There’s an interesting debate going on in the comments section of yesterday’s housing post about the relative costs of buying and renting a house.
David Sucher is in Seattle:
We have had a great discrepancy between buying & renting since the early 1970s i.e. it has always been far more expensive to buy than to rent and very few (like show me one and I’ll buy it) residential properties ‘cash-flow’ at a 20% down purchase. But people do buy when they can afford it. As markets are not likely to be wrong over such a long period of time, my conclusion is that the psychological value of owning is simply worth the extra $$$ and responsibility.
And Nicholas Weaver responds:
In terms of raw cash flow, buying costs more than renting under ALL conditions I’ve looked at. Even in a “sane” market, on a cash-flow basis, buying is expensive.
But notice that for “cheaper then renting”, I only consider lost-money (interest, tax, HOA) as ‘cost’ for buying, the rest of that huge mortgage payment you should see again, evenutally, so I don’t consider that a cost.
Well, maybe not all conditions. In fact, I’ve been doing some back-of-the-envelope sums and have come to the conclusion that buying is likely to be cheaper than renting. Take the example of someone who can buy their house with cash, and who doesn’t consider themselves a particularly astute or successful investor. Let’s say that the house costs $1 million, that renting it would cost $5,000 per month, and that property taxes and other costs of ownership are $500 per month. Let’s also say that the interest rate on cash deposits is 5%.
Do you buy the home or rent it? If you buy it, after one year you are down $6,000 in taxes and other expenses, so the cost of buying is $6,000. If you rent it, after one year you are up $50,000 in interest on your $1 million, and down $60,000 in rent, so the cost of renting is $10,000. Then come taxes. If you rent, your rent payments aren’t tax deductible, but your interest income is taxable. So if you pay 30% tax on that $50,000 interest income, that puts you another $15,000 in the hole. Meanwhile, if you own, those property taxes are tax deductible. Buying just became significantly more attractive still. Then, of course, you’re better off still if the value of your house appreciates over the course of the year.
How does a mortgage affect these calculations? Let’s say that you have $200,000 for a down payment, and the rest of the purchase price comes from a 6% mortgage. Now, if you buy, you’re still down $6,000 in property taxes, but you also need to pay 6% interest on an $800,000 mortgage, which is another $48,000. Total cost of buying: $54,000, all of which is tax-deductible. If you rent, you pay $60,000 in rent, while earning $10,000 in taxable interest income. Total cost of renting: $50,000, plus another $3,000 in taxes. You’re still better off buying, certainly if there’s any kind of nominal house-price appreciation going on.
Of course, if you tweak the numbers, you get different results. Crucially, if you can invest your money and get a higher return than prevailing mortgage rates, then it becomes much less attractive to buy. But no one would lend money to homeowners if it was that easy to get a higher return elsewhere.
In my example, how much would that house have to cost before it became cheaper to rent? Let’s say the house was $1.2 million, and we still had that 20% down payment. Cost of buying is $63,600, tax-deductible; cost of renting is $52,000 after taxes, which is over $74,000 before taxes at a 30% tax rate. How about $1.5 million? Cost of buying is $78,000, tax-deductible; cost of renting is $49,500 after taxes, which is about $71,000 before taxes. Finally, it’s cheaper to rent than to buy — assuming, of course, that house prices have zero nominal appreciation.
I’m not intimately connected with the housing market, but my gut feeling is that it’s not easy to find $1.5 million houses renting for $5,000 per month. Then again, depending on what state you’re in, the property taxes on a $1.5 million house might well be vastly greater than $500 per month, and I’m unclear on the extent to which property taxes get passed through into higher rents.
Still, this is all highly theoretical; I’d love to see some real-world calculations.