Why rent? To get richer
A contrarian's view: Houses don't appreciate any faster than the level of inflation over the long term, so forget about buying a home and put your savings into stocks.
By MSN and SmartMoney
I have something un-American to confess: I rent an apartment despite having enough money to buy a house. I plan to keep renting for as long as I can. I'm not just holding out for better prices. Renting will make me richer.
I normally write about stocks for SmartMoney.com, but the boss asked me to explain to readers my reason for renting. Here goes: Businesses are great investments while houses are poor ones, so I'd rather rent the latter and own the former.
Stocks versus houses: Returns
Shares of businesses return 7% a year over long periods. I'm subtracting for inflation, gradual price increases for everything from a can of beer to an ear exam. (After-inflation, or "real," returns are the only ones that matter. The point of increasing wealth is to increase buying power, not numbers on an account statement.)
Shares have been remarkably consistent over the past two centuries in their 7% real returns. In Jeremy Siegel's book "Stocks for the Long Run," he finds that real returns averaged 7% over nearly seven decades ending in 1870, then 6.6% through 1925 and then 6.9% through 2004.
The average real return for houses over long periods might surprise you: It's virtually zero.
Shares return 7% a year after inflation because that's how fast companies tend to increase their profits. Houses have their own version of profits: rents. Tenant-occupied houses generate actual rents, while owner-occupied houses generate ones that are implied but no less real: the rents their owners don't have to pay each year.
House prices and rents have been closely linked throughout history, with both increasing at the rate of inflation, or about 3% a year since 1900. A house, after all, is an ordinary good. It can't think up ways to drive profits like a company's managers can. Absent artificial boosts to demand, house prices will increase over long periods at the rate of inflation, for a real return of zero.
Robert Shiller, a Yale economist and the author of "Irrational Exuberance," which predicted the stock-price collapse in 2000, has recently turned his eye to house prices. Between 1890 and 2004, he says, real house returns would've been zero if not for two brief periods: one immediately after World War II and another since about 2000. (More on them in a moment.) Even if we include these periods, houses returned just 0.4% a year, he says.
The average pundit, planner, lender or broker making the case for ownership doesn't look at returns since 1890. Sometimes they reduce the matter to maxims about "building equity" and "paying yourself" instead of "throwing money down the drain." If they do look at returns, they focus on recent ones. Those tell a different story.
Between World War II and 2000, house prices beat inflation by about 2 percentage points a year. (Stocks during that time beat inflation by their usual 7 percentage points a year.) Since 2000, houses have outpaced inflation by 6 percentage points a year. (Stocks have merely matched inflation.)
Stocks versus houses: Valuations
But though stock returns have come from increased earnings, house returns have come from ballooning valuations, not increased rents. The ratio of share prices to company earnings (the price-earnings ratio) has remained relatively steady. It's about 16 today, close to both its 1940 value of 17 and to its 130-year average of about 15. Not so the ratio of house prices to rents. In 1940, the median single-family house price was $2,938, according to the U.S. Census Bureau, while the median rent was $27 a month, including utilities. That means the ratio of prices to annual rents was 9. By 2000, the ratio had swelled to 17. In 2005, it hit 20. We can adjust for the size of dwellings, but it doesn't make much difference. The ratio of single-family house prices to three-bedroom apartments is 19. In SmartMoney's hometown of Manhattan, where more detailed data is available, the ratio of condo prices per square foot to apartment rents per square foot is 22.
Two main events have caused house valuations to inflate since World War II. First, the government subsidized housing by relaxing borrowing standards. Before the creation of the Federal Housing Authority (FHA) in 1934, homebuyers who borrowed typically put up 40% of the purchase price in cash for a five- to 15-year loan.
By insuring mortgages, the FHA permitted terms of up to 20 years and down payments of just 20%. It later expanded the repayment periods to 30 years and reduced down payments to 5%. Today, down payments for FHA loans are as low as 3%. Aggressive lenders offer loans with no down payments or even negative ones so that homebuyers can borrow the full purchase price plus closing costs. Some require little documentation of income, assets or ability to pay.
That means more Americans can win loans for homes, and they can win them for far more expensive homes than their incomes had previously allowed. Two-thirds of American households own homes today, up from 44% in 1940, even though the percentage of Americans living alone has tripled during that time. The ratio of house values to incomes has risen 260% in just under four decades.
A second event helped boost house demand in recent years. Share prices plunged in 2000. The Federal Reserve, fearing that the decline in stock wealth would cause consumers to stop spending, reduced the federal-funds rate, the core interest rate that determines the cost of everything from credit cards to mortgages, to 1% by summer 2003 from 6.5% at the start of 2001. Since most of the cost of financing a house over 30 years is interest, monthly house payments shrank and demand for houses soared. In some markets a string of big yearly increases in house prices led to panic buying.
Stocks versus houses: Conclusion
For house returns over the next 20 years to match those over the past 20, the government and private lenders would have to "up the ante" by relaxing borrowing standards further. Given the recent attention paid to swelling foreclosures, that seems unlikely. I suspect real returns will turn negative over most of the next two decades, but that house prices won't necessarily dip. Since 1963, they've done so in only two years versus 18 for stocks.
That's because homeowners mostly just stick it out rather than sell during soft markets. But if house prices remain flat, they produce negative real returns due to the creep of inflation. According to calculations made by The Economist in summer 2005, house prices would have to stay flat for 12 years with annual inflation at 2.5% for the ratio of prices to rents to fall from its 2005 perch to merely its 1975-to-2000 average.
So to sum up why I rent: Shares right now cost 16 times earnings and over long periods return 7% a year after inflation. Houses right now cost 19 times their "earnings" and over long periods return zero after inflation. And they look likely to return less than that for a while.
Questions and objections
In what follows I've tried to anticipate and address questions and objections:
"You can't live in your stocks" or "Renters throw money down the drain."
Rent is the cost of owning shares with money you would otherwise spend on a house. Houses have ownership costs, too: taxes, insurance and maintenance. Rent costs about 5% of house prices each year if we apply the price-rent ratio of 19. House incidentals often cost around 2%.
If you have $300,000 and a choice between spending it on a house or shares, you'll pay $6,000 a year in incidentals if you buy the house or about $15,000 a year ($1,250 a month) in rent if you buy the shares. But the shares will return $21,000 a year after inflation while the house will return zero. (My numbers work out even better than these. I pay a smidgen less than $1,250 a month for rent, while house prices in my neighborhood are far higher than $300,000.)
Note that houses and shares have transaction costs, too. Homebuyers pay around 1% in closing costs when they buy and 6% in broker commissions when they sell. Share buyers pay $10 trading commissions, which are negligible for buy-and-hold investors.
"Homebuyers get tax breaks."
So do share buyers, but both are a bad deal. The interest on loans for houses (mortgages) and shares (margin balances) is tax-deductible. But the rates are almost always too high. A big house loan presently costs 6.1% interest, while a big stock loan costs about 9%. For the returns, we can forget about inflation because it helps debtors while hurting investors, making it a wash for those who borrow to invest. Still, nominal returns of 3% for houses and 10% for stocks aren't high enough to justify those rates. The tax breaks aren't really breaks at all. Moreover, a majority of homeowners don't claim them. Their incomes are low enough to make the standard deduction a better deal.
"What about the pride of homeownership?"
It's not for me. I define ownership as no longer having to pay for something and being able to do as I please with it. I own my coffee maker. Homeowners must pay taxes each year even when their mortgage payments are done. In certain markets they can't even make changes to the houses they've paid for without seeking the approval of others. Personally, I feel the pride of ownership for shares of businesses, and I'm proud to occupy a nice place while leaving the burden and poor returns and maintenance to someone else.
"You seem to knock government housing subsidies, but they've helped many Americans afford homes."
My inner socialist agrees. My other inner socialist worries that the government has effectively raised prices to the point where the middle class can't afford houses or buries itself in debt to own them. My inner capitalist is too busy watching shares to care about house prices. My inner conspiracy theorist notes that while politicians tout the social benefits of homeownership, none mentions its tax benefits to the government. I pay no taxes on the overall value of my stock portfolio, just on my cashed-in gains and collected dividends. But Americans pay taxes on the full $11 trillion worth of housing they own plus the $10 trillion worth of it they're still paying off.
Video: Should you rent or buy?
"Houses are bigger than apartments."
True, and both can be rented. A third of renters live in single-family houses. I prefer an apartment for now. I like not having to fill it with stuff. I like using a fifth of the energy of the average American. I like being 20 minutes from work and not having owned a car in 10 years. I like not stressing over whether to get the marble countertops or the imported tiles or the 52-inch flat screen. I'm not especially frugal; I spend a teacher's salary each year on restaurants and travel. But I guess I'm too busy or lazy right now to bother with a big house and its innards.
"Are you saying I should sell my big house and rent an apartment instead?"
No, unless you have more space than you need and moving wouldn't be disruptive to your family, and you want to cash in on recent housing gains, make more money over the next couple of decades, use less energy while simplifying your life, and you don't mind seeming odd to friends. In which case, yes. But really, I'm not trying to win anyone over. Strong demand for houses keeps my rent cheap.
"Renting is for poor people."
True. But it's for rich people, too. The average renter makes about $34,000 a year, but while the percentage of renters declines after incomes exceed $20,000 and rents exceed $600 a month, it jumps again once incomes top $150,000 and rents top $1,200 a month. In other words, poor people rent modest apartments for lack of choice. Middle-income people buy houses. High-income people, presumably with a dose of financial savvy, often rent nice apartments instead of buying.
"You say houses return zero. But I've made a fortune on my house in recent years."
I'm referring to inflation-adjusted returns over long periods, absent external boosts to demand. You're referring to gross returns over a short time period that combined lax borrowing standards and ultra-low interest rates. Over the next 20 years I believe houses will return zero or slightly less after inflation, and that stocks will return 7%.
"So you're never going to buy a house? What about raising a family?"
I might buy one eventually, but the longer I can put it off the more I'll get out of the shares I'll have to sell to afford it. I'm 34 now with a fiancée and a fish. I'm going to try to rent for at least 10 more years. If I have kids I'll probably move into a big apartment or a house once they reach running-around age. I'll rent, most likely.
This article was reported and written by Jack Hough for SmartMoney.
Published May 2, 2007
Rent apartment vs. Buy in Austin Texas
Rent Vs. Buy? - It Depends
Paying rent, they say, is just like throwing money down the drain.If you've ever rented an apartment or a house, you have probably had people tell you that you're making a mistake.
The truth isn't so simple. Most American families own their homes -- 67 %, a record level. But economists say renting makes sense for lots of people, especially those who expect to move within 3-4 years. The notion that renting is financially foolish and short-sighted is wrong.
The most common criticism of renting: You're not building any equity. Syndicated real estate columnist Ilyce R. Glink in her popular book, "10 Steps to Home Ownership" says "Paying rent, the adage goes, is akin to throwing money out of the window.
As a renter, you write a check each month to the landlord of your rental unit, and say good-bye to your money as you drop the envelope in the mail." There is no long-term benefit financially
This sounds right. But she misses a key point. When you rent, you pay for use of the house or apartment while you are there. However, when you buy a house, you pay not just for use of the property while you're there, but also for the right to sell it when you move out, and the selling costs costs you extra.
Another criticism of renting is that it's a bad deal because you miss out on the federal tax deduction for mortgage interest and real estate taxes. Homeowners can deduct the interest they pay on mortgages from their taxable income; doing this can save some people thousands of $ each year in taxes. That might seem like a strong argument for buying, but it is not as strong as you might think.
One major thing is the mortgage interest deduction lowers your tax bill only if your deductions exceed the standard deduction, which is $4,850 for single filers and about $7,500 for married or joint filers. Plus, even if your deductions do exceed the standard amount, you may not save very much at all.
Let's say your deductions total to $10,000, all due to buying a house, and that your tax bracket is 28%. If you file a joint or married return, your tax savings will only total about $700 a year ($2,800 x 28%). Why so little? Because you could have taken the $7,500 standard deduction even if you had not purchased a house. That's only $58.33/mo in tax savings.
For many middle and lower -income buyers, the mortgage interest deduction is irrelevant. For home buyers with higher incomes, the deduction is more relevant but may still provide little reason to buy vs. rent. The reason is because while the mortgage interest deduction lowers your income taxes once you own a house, it raises the price you must pay to buy the house in the first place.
The effect is similar to that when you buy a home in a good school district. You pay extra for the house, because you're getting access to good schools, not just the house. The mortgage interest deduction works the same way. You're paying extra, because the tax breaks that go with buying a house. In the language of economists, the tax benefits of homeownership are "capitalized" into the home's selling price.
Even if there is some tax benefit, it's likely that renters get the benefits, too. That's because rental property owners also get federal tax breaks and in a reasonably competitive market, some of those savings get passed on to renters.
"Anything that reduces the cost of providing the rental apartments sure gets through into the rental rate,if it's a competitive market," said David Seiders, chief economist at the National Association of Home Builders. The bottom line is that the tax advantages of buying over renting are much less clear than commonly believed.
Does this mean that buying a house never makes any sense? Certainly not. For one, buying a home is often a good investment.
Investing in real estate can be a smart move. As Princeton Univ, economist Burton Malkiel explained: "The real estate market is less efficient than the stock market. While there may be hundreds or thousands of knowledgeable investors who study the worth of every common stock, there may only a handful of prospective buyers assess the worth of a particular real estate property.Therefore, individual pieces of property are not always appropriately priced."
Yet investing in a home is hardly a sure-fire winner. Mark Obrinsky, vice president of research and chief economist at the National Multi Housing Council, an apartment industry trade group says "If you look at the average home price appreciation for the '90s versus appreciation of other assets, it's not clear that's the best place to put your money," The trade group that has begun a public relations campaign touting the advantages of renting.
Over the long run, the value of a house is likely to rise around 5 % per year, while bonds return about 7 percent and stocks about 8 %. Berson of Fannie Mae' offers similar estimates. --"In the stock market you might have on average gains of, let's say, 8 %, whereas in the housing market you might have gains of 4 %. -- double, perhaps."
On the other hand, there are other points to consider. "With a home you get the benefits of leverage. With a relatively small down payment you receive returns based on increases in the total value of your home. That's why even a four % annual rate of appreciation will nearly always out perform the returns you could get from stocks or bonds.You control the property for a down payment of only 5 to 20 percent.
But is leverage really a good reason to buy rather than rent? If it's leverage you want, you can get it in the stock market with options or by borrowing money to buy stocks (margin). Leverage also carries risks as well as benefits. When you're leveraged, the reason your expected return is higher is because you're taking a larger risk.
And house prices can fall! . While they rise on average, what matters for you as a homeowner is what happens to your house. And the value of your house could drop substantially.
If the price of your house falls by 20 % or more--as has happened in recent decades in Texas, California and New England--you've got a serious loss. While a loss of 20 % may sound bad, it's worse if you're leveraged. If you put down $10,000 on a $100,000 home--which then drops in value by $20,000-- your return isn't negative 20%, but negative 200%
When deciding whether you're better off renting or buying, strongly consider whether the neighborhood in which you're interested is going up in value, or down.
But knowing that house prices in a neighborhood have gone up recently is one thing; but knowing what they will do in the future is another. Most of the economists say that predicting housing prices is very very tough. It's no different than trying to figure out where the bottom is to Microsoft.
Calculating the length of time they are likely to stay in the same place is a more important concern than timing the market i is for renters who are considering buying a home.. The longer you stay, the more sense buying makes, because you have a longer period over which to spread the costs of buying and then selling.
But many buyers don't end up staying long. According to the National Multi Housing Council, -- About half of people who become homeowners move within 5 years. Many or most would have saved money had they rented.
Renters thinking about buying also need to consider how much they value the convenience of renting. While renting, you don't have to worry about keeping up the property or fixing things that inevitably break. You also don't have to pay for the repairs.
It is this convenience, as well as the flexibility to move at a low cost, that is the big advantage of renting rather than buying . If you value convenience and flexibility, you probably ought to rent. Then forget about those who claim you're throwing money down the drain.
To Rent or Not to Rent? That is the question.
Key points to consider when deciding to buy or rent include:
How long you plan to live there If you expect to stay there only 1-3 years, you'll probably be better off renting. You can avoid the costs of buying and selling, which can total 10% or more of the value of the property.
How much you value the convenience of renting. When renting, the landlord takes care of the broken dishwasher and leaky faucets and commode. When you own a home, these problems are yours to fix. You need to decide whether you want to take on these responsibilities and/or pay someone else to fix them for you.
Another is whether you can afford to buy in the area you want. If you're short on money, you will find it tough to buy in the neighborhood you like most. However, if you can't afford to buy there, you may be able to afford to rent in the area. If so, you may want to rent until you're ready to buy something.
Rent apartment vs. Buy in Austin Texas
Rent vs. Buy in Austin Texas: paying rent on an apartment vs. home ownership, renting, rental units, buying a new house, federal income tax deduction, mortgage interest, real estate taxes, leverage, tax returns, tax savings
Rent vs. Buy in Austin Texas: paying rent on an apartment vs. home ownership, renting, rental units, buying a new house, federal income tax deduction, mortgage interest, real estate taxes, leverage, tax returns, tax savings
