Monday, September 6, 2010

Renting versus Buying

Is buying better than renting? As with any other financial decision in your life, you have to do the math, and not rely on emotional thinking, jingoism or slogans.

One of the blogs I recently surfed had this entry cheerleading for home buying. Not surprisingly, it was a blog for a Real Estate Agency. I have nothing against Real Estate Agents - we've been in the business long enough and my partner is a former Agent. But many Agents tend to "sell" people on the idea of home ownership, largely because it generates commissions for the Agency.

Their "Five Reasons Buying is Better Than Renting" they gave are:

· Be your own landlord. The bank can only kick you out if you don’t pay; a landlord can be much less dependable – deciding to sell the property or choosing to live there themselves.

· Paying the principal is forced savings. Yes, it’s possible that home prices will fall further. It is also possible that your 401(k) will lose value. But over the long haul, both are likely to enjoy modest gains in value.

· Fixed-rate mortgages never rise – and eventually you pay them off. With mortgage rates at record lows, people who buy now are locking in real bargains.

· Good schools. Family-sized rentals are harder to come by in areas with excellent public schools.

· Spacious properties in pleasant neighborhoods. Sizable homes in attractive communities are almost always owned – not rented.

Um, these are some pretty specious reasons for buying a home. What their posting fails to mention is the basic equation in buying a house. It makes no sense to buy a home if it is cheaper to rent. Paying extra for the "privilege" of home ownership is stupid, period.

And buying a home can be a money-loser, even when housing prices are on the rise. Why? Because the transaction costs can be staggering. Traditionally, most Agents would advise their clients only to buy if they plan on staying in an area five years or more - because that is the time needed for appreciation to cancel out the transaction fees.

If you are live in a home for five years or less, consider the extra costs of owning versus renting:

1. Closing Costs: In a typical home sale, you end up paying a 5-6% commission to the agent. On top of this are lenders fees, points, mortgage tax stamps, title insurance, closing costs, appraisal, and other fees, taxes, charges that end up costing as much as 10% of the overall transaction.

In a traditional market (which we are seeing more of today) housing appreciates only a percent or two a year. So in order to "break even" on a home sale, you need to stay in the house for five years or more. Otherwise, you end up cashing out less than what you paid for the house.

That's called losing money.

2. Maintenance: Repairs, maintenance, and upkeep add a lot to the cost of home ownership. Mowing a lawn is no fun. Buying a $3000 lawnmower is even less so. You can easily spend thousands, if not tens of thousands of dollars a year in home "improvements" that add little or nothing to the value of a home. In addition to that are repairs, such as a roof, furnace, hot water heater, or the like.

When you are renting, few of these expenses are your concern.

3. Return on Equity: If you put down 20% or even 10% which is common these days, you are basically investing in something that has a zero rate of return. At the end of five years, if you are lucky, you might get your down payment back, with no interest or appreciation. So in addition to other costs, there is an "opportunity cost" in tying up capital in a non-appreciating or slowly-appreciating asset.

4. Deduction Schmuction: People hype about how mortgage interest is "tax deductible" and thus a good thing. But as I have said again and again, you can't deduct your way to wealth just as you can't eat your way to slimness.

In many cases, even with a deduction, you end up spending more per month that you would renting. Why is this? Well, chances are, the landlord has owned his property far longer than you, and thus owes a lot less on it. So he can rent it out for less than the cost of your owning the place, because he still makes money after paying the taxes, insurance, repairs and his mortgage. in fact, he might own the place outright, so he has no mortgage, and much of the monthly rent check is pure profit.

And here's the deal on rents: The market determines rental prices (like so many other things) NOT the cost of ownership. So what a place rents for is determined by the market, not what the carrying cost is of a mortgage and taxes. As a result, in many places in this country, it is cheaper to rent than it is to own, and many unfortunate investors are hemorrhaging cash, renting properties for less than their monthly carrying charges.

5. Condo Nightmare: If you are comparing renting an Apartment to buying one (as a Condo) then factor in the condo fees and all the hassles of the amateur management of a Condo board. Oh, give me the experienced dictatorial hand of a landlord any day over the vacillating, petty and abusive nature of any Condo board! Landlords want to keep tenants, so they are less overbearing and difficult as legend and lore would have you believe - provided you pay your rent on time and don't annoy the other tenants. Condo Boards, on the other hand, will pick a fight with you because you put a Christmas Wreath on your door - while at the same time failing to repair the roof!

See my article: Never Buy A Condo!

* * *

Buying a home and paying more money to own than to rent is a sure sign that housing is overpriced. "Do the math" first, before you buy!

Now lets look at the so-called "advantages" touted by these Arizona Real Estate Agents:

1. Be Your Own Landlord: This is a pleasant fantasy until the facet under the sink breaks and you realize you have to fix it. I sold a house to a fellow who was a renter for a dozen years. Two years later, he called to complain about a leak. He thought I was the landlord and would come fix it. I had to explain to him that he owned the house now, and was responsible for repairs. I kid you not! People really think this way!

The idea that the landlord will "throw you out" on a moment's notice is just a fear argument. In many States, you have to give a month's notice - if not more. And if a tenant really wants to, he can drag out the process for a year or more in many States, by forcing the landlord to begin eviction proceedings. No, the cards on that are all in the tenant's hand. A landlord is not going to "throw you out!"

And so what if they do? You just go rent somewhere else. There is no shortage of places to live in this country, what with the burst housing bubble and a shrinking population growth rate.

And as a former landlord, let me tell you that "throwing out" a tenant who pays the rent on time is the last thing you want to do. Vacancy kills, and having good tenants is the name of the game. If you have a positive cash-flow, why in God's name would you toss a good tenant?

I've sold off my investment properties over the years. But you know what? I never "threw out" any tenants. When tenants left of their own accord (usually because they moved out of State or bought a home of their own) I used that occasion to think about whether it was time to sell, or to re-rent. So when I sold my properties, no one got "thrown out."

The "be your own landlord" is a bullshit argument.

2. Forced Savings: While it is true that part of your monthly mortgage payment "pays down" the balance on the loan, effectively increasing your net worth, in reality, in the first five years of home ownership, you pay down little of the balance. In the five years we have had the house on Jekyll, we've paid down the balance maybe $15,000, and only then because I have made extra principle payments on the loan.

Real payback on a mortgage doesn't happen until the 10th year. And on average, most Americans move every 5-10 years. And many Americans refinance long before that, negating any equity pay-downs, which are offset by refinancing closing costs.

This argument only makes "sense" if you plan on staying in a place for 10 years or more. For example, if you have a steady job and are raising a family, you might stay in one place for a decade or more. If that is the case, then yes, home ownership might make sense. But for a young professional just starting out in a new town and a new job, buying a home right off the bat could be a bad move.

3. Fixed-rate mortgages never rise - and eventually you pay them off: There are two arguments here, and both are specious. Yes, mortgage rates are very good right now. They were good five years ago at 6.5%, and everyone then said "Oooh! lock in at these LOW LOW RATES!" because 6.5% looked pretty good compared to 11%. 4.5% is even better, of course. But will next year bring us 3.5%? Probably not.

But the point is, having been through this game for 20 years, and refinancing loans because "you have to lock in these new low, low rates!" I found that it is all just a game. Affordability of a house should not rest on interest rates. And in fact, it doesn't. When rates go up, house prices go down. When rates go down, house prices go up. The Fed is dropping rates right now to prop up sagging home prices.

Query: What happens to the price of your "bargain" home when the Fed raises interest rates back up? When mortgages go back to 5-7% (as they historically have) will your house have the same value? Or will it flatten back down? Think about this.

Yes, these are good rates these days. But don't kid yourself that a low mortgage rate makes the house a better deal in the long run. If you sell in 4 years, chances are, you will lose money, or at best, break even.

The second half of the argument is easier to debunk: Few Americans every "pay off" their mortgage over a period of 30 years. Mortgage-burning parties are a thing of the past, and many Americans are retiring with mortgages - or even taking them out at age 70 and beyond!

Again, the average American moves every 5-10 years, so the idea that you will pay off your home over 30 years and live there for free (there are still taxes and insurance to pay!) is somewhat a fantasy. A pleasant fantasy, but still a fantasy.

4. Good Schools: The Arizona Real Estate Agents claim that "Family-sized rentals are harder to come by in areas with excellent public schools." I am half-tempted to report them to the Arizona Realty Board on that one, as it smacks of red-lining. The truth is, in ANY neighborhood, there are homes for sale and for rent.

People get transferred and decide to rent out their house. Houses rent for all sorts of reasons. My parents rented a house in Old Greenwich, Connecticut, hardly a "bad neighborhood" with "bad schools". My Dad had a temporary executive job in New York at the time, and it made more sense to rent than to commit to buying. Smart move.

You really can't tell the "good" neighborhoods from the "bad" ones until you live in them. And if you are moving to an area from out of town, it may make more sense to rent for a year or so, until you are sure that (a) you like the new job and the new town, and (b) you know where you really want to live. Until you spend time "on the ground" in an area, it is hard to know where you really would be happy.

And a Real Estate Agent is the WORST PERSON IN THE WORLD to rely on to tell you where is a "good neighborhood". For one thing, as I noted above, it is borderline illegal in most States for Agents to talk about neighborhoods that way. For another, many Agents tend to think of areas that they like, or that they sell a lot of houses in, as being desirable.

For example, when we bought our vacation home in New York, we talked to an Agent who specialized in finding homes for College Professors at Cornell. We didn't realize this at the time, as it was a cold call. She kept trying to steer us to a neighborhood near Cornell where college professors lived - and not to the lake house we wanted to buy. When the only tool you have is a hammer, you tend to see every problem as a nail - and so did she.

Be your own judge - don't rely on a Real Estate Agent to pick your home or your neighborhood for you. Because, chances are, they have different values than you do. Or the house that they think is "desirable" is the house they have the listing for, and will get "both sides" of the deal on.

"Finding the right home for the right person" was the slogan of "Red Jacket Realty" on the Simpsons. And as it was explained to Marge, the "right home" is the one you are standing in front of, and the "right person" is the one you are talking to at the time!

5. Spacious properties in pleasant neighborhoods. Again, this argument is utterly specious and also a little bit of coded racism. After the housing bubble burst, a lot of mini-mansions in "good neighborhoods" sat empty or were "for rent" by their underwater owners or the banks. There are always houses for rent in neighborhoods like this, just as there are everywhere else.

But think first whether you need a "spacious house" in the first place. As I have noted here time and again, people tend to bankrupt themselves buying "as much home as they can afford" for little or no reason other than sheer status. The mini-mansion is not a happy home, in many cases, just a status symbol.

Instead, buy the home that makes you HAPPY - a house that is easy to maintain, has enough room for your family - but no room for excess storage of junky things. Spend less time and money vacuuming and dusting (or paying an illegal to do it) and more time enjoying life.

Should you rent? Should you buy? It depends on your life circumstances and plans, and also the market. In most cases, if you don't plan on staying somewhere for a decade or more, chances are, it is cheaper to rent a home than it is to buy one.

DO THE MATH - don't rely on slogans and pat answers from Real Estate Agents!