This article presents the various costs and benefits associated with buying or renting a single family residence (SFR), and provides a roadmap for making a well-informed financial decision.
One way, but by no means the only way, to decide whether you are better off financially renting or buying a single family residence (SFR) is to consider its price-to-rent ratio. This rule of thumb figure evaluates the price of a property and is more commonly referred to as the gross revenue multiplier (GRM). The GRM is calculated by dividing the asking price for a residence by the annual rent it or a comparable property commands.
A writer for the New York Times suggests the GRM tips at 20 times a property’s annual rent when considering whether to purchase or lease a home (or a comparable property). As perceived, an asking price more than 20 times a property’s annual rental value means renting is a better bet than owning. Likewise, the writer reports that if the price of a property dips below 20 times its annual rental value, purchasing a home will be the more prudent financial decision. [To read the full New York Times article, see In Sour Home Market, Buying Often Beats Renting.]
In many high-end neighborhoods and communities, like those in parts of Orange County, San Diego and San Francisco, it currently makes more financial sense to rent than to buy – based on the GRM of 20, or 14 for that matter. However, the average homebuyer is financially naive or has other pressures driving him to buy. A common pressure comes from friends and relatives who continuously beat the drum of homeownership, no matter what the financial circumstances dictate. It is this sort of societal purchasing pressure that contributed to the swell of homeownership in the mid-2000s, when the GRM was much too high in most of the neighborhoods in California. The urban and suburban poor, made up disproportionately of minority groups, have been especially hard hit by ill-informed decisions to “move on up” by buying a home.
It is important to understand the financial scope of the decision to rent or to purchase a property. A number of social amenities – externalities in economic parlance – are favorably associated with owning a home:
- the appearance of family stability;
- a safe investment (as safe as a home, it used to be said);
- activism for the benefit of one’s community;
- civic responsibility;
- political involvement;
- neighborhood collaboration to reduce crime; and
- investment in property aesthetics.
These amenities are in addition to:
- income tax savings through itemized deduction of property taxes and mortgage interest;
- equity buildup due to amortized principal payoff, property improvements and the property’s asset value inflation; and
- neighborhood appreciation in value due to increased desirability of the location.
However, to cite only the benefits is an exaggeration. Many generally unspoken consequences come with the ownership of a home. While the purchase of a home may promote a “liberated” feeling, a homebuyer ignores the grip of physical obsolescence, the cost of maintaining his property and the risk of resale and mortgage conditions – all at his peril.
A home exposes its owner to unnecessary financial risk when the need inevitably arises to extract the wealth locked up in a home’s equity. These risks have overwhelmed homeowners in California during this Great Recession. Many homeowners found themselves “house poor” with their earnings trapped in an asset rendered illiquid, while millions more found themselves in a worse situation, hampered by negative equity. When home values dropped dramatically (as they do in recessions, only more so this time due to the concurrent financial crisis) homeowners had no way to access the wealth they had stored in their home to stave off costly emergencies or fund any planned future purchases or investments.
The true costs associated with owning a home remain largely unspoken. First of all, the monthly payment on a maximum mortgage is not equivalent to the rent a tenant would pay to lease the same or a similar SFR. Implicitly, the financial lure of ownership is not significant unless the mortgage payment is less than the rental value of the property. This is because a homeowner’s mortgage is bundled with additional ownership and operating expenditures which come with the acquisition of any property:
- replacement of structural components;
- homeowners’ association (HOA) fees if the property is located in a common interest development (CID); and
With the exception of furnishings, these ownership expenditures as well as other expenditures such as water and trash are always included in rent. The expenditures included in rent are especially distinguishable if the SFR under consideration is a condominium unit. [See first tuesday Form 306]
Even with home prices depressed in California, prices are not yet low enough in most mid- to high-priced areas to make buying a better deal than renting. While housing prices have dropped, so have rents. Drops in both price and rents will continue during the remainder of 2010 and on through 2011. Distortions will eventually appear between the costs of construction and resale pricing, another fundamental in the buy-or-rent decision, triggering the time-to-buy radar.