Apr132015

Does housing math favor buying or renting?

Most markets trade at or below rental parity, and those with a long-term ownership horizon obtain significant benefit to owning.

OCHN-rating-10Renting versus owning is both an intellectual decision and an emotional one. The intellectual decision is first and foremost a financial analysis of the comparative cost of renting versus owning. The basis of this analysis is a price point called rental parity.

Rental Parity is the price where rent is equal to the monthly cost of ownership. When rent and the cost of ownership are imbalanced, it often signals individual properties or entire markets are overvalued or undervalued. I expanded on the rental parity concept to create detailed housing market reports, and develop the analysis of each for-sale property on the MLS found on this site.

Rental parity is a point-in-time analysis; therefore, it leaves out a couple of important financial factors: inflation and transaction costs.rental_parity

Inflation is the erosion of purchase power of money over time, or looked at another way, it is the increase in the price of some set of goods and services in a given economy over a period of time, as measured as the percentage rate of change of a price index. The effect of inflation on housing costs is that it tends to increase the cost of renting over time, and theoretically, it will increase the value of a house over time as well.

If the cost of rent is increasing, but your cost of ownership is fixed (assuming a fixed-rate mortgage,) then owning a home becomes less expensive over time and serves as a hedge against the impact of inflation. If you are a homeowner, inflation is your friend; if you are a homeowner with a lot of debt, inflation is particularly welcome.

There is one big cost of home ownership that works against the positive impact of inflation: transaction costs. When people buy a house, they pay some closing costs, but many of these get rolled into your loan and forgotten. When people sell a house, they generally go to a realtor to help them market the property and complete the paperwork necessary for the transaction. Real estate commissions for many years have been held at 6% in the United States, and the seller is the one who pays this commission.frustrated_FSBO_Dillema

From the time of purchase to the time of sale, inflation (or irrational appreciation) must have increased the value of the house enough for the sales price to cover the real estate commission or the seller will lose money. This is why it is often recommended for people who are not going to live in a given area for more than 2 or 3 years to rent instead of own.

Renting is freedom — freedom to move when you wish (within the terms of your lease.) Homeowners who go underwater lose this freedom of movement. (See: Sell now or be priced-in forever!)

This advantage of renting is nullified during a price rally as owners have this same freedom during those times, but this forgotten benefit becomes readily apparent once prices fall.

When determining whether or not buying or renting a home is the wisest course of action, the calculations on this site detail the point-in-time math revealing whether or not the property is a good deal today; however, for a more complete picture, prospective buyers must be realistic about how long they will be committed to living in the property. “Forever houses” are rarely forever as unforeseen circumstances prompt people to sell quite often.priced_out_forever

Unfortunately, the projections about future costs and benefits are universally overstated by rent-versus-own calculators, most of which are published by biased realtors who want the math to favor ownership. Even when these are more accurate, projections about future benefits and costs are viewed through the lens of today’s dollars as if inflation were a positive aspect of home ownership that makes people money.

Zillow’s and Trulia’s analysis is better than most, but they also overstate the benefits and their computed breakeven points — the amount of time someone must live in a house before the savings and appreciation outweigh the costs — this breakeven time is longer than they say.

Why the math on homeownership is not motivating renters

Diana Olick, April 8, 2015doesnt_pencil_mortgage

Rents are soaring, and mortgage rates are still historically low, but renters seem less and less inclined to buy, even when homeownership could save them money fast. How fast? Two years, according to Zillow, a real estate sales and analytics company. …

The highest break-even horizons were in Los Angeles at 5.1 years, Washington, D.C., at 4.2 years and San Diego at 3.8 years.

Shevy and I always tell prospective buyers that if they aren’t going to stay in a property 3 to 5 years, they should strongly consider renting because they may not get their down payment back. That’s sound advice in any market, but realtors almost never tell their clients this because it doesn’t activate greed to further motivate buyers to act.

And yet the math isn’t moving renters.

If the buy versus rent decision were about simple math, we’d likely have millions more homebuyers in the market, because the equation is tilted heavily in favor of buying,” said Stan Humphries, chief economist at Zillow.

coastal_californiaThat statement is not true in most of Coastal California because prices have already inflated to the limit of affordability, and the rent-versus-own math is at rental parity, so buyers don’t really gain anything unless they stay long term.

“But no matter what the numbers say, buying a home is a huge commitment. Every day, Americans make decisions to buy or rent based on any number of personal dynamics, including preference, flexibility needs, family factors and, yes, financial considerations.” …

Buying a house is always an emotional decision. Usually, the financial analysis is justification for an emotional decision, even among the most analytical people.

Younger renters, who may in fact want to buy, are struggling to save for a down payment, given their high rents and high level of student loan debt. Of renters surveyed by Zillow, 16 percent said they couldn’t qualify for a loan and 13 percent said they didn’t have enough for the down payment.

(See: Most Millennials won’t qualify for a mortgage until 2019)Superadequacy

This also shows up in demand for both new and existing homes—the bulk of which is on the higher end. Home builders say that’s where their business is, and that is why they’re not building as many cheaper, entry-level homes as they have in the past.

This is true. Builders are providing product almost exclusively for the move-up market, which explains much of why homebuilding languishes at construction levels near the lows of the last 60 years.

On the existing home side, still very tight inventory paints a similar picture. There are so few homes for sale that lower-end owners who may want to move up are not listing, for fear they won’t find somewhere else to live, somewhere they can afford.

Actually, the low-end owners are not listing because a large number of them are still underwater. Fear of finding a move-up home is a red herring.above_water

“It’s still a seller’s market,” said Jonathan Smoke, chief economist at Realtor.com. “Supply is not keeping pace with surging demand. We expect rising prices to persuade those who may be on the fence about listing their homes to do so in the coming months, leading to closer parity between supply and demand.”

Jonathan Smoke was interviewed by HousingWire, and he supposedly isn’t going to act like a clueless shill in the mold of Lawrence Yun and David Lareah, but based on the bullshit above, he isn’t living up to his advance billing.

Home prices, however, will be the key driver. Fast, investor-fueled home price appreciation in 2013 threw a wet blanket on sales in 2014. That’s because investors priced themselves out, and regular owner-occupant buyers couldn’t afford the new market. As price gains eased toward the end of last year, the hope was that buyers would return; the trouble now is, again, still-short supply buoying prices.

That is one of the clearest and most coherent statement of the conditions over the last two years.

Even though prices in most markets are high enough that investors aren’t interested in purchasing these properties as cashflow investments, that price point is about 30% below rental parity; thus many markets still have many homes available at or below rental parity. For long-term homeowners, the math still favors owning over renting, and unless we inflate another housing bubble, that will remain true.

The_Way_to_Grow_Poor,_The_Way_to_Grow_Rich_--_Currier_&_Ives_1875


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