I’ve been getting multiple e-mail requests about doing an analysis about renting versus buying especially in high priced areas. Since in my mind’s eye, the answer is rather clear for the moment since any equation will tell you outright that buying does not make sense with current prices and trends. There was no point in using mortgage calculators or figuring out tax breaks since the numbers were enormously tilted for people to rent or lease out their living quarters in banana republic metro areas. Yet it is important to understand that there will be a time, as has been the case in history, when purchasing a home will make economical sense even in bubblista areas. We can argue the merits of the pride of homeownership and the joy you get from having the unrestrained power to paint your living room hot pink, but it is hard to place a momentary value on that. And in the world of real estate investing, economics means everything as those in the subprime arena are learning the hard way. So we will simply focus on measurable numbers since it is pointless in using housing pundit rhetoric since many recent new homebuyers are learning that the only loyalty home builders have is to the bottom-line. First we will examine the fascinating fact that in many healthy metro areas, rental prices will increase while home price trend lower. Then, we will look at housing price declines and why spending $1 for two shiny quarters isn’t a smart way to invest. And finally we will delve into the tighter credit markets and the implications this will have on purchasing a home in the future.
Rental Prices will go up in the Short-term
First, let us take a look at rental prices in Los Angeles County via the Census Bureau:
Median Rent:
2005: $918
2004: $873
2003: $821
2002: $768
Keep in mind this is aggregate data for a county with the population of 9,758,886 people. But the trend is unmistakable, rental prices are going up across the board. From 2002 to 2003 rent prices went up 6.9%, from 03-04 they went up 6.3%, and from 04-05 they went up 5.1%. This trend is also appearing in more recent data even in the face of the mounting housing downturn. This data is useful because the majority of people in Los Angeles County rent. Yes, we hear the famous line of 70 percent of US households own their home but this is the Republic of Southern California and 51 percent of households rent. Clearly this trend will continue since many people will be losing their homes. And don’t believe the rhetoric from the housing lenders that they are trying to help these folks from losing their homes; they are using Orwellian propaganda trying to make is seem that they have their best minds trying to rework mortgage structures with at risk owners. What they call support is a piecemeal budget analysis with someone telling you, “maybe you can take on another renter or maybe you can cut back on your discretionary spending†but nothing in terms of true help. The true help would come in the form of restructuring the debt with a monetary cost to the company for putting people into these diabolic loans. Meaning, they would need to subsidize their mistake of putting people in mortgage products that had no possibility of being repaid and essentially converted the lender, Wall Street, and the buyer as a speculative racket that might as well be doubling down in Vegas. Again, we are hearing all this talk about help but nothing is happening. These folks are all hoping Uncle Sam will be there as the lender of last resort but somehow we are deeper in mortgage sewage than the government realizes. Then we have bizarre things happening in the current market and apparently everyone is now part of the housing complex.
Back to the renting issues. How are prices still going up in the face of what is happening? It is rather simple if you think about it. Many of these current subprime buyers will lose their home. They should have never been put into these mortgage products to begin with. So they will become part of the rental demand market. In addition, you have prospective buyers sitting even more steadily on the fence since there is little doubt housing is imploding. Even the most avid housing pundits are tempering their speech realizing that they’ll be seen as an enormous anti-Nostradamus by making chump predictions. So the demand being placed on the rental market will accelerate in the next year. Southern California is already a healthy rental market and with the accelerating mortgage problems, we will see rental rates remain healthy and possibly, increase at a stronger pace. In addition, you will see some sellers who are unable to sell that will become “unsuspecting†landlords. To recoup some of their losses they will need to charge higher rental rates but only to the extent that the market will bear. As you can see from our data, rental rates should trend upward by 5 to 7 percent which ironically, should increase the CPI owner’s equivalent of rent.
Spending $1 for a Kick-Back of Two-Quarters
But what about the tax benefits of owning? Aren’t all renters simply flushing their money down the porcelain toilet of perpetual loserville? First, there is a mistake in believing renting provides no economic benefit. Everyone needs shelter unless you are going the way of the nomad and living under the San Gabriel river. Renting provides the same economic substitute as owning a home aside from tax benefits, equity buildup, and the ability to take a sledge hammer into your kitchen wall should your heart desire. The only problem in hyper bubble markets like Southern California, renting an equivalent place will cost you 2 times less than owning. So for example, you may be able to rent a home for $2,200 that would cost you $4,000 if you were to buy it. And that $1,800 is being invested ideally at a rate outpacing inflation. The way housing is currently going, you’d be better off playing Keno at your local Indian casinos. So let us run some hypothetical numbers:
Home Price: $500,000
Rental Equivalent Price: $2,200 per month
Down Payment: $25,000
Assumed Rate of Return on Investments: 7%
House Payment: $4,057
Tax Savings: $806 (25 percent tax rate)
Principal payment: $424
Net House Payment: $3,252
With these assumption we will also use wonderland inflation data from the ministry of truth otherwise known as the BLS. We will assume inflation is running at 3 percent. In addition, we can safely assume that appreciation will be non-existent for a few years but we are being generous and factoring a 2 percent appreciation for this home. The inflation rate is important because this impacts our overall rate of growth in rental payments. Like I previously stated, we expect rental rates to go up in the short-term, but they will start trending down as the market starts seeing employment losses which lag. So assuming all of the above, purchasing this home will not break even until get this, 17 years! And why is that? Because we are investing the saved difference into an investment that is yielding only 7 percent. Here’s the break down after 17 years:
Value of Investment: $324,517
Value of Home Equity: $320,859
So it isn’t clear that you should own since the above factors in the tax savings as well. In the short-term scenario the numbers become even more obvious. If we are to look at the 5th year of owning this home, this is what we find:
Value of Investment: $106,843
Value of Home Equity: $56,379
And again we are factoring in a 2 percent growth rate for housing. Many bears are predicting nominal losses in the double-digits. So we are talking about a six-figure losing proposition for at least the next few years. Plus, what can you get for $500,000 in Los Angeles County right?
Tighter Credit Markets
The credit markets were self correcting until the Fed decided to jump in and give the implication that they were the lender of last resort. Now the implication is that we will have a bailout and the market is rejoicing. Yet looking at the mortgage reset charts and mortgage equity withdrawals, it is clear we are only entering the first stage of a multiyear housing bear market bailout or no bailout. And when we look at Real Homes of Genius, we understand that fraud and outright speculation will come crashing down. You must ask yourself that a large proportion of our population was involved to some extent in producing products that provided no socio-economic benefit to our society. 2/28 loans? Option ARMS? Need we dig into more data of people making $9 hour being put into loans with the assumption they are making $157,000? The only people benefiting from these loans were Wall Street and the lenders. No one else. Initially the claim was these people now have the pride of homeownership but what a crock that was. Lenders will continue to tighten since risk is now perceived in the market. This will make it more difficult for people to refinance, purchase discretionary items, and in general will put a pause on the consumer spending which greases the wheels of the American economy. We talked about debt being seen as the new form of money. But all this is changing. And Americans with a negative savings rate will have a hard time doing a paradigm shift in which lenders will require a down payment. Even a miniscule down payment like 5 percent will bring the market to a screeching halt. Everything is borrowed.
No one has a crystal ball into the future. Even Alan Greenspan didn’t see the subprime mess coming (or at least he would like us to believe that). Big Ben even in May of this year talked about the subprime market being contained in a “silo.†And of course we have the heads of housing lenders and builders making fools of themselves by making outlandish predictions that are now being verified in the arena of reality as false. Save up, run the numbers, and the time will come to buy. But right now, against the propaganda machine of the housing industry, this is not the time to buy a home.
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16 Responses to “The Rent vs. Buying Dilemma: Mortgages the Southern California Way. 3 Factors to look at: Increase Rental Prices, Housing Price Declines, and Tighter Credit Markets.”
This whole situation is very sad. Many people can’t afford to even rent a decent place where I live, let along buy. I wonder if this housing bubble never happened how much grief we could have saved everyone.
I disagree with you about rent rising, numerous reports out of San Diego and Florida show that overbuilding and oversupply there have lead to rental prices falling sharply. I believe that will be the case in SoCal as well, many renters are illegals as well and their work is drying up. People will cut the garderner, the maid, the add-on to the house and eat out less. All this effects illegals first and i think that is why the employment situation looks better then it might be as they are the first to go. Also many of the jobs created in Socal the last few years were related to real estate, realtors, brokers, title insurers etc. They will lose work and I think many will leave California as its to expensive, many came here just to exploit the bubble after all 6% in California is alot better then in Texas when you consider the price of the home. You touched on the part that i think is the real key, “investors” and speculators who bought homes to flip will be forced to become landlords. Even many who bought in ’00-’02 will find themselves without alot of money if they sell and will be forced into being landlords. I was renting a house in Simi which was bought late in ’03 the people moved to Texas and took out cash as many people did, they figured prices would keep rising. Well they didnt and tried to sell at the end of last year once or 1 year agreement expired they needed us to stay while they tried to sell and lowered the rent. We stayed, they took it off the market over xmas and then back on in March of this year we stayed 3 more months and moved to another rental 50% bigger house, 50% bigger yard and rent increased only $145 a month. They ended up pulling the home off the market shortly after we left and rented it again for the same rent. I figure they are stuck now being landlords for atleast a decade until they can break even. It is this that will really depress rents.
San Diego is ahead of the game by a year in terms of Orange and Los Angeles County. What I discuss in the article is that we will see a short-term increase in rental prices which is occurring in prime locations in LA and Orange County. Of course over the long haul prices will start to come down in tandem with housing prices.
I’m not at all sure rental prices are really rising (or if so, rising as fast as one might come to believe by reading rental ads) – I’m seeing a lot of “wishing prices” for rentals on Craig’s List that stay on the market for months, in particular for larger/more expensive places. Here in downtown L.A., they’ve been stable or falling for a couple of years now after peaking in ’05. I think a lot of the larger and more expensive units either don’t get rented at all or end up rented for huge discounts from what was originally asked.
I also disagree with rents rising. We moved into our gorgeous and spacious 1 bedroom apartment with lovely views of the hollywood hills and our own deck & garage in February 2010. We pay less than $1000/month. The landlord had tried to for 6 months to get someone in, the starting price being $1300. Many of my friends, especially in West Hollywood, negotiated their rent down around that period. More did than didn’t. The thing with LA is that so many people move here, but only so many people can sustain themselves here. With the rate of unemployment so high, lots of renters have returned to wherever they came from, creating a renter’s market! Thanks for the articles, we were thinking of buying, but now we’re not so sure. If it ain’t broke, don’t fix it.
Great, I wish you would have written this article earlier. Do you think your article applies to foreclosure buys? Or a great price on a fixer upper home in a very desirable area?
Yeah, I think rents here in Florida are stagnant at best. I am currently renting a 3/2.5/2 2200sqft, new construction, one mile from the beach for $1575 a month. The owners were trying to get 2K then 1800, then my wife and I suggested 1500. It would cost us about $3000 a month to own that house. I’ll wait a little longer.
Thanks for the great site.
I think your analysis is flawed because you’ve assumed that you can earn 7% on investments. I don’t think you can do that with equivalent risk. And it neglects taxes that have to be paid on the investments. You can get rates of return like that only by investing in a portfolio that includes equities, and on the bond portion of the portfolio your interest earnings are constantly sapped by taxes. In fact, a fence-sitter is more likely (and well-advised) to have his or her money in CDs or treasuries if a purchase is contemplated in under 5 years. CDs pay about 5%, or about 3% net of federal and California income taxes. This is at or below the rate of inflation. When you run those numbers, the problem for the renter becomes clear – as he waits, he loses purchasing power on his initial savings plus any money added to the pot over time. It’s true that, on average over a long period of time, an investor with money in a balanced portofolio that includes stocks will outperform the risk-free numbers I’ve given, and in fact for the stock portion can get tax-free compounding on the capital gains until time of sale. But by that logic, one could as easily show that no one should ever buy a house, because the long-term average return on real estate is lower than on stocks.
“I think your analysis is flawed because you’ve assumed that you can earn 7% on investments. I don’t think you can do that with equivalent risk.”
The assumption here is that there is equal risk with buying real estate. In fact, I would say buying real estate in the current market place is more risky then buying stocks or investing in other avenues. For the past few years, my portofolio in commodities and energy is doing much better then 7 percent. Biotech has also been doing well.
The purpose of this article is to highlight that buying in high priced areas does not make sense in the current market. However, I own cash-flowing real estate out of state which does make sense. And the one other benefit from owning property is leverage. But the analysis is for high priced metro areas and by running the numbers, buying right now doesn’t make sense.
And you are only looking at CDs and other low risk investments. Real estate in high priced areas has the misconception of being a safe investment; if anything, it is a short-term speculative play. You might as well short stocks in specific regions based on employment numbers, weather conditions, and population trends.
Simply following a one track strategy will never get you to financial success quickly. You can always follow the typical wealth building strategy of putting 10 percent into your 401(k) for 30 years and have a decent nest egg (assuming inflation doesn’t kill your return); but you need to think outside the box in the current marketplace to be profitable. That may include short positions, aggressive plays in certain sectors, and buying in underpriced areas. My guess is most people that read this site are looking to buy in high priced areas and are simply looking for an entry point in the market. With the current pro-housing rhetoric, it is clear that someone needs to run the numbers and offer a clear analysis that buying right now makes no sense. Never did I say people shouldn’t buy ever. What I did say is there will be a time to buy, simply not now.
Dr. HB.
question for you…
I’ve noticed that as of late there are many references to the “newer” ARM reset chart. When I look at the Credit Suisse one from the beginning of the year they don’t seem to match up. Not quite sure how I should be interpreting the data or which chart I should reference. Has the C.S. chart “modified” itself due to people refinancing into fixed rates? From what I understood, the second “egg” of the C.S. chart was thought to be harder one to swallow as there appeared to be more option ARMs resetting at that time.
Here is the tinyurl that links to the Credit Suisse chart that Keith had posted over on HP.
http://tinyurl.com/2tg2tx
Am I missing something here?
Thanks!
http://www.nytimes.com/2007/04/10/business/2007_BUYRENT_GRAPHIC.html
The link is to a great interactive tool I came across through one of the web’s housing bubble blogs. It compares how many years one would benefit from renting rather than buying. For my rented condo, I was glad to see that even if local housing (Alberta, Canada) appreciates 5% annually, I am still better off renting than buying for six years, and I don’t think the upswing in area housing will last that long anyways. (at 8% annual growth, renting still beats buying for 2 years)
Conversely, if home price appreciation turns negative (or even holds flat at zero), I am better off renting for 30+ years. 🙂
A similar analysis for Alfonso Rey, a condo buyer in San Francisco, here.
Just found the site. I really enjoyed the article. This whole housing thing is out of control in California.
I’m just a beginner – but if I understand this correctly, renting would only make sense if:
property appreciation rates increased; or
rents increase/property values decline such that the rental rates are more inline with monthly mortgage payments.
Great post Dr HB. I grew up with the value that renting is equivalent to throwing your money away. I think the environment we are in now has changed that idea. Your analysis on the numbers makes sense.
Keep it up. I enjoy reading your blog.
Cheers!
😉
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A couple quick thoughts.
1. The bubble will not burst until 2008. That’s when a majority of Arms will come due and foreclosures will start to saturate the market. In 2009/2010 you will see people think they are picking up real estate at a low value, so we will get another small peak in real estate. End of 2010 will start a recession type period and home values will really plummet over the next four years. I do not want to put all the stats here, but read some of the literature by Harry Dent.
2. People who claim that Southern California is a desirable place to live and there is a lot of demand for housing have to realize that there was not a worldly climate change that suddenly made Southern California so great. It has been desirable for a long time. It is merely speculators with deep pockets looking for a quick buck that made buying desirable.
http://www.johnbeckland.com/
[…]
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