Renting is superior investment to owning for most Americans

Despite being an outspoken renter over the last five years (I’ve actually been a renter since 2001), I still believe there are virtues to home ownership. The emotional benefits are palpable, and there are financial reasons to own. The main financial reason I plan to own again soon is to lock in a cost of ownership lower than the cost of a comparable rental. A secondary reason is to obtain the “forced savings” benefit of a conventionally amortized mortgage. I know a lender would give me a HELOC if I asked, but I have no intention of it. At some point, I want to pay off a mortgage and live truly free.

Renting has been good to me, particularly over the last several years. At some point, I will buy a home, although given the current state of inventory, it won’t be any time soon. A new study says perhaps I would be better off remaining a renter. Financially, to come out ahead as a homeowner, I will need to hold the property long enough for appreciation to cover the cost of selling. Plus, I will need to lay off the HELOCs. My plans are to do just that, so I will come out ahead. I recognize the need for a disciplined approach. For those who don’t have such discipline, they will be better off renting — unless of course, they plan to game the system and live as a Ponzi….

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Renting v. Buying: New Evidence Emerges & Informs Housing Policy

e21 Staff Editorial | 05/06/2011

The basic premise behind the panoply of government policies aimed at stimulating home construction and financing – the mortgage interest deduction, Fannie Mae and Freddie Mac, the Federal Housing Administration (FHA) loans, down payment assistance, among others – is that homeownership yields huge societal benefits in the form of improved neighborhood aesthetics, reduced crime, and more civic attachment.

The purported benefits of homeownership could actually be a classic case of reverse causality, as higher income households less likely to commit crime and more attached to the community tend to also be more likely to own homes.

The same is true of wealth studies that purport to show homeowners are wealthier than renters. It’s true that homeowners are generally much wealthier than renters, but it’s not because they owned their homes. People who have the financial discipline to sustain home ownership also have other financial habits such as saving which contribute to overall wealth creation. Although many renters also have these characteristics, a larger percentage of homeowners do; thus they have greater wealth.

However, even if these social benefits are only imaginary, the basic economic proposition of “owning” a home is often assumed to be so far superior to “renting” that government policies to allow the marginal household to buy a home make sense –simply because they provide an avenue towards wealth creation.

The sense that homeownership was an essential building block to household wealth was a key psychological driver of the mortgage boom. As much as government policy was to blame for getting people to purchase homes that they otherwise wouldn’t, it is important also to acknowledge the role played by “societal coercion.” As Yale professor Robert Shiller explains, “bubbles are impossible without extreme public enthusiasm.

No kidding.

Individuals who would have otherwise been content to rent were often asked by friends, colleagues and acquaintances, “why throw your money away on rent?”

Apparently, it’s okay to throw away twice the money on interest.

Whereas the rent check simply vanished each month, the mortgage payment helped to secure something tangible and allowed one to participate in the upside of house price increases. If a household could afford to buy a dwelling, the prevailing wisdom went, why in the world would they be so dense as to rent?

Like any real estate truism, there are times when it is foolish to rent — like when it actually costs less to own than to rent. However, the moment prices get pushed above rental parity, homeowners become the fools who are throwing their money away on mortgage interest.

This sentiment was intensified by expectations of continued price gains in 2004-2006, when first-time homeowners worried that if they did not buy soon, they’d never be able to afford a home.

Buy now or be priced out forever. Every realtor who says this should be rounded up and shot.

A new academic article in Real Estate Economics turns this conventional wisdom on its head. Using data from 1979 to 2009, the authors demonstrate that renting was the superior investment strategy for most of the past 30 years. Counterintuitive as the finding may be to some, it is actually quite logical. Unless someone possesses the cash necessary to buy a residence, he or she will be renting one way or another. The choice is between renting the property directly or instead renting the capital necessary to buy the property.

Amen. The only difference between renting property and renting money is equity participation. When you rent property, you don’t share in the gains or the losses if values change. If you rent money, you do. This choice seems like a no brainer if you believe real estate prices always go up. However, we all know that isn’t the case.

The amount of capital to be rented is a function of house prices, while the bulk of a mortgage payment is interest, which is the rental payment on this capital. After 2 years, the typical 30-year amortizing mortgage balance has been reduced by less than 3%. This means that a household that took out a $300,000 mortgage with a 5% interest rate to buy a home has only reduced its mortgage balance by $8,600 after two years despite spending nearly $39,000 in total over this period.

I am always amazed by how many people don’t recognize renting money is akin to renting property. The self-styled smart buyers were the ones who used interest-only loans. They recognized they weren’t making much progress on paying down a mortgage, so they didn’t even try. Idiots.

Housing advocates may respond by pointing out that at least the $8,600 in this scenario went towards home equity rather than simply being squandered on rent. But, as demonstrated in the Real Estate Economics article, the principal component of each mortgage payment – i.e. the portion of the mortgage payment that goes towards reducing the principal mortgage balance instead of interest – is an added expense renters don’t have. During the housing boom, the wealth created from housing was not principal amortization, but rather large price gains on a highly leveraged asset. A 20% increase in the price of a house purchased with 5% down results in a doubling of the homeowner’s equity. These wealth gains proved illusory and were a function of the leverage involved (20-to-1 in the case of a 5% down payment) rather than anything related to housing.

To fully understand this phenomenon, it’s worth taking a few moments to review the graph below. The impact of speculative bubble equity is obvious.

The relatively small down payment gets magnified many times over as lenders inflate bubble equity. The actual, sustainable price gains barely outpace inflation. The only real benefit from ownership is the forced savings of loan amortization — and that is a great benefit, assuming of course, that lenders don’t let homeowners plunder it.

They key to understanding why renting is so often superior are “price-to-rent ratios,” which reflect the difference between the monthly cost of renting or buying equivalent residences. While it is often less expensive to rent than it is to buy, the relationship can change over time causing one of the two options to be an especially (or comparatively) good deal in some circumstances.

One of the key features of my monthly reports is the relative valuation compared to historic norms and to rental parity. I make it easy to identify when circumstances favor renting or owning.

… To put this change in concrete terms, imagine a two-bedroom, 1,800 square foot condo. In 1999, it required a $1,200 per month mortgage to buy, compared to a $1,000 monthly payment to rent (a price-to-rent ratio of 1.2). For the price-to-rent ratio to increase by 2.2-times over this period it might have cost $3,000 a month (in mortgage payments) to buy the property in 2006, compared to a $1,100 monthly rent payment. In retrospect, it is remarkable that it was the household spending $1,900 per month less to live in the same property that was considered to be “throwing money away.

Yes, it is remarkable. Remarkably stupid. Back in 2007, this debate used to rage at the IHB. People would actually claim paying double the cost of ownership as compared to a rental was not a waste of money. At the time, considering how much illusory gains people obtained over the several years prior, this delusion was understandable, but no less foolish — as they all discovered when prices crashed.

Renting was better than buying for nearly all households during 2005-2007 because prices collapsed after that period. Importantly, the authors make clear that in general, renting is only the superior financial choice if the renting household has the discipline to invest its marginal savings into financial assets. Renting generates residual savings because the cash outlays tied to housing consumption (or purchase) are lower. But if renting households, or the individuals themselves lack the discipline to save this money, and instead increase non-housing consumption, any wealth gains will clearly disappear.

Just as renters most often squander any savings, unfortunately, loanowners often do the same through mortgage equity withdrawal.

The basic intuition is that the principal portion of mortgages is what usually leads to more wealth. But as this article shows, that’s because it represents incremental savings not because of anything intrinsic to the mortgage itself. Viewed in this light, the economic gains come not from “owning” a home but rather the forced savings generated by the principal portion of the monthly mortgage payment.

It is instructive that at the end of the analysis, the much-touted economic gains from homeownership really come from the forced savings of an amortizing mortgage.

This has always been the real benefit of home ownership. It was the reservoir for retirement most people could count on. The destruction and elimination of this reservior by lenders is one of the greatest tragedies of the housing bubble. The younger generations are currently being asked to overpay for baby boomers’ houses to fund their retirements, and later one, those same generations will be asked to pay more in social services to support the Baby Boom Ponzis who squandered their home savings through a lifestyle of mortgage equity withdrawal.

And this benefit only accrues to myopic households that would not otherwise save.

No. It’s worse than that. This benefit only accrues to households that don’t empty the housing ATM the moment any equity accrues. Lenders have eliminated the benefit of forced savings through unfettered access to home equity through HELOCs. Many homeowners are in fact loanowners who have come to regard home price appreciation as income they are free to spend.

Thus, the government could replicate the same economic benefit generated by federal housing policy through a simple deduction from checking accounts that could then be deposited into a tax-free savings vehicle. This is an important point to consider the next time someone argues that removing or lowering a housing subsidy will necessarily inflict an acute economic hardship on the nation.

Think about that idea. If we simply removed any limitations on contributions to IRAs, we could produce the same economic benefit as all the housing subsidies combined. The Ponzis won’t like that idea, but those asked to pay their bills should strongly consider it.