Own vs Rent Analysis

I thought originally to name the post "buy vs rent" analysis, but in reality, it is "own vs rent" analysis. I know people who owned property, then sold it and started renting. Renting turned out to be better than owning at that time. It is not always moving from renting to buying, neither it is a once-in-a-lifetime decision.

The result of the analysis depends on two things:

(1) the model (or formula) that is used and

(2) what exact values are assigned to variables.

The same model will give drastically different or opposite results depending on your future market expectation, and I would say overall your life values and expectations. When it comes to the primary property, for me personally it's less about the investment value of the property and more about a lifestyle and quality of life I want to have, and understanding the trade-offs. So both of the options (own or rent) may give you worse results compared to some alternative investments. But that doesn't matter, you still need to live somewhere, and preferably somewhere where you enjoy living. So we just compare two options to make a better choice on how to make it happen.

Let's consider two scenarios we can model.

Scenario 1. Same house to rent or own

If there is a particular home (or type of a home for a budget) in question, let's start with evaluating "own vs buy" for the same property (i.e. is it better to own $1M house or to rent a similar or same $1M house). Regardless of whether I own or rent, I will get the same lifestyle and quality of life, which is the key for me. The result of the analysis is to asses the best execution path from a financial perspective, and will greatly vary from place to place, primarily depending on the rent/buy ratio. In California the house you can rent for $5K would cost $2.5M and more to buy. In Chicago the house you can rent for $5K will probably be within $1M, so your rent vs own comparison would give completely different results.

Scenario 2. Different houses to rent or own

We can make an analysis by comparing renting a $1M house and owning a $0.5M house. Twice cheaper house means lowering the quality of the property and may lead to sacrificing the lifestyle to some extend (whether it's size, location, renovation level of the property, school district, or all of that). However, you can clearly see the financial trade-off of that decision and can make a call whether it's worth it or not. For me, there is no money that would justify a long commute to work or a bad school for kids. But I could definitely downsize and be less picky with the design. For the sake of modeling, the delta between two options is being invested (not spent on day-to-day life), but in reality, you may spend the delta on traveling and clothes or whatever you like. The model would tell you an idea of how much theoretically you would have to spare over the comparison horizon.

Often people compare mortgage payments with rent to make a call about whether it's better to buy. It's a good comparison to understand whether your budget can accommodate the mortgage payment, however that comparison is missing out on a very important piece: your downpayment that could have been used differently, and the overall alternative use of your money.

Once I heard a person saying that as long as all the expenses to keep up the house (tax, maintenance, HOA, everything non-principal) is less than rent, - it's already worth buying. That would be true assuming that your house investment return is the same as the alternative investment return, which is rarely the case.

The calculation I make helps to understand the required monthly housing budget and long-term relative value of own vs rent options based on your expectations of the property cost growth and alternative investment growth.

Let's talk about the parameters we need to make the comparison.

To model "owning" we need to define the following: - the cost of the property to buy

- understand how much you are willing to put as a down payment

- mortgage rate you will be able to secure

- your expectation of the property price increases (average per year)

- how much money do you think you would need for the house upgrade/renovation when you move-in, as well as regular monthly maintenance expenses (those you wouldn't usually have when renting)

- closing cost, property tax, HOA, any other fees and expenses that you may foresee for the home you buy

To model "renting" we need to know:

- rent price for a similar or different home (depending on the scenario you want to model)

- expected return on the alternative investment (i.e. if you are not buying a house - where do you put the money?)

- rent increases year over year. As a starting point, I use rent increase equal to property cost increase per year, but it can be modeled as a different value as well

Model assumption:

- housing budget is assumed the same for both scenarios, i.e. money that doesn't go into the house to own (down payment and monthly mortgage payment) is being used for rent, and the rest is invested in the alternative investment of your choice (e.g. stock market)

- we are looking into 30-years time horizon and calculating Future Value of each of the scenarios. It is possible to model for any period of time, but I use 30 years for simplicity

Model limitations:

- doesn't account for any tax advantages you may get from owning a property

- doesn't account for additional insurance if you pay less than a 20% down payment

- doesn't allow for easy horizon update (from 30 years to something else)

- doesn't account for inflation and non-housing expenses. While two options remain comparable between each other, actual numbers are not applicable to actual net worth or other estimations in a broader life context

Here is the google sheet you can play around with to put your numbers that are applicable to your life situation.

Let me walk you through the example of the house I am renting right now.

Based on the estimate, its market price now is $3.4M. We are renting it for $5.5K/month.

I think that over 30 years average yearly return on investment if I put money into an index fund, will be 8%, and the property cost will grow let's say 4.5% every year, and my rent will grow at the same pace. The mortgage I could get now would probably be around 5%, but let's say I refinance at some point and the average over the long term would be around 4%. I am not willing to put more than 10% as a downpayment, tax property is 1.25%/year, and there is no HOA. I also account for 100K renovation expenses that I would put into the house. So if I buy - I put $340K as a down payment, plus 100K renovation expenses, and my monthly payment for the next 30 years would be a little more than 18K including property tax. That's crazy, huh. Honestly, can't even imagine paying that, but let's continue modeling. If I rent, all the money I would put into downpayment and renovation, plus some upfront tax payment (467K) - is invested into the index fund, on top of that the money from monthly payments minus rent - is also invested every month into the index fund (starting with 13K every month, that number will gradually decrease as the rent increases every year).

With this input data above, I would be more than 40% better off if I rent for the whole timeline (30 years). So for the whole period of 30 years, I will be paying continuously growing rent which is already pretty high, and I will still have more capital in the end compared to buying the house (assuming that all the money I don't spend on the house - invested).

All those numbers are based on my personal expectations, as I mentioned in the beginning, - input different numbers, any you like - you'll get different results.

I don't know how the real estate market will perform, I don't know how the stock market will perform, nor do I know future mortgage rates or property tax. But we make decisions based on the best information we have today.

The next thing I can do is to find the theoretical house price which would make the options equal in terms of the future value of the capital. I continuously decreased the price of the house until the options yield the same future value, and it was about $2.3M. So now I know that it would make sense for me to buy a house that would keep the same lifestyle for me, or a lifestyle with reasonable sacrifice, only if it is $2.3M or less. As long as it is more than that, I am better staying at my current place and continue paying rent and investing all the rest into the stocks or whatever else I want to invest my money.

If rent goes up, if the mortgage rate goes down, if stock market crashes, if I move to another city or state or country where rent relatively to property cost is different, - I'll calculate and check again. Numbers will change, but the approach will not.

Cultural or family background may impact our decisions.

In the culture I am from owning property was (and to some extent still is) the only way of preserving and growing capital. So it became somewhat a must for everyone and one of the key life success criteria. People buy apartments they don't like in the neighborhoods they don't want to live paying mortgages they can't afford only to check the box and reduce anxiety (or parents' anxiety) over not having their own property. When I created the calculation for myself and played out dozens of different "what if" scenarios, it helped me to remove anxiety over buying a property, which was somewhat culturally engraved ("I am not financially secure/successful until I own a property"). I prioritized my desired lifestyle and informed financial decisions over checking the box.

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I will buy a property when it supports my desired lifestyle, makes sense in terms of long-term finances, and I can comfortably put the mortgage payment into my monthly budget, but not earlier than that.

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I hope my calculation and explanation will help you to make the best decision for you!

Disclaimer: The information provided in this blog post is for educational and informational purposes only. I am an AFC® (Accredited Financial Counselor) Candidate, not a licensed financial advisor, tax professional, or attorney. The content herein is not intended to be a substitute for professional financial, investment, legal, or tax advice. Always seek the advice of a qualified professional with any questions you may have regarding your individual financial situation. The opinions expressed are my own and do not represent the views of my employer.