Should I buy or rent?
Financial advice for the potential home-buyer and real estate investor
One of the most common questions I get as a financial advisor and asset manager is the following:
Should I buy or rent?
You might be surprised that everyone asks this question.
- 25-35 years: Younger professionals looking at their first home purchase
- 35-45 years: Mid-career folks moving into a larger house for kids
- 45-55 years: Advanced career people looking at investment properties, vacation home or changing house
- 55-65 years: People approaching retirement, looking to right-size houses after children leave home
- 65+ years: Retirees looking to move state or into a more manageable-sized home
Despite the importance of the real estate market, these investments are often overlooked by wealth managers and financial advisors. This is because real estate is 1) personal and 2) localized. It’s far easier for advisors to simply say “just invest in my company’s ETF.”
That’s rather unhelpful…
So if you want advice on whether to buy or rent, you either need to
- Do it yourself, or
- Find a wealth manager or financial advisor who actually cares
And even if you aren’t currently considering buying, knowing whether you should buy or rent is an important skill
I’d like to share my experience with you. Your own situation might differ, so your mileage may vary. But these are some good tips to get started.
If you have further questions, feel free to reach out. Every case is unique and I am always happy to help with financial advice and asset management questions.
A brief history of buying vs renting
It used to be common practice for Americans to buy a house unquestioningly. From the 1950s through 2008, homeownership had become part of the “American Dream”. An undisputed status quo.
Since then, homeownership has fallen back to levels not seen since the early 90s. Not only did the 2007-08 housing crisis cause people to rethink buying real estate, but it also made renting far more attractive thanks to a housing oversupply.
Home ownership rates have declined since their 2005 peak
Today, the decision to buy or rent is both financial and personal. Buying a home can help create an emotional place to hang your hat. Renting, however, can provide flexibility. Renting can also be financially prudent, especially in areas where housing prices are unsustainably high.
What you need to know about buying vs renting
Before you examine whether to rent or buy, it’s worthwhile to take a step back and ask yourself this:
“Why should I care in the first place?”
There are three key reasons.
1. It affects your well-being
Where you live has lasting effects on your health and happiness
Think of your childhood home for a moment. Recall how the neighborhood you lived in. The people around you and the friends you had. Think of how your environment shaped the person you are today.
If you feel you were significantly shaped by your environment, you’re not alone. Hundreds of studies have shown that where you live influences your health and well-being.
Renting vs buying can influence where you live. For many, owning a home means moving into the suburbs or finding a smaller starter-home. These choices have a lasting impact not only to ourselves but to our family, children, and friends too.
2. Real estate can be a great investment
Real estate can make you rich (over time)
By investing in real estate (whether as a primary residence or investment property), you are putting down a MAJOR amount of financial wealth into a SINGLE investment. Few wealth managers would ever recommend putting 60% of your net worth into a single stock. Yet, people do it all the time with real estate. Even wealthy families often invest the majority of their wealth in single-market real estate.
But what makes real estate a good investment?
US homebuyers have access to below-market LEVERAGE, thanks to favorable terms provided by the US government.
In the mid-1930’s, the Federal government established a series of programs designed to lower mortgage rates. They did this three ways: 1) subsidizing loans to banks, 2) backing loans and 3) creating a market for trading loans. These have caused profound effects:
Nowhere else in the world can you get a 30-year loan at a 4% fixed interest rate.
We often take low mortgage rates for granted. But nowhere else in the world offers sub-4% fixed mortgages.
In the absence of subsidies, no sane bank would make a fixed-rate 30 year loan at just 3.8%. In the rest of the world, 30-year fixed mortgages are unheard of.
That’s the true “secret sauce” of making money in real estate. For US residents, you are simply able to borrow more cheaply than anyone else in the world.
3. Leasing can generate cash flow.
Given the right investments, rental properties can help generate income to support your family.
Buy and lease a single property
If you want to rent your primary residence, you can still benefit from mortgage rates from buying an investment property.
- Buy a house using a mortgage
- Rent out the house
- Use the proceeds to rent a less expensive home to live in
- Keep the extra rental income as cash flow
Because US mortgages are so rate-advantaged, the lease payments will often cover the rent AND provide extra income to spare. You also have the advantage of owning the house after the mortgage payments are finished.
Buy and lease part of the property
Alternatively, investors can do the following:
- Buy a multi-family home
- Live in one of the units
- Lease out the remaining units to renters.
Again, in many cases, it’s possible for the renters to entirely cover your mortgage.
Financial considerations on whether to buy or rent
Now that you know why it’s important to consider buying vs renting, it’s time to examine how to decide.
Besides your willingness to own property, there are certain calculations to consider when buying or renting a property.
I will use an example of 643 Constitution Ave NE. This is an actual listing of a townhouse in the quiet neighborhood of Capitol Hill in Washington DC.
A beautiful townhouse in the middle of Capitol Hill, Washington DC
1. Down Payment
First, you need to make sure you have enough for a down payment. Mortgage lenders calculate risk based on a loan-to-value (LTV) percentage. A $1,000,000 property with a $800,000 mortgage has an LTV of 80%
800,000 / 1,000,000 = 80% LTV
Some mortgage lenders will allow up to 90% LTV, meaning you only have to put a 10% down payment. But mortgage rates tend to be higher. As a rule of thumb, I recommend doing a 80% LTV in most cases. This means a 20% down payment.
You also need to add up closing costs. These include realtor fees, deed transfer fees, recording fees and mortgage origination fees. Some of these fees may be paid by the seller
Example
643 Constitution Ave asks for $1,280,000
Down payment: 1,280,000 * 20% = $256,000
Deed recording fee: 1.10-1.45% to the buyer = $17,160
Real estate fees to the buyer: $0 (seller pays realtor costs in DC)
2. Mortgage
Next, you need to calculate your mortgage rate. Those with credit scores of 700 or above generally qualify for sub-4.0% rates for 30-year mortgages.
If you’re buying your first property, I generally recommend a 30-year fixed mortgage. Rates are lower, which gives you flexibility.
Even if you don’t hold the property for the full 30 years, you can always sell the property and repay the mortgage before then.
There are plenty of online mortgage calculators to help you get a sense of your monthly expense.
Example (continued)
643 Constitution Ave listed for $1,280,000 will require a 1,280,000 * 80% = $1,024,000 mortgage
At a 4.0% interest rate, monthly payment = $4,889
Use an online mortgage calculator to determine monthly payments.
3. Income
Next, you should calculate how much you can rent out the property. Even if you plan on living there, you should calculate the IMPLIED RENT (how much it would have cost to live there). That’s because if you didn’t buy, you would have rented in that neighborhood anyway.
You can look at neighboring properties for an idea of rental prices. Another trick some real estate agents use is to post rental ads on Craigslist. If you get 3-6 inquiries on posting, that is a good sign you can rent out the property for your proposed price.
When you calculate the return, you should also consider other forms of income. Can you subdivide the property to earn more income? Can you offer short-term rentals at better prices?
With the right property, leasing your property can be a breeze.
Example (continued)
Typical rents for townhouses on Capitol Hill range from $3,600/month to $4,200/month, depending on the quality of the residence. Additionally, this townhouse has a convertible English basement. The bottom floor can be converted to a one-bedroom and rented for an additional $1,800 – $2,200/month.
Total estimated rental income is $3,900 + $2,000 = $5,900
4. Expenses (if you are looking to lease)
If you will rent out the property, you also have to consider expenses.
General expenses
Typically, I suggest investors deduct 10% of annual rental income for general maintenance and real estate brokerage fees. If you list the property yourself, deduct just 5% to reflect no brokerage fees
Taxes
In the Washington DC area, annual real estate taxes are typically 0.5% of purchase price once you include credits and deductions. Check your local tax authority to get an idea of your actual real estate taxes.
HOA fees, insurance and common charges
Often, condos and co-ops will have homeowner association fees. These fees can range anywhere from $200-$2,000 per month depending on where you live.
Example (continued)
643 Constitution Ave will have:
General expenses: $5,900 * 12 * 5% = $3,540.00/year, or $295/month if you list the property yourself
Taxes: $1,280,000 * 0.5% = $6,400/year, or $533/month
HOA Fees: none
Homeowners Insurance = $1,150/year, or $95/month
5. Price Appreciation
Finally, you should consider whether property values can go up. This is probably the most difficult part of real estate investment. There are some guidelines you can follow, however.
1. Long-term neighborhood trends
Real estate investments are typically held for decades. So you should have a good sense of what the neighborhood may look like 20 to 30 years in the future.
Those who foresaw the urban Renaissance of cities like New York and Washington DC in the 70’s and 80’s earned hundreds of times on their initial investment.
Similarly, you should try picturing your neighborhood 20 to 30 years from now. Will people want to live there? Why?
2. Supply and demand
The best real estate investments are those where supply outstrips demand. One reason for sky-high prices in New York City, London and Hong Kong comes from government limits on building heights. Similarly, desirable neighborhoods such as Capitol Hill in Washington DC have a limited supply of land.
Before you invest in a real estate property, can enter how constrained supply may become relative to demand
Example (continued)
643 Constitution Ave sits in a highly desirable neighborhood in Washington DC, steps away from Capitol Hill. The neighborhood has significant restrictions on new construction in order to preserve the old town feel of the nation’s capital. Price appreciation will likely exceed inflation by 1 to 2% yearly. $1,280,000 * 1.5% = $19,200, or $1,600/month
With limited land and restricted building, Capitol Hill is expected to remain a highly valuable neighborhood.
Bringing it all together
Once you have all the information, it’s time to calculate whether you should buy or rent.
In our example, we had the following:
Income
Rental Income: $5,900/month
Price Appreciation: $1,600/month
Total Earnings: $7,500
Expenses
Mortgage: $4,889/month
General Expenses: $295/month
Taxes: $533/month
HOA Fees, Insurance and Common Charges: $95/month
Totals
Total cash flow: +$88/month
Total income (including price appreciation): $1,688/month
Taking a step back, this real-life example will basically breakeven at +$100 per month, and earn over $20,000/year once you factor in price appreciation. And once 30 years elapse, you will own the residenceoutright too.
In short, the renters are paying YOU to own your own property! This is the magic of low mortgage rates.
Conclusion
Should you buy or rent?
Real estate is often the single largest holding in a family’s portfolio of assets. In fact, the combined value of the US housing market ($33.3 trillion) is LARGER than the US stock market ($30.3 trillion). Once you add in commercial real estate and farmland, the total value of land in the US balloons to over $52 trillion, handily beating the size of the entire US stock market.
Yet, many people spend far more time planning a $5,000 vacation than they do a $500,000 or $5 million home purchase. That’s because there are so few resources to help people make good real estate decisions.
So if you’re considering buying a home or investment property, make sure you run through the numbers first. It’s a 30-minute process that can become the best investment of your life.
And if you need further help, feel free to contact us and see how we can help.
How can we help?
If you’re looking for advice about your own finances, you can contact us for more information. We at Jurnex Financial Advisors are asset managers who specializing in helping families and individuals navigate major life changes. If you want to get started in regaining confidence over your wealth, book a meeting with us today and see how we can help.
