Rent vs Buy Real Estate Tips
IS IT BETTER TO RENT OR OWN?
If you are visiting this site chances are you might be a first time buyer searching for listings or looking to learn more about the home buying process. You’re in the right place. If you are a “move up” buyer or relocating, you are also in the right place and there’s other relevant content to your unique situation here as well.
But if you are that first time Buyer, what I want to share with you are some of the data points the 100’s of people I’ve helped in this process have used to make the rent vs own decision. Just remember that everyone’s situation is different and there’s no right or wrong answer. That being said, unless you plan to be in a home for at least five years it almost always makes more sense to rent.
Let’s look at some pros and cons of each option and then take a deeper dive into the rent vs own debate.
ADVANTAGES OF BEING A RENTER
Flexibility: if you have to move for any reason it could be a lot easier to get out of your lease, particularly if you are month to month, than having to go through the process of listing and selling your home (or becoming the accidental landlord).
Cash Preservation: keep your money invested in the stock market or just in a savings account. You have a lot more liquidity.
No risk: housing markets go up and down. If you buy a home and have to sell in a down market, you may lose some - or even all, of your down payment, You can say the same about money invested in the stock market.
Amenities: utilities and HOA dues (where applicable) my be included in your lease.
No repairs: your landlord will have to maintain the home in a habitable condition.
DISADVANTAGES OF BEING A RENTER
No control: whether it is having a pet, painting a wall, or any number or other things, you are subject to someone else’s rules, regulations and limitations.
No financial benefit: once you pay your rent, that money is gone. Forever. And there is no opportunity to cash in on appreciation of property values.
The rent is too high: over time your rent payment will go up even with the new California statewide rent control laws in place.
No tax benefit: for many who itemize, their mortgage and property tax payments are their largest deduction. Even if the SALT deduction is less than it used to be, it is still a rather sizable deduction.
DISADVANTAGES OF BEING A HOMEOWNER
Decrease of liquidity: while not everyone has to put 20% down to buy a home, you are going to be tying up a significant amount of money for a number of years. And if you need to tap into those funds, the process, i.e. a sale, is lengthly and expensive.
Repairs: all the things you used to call your landlord to fix are now your problem. And they can be expensive and extensive.
Loss: yes, your home can be destroyed by earthquakes or fires. Or the market can tank and you are upside down on your mortgage.
Home Owner Associations (HOAs) can be restrictive and your dues can increase.
Increased liability: you might be responsible for accidents, injuries and other damages associated with your real property.
Loss of use: your home can be damaged by fire, earthquakes, floods and other circumstances beyond your control.
ADVANTAGES OF BEING A HOMEOWNER
Control: your house and your rules. Want to get that pet or paint, remodel or knock down a wall? Go for it.
Fixed payments: assuming you have a fixed rate mortgage and not an A.R.M. you know what your housing cost will be as long as you live in the property. No rent increases.
Taxes: for most people there are tax benefits to home ownership while they are living in the property and for many there are tax free gains upon sale.
Income property: instead of paying rent, you can be the landlord. Many times the first investment property owned is someone’s previous primary residence.
Short term rental (STR): have an extra room or ADU attached to your home? You may be able to get rental income from that while maintaining your primary residence.
Tap into your equity: you may not have to wait until you sell to be able to reap some of the financial rewards. Home owners often get Home Equity Lines of Credit (HELOC) to be able to pull some cash out. Other options are cash out refinances and Home Equity Loans. Typically you will pay a lot less interest for these than credit cards and in some instances they are tax deductible.
Live Rent Free: if you stay in your home long enough, the mortgage will be paid off and you will be living rent free.
Here’s some other things you might want to consider
YOU MAY NOT BE ABLE TO RENT WHAT YOU WANT WHERE YOU WANT
This is much more of a factor than I see written about elsewhere. Truth of the matter is that in the LA area and particularly in the communities commanding the higher rents, you might not be able to find an acceptable rental at the price compared to the options you have as a Buyer.
Here’s how I first started to notice this.
With rents having gone up so much over the past few years, at least in Southern California, one of the most common calls I started getting was “I can’t afford to rent anymore, I need to buy” which I find somewhat ironic since for many years it was the exact opposite.
What I came to understand people to really mean is that the value wasn’t there, in their opinion, for the rental property compared to what they would have to pay to own. In other words, no one wants to pay thousands of dollars a month for a dump.
THE FALSE EQUIVALENCY OF RENT VS MORTGAGE
When you are paying rent, that is 100% expense that is never recaptured. That money is gone - you will never see one cent of it again.
When you pay your mortgage, a portion of it goes toward paying down the principle. Think of it as forced saving. If you’ve ever looked at an amortization table, you’ll see that in the early years of a 30 year mortgage more money goes toward the interest. But over time more of the monthly payment goes toward the principle. So even if prices don’t go up dramatically, let’s say they stay flat, and you sell after 10 years of homeownership, you are getting your downpayment back PLUS all the principle you have paid down. And yes, I am being simplistic because obviously there are transaction costs involved in both buying and selling. But I’m sure you get the drift of where I am going with this.
THE 5% RULE
The 5% rule is fairly well known. Here’s how it goes.
multiply the value of a home by 5%
divide that number by 12
If the monthly rent on a comparable home is lower, it makes sense to rent. If the monthly rent is higher, it makes financial sense to buy.
Let’s do an example.
PURCHASE PRICE: $1,500,000
5% of $1.5M = $75,000
$75K / 12 = $6,250
The following goes further into this concept……
WHAT IS YOUR BREAK EVEN POINT AND HOW MUCH OR YOUR MORTGAGE IS RECAPTURED THROUGH APPRECIATION?
Let’s look at a simple hypothetical example to illustrate how the 5% rule works and then analyze breakeven points:
PURCHASE PRICE: $1,500,000
DOWN PAYMENT: $300,000
MORTGAGE AMOUNT: $1,200,000
MONTHY PAYMENT (5.75% rate): $7,000
PROPERTY TAXES: $1,500 month
TOTAL MONTHLY PAYMENTS: $8,500
ANNUAL PAYMENTS = $102,000
APPRECIATION NEEDED TO EQUAL PAYMENTS = 6.75%
Applying the 5% rule, it would make more sense to lease this property if the rent was lower than $6,250. Based on the current market as of this post, it is borderline.
What happens when the rent is higher, let’s say at $7K per month? You can still rent for less than your ownership costs might be.
What to do?
Try this “breakeven” analysis. At about a 6.75% rate of appreciation, your paper gain on the purchase price equals your payments and you are living rent free. Well, as I said this is a hypothetical example because it is still costing you $100K out of pocket.
Another way you might view evaluate this investment is what the rate of return on the $300K downpayment is. In my example above, if the property is increasing in value by $100K per year, that is an outrageous return on the original investment. But even at half of that, you are certainly beating bonds, CDs and the S&P 500 in most years.
As I said these examples are paper profits and I’m just trying to make a point meaning I’m not taking into account transaction costs in and out and maintenance and other expenses related to the property. I’m also not taking into account any income tax benefits along the way or the fact that most people will be able to benefit under current tax laws (check with your CPA) and not pay any capital gains on the sale.
A question I like to ask is after 5 years, 10 years, fifteen years and 20 years, how much of your monthly payment would be recouped from appreciation in the property?
THE RULE OF 20
Here’s another one. This is also referred to as the “price-to-rent ratio” and is calculated by dividing the home value by the annual rent amount. Got that? Here’s how it works. if the price to rent ratio is less than 20, buying might be a better option. On the other hand, if the ratio is greater than 20, renting might be better. The number varies by location and may be as low as 15 or as high as 30. It is best determined by looking at actual rents and sale prices in your area.
The math is simple, take the annual, not monthly, rent and multiply it times 25.
Here’s an example: if you are paying $4,500 per month, that’s $54K annually. Multiplied times 20 that would be a purchase price of $1,080,000. So if you can buy the property that you would be renting for $4,500, for $1,080,000, then according to this principle you should buy.
Here’s another way I've also seen people use this calculation.
Just reverse the formula and divide the sales price by 25 (then divide by 12) and ask yourself if you could rent the property for that amount if you had to.
The price-to-rent ratio and 5% rule are guidelines, so don’t get too carried away with these. I’ve seen the multiplier for the price vary somewhat over the years depending on what gross rent multipliers are being used by local appraisers. The same goes for the 5% rule. So let’s not get too far down that rabbit hole.
Keep in mind this is a simplistic guideline and does not take into account a lot of other factors.
LIFESTYLE CONSIDERATIONS
Because many jobs now allow workers to work from anywhere, many people have the option to live anywhere. In some situations that can be great, others not so.
If you are one of the many who have moved beyond commuting distance to where you work and have a less than secure job, it might make sense to rent unless you are certain that you can find another work from anywhere job if need be.
If you run your own business or know that you can find a job that allows remote work, buying is a great option. You might be able to afford a home that offers more than living in an expensive locale.
DON’T MAKE THIS MISTAKE
Surprisingly I’ve found that the number one reason many renters don’t become owners is not that they don’t have the downpayment or qualifying credit score.
It’s that they don’t understand the home buying process which truthfully can be quite daunting in California.
If you are reading this article and want to learn more about the home buying process, here’s some information that you might find helpful.
If you are in the Los Angeles area, you can contact me with any questions.