have significantly outpaced inflation.
From an investment perspective, you can think of your home as an asset with a higher dividend yield and lower capital appreciation potential compared to stocks.
You can borrow relatively inexpensively against your home
Secured mortgages are the cheapest way for the general public to borrow money. This means that your “cost of capital” is lower to purchase real estate than other types of financial assets.
Mortgages are also relatively safe – as long as you can make payments on time, the underlying real estate cannot be snatched away from you. And even if you cannot make the payments, the process the bank needs to go through to seize the asset is long and allows for all sorts of remedies. This is in contrast to margin borrowing to purchase stocks. Not only are rates typically more expensive, but margin loans may be “called” if Mr. Market is particularly depressed one day, resulting in the stocks being liquidated with little notice.
Taking these differences into account, there are a few key personal questions I always ask when trying to figure out whether it is better to buy or rent:
How long do you expect to live there?
Because the transaction expenses involved in purchasing a home are so high, the longer you expect to own the asset, the better it favors owning, because you can amortize those costs over your ownership period.
In the example above, I mentioned that transaction costs eat up approximately 8-10% of the value of the home. If your holding period is only two years, that comes out to 4-5% of additional cost per year that you need to factor in. If your holding period is thirty years, that comes out to only 0.2-0.3% on an annual basis.
Another way to think about it is that over a long period of time, the value that you derive from the home (living in it, owner’s equivalent rent) overwhelms the capital cost involved in purchasing it.
High transaction fees are the reason why long holding periods are imperative to the attractiveness of real estate as an investment. The longer the holding period, the more you can amortize (i.e. spread out) these costs and lower the effective annual cost.
What would you do with the downpayment money if you did not put it into the house?
The majority of individuals are not financially savvy, or trained to invest in stocks and bonds. Even with low-cost passive investment vehicles like ETFs, studies have shown that individuals get the better of themselves by trying to time the market, resulting in returns that lag the overall market over long periods of time.
The reason this is relevant here is that one needs to figure out their opportunity cost i.e. how would they invest the downpayment if decided to rent instead?
For very conservative individuals that might just put their money in the bank, they should use a fairly low opportunity cost, something like the then-prevailing interest or U.S. Treasury rate (currently 0 to 2%). For more aggressive investors, perhaps it is the long-term rate of return on U.S. stocks and bonds (5-7%). For really talented investors, the opportunity cost would be much higher.
How much do you value stability vs. flexibility?
This is really a personal choice or personality thing. Some people just love stability while others seek adventure and change and can’t sit still in once place. And people also change as they get older and move through different stages of life. Your needs are very different when you are a single bachelor than when you are married with three young children.
I often ask my single 20-something year old friends to think twice before buying their apartment because it is very likely that their life will change significantly before the decade is out. They might meet the love of their life the very next day, elope and get married and start popping out kids, and suddenly that studio apartment on the Lower East Side needs to be upgraded. Flexibility is much more valuable to folks that haven’t yet settled down.
On the other hand, I’ve noticed (in my personal life as well as the lives of others) that once you get married and start a family, stability becomes really important, especially for the kids. The number of things that you need to think about on a daily basis multiples, and worrying about rent increases or the fact that you might have to move out next year just adds to your already heavy burden. Stability is much more valuable to those who can see what their lives look like five, ten years from now.
Now tally it up
There are many buy vs. rent tools (such as this one from the NY Times) that take care of a lot of the calculations of figuring out which one makes more financial sense. Run the numbers and if they come out relatively close, factor in flexibility vs. stability before coming to a decision. For example, if the tool says it is going to cost you $500 more per month to own, then ask yourself whether having less flexibility but more stability is worth that much to you.
This was originally published in Quora in January 2016.