Should You Buy or Rent Your Home?

KEY POINTS

Non-financial factors (stress, privacy, ability to relocate) will weigh heavily on your decision to rent or own a home
A quick rent vs buy calculation as a rule of thumb can lead to poor financial decisions
The opportunity cost of investing in the stock and bond markets may outweigh the benefits of home ownership

Residential real estate continually dominates the headlines. Every market gyration reverberates through discussions at the company water cooler, to home with our loved ones, and virtually everywhere in between. Most families consider home ownership to be the cornerstone of any financial plan.

You may be experiencing a real fear of missing out (“FOMO”).

You might even say your legacy depends on it.

But does it?

We will concede that home ownership has become integral to the financial fabric of the industrialized world. After all, a quick sampling of countries illustrates the high proportion of home ownership¹:

Singapore 88%

India 87%

Netherlands 69%

Canada 69%

United States 65%

France 64%

United Kingdom 63%

Germany 51%

The question we all ask ourselves …

Rent vs Buy: which is better?

Rent vs Buy House

It is one of the most frequent questions we hear. Before we dive in and tackle this question, we must ask “Who wants to know?”

We will address two specific audiences:

· First time home buyers

· Parents buying a home for their children

First Time Home Buyers

We have watched our parents’ and grandparents’ generations generate substantial wealth through real estate. We have also repeatedly heard that renting is the same as throwing your money away. The American Dream, or Anywhere Dream, is to own your piece of the real estate pie: no matter what.

Home ownership is often viewed as a virtual birthright and ticket to adulthood.

But is it really all of that?

Do not let the FOMO take root.

A true comparison between ownership and renting goes beyond just the numbers. Fair warning, we do not provide a definitive answer. After all, only you can quantify such intangibles like your ability and willingness to do repairs, or your need for geographic flexibility.

We do provide a framework to guide you through the decision-making process.

Rent vs Buy House Factors to Consider

Let us start with a table to quickly provide context.

The non-financial factors are very individual centric, and their ratings are subject to change in the table above. We concluded that owning a home is more stressful than renting. However, you may attribute little weight to such stress, nor would you consider the less flexibility associated with moving while owning a home much of a negative.

We caution that your current views may change due to time and circumstance. A loss of employment, divorce, or children moving afar can quickly and unexpectedly change your perspective.

From a quantitative perspective, there are many variables to consider. To make it more challenging, they may also change without notice. Governments change tax codes. Banks change interest rates. Municipalities change landlord / tenant rights.

The only constant is change.

Rent vs Buy House Calculation

At a high-level there are several rules of thumb to help guide the rent vs buy decision. Here are two common ones to consider:

Both models recommend renting when comparing a $500,000 home versus a $2,000 monthly rental cost. However, both models also recommend purchasing a home if the rent increased a mere $85 to $2,085 per month. That is not a lot of money to sway what will likely be your largest investment decision to date. These models are only basic tools to reference in the decision-making process.

Before we look at our proprietary model, let us discuss some of the key financial variables from the table above.

Renting provides many benefits from a cash flow perspective. Although the landlord can change the annual rental costs, there are no ongoing costs or related stress associated with repairs, maintenance, renovations, appliance replacement, property taxes, etc.

From an investment perspective, renting reduces investment risk as the down payment for the house can be redirected and invested in a diversified portfolio of stocks, bonds, mutual funds, etc. The lack of leverage and interest rate volatility reduces risk that is inherent in a mortgaged property.

That last paragraph reads as an endorsement for renting over buying. Such is not necessarily so. Risk tolerance varies by individual. Home ownership may be just the ticket or those that want the risks associated with a concentrated leveraged investment.

Home ownership can provide the leverage to potentially: grow an asset that generates rental income, provides tax benefits, offers additional leverage against future growth, improves your credit score, and fulfills a substantial portion of your multi-generational legacy plan.

Rent vs. Buy House Financial Model

Now, let us see what we can glean from our proprietary financial model.

We used a 30-year time horizon from 1990-2020 and incorporated real world statistics applicable to the period related to: average U.S. home prices, annual U.S. inflation, annual S&P500 performance, and annual U.S. rental rates.

We assumed a home valued at $500,000 on December 31, 1989, a $100,000 down payment, a 6% fixed mortgage interest rate, and an initial monthly rental rate of $2,000 for a home of comparable value.

We used moderate assumptions regarding the amount and timing of maintenance costs, property taxes, and capital expenditures (roof, furnace, air conditioner, windows, doors, kitchen, bathrooms, etc.).

Taxes will vary based on your country of residence and / or citizenship. For our purposes, we assumed no capital gains taxes on the eventual sale of the house, and a 50% capital gains inclusion rate on the eventual sale of the securities. A personal tax rate of 24% was utilized for all taxable income.

We want to compare the two options based on today’s dollars. Therefore, we discounted each year’s cash flow to the current year at a 6% rate. Discounting is the process of converting a value received in a future time period to an equivalent value received immediately. Such discounting is essential due to the long-time horizon and the nature and timing of the cash flows for each option.

A key assumption we make is that the rental option also includes $100,000 of investable cash that would otherwise be utilized as a down payment on a home. Under the rental model, we assume these funds are invested in the S&P500 throughout the entire 30-year period.

So, what did we conclude?

First, we must preface this with the fact that the returns used for the real estate market and the S&P500 may vary dramatically depending on which 30-year period is utilized. Our period included many historic volatile events including the Asian financial crisis, Dot-com bubble, 2007/2008 financial crisis, the advent of massive central bank interventions, and many other notable events.

Having said that, we feel this 30-year period a reasonable baseline for our purposes.

In present value terms, purchasing a home is the better financial decision as it yields approximately $30,000 more than the rental option (a different conclusion than the rules of thumb noted above). We do not consider this difference substantial enough to sway the decision one way or the other. A simple tweaking of maintenance costs or renovation costs could narrow the gap substantially.

Another interesting observation is that the size of your down payment matters. The model changes dramatically If we increase the down payment from $100,000 to $300,000. In this scenario the rental option has an additional $200,000 to invest and generates approximately $90,000 higher present value than ownership. That is a $120,000 swing from our original analysis.

We recommend you incorporate a real-world analysis like the above into your ultimate financial decision. A quality analysis will require a firm understanding of how to budget which can be derived from our post How to Make a Budget That Works For You.

The qualitative factors should weigh heavily on your decision as their intrinsic nature may be of more value than the variances in your financial models.

Now, let’s consider our second model:

Parents Buying a Home for Their Children

I have a friend that bought a single-family home that is he rents to university students. He and his wife plan to sell the house after a few years and gifting the profit equally to their two adult children. Sounds like a great plan.

But is it the best plan?

Let us start with a similar set of options as in the First Time Home Buyer model: $500,000 house value, $100,000 non-leveraged down payment, and a $2,000 rental rate for a comparable home. We will also use the same 30-year period and all its related variable assumptions.

One critical change, you can leverage the equity built up in your existing home. This means a $400,000 loan will be taken out and either invested in the second house or into the S&P500. This will have significant ramifications to the rental option as it now includes a $500,000 initial portfolio rather than the $100,000 initial portfolio modelled under the First Time Home Buyer model.

A second material change, we assume the proceeds on sale of the second home will be taxable at with a capital gains inclusion rate of 50%.

In present value terms, over the 30-year period 1990-2020, renting a home is the better financial decision as it yields approximately $220,000 more than the purchase option. Such results are based on the actual performance of the real estate market and S&P500 from 1990-2020.

However, let us see what happens if we change the playing field.

If we fix the performance of the real estate market and S&P 500 equal at 5% during the same period, the present value of the purchase decision exceeds the rental decision by approximately $250,000. This is an approximate $470,000 swing based on a change in returns.

This illustrates the massive impact real market returns will have on your investment decision. We highly recommended you talk with your financial advisors to assess the various risks associated with each option and gauge your risk tolerance.

Your team must assess not only the risk of each option, but your ability to execute each option. From a real estate perspective, you will need to assess if your team has the skill set to select the correct property, maintain it, renovate it over time, and sell it at a profit. Similarly, you will need to assess if your team can manage a diversified investment portfolio over a 30-year period fraught with all the market volatility implicit in global investing.

Legacy Impact

Residential real estate will represent the largest investment for many families. It can be a powerful asset that provides a place to call home, a lifestyle, a retirement nest egg via downsizing, and a source of leverage for further investing.

For those that invest in a second home for their children, the decision to invest is only the first step. One key question will be whether to put the legal title of the house in your name or your child’s name. We have spoken to parents concerned about the potential for their child to divorce and then being forced to watch half of the equity in the home transferred to the ex-spouse. Such decisions require professional legal and tax advice beyond the scope of this post.

Conclusion

The buy vs rent decision is fraught with risk. You cannot rely on an internet search and related quick ratio model to give you a definitive yes or no answer. The wonderful thing about this decision is that it forces you into critical dialogue with your spouse, financial advisors, and potentially other family members. You will come out of the journey with a much better understanding of your risk tolerance and how best to accomplish your legacy goals.

Happy Legacy Planning!!!