Why Do People Buy Real Estate, Instead of Just Rent? (An Analysis that Follows the Money)

There’s a prevailing zeitgeist that buying real estate is a can’t lose scenario. Spoiler alert: that’s not true. Money is lost on real estate every day. People, neighborhoods and cities had a rough time during the Great Recession. Despite all of that, I still want to show an analysis of renting vs. buying, and how how certain conditions change the math. For most of us, buying a house will be the largest single purchase we ever make. Understanding why it’s a good/bad idea to fork over multiples of our annual salary on a pile of wood, concrete and some dirt is worth looking into.

To do my analysis, I found two properties built about 30 years ago – one for rent, the other for sale. They’re about the same size, same number of bedrooms and bathrooms, look about the same from Google street view, so for this analysis, I’m going to assume they’re equal substitutes.

The house for sale is currently on the market for $620K, and was built and sold in 1987 for $174.5K. The house for rent is on the market for $2,995 per month, and using the FRED Rent Consumer Price index for LA/OC/Riverside Counties, I estimate that house was for rent in 1987 for about $1,130 per month.

My analysis estimates who has more equity after 30 years, one rents and the other buys, if they spend the same for housing and retirement throughout the 30 year period. Cash FlowsTo keep the total outlays constant, cash for investments for the renter are the same as what the buyer spends on their house, and vice versa. Think of it this way – both parties have two cash flows, and the one that they’re not living in goes to investments. Total cash flows are shown on the chart to the right.

Already there’s an advantage for the home buyer. Although the renter gets a head start on investments, as rent starts to increase, the home buyer gets a huge bump in investment cash available in last ~10 years. Compounded aSavings and Returnst a rate of 7.9% over the 30 year period (the S&P has had a good run these past 30 years…), total returns on investment income are impressive!

From an investment returns perspective, it appears that the renter has a slight advantage in investment savings over 30 years. That initial house down payment compounds over the years to keep the renter’s portfolio ahead of the home owner. But… this doesn’t include other home ownership advantages, including an income tax deduction for mortgage interest and property taxes, nor does it include the cost of rent.

So how good of an investment is a house?

After all of the mortgage payments, property taxes, appreciation and excluding things like repairs and upkeep (usually about 1% a year for the value of the property) and Real Estate Cash Flowsinflation, I found our house had a 4.6% rate of return on investment – before maintenance, upgrades, house insurance and so on. Yeah, there’s a lot of things that do better than that (the stock market, probably even baseball cards). Even including the income tax deduction, the house is still cash flow negative before its sold. So really, why buy a house?

Well, because the alternative is rent – and 100% of your rent payment evaporates. Over 30 years, renting costs about $691K – and that’s money you’ll never see again. That’s about $146K more than all of the mortgage payments and property taxes! Owning a house isn’t necessarily a great investment – but it’s better than the alternative (unless you can find a way to live for free for 30 years!).

Side by side, this isn’t really even a contest anymore. The 30 year renter is considerably behind the home owner, and because of income tax Own vs. Buy Table (V0).PNGdeductions, the renter is even behind the home owner before the house is sold. Rent, really, is a killer to someone’s long term finances.

But there has to be a time when it makes sense to rent, rather than buy. There are easy examples (for example, if you don’t pay rent). But what are those scenarios where it makes sense to go rent, instead of buy?

Here is a variance analysis, where I just changed a single variable to see how that would impact the math, and the equity difference between the home owner and the rentVariance Analysis (V0)er. A larger number = better for the home owner, and the red line is the original scenario.

There are two scenarios where buying isn’t as good as an option as owning: when interest rates are exceedingly high and, when you know you can get an obscene return on your investments. But fair warning, for this to work, rents have to hold the same growth rate over time and inflation has to remain near zero. Two things that just don’t generally happen at the same time.

Here’s the bottom line: rent is expensive, even when its cheap.

(Non-Exhaustive) List of Assumptions:
Mortgage rate in 1987: 10.21%, Mortgage Rate in 2017: 3.6% (Freddie Mac)
Investment rate of return for 30 Years: 7.9%, Past 17 Years: 3.3% (Yahoo Finance, S&P Historic Values)
House Buyer Purchase Price in 1987: $174.5K (Zillow)
Current List (sale) Price: $620K (Zillow)
Property Taxes: 1.1% (Calculated From Recent Tax Information)
Rental Price: $2,995 (Zillow)
FRED Consumer Price Index, YoY Change since 1987 for LA/OC/Riverside: 3.42%
Property Tax Increase Limit: 2% (Legislative Analyst’s Office)
Down Payment: 20%

About the Author: Aman Williamson is the founder and owner of Property Marketing Studio™. Aman brings his experience in marketing, real estate, sales, and strategy, to the real estate marketing world. If you need analysis, planning or any other business consulting services, contact Aman directly: aman@propertymarketingstudio.com

Disclaimer: This is just for informational purposes only and please do your own due diligence to identify what works well for your particular situation, needs and desires.