Renting vs. Buying a Home

When you’re young, you should start by renting. Quickly save up a down payment and buy a house once you have enough for a down payment. This keeps you from throwing away your hard earned money. This is the traditional advice given to someone my age. However, this isn’t the best advice for everyone.

As usual, I like to use real-life numbers when exploring my options. In this case, I’m going to look at a real rental in my area as compared to buying in the area.

The rental prospect is a 1,640 sq. ft. home with 3 bedrooms, 1.5 baths. This house was built in 1936 and situated in a nice, quiet neighborhood. It’s currently listed for $2,590/mo. The home was purchased in 1999 for $565,000.

A few blocks away we have a 1,550 sq. ft. home with 3 bedrooms and 2 bathrooms. This home was built in 1936 and is listed on the market for $825,000. This house has only been on the market for 20 days, so there’s no reason to think the price is too far off the market at this point. (Update: The house sold for $830,000 within a month of being listed for sale)

From what I can tell from the pictures online, both homes appear similar in condition.

Now, there are many factors that will determine whether it makes sense to buy or rent a home. Some of these factors can be quantified, and others can’t. The pride associated with owning your home can’t be quantified. This is going to be different for each person. Some of you may want to own your own home, while others may want the freedom that renting provides. Renting vs. buying a home will also be largely affected by your career and lifestyle. If you’re not sure where you are going to want to live in five years then it’s not going to make sense for you to buy a home.

There are some nifty tools online that will help you with the math of whether renting or buying makes sense for you. One of the tools I find neat is a graphical rent vs. buy calculator provided by the New York Times. As you can see below, the NYT calculator says that buying will pay off after 19 years. This, of course, is based on a number of assumptions that are simply too hard to predict. The greatest variance is going to come from the annual price change assumption. The safe assumption is the long-run inflation rate, so I used 3%. (To get a better understanding of a long-run appreciation of homes, I highly recommend this post) If I were to change this assumption up to 5%, NYT believes it makes sense for me to buy as long as I plan on staying in the place for 5 years.

Rent vs. Buy House

You have to be careful when looking at these calculators because, if you intend to sell the home after the holding period, you must factor in your selling costs, which are typically about 6-7% of the home’s value. So if I intended on staying in the home for 19 years and selling, I wouldn’t really be coming out ahead. I’d have to factor in the 6% selling costs.

There’s no doubt that most of us either want to, or already do, own a home. It’s the American dream. And the only guarantee when it comes to home prices is the price today. Who knows what tomorrow will bring. If you want a home, and you can afford it, then I think it’s going to make sense for you to buy a home you want. I think the decision is much more personal than any financial calculator can convey. So, some quick rules of thumb: If you want a home, can afford it, and plan to stay there at least 10 years, go for it. If you want a home, can afford it, and only plan to stay there 5 years, then I’d say hold off. Particularly with the current volatility, I’d only buy a home at this point if I intended on being there a while. Whatever you choose to do, as long as you’re aware of the costs and associate risks, any decision you make is going to end up just fine.


Case-Shiller Index Update for December 2010

Case-Shiller index data through December 2010 was released today, and the news isn’t good for home owners.

“Data through December 2010, released today by Standard & Poor’s for its S&P/Case-Shiller1 Home Price Indices, the leading measure of U.S. home prices, show that the U.S. National Home Price Index declined by 3.9% during the fourth quarter of 2010. The National Index is down 4.1% versus the fourth quarter of 2009, which is the lowest annual growth rate since the third quarter of 2009, when prices were falling at an 8.6% annual rate. As of December 2010, 18 of the 20
MSAs covered by S&P/Case-Shiller Home Price Indices and both monthly composites were down compared to December 2009. Both Los Angeles and San Francisco reported negative annual rates of return in December, leaving San Diego and Washington DC as the only two cities where home prices are
increasing on a year-over-year basis, +1.7% and +4.1%, respectively.”

It looks like we’re seeing more evidence of that Case-Shiller 2011 Double-Dip that I wrote about before. Both Cleveland and Las Vegas home values are below their 2000 levels. On average, we’re at 2003 levels. We’re also approaching the bottom of the trough reached in 2009. Below is a quick chart I made using the data since 2000.

Case-Shiller Index 2011

I don’t have a whole lot of other insight at this point. Just think it’s interesting to watch everything unfold.

Double-Dip In Real Estate Coming

Real Estate obviously impacts so many people. For most people, their home is their largest asset (assuming they aren’t under water). In recent years, the home even became the “retirement fund” for some. As you know, that bubble burst. If you generally don’t follow up with the different housing metrics you may be assuming we’ve pretty much bottomed out. That seems to have been the consensus over the last half of a year or so. However, it doesn’t seem like the price of housing is done falling for now. In May the tax credits for purchasing a home expired, and guess what? Housing prices have been declining since.

To give you some background on what I’m looking at, first let me introduce you to Robert Shiller. Shiller is a professor at Yale who wrote the book Irrational Exuberance. In Irrational Exuberance, which was published in March 2000, Shiller made the argument that the U.S. stock market was in an extreme speculative bubble. We know how this one ended…It was the largest stock bubble in a while. Stay-at-home moms had become day traders. You may think back and say: “Hey Will, it’s obvious that the market was in a bubble. All he did was write a book about it.” If that’s the case, someone didn’t warn this Amazon reviewer about the bubble: “He [Shiller] reminds me of most old school economists who have no understanding of the current market and can only rationalize it as a bubble.” Agreed. If only these academics would stop messing around with the markets. We all know that the world has changed and the old rules of the market don’t apply. Things like P/E ratios and PEG ratios. Who needs those? Why would a company need to be profitable? Nothing is wrong with unprofitable companies having billion dollar valuations. Haha.

Okay, but back to Shiller. So he published the first Irrational Exuberance book in 2000. Guess what he published in 2005? The second edition of Irrational Exuberance. In this Second Edition he argued that the housing market was experiencing a bubble. Shiller warned that “significant further rises in these markets could lead, eventually, to even more significant declines. The bad outcome could be that eventual declines would result in a substantial increase in the rate of personal bankruptcies, which could lead to a secondary string of bankruptcies of financial institutions as well. Another long-run consequence could be a decline in consumer and business confidence, and another, possibly worldwide, recession.” Seriously…Could you be more correct? The timeliness of both of his books still boggles my mind. The bursting of the bubble occurred in 2006.

So, now you’re probably wondering why I introduced Shiller. Well, he created an index of housing prices dating back to 1890. The index is now maintained by S&P, but he’s still involved. I think the best way to explain this is going to be to start with the graph. (You can click for a larger image)

Case-Shiller Index 1890 to 2011

The Case-Shiller index measures the value of single-family homes over time. Check out the description on the image above for an explanation of how the measurements shown are used. Basically, what the Case-Shiller index tells us, is that over time, housing prices haven’t changed much when adjusted for inflation. I added the red part in basically to show you what housing prices have done since their peak. The red-line is not accurate cause I just drew it by hand on top of this image from Irrational Exuberance/NYTimes. It still gives you a rough idea though. As you can see in this image below, it appears that between the end of World War II and 2000, there was a period of normalization in the range I’ve marked in blue. It looks like prices began to hang out around 110 (instead of 100).

Case Shiller Recent History

To deal with this apparent shift, the Case-Shiller index was adjusted to peg 100 as the 2000 rate. (Note: on the first graph above, this would be about ~115). Okay, it might be getting confusing at this point, so just check out this graph from the recent press release:

Case-Shillder Index Down 1987-2011

If housing prices are to revert to their mean over the last 50 years, they still need to drop approximately 33%. I’d say that if you were to ask the average person whether they think housing prices will continue to go down, they would say no. That means either: 1. Housing prices aren’t going to revert back to the 100 level, or 2. There’s a disconnect between what people want to think their homes are worth, and what they are actually worth. I’m not a betting man, but I think I’d place my money on the second option. I’m not one to buy into the whole “new economy” explanation (as is used to justify just about any bubble pricing). I also think that people are too attached to the price levels they saw in the past to give in and realize the true value of their homes. Nobody wants to “lose” all that money in equity that they had in their home. If housing prices are indeed going to return to their historical level, the prices can either remain stagnant for years while inflation catches up, or they can fall. I think we might see a bit of both. Maybe 20% falling, and then stagnant prices. I really don’t study the subject though, so there are many others who can make more educated assessments.

Either way, as someone who is looking to buy a house in the future, I’m excited at these prospects. For those of you who already own a home, this should not affect you unless you’re planning on selling your home anytime soon. If you plan on living in your home for the next 10 or 15 years, these short-term gyrations shouldn’t affect you. Whichever way the market goes, there’s not much we can do about the pricing. And like the stock market, it’s difficult to time the market. You can tell when things are on discount, or when the prices are inflated overall, but it’s difficult to predict the short-term future of prices and truly time the market. Wealth in real estate depends largely on entry price, and the only way to guarantee a price is to buy now.

What do you think? Are you buying a home soon? Does this information make you want to hold off and wait? Let me know by commenting below.