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Home Publications Blogs Beat the Press Owning Versus Renting: Right Topic, Wrong Math

Owning Versus Renting: Right Topic, Wrong Math

Wednesday, 21 April 2010 04:22

David Leonhardt devoted his column today to an analysis of the relative merits of owning versus renting. It is useful question to raise, since many policy types have pushed homeownership in situations where it was virtually certain to lead to bad outcomes. (Did anyone lose their job for getting moderate income families to buy homes at the peak of the bubble, 2004-2007?)

While this is the right question, Leonhardt's math is off. He assumes a 20 to 1 price to rent ratio leaves a rough balance between owning and renting. In fact, the ratio would be closer to 15 to 1, it's long-term average.

The arithmetic is straightforward. The average real interest rate on mortgages is somewhat over 4.0 percent. Property taxes average 1.0 percent, as do the combination of maintenance costs and insurance. This brings average real annual costs to 6.0 percent of the sale price. Then there are turnover costs (realtor fees and various closing costs) that average roughly 10 percent of the sale price on a round-trip basis. The median period of homeownership is 7 years, which gives a cost of 1.4 percent a year, raising the total to 7.4 percent.

Even if the mortgage tax deduction knocks this down by a percentage point, this still leaves annual costs at 6.4 percent of sale price -- much closer to 15 to 1 ratio than Leonhardt's 20 to 1 ratio.  (A full percentage point tax benefit would be very high -- the actual tax benefit will be based on the difference between tax deductions including mortgage interest and the standard deduction. This will in the vast majority of cases be far less than the full mortgage interest deduction, since the overwhelming majority of homeowners would take the standard deduction if they were not owners.)



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written by fabian59, April 21, 2010 8:46
While I appreciate the simplicity of the price-to-rent ratio, I find that the choice of appropriate prices and rents can be somewhat arbitrary, particularly regarding rents. For example, in a previous article written by David Leonhardt, he laid out the calculations which led him to the purchase of a house in the Washington, DC area in 2008. He wrote that “In the neighborhoods where we were looking, two-bedroom condominiums were selling for $400,000 and being rented for about $2,100 a month, which makes for a rent ratio of 16. Four-bedroom houses were selling for $700,000 and being rented for almost $4,000, which makes for a rent ratio of 15. No matter the price range, pretty much every apples-to-apples comparison produced a similar ratio.”

In Mr. Leonhardt’s example, the rental rate for a 4BR house seems on the high side. I live in the DC area, and our rent for a 4BR/2BA house in 2008 was in the low $2,000 range.
Bet on inflation?
written by skeptonomist, April 21, 2010 9:32
The article does not mention inflation, which can have a critical influence on the future value of real property bought with credit. At times it makes sense to bet on inflation. Many people, including economists, are predicting increased inflation in the future, based on predicted government deficits. Of course economists have a poor record of predicting inflation and understanding its causes. It might be a good idea to reflect on what actually caused the last major bout of inflation in the 70's and 80's (and on what economists at the time thought caused it).
Depends on Your Perspective
written by leo, April 21, 2010 11:36
There was a similar discussion of this on the NPR site over the weekend thanks to a comment by Reuter's Felix Salmon that there was no difference between renting and owning. It was interesting that the majority of people downplaying the difference actually owned their own property.

I merely pointed out that it's not really a choice for people to invest in their homes or in something else since for most people, the only investment they have is in their homes. You don't have home-owners on the one hand and smart/savvy renter-investors on the other. What you have are home-owners and poor people.

Some dded costs
written by David Cay Johnston, April 21, 2010 1:01
Less than half of mortgage holders itemize so the interest cost is for many 150 to 200 basis points higher than Dean cites.

And property taxes are often 2-3% (where I live almost 4%, because Western NY housing is so cheap). About 70% of low six-figure home owners are on AMT and cannot deduct property taxes, as are a large minority of $50k-$100k home owners.

Then there are costs of moving. If you stay for decades buying is a much better deal than if you move after even one decade, what with the real estate commissions and fees. And homeowners tend to own more stuff, making moving much more costly.

But if you diligently pay off your mortgage then your monthly nut drops, you have money to spend or invest and you can better survive the risks of job loss or injury, especially in states with homestead protections against creditors.

So, Dean, how did your house sale and renting work out? Still renting? Plan to buy back in if so? The numbers would be enlightening on market timing in real estate.
written by PeonInChief, April 21, 2010 1:47
I've been thinking about this issue, as I've gotten a few emails from tenants whose former landlords' lenders have been trying to get the tenants to purchase the properties. For the moderate-income tenants I'm dealing with, it's not just a matter of a price to rent ratio. There are other issues equally important--the condition of the property (particularly major systems like the roof, foundation, plumbing etc.), how long the potential buyers are likely to stay, the condition of the housing market (whether rents are rising or falling, how many other REOs are on the block) and so on. Perhaps middle- and upper-income people can make the decision on a price/rent ratio, but those of us in the poorest 65% have to do more difficult calculations.

And I think Baker already bought a house--a big, expensive one.
Your mileage may vary.
written by ohwilleke, April 21, 2010 5:49
For people who don't itemize on their 1040, have credit that forces them to pay a mortgage interest rate higher than a prime interest rate, or are likely to hold onto their home for much less than a decade, or are likely to have unstable income or employment, renting is usually better. One of the biggest virtues of renting is that your rent is based on the mortgage interest rate available to a typical landlord, not you. It also gives you greater flexibility to move on to better income opportunities.

But, owning a home can make better than average sense for people with stable incomes, stable employment and long likely periods of home ownership (e.g. most civil service protected or tenured government workers). The forced savings aspect of a mortgage makes it a major form of wealth development for middle class families.

Much of the tax benefit comes from having a tax free return on your investment, rather than the itemized mortgage interest deduction. Housing prices in the long term tend to match the rate of inflation. But, new home owners greatly leverage this return on their down payment and principal payments; and this kind of leverage simply isn't available in stocks and bonds. So, they may be getting a tax free rate of return on their principal investment five times to twenty times the rate of inflation. If housing prices are rising a 3% per year with inflation, return on principal payments for a new homebuyer is around 15% tax free for a family with a conventional mortgage and around 60% tax free for a family with a low down payment mortgage (on top of the new home buyer tax credit). The typical after tax return on down payments and mortgage principal payments is typically better than a stock market portfolio for a new home buyer. Also, unlike a stock market portfolio typically receives substantial protection from creditors claims under state homestead exemptions.

And, while the tax benefits for low income people in stable housing markets can be modest, for high income people in places with high state and local income taxes, the government can be subsiding 40-45% of your interest and property tax payments and a decent tax free investment return, and landlords often pay higher property taxes than homeowners which get passed along to renters. This makes homeownership a no brainer.

In the same vein, homeownership is a form of home made rent control largely unavailable outside New York City in the rental market at any price, and greatly reduces your housing costs right around the time that your income tends to fall when you retire.

If you are going to be in a house for 20 years or more, the housing bust risk in that time horizon is far lower, the return on investment and hedge against housing inflation element is much greater, the likelihood of getting income tax benefits for some of that period is greater, one time transaction costs from buying and selling the house are a much lower share of the total, and the forced savings element which happens mostly on the tail end of a mortgage, is a much bigger deal. But, expected length of homeownership is from a practical perspective frequently much more important for most buyers than short term variations in price-rent ratio.

Finally, homeownership is a better deal for almost everyone when housing prices are rising. While those who bought at the top of the bubble market in California or Nevada with decent down payments were devistated, people who bought in the early 2000s with little or nothing down were dramatically better off than those who rented. Mortgage underwriting was lax in the early 2000s mostly because rising housing prices meant that people who couldn't make payment could simply sell quickly and pay off their mortgages without defaulting.
Props to ohwilleke
written by leo, April 22, 2010 10:05
Excellent overview.
written by jesse, April 22, 2010 3:53
I would include depreciation in your calculations as this will add another 1-2% onto your assumptions. Also the dwelling type will have different costs depending upon future land usage. From that perspective, a run-of-the-mill condo is pushing up around 10%.

I also disagree the mortgage tax deduction should be used. Financing in the long run is not a requirement: a property should make sense to purchase with 100% cash.

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.