Why Renting is Almost Never a Good Idea
Time is on your side if you own real estate, and works against you if you rent.
I hate social media and see it as a waste of time, yet that seems to be where all the eyeballs are nowadays, so following the advice of other solopreneurs who grew their business through lead-gen I decided to check out my Facebook feed and stumbled into the age-old "rent vs buy" debate.
While for the most part the arguments were pretty similar to what I'd expect, some claims surprised me - not because they were stimulating, but because they opened my eyes to the flaws in thinking of the average renter. Flaws that I myself used to have when I only saw a smaller piece of the puzzle, flaws in thinking I used to have when I was trying to optimize my first mortgage in a dimension that ended up being completely irrelevant (total money paid to the lender). The post that peeked my attention stated the following:
Renting doesn’t come with:
- Maintenance costs
- Property taxes
- Inability to easily move
- Significant down payment
- Decrease in property value
FWIW, I can rent my current apartment in CA for 30 years and still wouldn’t get to the cost of a nearby condo, much less a townhome or single family home. A 30 year mortgage would end up costing significantly more than the purchase price, require a substantially large down payment, and there isn’t any guarantee that home prices won’t decrease or stagnate.
These are mostly valid points, and the first 4 bullets I agree with, they can basically be summarized as "headaches", and that's exactly what real estate market is known for. The last bullet, however, is only true in a declining market. While the California market this post mentions may indeed continue declining short-term due to asinine policies they've been pushing driving businesses out, long-term all real estate goes up. So this individual is either thinking short-term or doesn't understand economics that drive real estate prices up.
Guaranteed Appreciation
Over the long term, any decrease in property value is temporary. If you hold the house for 30+ years and you didn't buy in a city that's driving its residents out (and if you did, use Investomation next time to do your research), it's guaranteed to appreciate for one simple reason: inflation, which I already spoke about in an earlier post.
Inflation is programmed into the US economy, even The Fed thinks 2% inflation is healthy. I do too, it encourages business growth. What I don't think is healthy is the way US Bureau of Labor Statistics measures inflation.
Ok, so we got guaranteed 2% annual inflation enforced by an entity closely tied to the US government, basically a hidden tax on money that doesn't participate in the economy. That means long-term the US dollar is guaranteed to keep falling, and indeed any chart you pull up that shows the buying power of the US dollar after we came off of the Gold Standard will confirm this.
Apply 5/1 leverage to that via mortgage and you got the only asset class that actually benefits from inflation. On top of that, rent grows with inflation too. The fact that you're paying significantly more than you would have had you bought the house with cash is completely irrelevant because you pay it off 30 years later, with devalued dollars. Compound interest is a wonderful thing, yet many people don't understand it, including the author of the comment above.
But what about the interest on the loan, doesn't that compound too? Sure, but is that interest higher than 2% target inflation with 5x leverage? Of course I've oversimplified the mathematics here, by omitting maintenance costs and property taxes, so you could still lose your shirt here if you're unable to hold the house for 30 years and have to sell sooner. This is easier with rent revenue, and I'm assuming the owner wouldn't just hold the property vacant. They'd either rent it out or live in it themselves, negating their own rent, which brings me to my next point.
When Is It Worth It To Rent?
Time is on your side if you own real estate, and works against you if you rent. Even in the worst markets to own in, like San Francisco, where rents are lower than the mortgage payment, the mortgage payment is constant, rents go up in price every year. In the worst case scenario, rents will overtake your mortgage after 10 years - historically it has been closer to 5 years for most areas. On the other hand, markets like Milwaukee don't appreciate well, but the rental income often pays off the entire house within a few years. Even if you plan to move to a different city within a year or two, it may be worth it to buy real estate if it cashflows after you move.
There IS actually a case when it's worth it to rent. When an area appreciates, house prices go up faster than rents. Let's look at an example:
When I purchased my first rental in Boston over a decade ago, it cost $500k. This was a triplex, so it rented for $6,000. A single-family in Boston at the time costing the same would have rented for $2,500. That same year, I bought a single-family rental in rough area of Chicago for $50k. That single-family rented for $1,300. So my rent/price ratio in Chicago is 2.6%, while in Boston it's only 0.5% on a similar home.
Same concept holds in all markets, even locally. A house in A-class neighborhood will have a lower rent/price ratio than one in C-class neighborhood (more on the concept of neighborhood classes here). This means that buying real estate in C-class neighborhoods to rent out, while renting your own home in A-class area is a more profitable than simply buying a home in A-class area, because you pocket the rent/price spread. This assumes that you're willing to deal with the headaches of a C-class area, mostly boiling down to worse tenants and increased property crime.
If you still don't believe me, let's try with an actual example. You have $200k you want to invest, we'll look at 3 possible scenarios:
- You rent while investing the $200k in the stock market.
- You buy a primary residence in an expensive market, using $200k as a downpayment on a million-dollar home.
- You buy rentals in cheaper markets using the same $200k as a downpayment for them, while renting in an expensive market.
Scenario 1
Stock market tends to go up around 7% per year. You're also paying capital gains tax on your stocks when you sell. Your rent in most metro areas will go up 5% per year (hinting at the fact that 2% annual inflation figure claimed by The Fed underestimates real inflation). Let's say you rent a million-dollar home for $4,000/month. The first year you spend $48k on rent. The second year, after 5% rent increase, you spend over $50k. After 5 years, you will have spent north of $265k on rent. Your $200k invested in the stock market with 7% interest is now worth $280k, before taxes. You've made roughly $65k after taxes, putting your total expected value after 5 years at -$200k after taxes. That's right, despite being on top of your game with stocks, you've still lost money due to rent.
Scenario 2
The second scenario has you lock in today's monthly mortgage payment, and you'll be paying around $6,500 monthly mortgage (combined with taxes and insurance) on a million-dollar home. Five years later you decide to sell. By this point, you will have paid $390k in mortgage + taxes + insurance. Your house has been appreciating at 5% per year (pretty typical in most metro areas) and is now worth $1.276 million. You sell it, paying 4% commission fees to your brocker (roughly $50k). Your net gain on the sale of the home is $226k, which is exempt from taxes. At the same time, you will have paid off about $54k of your mortgage principal (the amount you borrowed). Your total expected value after 5 years of ownership is therefore -$110k, after taxes. We're already ahead of the renter investing in the stock market. But it gets better.
Scenario 3
For our 3rd scenario, we'll rent our primary residence while buying 5 properties in cheaper markets to rent out. Each rental property is worth $200k, with $50k downpayment. This means our monthly mortage will be around $1100 after taxes and insurance. Each of these should rent for around $1500/month. We're netting $400/month x 5 properties (I'm oversimplifying here, there are other expenses you want to factor in if you're going to be holding long-term, which my napkin analysis spreadsheet does a good job estimating).
So we're making $2000/month from our rentals. As all rental income, this figure will go up 5% per year, making us north of $131k at the end of the same 5-year period. This is before taxes, but the good thing about real estate is that it's the most tax-advantaged asset class in US. If you do your taxes correctly, you'll be offsetting most of your rental income with expenses (to put things in layman terms, Uncle Sam is footing the bill for your property repairs/improvements). If you need a competent tax advisor who can help you file your taxes correctly for maximum write-off, reach out to us via our support form and we'll connect you with one.
Our rent for the primary residence will be the same as in the first example, increasing at 5% per year. After 5 years, we will have spent $265k on renting our primary residence. You can already see that about half of that cost is offset by our rental income. But that's just the tip of the iceberg. Each of our rentals has been appreciating at the same 5%/year as in the 2nd example, and each is now worth $255k. Each property has about $11k in equity from principal payoff. If we were to sell each one of them (with the same 4% agent commission), we'd net $55k from each, before taxes, or $275k for all 5 properties.
Unlike your primary residence, your rentals are not tax-exempt, but you could use a 1031 Exchange to roll your profits into another property (basically, you only pay taxes if you decide to quit real estate for good). Let's assume that's exactly what you decide to do, as silly as it seems. After paying capital gains taxes, you're left with $233k. Your total expected value after 5 years is therefore $99k.
Let's recap:
- Scenario 1 (renting + stock market) results in us losing $200k.
- Scenario 2 (home ownership) results in us losing $110k.
- Scenario 3 (own + rent) results in us making $99k.
Keep in mind that this is a conservative estimate, because we did nothing to minimize our tax burden on the sale, and we didn't take full advantage of compounding interest because we sold the property only 5 years after buying it. If we were to take this example and extrapolate it out to 30 years, we'd have no mortgage left, and compounding interest would skew these numbers even more in favor of scenario 3.
To put things in perspective, after 30 years of renting, you'd be losing a couple million dollars with scenario 1, making a few hundred thousand with scenario 2, and coming out several million dollars ahead with scenario 3. Feel free to do the math yourself. I realize that I've completely glazed over all the headaches of owning real estate, but that's what property management is for.