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Rent or Buy?

by Arnold Kling

This article looks at buying a home from the standpoint of an investment decision. Before we proceed, 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:

These concepts are abstract--that's the way financial analysis works. It's not like doing a monthly budget. Bear with me. We'll put together a sample worksheet that includes all of these factors. A similar worksheet may be found at Rent vs. Buy Calculator.

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.

For more discussion, see the explanation of the formula.

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