To Rent or To Buy?•
Posted on September 12 2011
By: Konrad Raubenheimer
To buy or not to buy? These days, that really is the question. Asking him/her to come back to your place would feel so much better if the damned place was actually yours, wouldn’t it?
A house is not just an essential part of the American dream, it’s a belief about pride and security that’s hardwired into us all. “Owning a house” is one of the top things men list as a priority in their lives.
It’s this fantasy about a house that leads to irrationality, and that drives us to make bad decisions. By that we mean decisions that cost you money needlessly. That said, buying a house and building equity is one of the best investments anyone can ever make. All things being equal, it’s better to own than to rent. With property prices down, interest rates at a low and some desperate sellers, there is no doubt that there are some excellent deals out there. But if you follow these simple rules as a guideline, and drop the sentimentality and pride, you’ll be better off.
-Treat It Like Any Other Investment
So, you’re thinking of buying. The first thing you need to do is lose the sentimentality. The joy of owning a house is not a factor yet. Like any analysis, we have to start with the basics. When dealing with possibly the biggest expense and investment most people will make in their lives, it’s bizarre to think that many people will put together household budgets that analyze what kind of breakfast cereal they buy, but will throw thousands of dollars away on their houses, all in the belief that it just goes with the territory. There are many additional expenses other than the mortgage payment that go hand in hand with owning a house. Get them all down on your spreadsheet when starting to think about buying.
-Think About It As A Buy-To-Rent To Gauge Its Relative Value
The only simple way to determine if it’s a good idea to buy or rent is to not think of the house you want to buy as one you’ll be living in. If you think of it as a buy-to-rent piece of property, all of the dynamics of the market become easy to interpret, and we can leave emotions aside. Sentimentality out the way, we can get scientific and do our math.
Let’s say you bought the place you’re looking at with cash. What can you rent it for? What are the taxes, the insurance, the maintenance costs and the management fees? Deduct these from your annual rental income. This magic number (less a month or two’s rent in case of vacancy) is your net rental income. Divide this net rental income by the cash price of the house, and you’ve got your return, called the capitalization rate by people who write for The Wall Street Journal.
That’s it -- we’re done. If this capitalization rate is less than the rate you could get on a less risky investments like a high-grade bond, we suggest you either sell (if you already own the property), or keep being a renter. That’s the simplest way to look at it. Now we can consider some twists.
-What’s The Market Doing?
This is unfortunately not as simple as people make it out to be. If prices go down, more people buy. This pushes prices up. The more people are buying, often the cheaper rentals become. Thinking about your investment on the buy-to-rent basis as described above helps make sense of this all, if only because you can, to a large extent, ignore these dynamics. If the values of properties are going up, rental incomes should too. And if they aren’t, you’re at risk of floating around in another bubble.
-Can You Make The Deposit?
As a rule of thumb, if you can’t put down at least 10% to 20% of the purchase price as a down payment on the house, you shouldn’t really be thinking about buying. It’s not only the best way to discipline yourself to save the bucks needed to buy a house (and test if you’re capable), but will give you a cushion in times of trouble (no one needs to be told what negative equity is these days). Let’s not forget that it will also reduce tremendously the amounts you end up paying (read: wasting) on interest.
Like with any investment, the discussions can and should get a lot more in-depth. We hope to have gotten the ball rolling in that direction for you.