Buy vs. rent — #1 — the big picture

September 4, 2006

Clients and friends often ask me if it really makes financial sense to buy a home instead of just continuing to rent. It’s a fair question in a high-priced market like ours, especially since, over the last few years, housing prices have risen dramatically, while rents have stayed flat.The standard (self-serving) industry answer to the buy vs. rent question is, “It always makes more financial sense to buy because, ah, prices always go up, and, ah, oh yeah, don’t forget about the great tax deductions!”There has to be a less fluffy answer to that question, and I think it boils down to your beliefs on two key issues:

  1. How long do you believe you’ll be in the home you’re considering buying?
  2. During that time frame, what do you believe will be the average annual property appreciation rate?

At a gut level, this makes sense. If you’re going to be in the home for only 1 year, and you think the property will only appreciate 3%, then you’re probably better off renting for that year. On the other hand, if you’re going to be there for 20 years, and you think the appreciation rate will be 10% per year, it’s obviously a slam dunk to buy. But what about in less obvious cases? 5 years, and 6% appreciation? 3 years and 5%? 7 years and 3%?

I’m an Excel nut, and I’ve built a gajillion financial models in a previous life, so I thought I’d create a model to help decide the buy vs. rent issue, using the two questions above as variables. Making a number of other assumptions (which I’ll outline in future posts), you come up with the following graph.

Here’s how to read the graph: Find the single point that represents your beliefs about questions 1 and 2. (ie. if you think you’ll be in your home 5 years, and property will appreciate 6% per year during that time, find 5 on the horizontal axis, and go up to the level of 6% on the vertical axis.)

If that point is in the gold-shaded “Better to own” part of the graph, then it’s, well, better to own! If that point is in the grey-shaded “Better to rent” part of the graph…you get the picture.

The graph shows what we intuitively understand: the longer you’re going to be in the home, the lower appreciation rate you need to expect in order to come out ahead owning instead of renting.

It also shows that, even in the Bay Area with our pretty wacky price vs. renting differential, you only need to make modest assumptions about future appreciation in order for buying to make more sense than renting. Over a 5-year period, you only have to expect about a 4% annual growth rate in order to be better off buying. Over the last quarter century (the amount of time for which I have detailed data), most 5-year periods well exceeded that threshold.

In future posts, I’ll explain the other assumptions in the model: purchase and rental prices, interest rates, the type of mortgage, expenses, tax rates, and so forth.

Finally, a few caveats:

  • The above graph is specifically based on Bay Area assumptions about purchase and rental prices. If the area you live in has significantly different ratios, your graph will look different.
  • I am a real estate professional, but I’m probably not your real estate professional, so I don’t know your particular situation. Talk to your Realtor for personalized advice.
  • I’m not a tax accountant. For full details about the financial and tax consequences of buying a home, please talk to your accountant.

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Written by Kevin · Filed Under Buy vs. rent, For buyers, Real estate 

Comments

3 Responses to “Buy vs. rent — #1 — the big picture”

  1. Mike on July 23rd, 2007 9:21 am

    Stumbled upon this website and saw the rent/own graph, but I’m confused… It sys, generally, if you plan to live in your house for at least 5 years, the house needs to appreciate at least 4% each year to make it worth buying instead of renting. But what about the APR you’re paying on that loan? If the APR on your 30-yr fixed is 6%, then wouldn’t you be losing 2% every year if the house appreciates 4% per year, but you’re paying 6% per year in interest? I would guess your house would have to appreciate at least APR + 4% to make it worth buying, right?

  2. Kevin Boer, Realtor, Alain Pinel Realtors on July 23rd, 2007 9:34 am

    Hi Mike,

    Thanks for dropping by. The answer to your question lies in the power of compounding, the tax write-offs of home ownership, and the fact that rents tend to increase whereas mortgages tend not to (unless you got an adjustible).

    If none of those things were true, your point would be correct. If you want more details, or the complete spreadsheet behind this model, let me know.

  3. Nandini on August 7th, 2007 8:16 am

    I would like the complete spreadsheet behind this model. I am surprised that the house only needs to appreciate 4%.

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