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| Cadmium Red Light by Lisa Dahl |
Introduction: Sometimes the answer is clear but many times it isn't
The decision of whether to rent or buy your home involves a multitude of concrete financial variables and hazy, difficult-to-quantify personal preferences. The key financial variables, while easy to observe today, are impossible to accurately forecast into the future. And it's these forecasts that will ultimately dictate whether you'll be financially better off buying as opposed to renting your home. But personal preferences, either to rent or buy, can significantly alter this decision and many times trump less-than-rosy (or very optimistic) financial assumptions. While the answer will be different for everyone, the key is to collect and understand all the objective information and then be honest about the emotional preferences made to support your decision.
Don't generalize the ungeneralizable
Real estate economics is a hyperlocal issue. Brazil is not the United States, Pittsburgh is not New York, and a multi-family brownstone in Ft. Greene is not a new construction one-bedroom on the Upper East Side. An unattached 26 year old living in Chicago will have many options to rent or buy while an eight person family in a suburb of Des Moines might have no choice but to buy one of ten available houses. Buying (rather than renting) a single family home in Detroit or Dayton is a much more obvious choice than in Honolulu or San Francisco. The variables affecting rent vs. buy are all location specific and largely dependent on the type of living space. Always keep this in mind when you hear or read something about real estate writ large.
Like any asset, the price of real estate goes up and down
The investment characteristics of real estate are very similar to other income-producing financial assets like stocks or bonds. Theoretical fair value can be ascertained in various imprecise ways but like any asset in our capitalistic construct its price at any given moment is determined by supply and demand. For any given geographic location the supply and demand function is shaped by a long list of factors: worker's average income, population growth, job growth, the unemployment rate, infrastructure quality, educational system quality, prevailing mortgage rates, availability of mortgage credit, rental yields, supply of new and existing homes for sale, crime rates, rental vacancies, bankruptcy/tax law, zoning laws, etc. And like with most assets you'd expect its long run price growth after inflation to increase at the rate of long run real economic growth, +2.0% to +4.0% per year. Pretty boring, right?
There are a handful of widely recognized indices that track US home prices. I'd recommend following the S&P/Case-Shiller home price index, published monthly on a three month lag. Here is a PDF of the most recent report and a separate link to where you can check it in the future. Note that on page 4 of the report the month over month and year over year changes are broken out by the 20 major cities that make up the composite index. As I remarked earlier, home price changes vary dramatically from city to city. Harvard economics professor Edward Glaeser wrote this great opinion piece commenting on the latest Case-Shiller report and other issues relating to the factors affecting housing supply and demand.
Try understanding the financial inputs then prepare to throw money away
The best way to begin is to take time understanding how various financial assumptions affect your decision. This can be accomplished most easily by fiddling around with an interactive rent vs. buy calculator like this one on the New York Times website. Make sure you open up the advanced settings by clicking on the blue box at the top right corner of the chart and notice the input fields under the subcategories of buying, renting, and other. For a more in-depth exploration try running this more detailed calculator constructed by the Federal Reserve bank of Cleveland. I'd recommend sticking to the NYT version as the Fed's calculator is probably a bit too clunky for its own good.
The classic justification used by many who decide to buy is that "they were tired of throwing money away on rent." You are going to throw money away whether you buy or rent. Some would even argue that as a taxpaying homeowner you've simply made the decision to rent from the government rather than from a property owner. I don't agree with this as ultimately you will bear the cost of property taxes whether you buy or rent since the taxpaying owner will almost certainly pass this cost on to renters. A better way to phrase this cynical idea is simply to say that with the existence of property tax no one really owns their own property as we all are just renting from the government.
When you rent, the money you throw away is rent, renter's insurance, and potentially a broker's fee. When you buy, the money you throw away is buying/selling closing costs, lawyer fees, property taxes, mortgage interest, maintenance/common charges, renovation costs, homeowner's insurance, etc. Remember that money thrown away when buying doesn't include the down payment or money that goes towards paying down the principal of the mortgage. This is the portion of your home you actually own, known as home equity. Even if you bought your home in cash you will still throw away money every month for all items on this list except for mortgage interest.
Let's continue using the idea of throwing away money for the following mental exercise. Imagine we were able to find two identical homes, one for rent and one for sale. Assume that in each case the money being thrown away every month is also identical (again, for the buyer this doesn't include payment contributions to equity). If you're throwing away the same amount of money in both cases what then will dictate whether it's better to buy or rent? The answer will depend mostly on three important financial variables: the future path of rents, the future path of the home value, and the investment opportunity cost. Investment opportunity cost is just a fancy way of asking "What is the return I could earn on a different investment as an alternative to putting my money into the equity of this home?"
Each calculator input will affect the answer differently. You can classify the characteristics of every input into a few binary categories: one-time vs. annuity (they occur every year), known vs. unknown, and fixed vs. variable. The cost of the home is known, fixed, and usually incurred as an annuity (or one-time if you buy in cash). Rents are a variable, unknown, annuity cost. The mortgage rate is an annuity cost that is known and fixed (assuming you have a fixed rather than adjustable rate mortgage).
One-time "friction costs" like broker or lawyer fees will impact the result more if you project a short stay of only a few years or less. On a longer time horizon the inputs that register yearly and accumulate over time will carry a larger weight (what I call annuity inputs). When playing around with the calculator you'll notice that my three highlighted inputs: growth/decline of rents, growth/decline of home value, and investment opportunity cost, all have a disproportionate influence on the outcome. Notice that I left off mortgage borrowing rates from this short list. While this rate has a very important weight in the calculation it's also one of the few inputs that is both known and fixed. It's not a coincidence that the three highlighted inputs are each unknown, variable, and annuity.
Our thought experiment is based on the assumption of finding identical apartments where money being thrown away is the same in renting as it is for buying. And while it won't be easy in practice to locate these twin apartments this construct is a good way to mentally separate the money that goes towards consuming your home (money that is thrown away) from the money that goes towards the investment in your home (home equity).
Back to our example. If one of our throwing away money inputs change, i.e. mortgage borrowing rates fall, then all else equal, one would be able to buy "more home" for the same monthly outlay. When mortgage rates decline people will shift their preference away from renting to buying. The US Federal Reserve Bank is currently keeping interest rates low to incentivize people to do just that (though their actions aren't the only reason why interest rates are at historic lows). In fact, NYC renters are getting a double dose incentive to become homeowners as rents are rising while mortgage rates are declining. In this scenario you'd expect housing prices to rise, rents to decline, or some combination of the two in order to restore a more sensible equilibrium. My friends know that I've been a renter my entire adult life for a wide variety of reasons despite having the fortunate ability to own my living space. One of the main reasons I've been a renter is that until recently the throwing money away cost of renting for the space I require has been quite low relative to the throwing money away cost of buying. That has changed very quickly in the last six months and as a result I've now become a prospective home buyer.
How do you value real estate?
Remember that for the purposes of our exercise we set the rent vs. buy equilibrium at the level where one can rent or buy the identical apartment by throwing away the same amount of money each month. Let's refine this idea a bit. When home values rise enough relative to rents people should consider selling their homes and renting instead (very few people had the wherewithal to make this difficult choice in 2006). On the flipside, if houses get too cheap relative to rents one should stop renting and buy a house, or buy an additional house and rent it to someone (this describes the current paradigm in many US cities). In financial parlance the terms rental yield or capitalization rate are used to measure the viability of owning property that is rented out to tenants. A quick Google search for rental yields returned this site where at the time the author's rudimentary analysis concluded that buying homes to rent them out was a potentially worthy strategy in the Dakotas, Oklahoma, and Washington DC. The rent vs. buy equilibrium can be described, analyzed, and debated in these terms. A fair equilibrium between rents and prices can be defined as the level at which rental yields equal the return of alternative investments of equivalent risk. For the same amount of thrown away money a buyer should most certainly get "more home" than a renter as compensation for (1) tying up investment capital (2) accepting home price risk and (3) accepting liquidity risk. The job of a traditional REIT fund manager is to scour real estate markets to find properties providing adequate investment returns. I've long held this Vanguard index fund of diversified traditional REITS in my own investment account both as a portfolio proxy for physical real estate and as a very loose hedge against rising rents. The current 3.30% dividend yield paid to fund holders represents the average rental yield across all owned properties. Note that a traditional REIT is not the same as a mortgage REIT.
As I said earlier, it's very difficult to compare generic pricing measures across different cities and countries. I liked this 2010 NPR article highlighting two simple metrics for thinking about bigger picture valuations. The author looks at two ratios by US city: home prices relative to rents and home prices relative to incomes. What's important here is the comparison of one city's current ratio to the same city's ratio in the past. While it's interesting to ponder why New York is so different than Seattle, New Yorkers deciding whether to rent or buy should be more focused on where their ratios are now relative to the past. The NYT and The Economist occasionally run similar analyses.
Unquantifiable financial considerations
Valuing liquidity: An asset characteristic that is commonly unconsidered, and in my opinion, severely undervalued. Let me try to illustrate with an example. Let's say that in your grandmother's will you were given the option of receiving one of two assets: shares of IBM stock or an undeveloped plot of arid land. The two assets have identical value, are estimated to both return 5% per year, and have similar tax consequences upon sale. Which asset would you take? Unless you've always been dreaming to develop that specific plot of land, wouldn't you rather just take the cash value of your inheritance and decide what to spend it on later? Shares of IBM stock trade constantly, and are very easy to liquidate (sell) at a moment's notice. The plot of land on the other hand will be more of a hassle to deal with whether you keep it or decide to put it on the market (forcing you to expend time, another valuable asset). Given the same expected return liquid assets should always trade at premium to illiquid assets. Said another way, if I chose to invest my savings in liquid Google stock at a 5% expected annual return I will require a greater expected return on a more illiquid investment like real estate, art, precious stones, antiques, etc.
Every person will require a different liquidity premium depending on their circumstance and preference. Since the ability to transfer wealth between different assets transparently and quickly is of very high value to me I will be less inclined to buy real estate as my required liquidity premium is higher than the average person.
Diversification risks: Related to liquidity it's important to consider the diversification risks of purchasing a home. For most people the decision to own a home is the decision to buy a potentially volatile asset valued at multiple times their net worth. The basic laws of leverage state that the value of a house purchased with a 20% down payment only needs to fall by 20% in order for you to lose 100% of your money (on the flipside, you stand to make a 100% return or double your money if the house value increases by 20%).
Most people in society unwittingly become quite long what I call the "prosperity trade." What I mean by this is that people tend to put all their life eggs in one basket: their job, spousal relationship, house, 401k, etc. All these things are generally correlated and tend to perform well when the economy is prospering and not so well when the economy falters. One of the risks of owning an illiquid levered asset like real estate is that it can be very difficult to sell at the exact moment when you most need to sell. If you just lost your job and need to sell your house to raise cash or relocate it's likely that someone else in your neighborhood is in same situation.
"Locking in" your rent. Yes, you lock in your rent through the purchase of a home but the value of that certainty must to be balanced against the investment opportunity cost and risk to an adverse movement in the home price.
Other more remote risks resulting in perceptual paradigm shifts should also be considered. Imagine a horrific event like 9/11 multiplied by 10, the discovery of a gigantic fault line, a quickening of rising ocean levels, or a dramatic policy shift prompting a state's primary job-creating industry to migrate to another city or country.
The rule of law: Government policies like the tax deductibility of mortgage interest or the recently expired first-time homebuyer credit have a heavy hand in influencing people's decision of whether to buy or rent. Most government policies are explicit or implicit subsidies that incentivize buying over renting. You can add this qualitative factor to the list of inputs that may impact the future rent vs. buy equilibrium. Rather than delving deeper into this complex subject I'll simply say that I agree with the points brought up in these two opinion pieces. Another critical consideration beyond the scope of this note are the current and future monetary policy actions of the Federal Reserve Bank.
The Strategic Default Option: The option to voluntarily walk away from the mortgage on your underwater house had much more value in the days of low to no down payment loans (NINJA loans). It's difficult to gauge the current value of this option but given the recent lessons learned by banks it's now likely a consideration only for those who have stellar credit.
Unquantifiable preferential / emotional considerations
The freedom to remodel: This is the most common intangible factor I've heard from those in favor of buying. This has become a more significant variable for me as (1) I've become more rooted in NYC (2) spend less time "out" and more time in my home and (3) am more comfortable and certain about my aesthetic preferences.
The psychological desire to own: I'm fascinated by this strong intangible preference though it's not something I'm qualified to opine on. As we enter the age of the Cloud I believe that people's preferences will slowly shift towards focusing more on utilitarian use rather than ownership. We've already seen this shift in real estate as homeownership rates continue to decline. This isn't just due to a simple shift in preferences. Many people are being forced into becoming renters as mortgage credit standards remain tight as the economy continues to stagnate.
Having more control over when you want to move: It's debatable whether homeowners at large have more control over their own moving destiny than renters. If you are a homeowner that can potentially sustain large losses in order to sell and move, then yes, you have lots of freedom. The downside with renting is that unless you live in a rent controlled/stabilized situation you are at the whims of a landlord who might decide to dramatically raise rents or sell the building.
Forced savings: Many make the argument that owning real estate is a way to force someone to save money. The less people understand about the economics of ownership the more likely this is to be true!
Choose your piggy bank
As mentioned earlier, some of the most important unknown inputs to the calculator are also the most difficult to forecast. For the moment let's put aside the first two highlighted inputs: growth/decline in rents and the growth/decline in apartment value as these are somewhat intuitive. What's less intuitive, and most important in my opinion, is the third input: investment opportunity cost.
As someone who has worked in the financial realm for over a decade I'm consistently surprised at how myopic and siloed most people's views are when it comes to wealth and investing. For example, I believe that free time is the most consistently undervalued asset in our society. Also, people wrongly see investments in themselves as being unlike traditional investments in stocks, bonds, currency, real estate, and precious metals. Economically speaking, the ability to earn income over your lifetime is the most valuable asset you'll ever own. Anything you can do to enhance your lifetime income like job training, professional degrees, or staying physically/mentally healthy should be seen as an investment just like buying a share of Apple stock or a US Treasury Bond. There is a reason why disability insurance is so expensive. This insurance protects the asset that is your ability to earn income over a lifetime just as homeowner's insurance protects the asset which is your home.
This brings us to the most important point of the note: The choice of whether to buy or rent is ultimately an asset allocation decision. You're going to throw away money whether you buy or rent. But a home buyer must also set aside additional savings that will go into the piggy bank that is home equity. Would you prefer to put this money in the NYC real estate piggy bank or into some other piggy bank like Apple stock, Walmart bonds, a master's degree, Chinese contemporary art, or your friend's new tech start-up? Or perhaps you'll opt to buy some free time by socking away the cash so that you're able to take six months off from your job. This is why the calculator input of investment opportunity cost is so critical. If you think the home value will rise 5% annually but that an investment in Chinese contemporary art would return 20% the calculator will conclude it's better to rent and use the down payment money to invest in Chinese art. If you believe NYC real estate will rise 10% per annum and that no other investments could yield over 3%, then the decision will clearly be to buy. If you think all assets were poised to decline, including NYC real estate, the calculator would say you're better off renting and keeping your piggy bank savings in cash. This of course also depends on what you assume for the other factors including the third input I previously highlighted, the future path of rents. If you think rents will rise 6% annually with both home prices and investment opportunity costs at positive 1%, it will probably make sense to buy. If rents and housing prices are declining in tandem then renting will be the way to go. If you'd like to read more, this blog post discusses a great academic paper written on the topic of investment opportunity cost as it relates to the rent vs. buy decision.
Conclusion: Facts, forecasts, and emotion
The decision whether to rent or buy your home depends on many quantifiable and unquantifiable factors specific to each person's life situation. Lay out the key quantitative inputs, be honest about your own qualitative biases, then try to make an objective decision based on your personal situation, not someone else's. Emotional factors aside, the choice to own a home is above all an asset allocation decision. If you're fortunate to have the savings to buy a home the decision will ultimately come down to whether you want to invest those savings in the form of home equity or something else that may potentially earn a higher return or just make you a happier person.
There are a handful of widely recognized indices that track US home prices. I'd recommend following the S&P/Case-Shiller home price index, published monthly on a three month lag. Here is a PDF of the most recent report and a separate link to where you can check it in the future. Note that on page 4 of the report the month over month and year over year changes are broken out by the 20 major cities that make up the composite index. As I remarked earlier, home price changes vary dramatically from city to city. Harvard economics professor Edward Glaeser wrote this great opinion piece commenting on the latest Case-Shiller report and other issues relating to the factors affecting housing supply and demand.
Try understanding the financial inputs then prepare to throw money away
The best way to begin is to take time understanding how various financial assumptions affect your decision. This can be accomplished most easily by fiddling around with an interactive rent vs. buy calculator like this one on the New York Times website. Make sure you open up the advanced settings by clicking on the blue box at the top right corner of the chart and notice the input fields under the subcategories of buying, renting, and other. For a more in-depth exploration try running this more detailed calculator constructed by the Federal Reserve bank of Cleveland. I'd recommend sticking to the NYT version as the Fed's calculator is probably a bit too clunky for its own good.
The classic justification used by many who decide to buy is that "they were tired of throwing money away on rent." You are going to throw money away whether you buy or rent. Some would even argue that as a taxpaying homeowner you've simply made the decision to rent from the government rather than from a property owner. I don't agree with this as ultimately you will bear the cost of property taxes whether you buy or rent since the taxpaying owner will almost certainly pass this cost on to renters. A better way to phrase this cynical idea is simply to say that with the existence of property tax no one really owns their own property as we all are just renting from the government.
When you rent, the money you throw away is rent, renter's insurance, and potentially a broker's fee. When you buy, the money you throw away is buying/selling closing costs, lawyer fees, property taxes, mortgage interest, maintenance/common charges, renovation costs, homeowner's insurance, etc. Remember that money thrown away when buying doesn't include the down payment or money that goes towards paying down the principal of the mortgage. This is the portion of your home you actually own, known as home equity. Even if you bought your home in cash you will still throw away money every month for all items on this list except for mortgage interest.
Let's continue using the idea of throwing away money for the following mental exercise. Imagine we were able to find two identical homes, one for rent and one for sale. Assume that in each case the money being thrown away every month is also identical (again, for the buyer this doesn't include payment contributions to equity). If you're throwing away the same amount of money in both cases what then will dictate whether it's better to buy or rent? The answer will depend mostly on three important financial variables: the future path of rents, the future path of the home value, and the investment opportunity cost. Investment opportunity cost is just a fancy way of asking "What is the return I could earn on a different investment as an alternative to putting my money into the equity of this home?"
Each calculator input will affect the answer differently. You can classify the characteristics of every input into a few binary categories: one-time vs. annuity (they occur every year), known vs. unknown, and fixed vs. variable. The cost of the home is known, fixed, and usually incurred as an annuity (or one-time if you buy in cash). Rents are a variable, unknown, annuity cost. The mortgage rate is an annuity cost that is known and fixed (assuming you have a fixed rather than adjustable rate mortgage).
One-time "friction costs" like broker or lawyer fees will impact the result more if you project a short stay of only a few years or less. On a longer time horizon the inputs that register yearly and accumulate over time will carry a larger weight (what I call annuity inputs). When playing around with the calculator you'll notice that my three highlighted inputs: growth/decline of rents, growth/decline of home value, and investment opportunity cost, all have a disproportionate influence on the outcome. Notice that I left off mortgage borrowing rates from this short list. While this rate has a very important weight in the calculation it's also one of the few inputs that is both known and fixed. It's not a coincidence that the three highlighted inputs are each unknown, variable, and annuity.
Our thought experiment is based on the assumption of finding identical apartments where money being thrown away is the same in renting as it is for buying. And while it won't be easy in practice to locate these twin apartments this construct is a good way to mentally separate the money that goes towards consuming your home (money that is thrown away) from the money that goes towards the investment in your home (home equity).
Back to our example. If one of our throwing away money inputs change, i.e. mortgage borrowing rates fall, then all else equal, one would be able to buy "more home" for the same monthly outlay. When mortgage rates decline people will shift their preference away from renting to buying. The US Federal Reserve Bank is currently keeping interest rates low to incentivize people to do just that (though their actions aren't the only reason why interest rates are at historic lows). In fact, NYC renters are getting a double dose incentive to become homeowners as rents are rising while mortgage rates are declining. In this scenario you'd expect housing prices to rise, rents to decline, or some combination of the two in order to restore a more sensible equilibrium. My friends know that I've been a renter my entire adult life for a wide variety of reasons despite having the fortunate ability to own my living space. One of the main reasons I've been a renter is that until recently the throwing money away cost of renting for the space I require has been quite low relative to the throwing money away cost of buying. That has changed very quickly in the last six months and as a result I've now become a prospective home buyer.
How do you value real estate?
Remember that for the purposes of our exercise we set the rent vs. buy equilibrium at the level where one can rent or buy the identical apartment by throwing away the same amount of money each month. Let's refine this idea a bit. When home values rise enough relative to rents people should consider selling their homes and renting instead (very few people had the wherewithal to make this difficult choice in 2006). On the flipside, if houses get too cheap relative to rents one should stop renting and buy a house, or buy an additional house and rent it to someone (this describes the current paradigm in many US cities). In financial parlance the terms rental yield or capitalization rate are used to measure the viability of owning property that is rented out to tenants. A quick Google search for rental yields returned this site where at the time the author's rudimentary analysis concluded that buying homes to rent them out was a potentially worthy strategy in the Dakotas, Oklahoma, and Washington DC. The rent vs. buy equilibrium can be described, analyzed, and debated in these terms. A fair equilibrium between rents and prices can be defined as the level at which rental yields equal the return of alternative investments of equivalent risk. For the same amount of thrown away money a buyer should most certainly get "more home" than a renter as compensation for (1) tying up investment capital (2) accepting home price risk and (3) accepting liquidity risk. The job of a traditional REIT fund manager is to scour real estate markets to find properties providing adequate investment returns. I've long held this Vanguard index fund of diversified traditional REITS in my own investment account both as a portfolio proxy for physical real estate and as a very loose hedge against rising rents. The current 3.30% dividend yield paid to fund holders represents the average rental yield across all owned properties. Note that a traditional REIT is not the same as a mortgage REIT.
As I said earlier, it's very difficult to compare generic pricing measures across different cities and countries. I liked this 2010 NPR article highlighting two simple metrics for thinking about bigger picture valuations. The author looks at two ratios by US city: home prices relative to rents and home prices relative to incomes. What's important here is the comparison of one city's current ratio to the same city's ratio in the past. While it's interesting to ponder why New York is so different than Seattle, New Yorkers deciding whether to rent or buy should be more focused on where their ratios are now relative to the past. The NYT and The Economist occasionally run similar analyses.
Unquantifiable financial considerations
Valuing liquidity: An asset characteristic that is commonly unconsidered, and in my opinion, severely undervalued. Let me try to illustrate with an example. Let's say that in your grandmother's will you were given the option of receiving one of two assets: shares of IBM stock or an undeveloped plot of arid land. The two assets have identical value, are estimated to both return 5% per year, and have similar tax consequences upon sale. Which asset would you take? Unless you've always been dreaming to develop that specific plot of land, wouldn't you rather just take the cash value of your inheritance and decide what to spend it on later? Shares of IBM stock trade constantly, and are very easy to liquidate (sell) at a moment's notice. The plot of land on the other hand will be more of a hassle to deal with whether you keep it or decide to put it on the market (forcing you to expend time, another valuable asset). Given the same expected return liquid assets should always trade at premium to illiquid assets. Said another way, if I chose to invest my savings in liquid Google stock at a 5% expected annual return I will require a greater expected return on a more illiquid investment like real estate, art, precious stones, antiques, etc.
Every person will require a different liquidity premium depending on their circumstance and preference. Since the ability to transfer wealth between different assets transparently and quickly is of very high value to me I will be less inclined to buy real estate as my required liquidity premium is higher than the average person.
Diversification risks: Related to liquidity it's important to consider the diversification risks of purchasing a home. For most people the decision to own a home is the decision to buy a potentially volatile asset valued at multiple times their net worth. The basic laws of leverage state that the value of a house purchased with a 20% down payment only needs to fall by 20% in order for you to lose 100% of your money (on the flipside, you stand to make a 100% return or double your money if the house value increases by 20%).
Most people in society unwittingly become quite long what I call the "prosperity trade." What I mean by this is that people tend to put all their life eggs in one basket: their job, spousal relationship, house, 401k, etc. All these things are generally correlated and tend to perform well when the economy is prospering and not so well when the economy falters. One of the risks of owning an illiquid levered asset like real estate is that it can be very difficult to sell at the exact moment when you most need to sell. If you just lost your job and need to sell your house to raise cash or relocate it's likely that someone else in your neighborhood is in same situation.
"Locking in" your rent. Yes, you lock in your rent through the purchase of a home but the value of that certainty must to be balanced against the investment opportunity cost and risk to an adverse movement in the home price.
Other more remote risks resulting in perceptual paradigm shifts should also be considered. Imagine a horrific event like 9/11 multiplied by 10, the discovery of a gigantic fault line, a quickening of rising ocean levels, or a dramatic policy shift prompting a state's primary job-creating industry to migrate to another city or country.
The rule of law: Government policies like the tax deductibility of mortgage interest or the recently expired first-time homebuyer credit have a heavy hand in influencing people's decision of whether to buy or rent. Most government policies are explicit or implicit subsidies that incentivize buying over renting. You can add this qualitative factor to the list of inputs that may impact the future rent vs. buy equilibrium. Rather than delving deeper into this complex subject I'll simply say that I agree with the points brought up in these two opinion pieces. Another critical consideration beyond the scope of this note are the current and future monetary policy actions of the Federal Reserve Bank.
The Strategic Default Option: The option to voluntarily walk away from the mortgage on your underwater house had much more value in the days of low to no down payment loans (NINJA loans). It's difficult to gauge the current value of this option but given the recent lessons learned by banks it's now likely a consideration only for those who have stellar credit.
Unquantifiable preferential / emotional considerations
The freedom to remodel: This is the most common intangible factor I've heard from those in favor of buying. This has become a more significant variable for me as (1) I've become more rooted in NYC (2) spend less time "out" and more time in my home and (3) am more comfortable and certain about my aesthetic preferences.
The psychological desire to own: I'm fascinated by this strong intangible preference though it's not something I'm qualified to opine on. As we enter the age of the Cloud I believe that people's preferences will slowly shift towards focusing more on utilitarian use rather than ownership. We've already seen this shift in real estate as homeownership rates continue to decline. This isn't just due to a simple shift in preferences. Many people are being forced into becoming renters as mortgage credit standards remain tight as the economy continues to stagnate.
Having more control over when you want to move: It's debatable whether homeowners at large have more control over their own moving destiny than renters. If you are a homeowner that can potentially sustain large losses in order to sell and move, then yes, you have lots of freedom. The downside with renting is that unless you live in a rent controlled/stabilized situation you are at the whims of a landlord who might decide to dramatically raise rents or sell the building.
Forced savings: Many make the argument that owning real estate is a way to force someone to save money. The less people understand about the economics of ownership the more likely this is to be true!
Choose your piggy bank
As mentioned earlier, some of the most important unknown inputs to the calculator are also the most difficult to forecast. For the moment let's put aside the first two highlighted inputs: growth/decline in rents and the growth/decline in apartment value as these are somewhat intuitive. What's less intuitive, and most important in my opinion, is the third input: investment opportunity cost.
As someone who has worked in the financial realm for over a decade I'm consistently surprised at how myopic and siloed most people's views are when it comes to wealth and investing. For example, I believe that free time is the most consistently undervalued asset in our society. Also, people wrongly see investments in themselves as being unlike traditional investments in stocks, bonds, currency, real estate, and precious metals. Economically speaking, the ability to earn income over your lifetime is the most valuable asset you'll ever own. Anything you can do to enhance your lifetime income like job training, professional degrees, or staying physically/mentally healthy should be seen as an investment just like buying a share of Apple stock or a US Treasury Bond. There is a reason why disability insurance is so expensive. This insurance protects the asset that is your ability to earn income over a lifetime just as homeowner's insurance protects the asset which is your home.
This brings us to the most important point of the note: The choice of whether to buy or rent is ultimately an asset allocation decision. You're going to throw away money whether you buy or rent. But a home buyer must also set aside additional savings that will go into the piggy bank that is home equity. Would you prefer to put this money in the NYC real estate piggy bank or into some other piggy bank like Apple stock, Walmart bonds, a master's degree, Chinese contemporary art, or your friend's new tech start-up? Or perhaps you'll opt to buy some free time by socking away the cash so that you're able to take six months off from your job. This is why the calculator input of investment opportunity cost is so critical. If you think the home value will rise 5% annually but that an investment in Chinese contemporary art would return 20% the calculator will conclude it's better to rent and use the down payment money to invest in Chinese art. If you believe NYC real estate will rise 10% per annum and that no other investments could yield over 3%, then the decision will clearly be to buy. If you think all assets were poised to decline, including NYC real estate, the calculator would say you're better off renting and keeping your piggy bank savings in cash. This of course also depends on what you assume for the other factors including the third input I previously highlighted, the future path of rents. If you think rents will rise 6% annually with both home prices and investment opportunity costs at positive 1%, it will probably make sense to buy. If rents and housing prices are declining in tandem then renting will be the way to go. If you'd like to read more, this blog post discusses a great academic paper written on the topic of investment opportunity cost as it relates to the rent vs. buy decision.
Conclusion: Facts, forecasts, and emotion
The decision whether to rent or buy your home depends on many quantifiable and unquantifiable factors specific to each person's life situation. Lay out the key quantitative inputs, be honest about your own qualitative biases, then try to make an objective decision based on your personal situation, not someone else's. Emotional factors aside, the choice to own a home is above all an asset allocation decision. If you're fortunate to have the savings to buy a home the decision will ultimately come down to whether you want to invest those savings in the form of home equity or something else that may potentially earn a higher return or just make you a happier person.
