Sep 30, 2016
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Comparing the True Costs of Buying Vs. Renting

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By Kirk Chisholm, Series 65

In this article, I will be examining whether it makes sense to rent or buy a home. This is the third and last article of this series. The first, Should You Rent or Buy a Home?, examined what factors you should consider when renting versus buying a home. The second, What is the True Cost of Owning a Home?, examined the full cost of owning a home.

Start With the Real Numbers

Numbers don’t lie, so let’s look at some real numbers. There are many calculators available online to help you figure out whether to rent or own. Unfortunately, very few include the true costs of owning a home. If you read the prior article, you will have some understanding of what was left out and how to calculate it. The math in this article will be relatively straightforward and a bit more eye opening. I will be showing you some examples of real properties that I have found in the past year to illustrate this secret that very few people know.

There is a myth out there that when you rent you are paying someone else’s mortgage, so why don’t you pay your own? This is a farce. It doesn’t matter whose mortgage you are paying, what matters is your costs to live in that home. No matter where you live, the cost to live in your home is an expense. If you rent, you pay rent to a landlord. If you own, you pay a mortgage, taxes, insurance, maintenance, etc. There are costs for both options. Unless you live in a tent you will be paying for a home either way.

The reason many people think that owning is better than renting is that they equate owning a home as an investment rather than an expense. Once they make the realization that it is also an expense, the picture should become much clearer. (For more, see: What to Consider When You Finance a Home.)

If you buy a home, it is an expense. If you buy a home and rent it out to a third party, it becomes an investment. A better way to put it is that when you are renting, you rent from a landlord. When you buy a home to live in, you are renting from yourself. Since you do not get any monetary gain from paying yourself, it is 100% expense.

Renting vs. Buying: Which is Cheaper?

In my last article you saw that on average when you buy a home, you are not making money on it. Given the fact that you usually have to put down 20% you are actually losing out in opportunity costs with those funds. But the question remains – which is actually cheaper?

Are you looking at renting versus buying a home in an upper-class neighborhood? Everyone has to live somewhere, but most people live in a location that is affordable according to their monthly cash flow. If you make $5,000 each month in income, it is unlikely that you will be renting a home for $4,000 a month. This tends to limit the number of people who rent high-end homes. The limited number of renters tends to bring the monthly rent down to a more reasonable price than if they were to buy the same home. This effect creates an opportunity for people to rent a high-end home for much cheaper than the price they would have paid to buy it. (For more, see: How to Avoid Common Middle-Class Money Traps.)

Example 1: High-End Suburban Single-Family Home

I noticed this difference a number of years ago while comparing different homes in a financial plan for a few clients. One home I saw was both for sale and rent. I was shocked at the difference. This home was listed for $1.4 million. It was also listed for rent at $4,000 per month. It would cost about $48,000 a year to live in this home plus heat, electricity and miscellaneous items ($13,000) if you were a renter. That means it would cost you about $61,100 a year to live in the home that would cost $1.4 million plus expenses to buy. (For more, see: 5 Financial Planning Decisions You Won't Regret.)

Expenses

Let’s look at the numbers of what it would have cost to buy this home.

  • Mortgage – To buy that home valued at $1.4 million, you would have to put down a minimum of 20%, which is $280,000. This would give you a mortgage of $1,120,000 at a 4% interest rate over 30 years. The payments for this mortgage (30-year fixed) would add up to about $64,160 per year. This is already more than the annual cost to rent the same home.
  • Property Taxes – Taxes on this property were $17.90 per thousand or $25,000. In my prior article, I assumed a 1.5% property tax rate. This rate was a bit higher than average.
  • Property Insurance – This was estimated at about $3,600 a year.
  • Heat – The estimate on heat was about $7,500 per year.
  • Water and Sewer – This was well and septic, so the average annual cost of maintenance and a new system was about $1,000 a year.
  • Electricity – This bill was about $4,600.
  • Appliances – This was estimated at about $1,000 a year on average. When you rent, this is not typically a cost you have to bear.
  • Home Repairs – On average I estimated it at about 1%, or $14,000 a year.
  • Lawn Care and Snow Removal – This can vary on the size of the property and the location, but I estimated it at about $4,500 a year.

For the more astute readers, yes I missed the annual tax benefits. But I also didn’t include renovations, closing costs to buy the home, later costs to sell the home, capital gains taxes for selling the home, or other costs which inevitably come up.

The total costs each year to live in this home that we're looking at would be $61,000. However, that $61,000 amount does not include the costs of the mortgage. The seller/landlord of this home did have a mortgage. The $61,000 was just to live in the home if the home was bought for all cash. If you include the payments for the $1,120,000 mortgage, it would cost $125,500 a year to live in this home. That means you would be paying double what it cost to rent in order to buy this home. Not much of an investment is it?

Even if you remove the principal payments, which are payments to yourself, you would still have to pay over $800,000 in interest over the life of the loan. This comes out to about $26,800 per year on average in just interest payments.

How to Calculate Renting vs. Buying

There are a few ways to look at this renting versus buying a home argument. See the chart below for the full comparison.

  • Cash Flow – You could simply look at this comparison as a cash flow out-of-pocket calculation. This is what most people do. How much will it cost me each month? I don’t think this is the best approach, but the odds are that you will use this method since it is by far the most popular. Based on cash out of pocket each month, renting this home will add up to $61,000 each year while owning will cost you $125,500.
  • Net Expenses – This method looks at the comparison based on the cash that doesn’t get returned. Compare expenses and add only mortgage interest payments, since mortgage principal payments eventually get returned. This would mean net expenses each year of: renting ($61,100) versus owning ($98,600). The difference is $37,500 more each year if you own the home.
  • Highest and Best Use of Capital – This method measures all of the capital you have to spend and compares it to what it could be used for. If you own a home, you would have to put down cash to make the purchase. In this case, you have to put down 20% or $280,000. This money will not be productively used while you own the home since you cannot take it out. It will only appreciate proportionately to the appreciation of your home. If you took this same $280,000 and invested it in something that earns 5%*, this $280,000 would be worth $1,210,000 after 30 years, a gain of $930,000. If you buy a home (at a 2% inflation rate) it will appreciate to $2,536,000, a gain of $1,136,000. The difference between renting and owning in this case is $206,000 in favor or owning. However if you add in the annual costs of $37,500 for owning versus renting a home, you would have $919,000 (or $30,600 a year) more money at the end of 30 years if you were renting.

* Investment performance numbers are an example and not meant to simulate actual investment returns.

The conclusion of this example is that renting wins hands down on all accounts.

Example 2: High-End Urban Condo

Real estate agents tend to send flyers to the owners of units in condo buildings showing what their neighbors’ units sold for. I have one of these flyers for a condo building in Boston and will use these real rental rates and sale prices for this example. The reason for this example is to show you that the first example was not an isolated incident. (For related reading, see: 5 Financial Strategies to Last a Lifetime.)

This condo building in Boston has a unit for sale for $900,000. An identical unit is on the market for rent at $3,900. These numbers are supported by recent sales and rentals as well.

Three Methods of Calculation

  • Cash Flow – Using this method it would cost $16,400 more to own than rent this condo.
  • Net Expense – Using this method, it would cost $3,750 more to rent than own this unit.
  • Highest and Best Use of Capital – Using this method it would cost you $8,150 more to rent than own this unit.

This example is a bit more equal than the last one. However, there are a lot more assumptions which are made with the owning of a unit such as: inflation rates, condo fees, potential assessments (which can be alarmingly high if the property does not have adequate reserves), and more. As we make our comparison using lower home values, the renting versus owning a home calculation becomes more even. (For related reading, see: Don't Let Risk Ruin a Great Financial Plan.)


Summary

We have looked at two examples of high-end homes and it should be clear that higher end homes favor renters versus owners. This is not the case for all homes, just homes over a certain valuation. I have not determined what the valuation is at the moment which tilts the scale in favor of the owner, but I suspect it is around $700,000. The mid to lower-end home prices tend to favor owning. This is mainly due to the rental rates being proportionally higher compared to home values. In higher-end homes, the rental rates tend to max out, while the valuations continue to climb. Here is a chart of the cap rates for apartments by REIS Reports. Lower cap rates tend to mean it is better to rent and higher cap rates tend to mean it is better to own:

The best way to make this determination for yourself is to run these calculations to see which choice works best for you. As we conclude this series here are key points to keep in mind:

  • Renting versus owning is about more than just numbers.
  • Buying a home to live in is not an investment, it is an expense.
  • If you are looking at living in a high-end home, consider renting. It is likely that it will be cheaper than owning it.
  • Always run the true costs of owning a home before buying one.
  • Consider all three methods of calculations to know what renting versus owning a home means to you. (For more, see: 3 Habits Happy People Use in Financial Planning.)
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