Buy vs. rent — #3 — the long term

September 13, 2006

In my previous post on this topic, we confirmed people’s intuition that in the Bay Area, it’s usually quite a bit cheaper in the short run to rent than to buy — even with aggressive financing options such as interest-only loans. So why would any sane person actually buy a property here?

Turns out it’s the financial benefit, and not insanity, that drives people to buy, bubblistas’ theories to the contrary notwithstanding. Continuing with our saga about our Mountain View home with a rental value of $2400 per month and a purchase tag of $825,000, let’s continue running the numbers, this time over a five-year period instead of just a month. If you were to buy the home today, you’d be out your 10% down payment of $82,500. During your first year of owning the home, you’d be out another $55,000 in combined mortgage, tax, maintenance, and insurance payments — that’s after deducting your substantial tax savings. Your first year’s rent, however, would be only $28,00. Ding ding. Round 1 to the renters.

Let’s assume that rents are increasing by 5% per year. (Again, purists may object that that hasn’t been the case over the last half decade. True point…but go further back in time to the late 90’s dot.com era when rents were increasing literally around 15% to 20% per year. Over the long term, 5% is probably a reasonable approximation.) In year 2, you’d pay $30,240 in rent but be out over $50,000 if you owned the property. Ding ding. Round 2 to the renters.

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It’s looking like a one-sided contest so far, but let’s wait till the end of year 5 where you’ll see the the owners, pride intact, perform a solid KO over the renters. By the end of year 5, you’d have spent a total of $159,00 to rent the property. Your total ownership expenses, after considering your tax benefits, would be nearly $343,000. Let’s say you sell at the end of year 5. Further, let’s assume properties have been appreciating by 5% per year during that time, and that your selling costs are 6% for realtor fees and 1% for miscellaneous other fees. Keeping in mind Uncle Sam’s generous $250,000 capital gains tax exemption ($500,000 for married couples), you would end up pocketing $286,000, meaning that over your five year ownership period you’d have spent $56,000 out of pocket instead of $159,000 if you’d rented. (If you’re a hard-core numbers type and want to see the math behind these numbers, let me know.) Let’s update our graph:

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“But…but…but” sputter the renters, reeling from their blow, “that’s not fair! Owners may end up paying less in the long run, but surely it’s got to count for something that in every single year we renters paid less? Isn’t there something about the time value of money?”

Fair point.

To account for the fact that a dollar spent today is more painful than a dollar spent tomorrow, we use a neat Finance 101 trick called “Net Present Value” (NPV) which enables you to compare two completely different sets of expenses — like five years of ~$30K per year in rent vs. five years of ~$50K per year in ownership expenses followed by a windfall of nearly $300K.

The NPV, as it turns out, evens the players up a bit…but the owners still win, hands down, by about $50,000 in NPV. (Again, for folks interested in the numbers, I used a discount rate of 5.8%, which again I’m happy to explain to anybody who asks.)

Rounds 1 through 5 go to the renters…but the final KO, and a solid one at that, goes to the owners.

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

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