Real Data SF October Newsletter: Own or Rent?

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Own or Rent? Your Home as an Investment

This month I want to bring together two recent analyses we’ve done on home ownership. The first looks at whether homes are good long-term investments. During the heart of the economic winter, in April 2010, I argued in this post that there are better investments than buying a home. Rather, the almost universal urge to own a home is about satisfying our hard-wired need for “shelter” – a cave that’s secure from marauding creatures (and humans), where we can paint our dreams on the walls without worrying about the landlord.

I still think that’s true, despite the housing recovery and the positive effect that it’s had on long-term home price appreciation. Here’s a chart direct from Freddie Mac that shows long-term national home price appreciation.

Note that this summarizes nominal and real (inflation adjusted) annual rates of growth (and decline) in the national housing market. This next chart shows what’s going on closer to home in the Bay Area market, using Case-Shiller’s high tier home value index, which tracks homes valued in the top third – currently around $800,000. There aren’t too many neighborhoods in SF where you’ll find a home selling for less than that.

The takeaway here is that nominal home prices have increased 244% since 1988 — or about 5% annually — while inflation has gone up by 97% — or a little less than 3% annually. In essence this simply confirms the common wisdom that holding real estate over the long term is a good inflation hedge because property values go up more than the rate of inflation.

But this analysis assumes that you’re buying a house for cash – which few of us are able to do. Rather, we use debt, thus “leveraging” our investment. So if we put 20% down on a home worth $1 million, any increase in the home value results in a five-fold increase in our equity. The magic of leverage!

Looked at this way, homes start looking pretty good as an investment. Based on a long-term home price growth rate of 3%, our actual equity investment would be increasing by 15% annually assuming we’ve put 20% down.

And this doesn’t include the additional equity building up in our home as we pay down the debt, not to mention all the psychological benefits of being able to draw pictures of mastodons on your home’s walls. For a complete discussion of homes as an investment, take a look at our Chief Economic Guru’s article, posted here.

The inevitable corollary to this analysis is whether it’s better (read cheaper) to rent or buy your home. There are a lot of rent vs buy calculators out there. It’s important to be clear about what each of them is comparing. This one, by the New York Times is one of my favorites. (Be sure you go into the advanced settings to input things like your tax rate and expected annual home appreciation.) It essentially compares your total after tax cash outlay on renting vs. buying and determines when you “break even.” That is, when the total cash outlay on buying is less than that on paying rent every month.

This one, available at Paragon’s website, focuses on investment returns though you can also use it to calculate a cash outlay break even point. (Note – Mac-users may have difficulty with the Java applet the site uses.)

Say you decide to rent. You dump the money you could use for a down-payment on a house into the stock market or bonds instead and get a return on that investment. Now compare that to how that same amount of money would grow if you invested it in a house. We used the Paragon calculator to do a rent vs buy comparison on a typical 3 bedroom home in SF. We assumed the home would rent at $4,500 per month and would sell at $1,050,000. We also assumed a 20% down-payment, a loan at 4.5% and 4% annual price appreciation (1% less than the long-term rate we discussed above). Here’s a screenshot of the result:

Conclusion: Viewed an investment, you’d be better off buying a house after 1.5 years than sticking your cash for the down payment in an investment yielding 2.5%.

Now, my main quibble with this analysis is that 2.5% seems too low a return on an investment alternative to home ownership. But even if you increase the return to, say, 7% — more in line with a safe stock portfolio – a home is still a better investment after 1.9 years. Such is the magic of leverage!

As always, comments, criticisms, and kudos always appreciated!

Misha

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