Saturday, July 19, 2008

Buy A House Or Rent One?

The New York Times reported today (July 19, 2008) that: "from 1985 to 2002, the average American home sold for about 14 times the annual rent for a similar home, according to Moody's Economy.com. By early 2006, home prices ballooned to 25 times rental prices. Since then, the ratio has dipped back to about 20 - still far above the historical norm."

I say that the price to rent ratio should be about 8; not 25, not 20, and not 14.

This ratio of 8 depends on the value of money and the direction of house prices. Here is how I calculate the ratio of 8 and how you can adjust the calculation for future events. By the way, I learned this ratio of 8 rule from some very experienced people about 50 years ago when I was selling real estate.

Imagine you are an investor. The investor currently needs monthly rent equal to 1% of the house value. Yes, 12% of the house value per year. The 12% goes roughly this way: 6% or 7% for the money (investor provided and/or mortgage) 2% or 3% for property taxes (depending on local law), 2% or so for repairs, maintenance, insurance, and vacancies, and 2% or so for the investor to cover management, profit, depreciation, and risk. 100 divided by 12 is roughly 8.

If you, the investor, believe that the property will increase in value, you may be willing to take less rent to get the property appreciation. For example, in the farm land boom a couple of decades ago, the farmer could sell his land (no repairs, maintenance, vacancies, building insurance, or building depreciation) to a big city investor and then lease it back for less than the amount of the property taxes. Many farmers sold. Many big city investors were very sorry later.

Suppose you are trying to decide whether to buy or rent a $200,000 house. If you can rent that house for $2,000 per month (1% of the value) you are probably dealing with an investor who expects no major value appreciation (or depreciation). If you can rent that same house at $1,000 per month, you are dealing with an investor who expects 6% annual appreciation and can handle a negative cash flow while he waits - or a desperate owner (perhaps already in foreclosure) who figures that any rent is better than no rent at all.

Please note that there are limits to this 12% of the value per year rule. Suppose you are the investor and you buy a house for $20,000. Do you then ask for $200 per month in rent (the 1% of value)? Absolutely not, you ask for $600 per month. Why? Because the local welfare agencies will pay $600 per month on behalf of their client and the welfare agency pays this amount directly to the landlord. This welfare agency rent amount becomes the local rental minimum amount. This is why slum landlords get rich.

There are other limits to the 12% of value per year rule. Suppose you are the investor and you buy a house for $250,000. Do you then ask for $2,500 per month in rent (the 1% rule)? Absolutely not. Why? Before you bought the house you checked the local rental market and you know you can get much more than 1% per month. This is how landlords in tight rental markets get rich.

With housing, there are two important things to remember. First, a house has no intrinsic value. Nothing, Nada. Picture one of those western mining towns where the building are all still standing but all the people left after the mine closed. No jobs, no people, no value. Second, an income producing property that does not produce income has no value. Nothing. Nada. Picture Detroit. The population was over 2 million. Now the population is under 1 million. Half the people left. Roughly half the houses are empty and abandoned.

Owning a house is said to produce wealth. This is fiction. Renting a house for less than the landlord cost transfers wealth from the landlord to the tenant.

One last point: Do not be fooled by the many "rent vs. buy" calculators available on the web. All the calculators I saw ignore the cost of upkeep, repairs, and maintenance; they just compare the mortgage payment and property taxes to the rent payment amount. If you rent and the roof leaks, or the roof need replacement, or the furnace stops working, or the house needs painting, or the driveway settles, or the carpet needs replacing, you call the landlord and he pays for it, not you.

One more last point: Do not be fooled when someone says "but you can deduct mortgage interest and property taxes if you buy and you can't deduct anything if you rent". People with lots of mortgage interest and property taxes are generally in very low tax brackets such that the tax deduction has little value if they itemize (and no value at all if they take the standard deduction).

One final point: The New York Times article also says that "by the reckoning of Economy.com, enough houses are on the market to satisfy demand for the next two-and-a-half years without building a single new one" and that "in Los Angeles, San Francisco, Phoenix and Las Vegas, house prices have in recent months declined at annual rates of more than 33 percent". I do not want to be the landlord renting at 1% per month - or at any other percentage - in these uncertain times. Do you?

3 comments:

Jon Gutek, JD/CPA said...

Bloomberg.com reported today that "the three-bedroom house at 1916 Prospect St. in Flint Michigan" which "sold in 2005 for $110,000", owned by "Fannie Mae, the largest U.S. mortgage finance company" has a real estate broker who "couldn't find a buyer who would pay $6,900" and who advised cutting the price to $5,000. The broker still couldn't sell it. "There's oversupply," he said.

This illustrates my point; a house has no intrinsic value. Do you think I am wrong and that real estate is sure to come back? Here is your chance to make some real money!

Jon Gutek, JD/CPA said...

The truth of the matter is that a house is an emotional issue, not a financial one. Most people will pay virtually anything to be a "homeowner" rather than a "tenant"; renting is never an option for them even if the rent is less than the property taxes.

Eric said...

Fantastic article! It's so refreshing to read from an author capable of independent analysis and not swayed by John Q public's love affair of housing as the ultimate investment.