Renting or buying - which makes more financial sense?

Buying a home is the epitome of the American dream. Everyone agrees that owning your own home, maybe even owning multiple homes, is one of the surest ways to financial independence and a comfortable retirement. This seems to be especially true over the last decade (this article was written in August of 2022). Housing prices have gone crazy – anyone owning a home is quickly increasing their wealth, leaving behind all the renters.

But what if that thinking is wrong? In the equity markets, there is a concept called the Efficient Markets Theory. One corollary of this is that markets are really efficient – if an asset generates a high return, many investors will pile money into that investment driving its price up, and thus it’s future returns down. Investment returns tend to return to the mean.

Could the housing market be efficient? At first glance, it’s far from efficient. But when I refer to an efficient housing market, I mean that if houses generate an outsized rental income, then a lot of investors will put money into rental homes. That will drive housing prices up, and rental income as a percentage of the purchase price down. Eventually, those investors will leave the market, allowing housing prices to equalize a bit (though they probably wouldn’t come down immediately, like equities do in a stock market crash).

Full disclosure – I’ve been a homeowner for many years. And housing prices (and rents) can get way out of whack over short timeframes in particular regions, states, or neighborhoods. But I believe, over the long term, buying a home versus renting is not a slam dunk either way. If you include all the costs of both buying and renting, the economics are pretty close. The decision on whether to buy or rent comes down to your locality, and the emotional rewards of doing one or the other.

Let’s first look at the economics, and how I came to this conclusion.

Lately, whenever someone sells their house, they’re likely to tell you how much money they made on the house. And it was probably a profitable transaction. But in my experience, few homeowners total up all the costs incurred while owning (and selling) real estate.

Let’s take an example – my own. We bought our house in Corona, California back in 2018 for $565,000 – which in the Southern California market wasn’t a bad price at that time. We had the good fortune to sell it in mid-2022 for $900,000. At first blush, we made bucket of money – the value of the property rose $335,000 (almost 60%) in four years! That’s a juicy profit, right? Not quite. Running the numbers, we spent about $42,000 in selling costs, and we only paid a 4% commission. If it had been a standard 6% rate, the selling expenses would have been closer to $60,000. But sticking with the actual costs, that still leaves us a profit of $297,000.

Throughout those four years of ownership, we also had maintenance outlays – painting, a new HVAC, minor and major repairs, some electrical work, and new shutters. All told, after totaling as many invoices as I could find, a conservative estimate is $29,000. That’s pretty close to what experts say you should put away for home maintenance – 1% of the value of the home per year ($29,300 over four years if you take 1% of the average between $565K and $900K). That leaves us $268,000 in profit – still a pretty hefty increase!

Unfortunately, we’re not done. What comes along with home ownership? A mortgage, insurance, and taxes. For us, the principal and interest, as well as the impounds for insurance and taxes was about $2800 per month. That’s a bit more than $145,000 over the 52 months we lived in the house. Now, that $2800 paid for a roof over our head. If we hadn’t owned the Corona house, we’d have rented a place. But it’s likely we’d have paid far less than $2800 per month. When we first moved in, market rent was around $1800, but when we moved out it was closer to $2400 per month. Let’s use the mid-point - $2100 per month. That means the homeownership premium was around $700 per month, or $37,000 over that time. Now our profit is $231,000. Out of that, we need to subtract the cost to maintain our pool and have someone take care of the lawn. Together, we paid out $275 per month, or $14,000. We’re down to $217,000 – aren’t we done yet?

Not quite. We have the purchasing costs, which are much more reasonable than on the selling side. But the closing costs for the purchase of the house were $11,000. And lastly (finally!), there’s the opportunity cost of our down payment. We could have taken that down payment and stuck it in the bank earning interest instead of buying our home, so we have to take that into account. Interest rates were low for most of those four years (I used a blended average of 1.5%), but our down payment was $113,000, so the interest is not insignificant. Over four years, it would have been just a hair under $7,000. I could have used a more aggressive investment return, like that of the stock market, assuming that I would invest the down payment in equities for those four years. Doing that would have increased the investment return to $52,000 instead of $7,000 (using a 10% rate of return). But let’s use the more conservative route of putting it in the bank. That would bring our profit down to $199,000. To equalize things, we’d need to add back about $4000 in principal paid down in those mortgage payments above. That gives us a net gain of $203,000.

Does that mean buying is $200K more lucrative than renting? Not necessarily. The example I just cited was in one of the hottest real estate locations in the U.S. during one of the hottest real estate markets in the last 50 years. If our house had appreciated a more normalized 5% per year (yes, you read that right, the average real estate gain over the last 50 years is about 5%), then it’s value at the time of our sale would have been around $700,000. That means, after all the costs I listed above, we’d have a profit of $3100 over those four years. Very close to parity with rents during that timeframe.

So, the decision on whether to buy or rent comes down to two things – your local real estate market where you’re shopping for a home or renting; and your own psychology. Let’s start with the first variable, your local market.

To do so, we’ll introduce a real estate investing term called “cap rate” (or capitalization rate). This is simply the rate of return of a rental unit. It’s calculated by dividing the Net Operating Income (the rent of the unit – expenses other than the mortgage) by the purchase price. If you purchased a single-family home for $200,000, received $18,000 in rents ($1500 per month) and spent $6000 in marketing, maintenance, taxes, and insurance – your NOI would be $12,000, giving you a cap rate of 6%.

The average cap rate in the U.S. in 2022 was approximately 7%, but that includes all rental housing – single-family dwellings, apartments, and condominiums. But it’s a place to start. If twelve months of rent on a single-family dwelling is more than 7% of the value of that same house, it’s likely better to buy in the long run than it is to rent. And if the reverse is true (rents are below 7%), it means housing prices are elevated, and renting for the time being is probably a better financial decision. I looked up the numbers for Riverside County, where I owned my Corona house, and cap rates in August of 2022 were around 5.48%. That makes renting a better bet.

But the second factor in our decision-making is your psychology. For a lot of people, owning a home, having the security of a fixed payment every month, and being able own an appreciating asset, has an outsized emotional value. And that’s okay. But I would caution a home-buyer, either a financial or an emotional one, that the longer you stay in the house, the more profitable (in both senses), the transaction will be.

Unless you bump into a hot location in a hot real estate market with low interest rates, selling before you’ve owned the place for at least five years, is likely to be unprofitable. Even though it might feel like you’ve made significant gains on the surface – after accounting for costs, you may not be ahead after all.

So, what’s the conclusion: should I buy or rent? I would use the two parameters above. First look at the current cap rate in your local market and compare it its historical rates. Don’t just use 7% - the Southern California real estate market might never exceed a 7% cap rate. But if it’s well below the historical cap rate, perhaps renting a bit longer would be smart (and it gives you more runway to build up that down payment). It might seem like prices are going to continue surging ahead and you’ll never be able to buy – but the market is telling you that rents are low in comparison to buying. So rent.

But don’t forget the psychological aspect. If owning a home is important to you, and you plan to stay in the house for a long period of time, then it might not be the most optimal time to buy, but the finances will most likely work out in your favor over the long run. As they are likely to if the cap rate is above its historical trendline.

In short, there’s no one-size-fits-all answer to this question. It comes down to where you’ll be buying or renting, and your emotional makeup. Do the research on your neighborhood, and do some reflection and soul-searching on yourself. Both will be time well spent.