Buying A Home Versus Renting One During A Real Estate Bubble: Should You Wait Or Jump In?
BATTLECALL GUEST EXPERT: Robert J. Abalos, Esq., InvestingInLand.com
I've gotten a flood of emails lately from people that read something like this:
"I live in (name your city) and real estate prices here are skyrocketing. I currently rent and I want to own my own home. But I'm concerned buying now is dangerous because I read about a real estate bubble. Yet if I wait and don't buy prices may be higher a year from now. What do you think I should do?"
I always answer this type of email this way.
First, I can't tell you what to do. Owning a home is NOT strictly a financial decision. As I've said many times before, owning your own home is a LIABILITY, it is not an asset. It costs you money every month, it does not put money into your pocket. The classic definition of an asset is one that provides you with income, or as Wall Streeters would say "Assets feed you, liabilities bleed you." Therefore, owning your own home means incurring a financial liability that normal due diligence would likely persuade you out of assuming.
People own their own home for mostly psychological reasons, with forced savings and appreciation benefits low on the list. Newlyweds want to bond as husband and wife so they own a home and often fix it up and decorate it together. Families strive to put down roots and join a community for the sake of children and career. Single people often want to feel like they are "growing up" so they buy.
The one financial reason people often give for buying their own home is that "owning a home is a good investment." Generally they mean that renting makes no one but their landlord rich and forced savings through monthly mortgage payments and price appreciation will yield a bigger payoff in the future for them instead of renting.
Unfortunately, that's no longer true.
Renting is Cheaper Than Buying
Traditionally, it was cheaper to buy a home than rent one. That was the rule of thumb for many years, most of the 20th Century in most cities in fact. The notion was that renters paid for the convenience of being able to move whenever they wished and for having someone else handle all the chores associated with real estate ownership like fixing things when they broke and common area and outdoor maintenance. Think of how hotel rooms are priced right now versus apartments in the same geographic area or even in the same building. Hotel rooms cost more per night to occupy. Why?
Real estate appreciation in the 1970s and through to the present day has distorted the orthodox formula and the absurd price appreciation of properties over the last five years has made the situation crystal clear.
IT IS CHEAPER TO RENT THAN BUY THE SAME PROPERTY.
This is true in my own personal case, an example I've described before.
I live in downtown Seattle, Washington in a mixed use building of condos and apartments. I could afford to buy a condo in my current building, but why should I?
Since most every non-transient tenant that can afford a home is flocking to buy a house or condo and take advantage of low down payment "First Time Homebuyer" programs, landlords especially in premium apartment buildings are desperate for "good" tenants. Like in many major cities, tenant incentives to sign leases are common here in Seattle.
My monthly apartment rent is $2,550. Once a year I am given a FREE month's rent to sign an annual lease. So I live free one month a year. Another way to think about it is that my monthly rent is $2,337.50 or $2,550 x 11 payments divided by twelve months.
To move into my apartment I was charged $440 in various fees like a cleaning deposit and credit check. To buy one of the condos in my very same building, priced between $500,000 and $700,000, I would have had to put down say $50,000 to $70,000 on a 90% LTV mortgage and carry a monthly payment of $3,381.98, assuming a 30-year loan at 5%. PLUS I would have a condo fee of $385 per month.
Also realize that taking $70,000 out of savings for a down payment would have cost me an additional $116.67 a month in lost interest at 2% per year.
So renting my apartment right now costs me $2,337.50 per month. Buying the same apartment in the same building would cost me $3,883.65 per month, a difference of $1,546.15 per month. This figure also does not include all those traditional intangible benefits of renting that were the basis of the old rule, like the fact I can move at any time or that I do not have to pay to get things fixed. In fact, my washing machine recently broke and another one was given to me the next day. If I owned that unit, it would have cost me $400.
The Value of Negative Imputed Rent
Advocates of home ownership would point out that renters have no stake in the future appreciation of the property. After all, leasing gives you nothing but a box filled with rent receipts while buying means forced savings and equity buildup over time that can be considerable.
They are wrong for four reasons, especially now that real estate prices have risen so fast and so far.
First, buying properties at inflated prices sets the appreciation bar too high. Properties do not appreciate from their purchase price but from their actual economic worth. If you buy a house worth $100,000 for $150,000, in time your house will grow in value but the appreciation will start at $100,000. This is common sense. If you overpay for something, someone else has to make the same mistake when they buy it from you or you will lose money.
Second, most of the gains on real estate from long term appreciation are just inflation adjusted gains and not real but merely mathematical illusions. Again, this is common sense. If the price of everything rises 5%, you haven't gained a penny in purchasing power when the price of your home rises 5% too. Think of it this way. Assume you work at a job where everyone makes $100 per week in salary. I see that inflation has risen the price of everything you buy 10%, from your food to your utility bills to your clothes. So I take pity on you and give you a 10% raise. You can brag to your friends and family you just got a 10% raise and are now making $110 a week but you haven't gain a cent in real terms. You are just where you were before, only now paying more for the very same things. Inflation compounded gains are generally not factored out of long-term appreciation reported profits. Neither are property taxes paid, mortgage interest, broker or sales costs to buy or sell, or repair expenses incurred. People will say "I bought my home in 1970 for $25,000 and just sold it for $500,000." Of course their actual profit is far from $475,000 but most just think of it that way. Any financial calculator will tell you that an asset rising from $25,000 to $500,000 over 35 years is merely a 8.94% annual gain. If just 3% of that annual sum is inflation, the annual yield on this purchase BEFORE interest, taxes, and repairs is less than a government bond would earn and far less factoring in those required holding costs.
Third, advocates of long term home ownership ignore depreciation which is not deducted on tax returns like it is on rental properties but nevertheless still is a real cost of owning a home. Again, this is common sense. As homes age, they require more and more maintenance, repair, and modernization. A thirty year old home may be paid off in full and owned free-and-clear but it has costs, often monthly costs, that a new property does not have. Not just repair and improvement costs like getting rid of that 1970s avocado green kitchen motif and a new water heater but lower energy efficiency and higher maintenance costs. Unless your older home is unique, like a Painted Lady Victorian with original woodwork, the critical question is why would someone want to own a thirty year old home in a subdivision where the natural life of all improvements are coming to an end where they can buy a new home for almost the same price and have none of the higher costs of the older home shifted to them?
But fourth, the real reason renting is cheaper than buying these days is negative imputed rent. Think of this concept as a subsidy being given a tenant by a landlord equal to the negative cash flow on that property or the difference between buying a property and leasing the same unit to a tenant. In my case described above, it costs my landlord $3,883.65 to lease my apartment (or one just like it) but I only pay $2,337.50 per month to live there. So my negative imputed rent subsidy is $1,546.15 per month.
The concept of imputed rent is used by the government to explain how homeowners are not really "poor" by welfare standards since they own an asset that has rental income value. So if you own a home and could rent it out for $1,000 per month, you have an "imputed rental income" of $1,000 per month for welfare qualifications. Of course this makes no sense since people living in their own homes have no such income of any kind. How can they rent their home to tenants and live there at the same time?
But the concept of negative imputed rent has real application to tenants like me. I'm getting a subsidy from my landlord of more than $1,500 per month to live in my apartment. They are bearing a heavy negative cash flow on my unit so I can live there, in other words, they are underwriting my lifestyle. So why should I buy it? The greater question is why does the landlord rent these apartments at all? Why not just sell these units, stop the negative cash flow, and cash in while condo prices are sky high?
Don't ask me. I don't know the answer. I suspect they think these condos will have greater value in the future, like in the year 2030. Bad math but I'm not going to risk my subsidy to explain it to them.
Some Advice for Prospective Home Buyers
I want to own my own home too. But I'm not willing to pay an extreme price for one either, especially when I have a great leasing deal right now.
But I continue to look. All local real estate markets are flawed and despite all the price hysteria, sellers occasionally do some dumb things and I want to be there when one is the mood to play the fool. A rising tide of prices does not lift all properties equally. Some are stuck in the mud waiting for you to find them like seashells on the shoreline.
First, I would get to know the properties where you want to live. ALL OF THEM. Study recent sales in your target area. Visit the properties and see what $275,900 or $635,800 buys in your town. If 234 Main Street just sold for $445,500 go see it and see what nearly half a million dollars buys. I recently saw a 1,100 square foot Cape Cod house in an area of Seattle called Green Lake that sold for $620,000. Whoever bought it must have been nuts. You had to see this tiny decrepit house with your own eyes to understand why.
Second, keep saving and building your credit rating every month. If it takes you a year to buy, you should be saving at least that negative imputed rental subsidy you receive each and every month by renting. If your landlord has a negative cash flow on your house, condo, or apartment, realize that is what you would be paying if you were in their shoes. So be prepared to be by saving that sum now. When you buy, the more cash you have and the better your credit, the lower your costs of home ownership.
Third, don't be pressured into buying. A "Buy Now or Be Shut Out" mentality is foolish and dangerous. It's the classic sign of a financial panic and brokers and sales agents will twist your arm to buy now before you are priced out of the market. Single family homes and condos in your area are not going anywhere. You want a good deal, not just any deal. You'll be living with the price you pay and the mortgage terms for a long, long time.
Fourth, forget about finding cheap properties through normal retail sales channels like MLS or your neighborhood real estate agent. Competition there these days is fierce. Even the foreclosure market is tough. There are more bargain hunters on the courthouse steps now than on eBay. A person I know recently defaulted on a home mortgage and received nearly 1,000 letters and postcards from investors seeking a pre-foreclosure way of "helping her out." They all wasted their time and postage money. Rely more on private channels to find good deals, for example, direct mail appeals to property owners who are thinking about selling. Often sellers with emotional ties to properties will sell at better terms than financially motivated ones.
Fifth, calculate your actual cost of homeownership, including condo or association fees, property taxes, monthly repair costs, and the like and then compare it to leasing the same property. When both numbers are just about the same, you should buy. These days it will cost more to buy than rent and you should expect that but it should not be much more, or like in my case 67% more to buy than lease.
Sixth, think of your home as what it really is. A LIABILITY. It's not an investment. It will drain you financially, not make you money. Ask any new homeowner and they will tell you how broke they are just like any new parent with a baby will complain about not getting any sleep. Own your own home for emotional, creative, and comforting reasons, but not financial ones. Most people who are planning on moving over the next five or seven years SHOULD NOT BUY at all. The costs are just not worth it. People think they are reaping windfalls on homeownership but in reality they are not. In my Investing in Land Home Study Course I describe how my own father's house went from $28,500 to $375,000 in value over thirty years. Sounds great, but when you figure out the real numbers subtracting inflation a U.S. Savings Bond was a better investment.
Like I said earlier, I can't tell all of you who email me what to do, whether you should buy or keep renting, or the reverse, whether you should sell now to take advantage of high prices and rent. I can just tell you what I'm doing. I'm waiting to buy. The current real estate bubble is an absurd phenomenon built on greed and speculation and fed with cheap money. Every day I'm more convinced that the bubble will pop not with an explosion but with a slow leak. Prices will not collapse overnight but will slowly retreat. The reason is most sellers would rather pull properties off the market than experience sharp losses. But prices will drop and fall for some time as median values head towards their traditional mean.
When will this happen? Soon, but I don't know when. But it will.
P.S.
Inevitably when I write on this subject I get emails thanking me. I also get ones that read something like this:
"You are such a (insert the expletive or obscenity of your choice) idiot. You don't know what you are talking about. I bought my house for $250,000 last year and just sold it for $425,000. I'm making a fortune while you do nothing. HA! HA!"
Of course people make money during real estate and stock market bubbles. But they are lucky and not smart. In fact, they are quite dumb for risking their money at ridiculous valuations and should be thanking God someone came along even dumber to bail them out of a bad investment.
It's called the Greater Fool Theory. The problem is some fool needs to be at the top of the pyramid and they take the great losses. And that's what a real estate bubble is, a pyramid scheme where speculators treat real estate as little pieces of paper like lottery tickets that pay out big winnings instead of tangible assets that have intrinsic values. Just like most pyramid scams too, the early players make big money at the expense of those that get in at the end. Remember the famous con man Charles Ponzi made not only himself but lots of other people rich. He just couldn't make everyone rich.
When I get emails like I describe above I am reminded of the experiment The Wall Street Journal plays where they have a chimpanzee throw darts at a copy of the financial pages to pick stocks and then see if a panel of professional money managers can beat the chimp with their selections. Often the chimp wins.
The purpose of the game is not to prove that chimpanzees make great financial advisors and that you should hire one to manage your own investment portfolio. The game demonstrates that some markets are so absurd that even a chimp throwing darts can succeed.
Understand?
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