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To Rent or Buy? That is a question that most renters ask. Many wonder if they are ready to move to the next step towards
homeownership. But will your payments be more or less? Is it worth doing so? How much cash do you have to put out?
The article below was written by Arnold Kling who earned an undergraduate degree from Swarthmore College, and a Ph.D in
economics from the Massachusetts Institute of Technology. From 1980 to 1986, he was an economist with the Federal Reserve
Board. Then, he spent seven years with the Federal Home Loan Mortgage Corporation (Freddie Mac).
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This section looks at buying a home from the standpoint of an investment decision. It is worth pointing out that
there are other considerations. On the plus side, factors include pride of ownership, the fact that having to meet a mortgage
payment may help to discipline your spending, and the ability to redecorate or remodel without getting a landlord's permission.
On the minus side, there are responsibilities for maintenance and the risks associated with putting a lot of your financial
eggs in your residential basket.
The financial factors that affect the house as an investment are:
1. Rental value
2. Appreciation net of depreciation
3. Carrying cost
4. Transaction costs
These
concepts are abstract--that's the way financial analysis works. It's not like doing a monthly budget. Bear with me. Please
put together a sample worksheet or that includes all of these factors.
Rental value
Line 1. Enter the house price. Example $100,000
Line 2. Enter the monthly rent on
that house or on a house with equivalent square footage in the same neighborhood. (If only smaller houses are rental units
in that neighborhood, then multiply the rent on the rental unit by the ratio of the square footage of the house for purchase
to that of the rental unit.) Example $600 per month.
Line 3. Multiply line 2 by 12, to get an annual rental value.
Example $7200.
Appreciation value
Line 4. Estimate future appreciation of the house net of depreciation.
Here is where it would be nice to have a crystal ball. In the absence of that, let's assume that the price will go up by 2.5
percent per year. Example 2.5 percent.
Line 5. Calculate the appreciation benefits of owning the home: (line
1) * (line 4)/100. Example $2500
Carrying cost
Line 6. Enter the annual percentage rate for the
mortgage. Example 8.5 percent.
Line 7. Enter the annual property tax rate. Example 1.5 percent.
Line
8. Enter your income tax rate. Be sure to include your state and local income tax rate, assuming that mortgage interest is
tax deductible on your state income tax as well as your Federal return. Try to use your "marginal" tax rate, that
is the tax rate on your last dollars of income (although if you really want to fine tune this you might have to take into
account that the mortgage deductions will lower your marginal tax rate). Example 25 percent.
Line 9. Calculate
the carrying cost. We do the calculation as if we were financing the entire house. We use the house price, not the mortgage
amount.
(line 1)*(line 6 + line 7)*(100 - line 8)/(100.0*100.0)
Example $7500
Note:For
condominiums, condo fees should be added dollar for dollar to the carrying cost in this calculation. If the condo fee is $200
per month, then add $2400 to the annual carrying cost.
Transaction costs
Line 10. Enter the number
of years you expect to own the house before you sell. Example 5 years.
Line 11. Calculate expected costs as a
percent of selling the house when you sell. Example 6 percent commission.
Line 12. Annualized selling cost factor.
(1.0 - (line 11)/100)^( 1.0/(line 10) ) Example .9877
Line 14. Transaction costs
(line
1) * (1.0 - line 12) Example $1230
Total net investment value
If this figure is positive, then the
house is a good investment:
line 15. rental value plus appreciation less carrying cost and transaction cost
(line 3) + (line 5) - (line 9) - (line 14) Example $970
If you set this up as a spreadsheet, some
interesting figures to play with are the rate of appreciation (line 4) and the number of years before you sell (line 10).
You will see that the rate of appreciation really affects the investment value. Also, if you plan to stay only 2 or 3 years,
then a 6 percent real estate commission means you will face an uphill battle to achieve a successful investment.
Another important lesson here is the significance of rental value. What you will find is that in highly speculative markets
the rental value will be low relative to carrying cost, because people are assuming implicitly that prices are going to continue
to increase rapidly. This is a dangerous situation in which to buy a house, because the bubble may be about to burst. On the
other hand, when markets have been slow and the rental value is high relative to carrying cost, it may be a good time to buy.
When you are looking at the "rent vs. buy" decision from an investment standpoint, the rental value is an important
benchmark that should not be overlooked.
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Take some
time to think this investment through. Make an appointment with your bank's residential loan officer to prequalify you for
a home loan and discuss other matters about closing costs, fees, and all other expenses you'll need to purchase a home. Don't
be in a hurry to jump into something without doing your homework. Remember, buying a home will be the single most expensive
purchase you'll probably make so seek all the advice you can.
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