Key Take-Aways
- Though homeownership could be a powerful tool to build wealth, it is not always the best tool
- Comparing rent to a mortgage is not an adequate comparison, instead, we want to compare the unrecoverable cost associated with renting compared to the unrecoverable cost of owning
- The unrecoverable cost of renting is the monthly rent! Unrecoverable cost of ownership comes up to around 5% of a homes purchase price (2% from property taxes and maintenance and 3% from the cost of capital)
- In general, if your annual rent is less than 5% of the purchase price of a home of interest, then you are better off renting and investing the down payment as well as the monthly cost difference. If the opposite is true then buying could prove a wiser long-term financial move
Is it better to rent or own?
For many, buying a home will be the single largest purchase in their lifetime. It makes sense then that many feel unsure when to make the jump or even if homeownership is right for them. The decision to buy versus rent is an incredibly personal choice, with several non-financial factors playing a significant role. For example, renters may enjoy the flexibility that comes with renting such as new neighborhoods, the ability to upgrade/downgrade easily based on life changes, and the convenience of letting someone else take care of maintenance. On the other hand, homeownership also provides non-economic benefits such as a sense of stability, pride of ownership, and the freedom to make the space your own.
Unfortunately, creating a framework to compare the non-financial costs and benefits of renting or owning is incredibly difficult as those are ultimately a matter of personal preference. That said, there does exist a simple framework to compare the financial impacts of renting versus owning with just a few assumptions.
But why use a framework to compare the financial benefits of renting versus owning? Renting is always a waste of money, and homeownership is the safest investment, right?
Homeownership, a not so sure bet
Historically, homeownership has been seen as a pillar of the American Dream and a sure path to build wealth over the long term. That was true for a good part of American history, however, then came the Great Recession of 2007-2008, where the impossible happened. During the Great Financial Crisis, home prices went down and in a big way. Mortgage delinquencies and eventually foreclosures jumped to record highs. According to Pew Research, the number of homes with at least one foreclosure filing increased from 717,000 in 2006 to 2,330,000 in 2008. Data from RealtyTrac showed that nearly 6.3 million homeowners lost their homes to foreclosure sales between 2006 and 2016 as the damage of the Great Recession worked its way through the U.S. housing market.
Even in a normal year, roughly 250,000 homes in America will ultimately get repossessed by the bank, making homeownership a not-so-sure bet. For this reason, a basic framework is needed to help evaluate what makes the most financial sense between buying a home or renting.
Unrecoverable Cost
Many believe that an analysis on the question of renting versus owning is as simple as comparing a potential mortgage to potential rent. Though both are monthly recurring costs, they are not directly comparable and a proper analysis requires drilling down into the details in order to calculate the unrecoverable cost associated with owning and the unrecoverable cost of renting. And to be clear, unrecoverable costs are those where you pay and you are left with no residual value and no way of recouping those costs—effectively you spend money and have no way of recapturing those funds at a later date.
Unrecoverable Costs of Renting
Calculating the unrecoverable cost of renting is very simple, as it’s your monthly rent. It is an unrecoverable cost because after you pay your rent, there is no way of recapturing any part of those funds. You pay your rent and the money is gone forever. For many, this is more than enough reason to own a home versus rent, as the money spent on rent is gone for good. But let’s continue.
Unrecoverable Costs of Owning
Creating a framework for calculating unrecoverable costs for owning from scratch would be an incredibly difficult task, luckily PWL Capital has already conducted the research and developed a solid framework that we can use to properly determine the unrecoverable cost associated with owning. According to the framework developed by PWL Capital, the unrecoverable costs of owning are property taxes, maintenance, and the cost of capital.
Property Taxes – 1%
Though property tax rates vary from state to state, data from mortgagecalculator.org shows that the median property tax rate in the U.S. stands at roughly 1%. Property taxes are unrecoverable, as you will pay property taxes and will have no means of recouping those funds—just like rent, it’s gone forever.
Maintenance and Repairs – 1%
A variety of costs fall under this category, such as toilets, appliances, and basic lawn care. However, there are some easily overlooked unrecoverable expenses such as replacing a roof or removing a tree. Since these costs do not happen every year, people often forget these. Unfortunately, data on this is difficult to come by, but within the single-family rental market, many active investors use 1% of the purchase price as a ballpark figure to estimate maintenance costs on a potential rental property.
Note, if you have an HOA some of these items are taken care of for you, but you are paying a monthly HOA and so the end result is the same. Additionally, even if you undertake all of the maintenance and repairs yourself, your time has a cost associated with it as by doing the work yourself you are skipping out on other activities.
Cost of Capital – 3%
It goes without saying that buying a home costs money, and whether you take out a traditional mortgage or pay for the home in all cash, there are still capital costs associated with the purchase. Overall the cost of capital ends up being about 3% and breaks down into two pieces:
- Cost of Debt – This is simply the interest on your mortgage. Right now, with 20% down, and a credit score of 700+, the average 30-year fixed mortgage sits around 3.5%.
- Cost of Equity – As mentioned above, if you put 20% down or buy all cash that money will be tied up in your home in the form of equity. Using data from Credit Suisse Global Investment Returns Year Book 2019 that tracks assets globally going back to 1900, we can determine the cost associated with the money locked in your home as equity. If you are buying a $500k home with a 20% downpayment, the down payment will be $100k and we can assume it will grow at the long-run rate of global real estate, which stands at 1.3% after inflation. Alternatively, you can take the $100k and invest it in a globally diversified stock portfolio with historical returns of 5.0%, after inflation. With those historical values in mind, we can adjust the returns of real estate and stocks with the long-term target inflation of 2%. After doing so we get nominal returns of roughly 3% for real estate and 7% for stocks.
With nominal returns of real estate at 3%, and 7% for equity markets, the difference between the two stands at 4%. This means even if you paid for your home in all cash, you would still have an effective capital cost of 4% annually as that money could have been in the stock market earning a higher rate of return over the long run instead of sitting as equity in a home. To account for rounding done earlier, and the fact that most people will get a low-interest mortgage, we will round down the cost of capital from 4% to 3%. Note, this will overstate the financial benefit of owning compared to renting.
Comments on the cost of capital
Before going on, I’ll address two immediate concerns many may have regarding the above figures. First, real estate going up at just 3%—have I been living under a rock? Despite strong recent gains in real estate prices, it would be unwise to assume this will continue with no end, that line of thinking is exactly what hurt so many in the financial crisis of 2008. Additionally, it’s not hard to find places where home prices have been flat to negative—when adjusted for inflation. Betting on home price appreciation throughout much of Spain and Italy would have been a losing investment for the last few years, and in China, the largest real estate developer, Evergrande, is on the verge of bankruptcy. To say real estate is a surefire investment and always guaranteed to produce strong positive returns is to ignore key data.
Next, looking at stocks, many would say returns of 7% seem too low. Looking at the S&P 500 we can see that it has grown at a compounded annual growth rate of roughly 9% over the last 50-years. And though this is true, for a proper analysis we cannot cherry-pick data and only include the best performing market. The long-term return for global equities of 7% includes not only the best-performing markets but also the markets that went to zero such as the complete collapse of equity markets in Russia in 1917 and China in 1949.
Putting it all together and the 5% rule
Now building up to the 5% rule, we have found that on average property taxes and maintenance costs in the U.S. stand at roughly 2% of the purchase price of a home, and we found that the cost of capital stands at 3%. When we sum these values up, we arrive at 5% and that represents the expected unrecoverable costs associated with owning a home, and with this, we can do a proper comparison of renting versus owning.
With the 5% rule, we can now easily calculate the unrecoverable costs associated with a home of interest simply by multiplying its price by 5% and dividing by 12—this value could then be compared to monthly rent. As an example, if you were looking to purchase a home for $1,000,000 (median sales price in Alameda County), the unrecoverable costs annually would be about $50,000, and dividing the annual costs by 12 gets you to monthly unrecoverable costs of $4,166. If you can then find a comparable place to rent for less than $4,166, then renting may be a better financial option assuming you invest the potential downpayment (you are even better off if you invest the monthly difference in rent vs mortgage).
This framework allows you to work the other way as well to determine if buying makes more financial sense compared to your current rental. Using the above example, if you have a monthly rent of $4,166 but you find your dream home is going for $900,000, then based on this framework it is more financially advantageous to buy versus continue renting.
Digging deeper
Though the 5% rule is a fantastic tool to provide a quick estimate when trying to decide to buy a home or rent, there are a few items worth noting that could call for some minor adjustments to the 5% rule.
Value add real estate
The 5% rule assumes that the home under consideration is move-in ready, and does not account for ‘sweat equity. If you are considering buying a house where you believe you can materially add value through renovations and repairs, then this would improve the forecasted rate of return for real estate and decrease the overall cost of capital. The net result would be adjusting the 5% rule lower, to say 4%.
Stock market returns versus valuations
Earlier in building up to the 5% rule, we used the long-term historical return of 7% (adding in targeted inflation) for global stocks. Research by academics and practitioners has shown that valuations matter and long-term equity returns are a function of stock valuations at the time of purchase. A simplified, yet fairly accurate, way of forecasting long-term stock returns (10+ years) is to take the inverse of the market PE ratio to get what is called earnings yield and use that value, plus targeted inflation rate, as the forecasted stock returns. When PE ratios are elevated, it could reduce forecasted stock returns and as a result, increase the cost of capital, and favor owning as you would lower the 5% rule to 4% or 3%, depending on the forecasted rate of returns. Alternatively, when PE ratios are low, it favors renting as this results in an increased cost of capital and would warrant adjusting the 5% rule higher to say 6% or 7% based on the new forecasted rate of return for global equities.
Investing the difference
If the 5% rule, or variation of it, shows that renting is better than owning, the benefits are even greater if your monthly rent is cheaper than your mortgage plus estimated maintenance costs. If you invest the monthly difference between rent and mortgage into a globally diversified portfolio, the future long-term wealth gains can drastically outpace any gains associated with owning.
Conclusion
The decision to buy a home is the largest financial decision for most households, and though there are several personal factors to consider, there is no getting around the economic and financial impacts of homeownership. The age-old wisdom that homeownership is always a good decision, and always the best path to financial prosperity does not provide a robust framework to truly compare the financial impact of owning versus renting. With help from PWL Capital, we arrived at the 5% rule that states generally, if you can find a comparable rental where the annual rent is less than 5% of the purchase price of a target home, then you are generally better off renting and investing the downpayment, and monthly difference in rent versus monthly unrecoverable costs, into a globally diversified equity portfolio. Conversely, if you take your annual rent and divide by 5% and you find your dream home is at or less than that value, then homeownership will generally result in a larger financial gain.
Share and Comment
If you liked this article, please share this post with a friend! Or if you have any questions, please feel free to ask below! Thank you!