Deciding whether to rent or buy your home is one of the eternal personal finance questions. My two cents on this topic may be counter-intuitive to conventional wisdom you may have heard.
There are compelling non-financial reasons to buy your home instead of renting one. For example, you may want:
- this neighborhood, school system, or kitchen
- to stay near existing friends
- to maintain stability
These are all sound, but that doesn’t mean it makes good financial sense.
Many of us hear stories of family, friends, and neighbors who made a “killing” in real estate. Some of the tales may even be true. Because people are more likely to mention their successes than their failures, you don’t get a balanced view of real estate returns by relying on these narratives. Casinos and lotteries have winners every day, but that doesn’t mean you should gamble.
If you were to examine historical numbers, you would see that residential real estate has been a mediocre financial investment. Over long periods of time, residential real estate values tend to just keep up with inflation. Its real rate of return (ie, net of inflation) is near zero. That’s hard to believe if you are currently living in San Francisco or Boston, but the long-term numbers are clear.
We are also easily fooled by compound growth. Consider a house that tripled in value over 25 years. At first glance, that seems worth boasting about at your next cocktail party, but if you were to run the numbers, you should probably stay quiet.
The annualized return is about 4.5% — not terrible, but only about half of what you could have expected from the stock market. And, that ignores all the money you poured into your home over those years — property taxes, a new roof, plumbing emergencies, buying and selling fees, etc. Those expenses would eliminate much of that 4.5% nominal return and you would be back to earning a return roughly equal to the inflation rate — or not much more than if that money had been invested in bank CDs.
Contrast home ownership with stock ownership. Stocks are costless to own and you receive dividends; with your home, it is as if you have to pay dividends after purchasing it. That’s not a great asset in which to invest.
Why is residential real estate a poor financial investment?
- It’s a money pit. While some tasks may be well-suited for DIY projects, many require expertise and/or equipment that you probably don’t have.
- Like cars, the value of a house depreciates the minute you step into it. Over time, construction methods become more efficient, there is inevitable wear and tear, building codes and design tastes change, and you’re stuck with last year’s model.
- Buying and selling a house incurs substantial transactions costs. The largest is the broker commission but there are other significant expenses such as mortgage fees, appraisals, title insurance, and legal fees. For example, in my state of Massachusetts, there is a county tax that amounts to another 0.5% of the sale price.
- Your net worth is too concentrated in a single asset — your home. Renting allows you to diversify your asset base more broadly.
- You have less mobility. You probably bought the house planning to stay there for many years. Sometimes things change and it’s not always easy to sell a house quickly. If the unexpected happens, this “option value” can be worth a lot.
- Finally, while it is true that there’s no new land being created, land use can become more efficient over time, such as when zoning laws change or land is reclaimed for residential use.
A common belief is you get to live in the house “for free” as you pay your mortgage. While this “free rent” myth is not entirely false, it ignores your maintenance, taxes, and other expenses you do pay.
Buy a house for the non-financial reasons but don’t do it because you think it’s a great investment. A better financial foundation is to rent and invest the excess funds that are not being poured into the money pit.
Questions about buying a house? Please get in touch.
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Update: The NY Times has a terrific calculator that helps answer the rent versus buy question. Based on lots of inputs that you can dynamically change, their model has a breakeven point when your monthly rent is roughly equal to 0.5% of the purchase price of the equivalent house. In other words, if a house or condo could be purchased for $400,000, then a rent of $2,000 per month would be financially equivalent.
Update #2: One doctor’s view on owning the big house.