Rent vs. Buy: What the Standard Indices Aren’t Telling You Stan Humphries August 1st, 2012
Rent or buy? It’s a popular topic, and plenty of experts are quick to trot out a simple rent vs. buy index and tell you that if you live in, say, San Francisco, you should be renting, while if you live in Detroit, buying makes more sense.
But is it that easy? Do these simple indices capture everything potential buyers and renters should consider?
From our perspective, the answer is a resounding no. Indices that look only at monthly rents and compare them to mortgage payments for similar units or homes are only looking at a tiny part of the overall picture. So what aren’t these widely-used indices telling you?
- Time horizon: How long you plan to stay in the home is one of the most important factors to consider when making a rent vs. buy decision and is a particularly glaring omission in most analyses using simple price-rent ratios. While a good rule of thumb used to be that a buyer should intend to live in their home for at least 5-7 years in order to overcome transactional costs, the housing recession has reset prices in some areas so much that buying looks pretty attractive in less than two years.
- Future prices and rents: Do you expect prices and rents to rise or fall during your time in the home and by how much? Nationally, June rents were up 5.2% relative to year-ago levels. Home values were up 0.2% over the same period. Buying starts to look a lot more attractive once home values stabilize but rents are still going through the roof.
- Tax deductibility: Tax benefits may not be a standalone reason for purchasing a home, but it can certainly be a nice perk. As a buyer, property taxes and mortgage interest can be deducted when filing for federal and state income taxes.
- Maintenance costs: When you decide to become a homeowner, you’re signing up for a “for better or for worse” relationship with your new house, inheriting all the financial responsibility associated with its maintenance. On the positive end, you have the freedom to leave holes in the walls where you want to hang photos, paint, landscape, and remodel as you see fit. But, when a pipe bursts, termites settle in your basement or the kitchen sink clogs, getting it fixed will be on your dime.
- Transactions costs: The down payment is the primary upfront cost one associates with buying a home. There are various other transaction fees and closing costs, however, which can affect your monthly payment, or simply how much money you need to set aside before even starting the house hunt. These extra transaction costs can include loan setup fees, property inspections, the escrow or title company’s fees, homeowner’s insurance, mortgage insurance and more.
The conventional price-rent ratio doesn’t consider any of these pieces of information. Moreover, most analysts compute the simple price-rent ratio by comparing the prices of current for-sale listings or recent sales to the prices of current rental listings. This approach usually leads to comparing very different sets of homes, because homes for sale can differ quite a bit from homes for rent (rental homes are typically of lower quality). As a result, this leaves you really comparing apples and oranges.
What’s a better way to think about the buy vs. rent decision? Zillow has just introduced the “breakeven horizon” which is how many years of homeownership it would take before owning a home becomes more financially advantageous than renting the same home. Zillow’s breakeven horizon is computed at the home level and incorporates all possible costs and benefits associated with buying and owning a home, such as the down payment, purchase costs, mortgage payments, property taxes, utilities, maintenance costs, tax benefits etc., as well as all the costs associated with renting the same home. It also includes expected home value and rental price appreciation.
We compute this on city and metro levels (see interactive data below). It is a much more useful metric for several reasons. First, it’s much more comprehensive since it includes all relevant information. Second, it has a much more intuitive interpretation than the abstract price-rent ratio. Third, if a consumer knows that they want to buy, it allows them to target cities and metros that are appropriate given the length of time that they intend to live in the home. Alternatively, if they are unsure whether they want to buy or rent but they do know where they would like to live and how long they intend to live in their next home, the breakeven horizon offers them guidance on whether to buy or rent.
How much difference can it make looking at a simple versus comprehensive measure? Consider that Concord, NH and Saint Marys, GA have very similar simple price-rent ratios (both 15.3) yet the breakeven horizon for Saint Marys is 2 years versus 6 years for Concord. Two big factors behind these differences are the dissimilarity of the rental and for-sale inventory being used to compute the simple price-rent ratio and the big differences in property taxes between these two cities.
With all of that said, “rent or buy?” may be a simple question, but it doesn’t have a simple answer. A wide range of factors have to be considered before making a decision between the two. Why use a metric that only incorporates a few of these factors?