Another look at renting versus buying

There are those that worry that a new bubble is forming. Rents are a good yardstick: house prices that appreciate in line with rents make sense, since both are a sign of demand. But when one outstrips the other, it is time to review whether to buy or rent. In most Texas metros, rents have been outstripping home and real estate appreciation. Renters should worry. Obviously with rents increasing over 50% in all Texas metros over the last ten years, now is the time to buy.

Deciding when the right time to buy a house or investment real estate is hard. Homes and real estate investments are a costly investment. The slightest up or down tick in the market can cost or save huge sums. In most of the US, those deciding on a purchase are hearing particularly confusing signals. Prices have soared for the past couple of years, suggesting that those who wait will suffer. But slowing price appreciation, weak construction data, and jitters about a possible interest-rate rise (among other worries) suggest that values might drop, as they did after the bubble of five years ago.

Those looking to buy a home or real estate investment have reason to be nervous: during the ‘bubble’ years values in some areas of the country were appreciating by over 40% annually. California and the sand states (Nevada, Arizona and Florida) come to mind.. Texas was never in that category. Texas was 50th in appreciation for a number of years. Looking back, that is not necessarily a bad thing.

The common wisdom for decades was to buy a house as soon as you can, because it’s a great investment. That “wisdom” hurt many in the past decade as the market tanked. But was it because real estate cooled, or because they were using their home as a personal ATM, constantly refinancing to the max as appreciation was so strong? Let’s take a cold, hard look at the economics of owning a home.

In the past, the own-or-rent decision was largely about whether to live in a house or apartment. The own-rent decision should be apples-to-apples with comparable properties. If you are thinking about moving from a small apartment and buying a medium sized house, you’ll find that it’s more expensive simply because you’re getting more square footage and a yard.

Also the ability to find a steady flow of cheap “distressed” housing is pretty much over. Between 2008 and 2011, over a third of all sales nationally were in this category: either foreclosed homes or those being sold at a loss, often by banks. This wasn’t happening in Texas. Less than .015 of all homes went into foreclosure in the Texas region. And presently it is almost nonexistent.

Because of the lending ‘bust’ the pipeline of new houses is a trickle of new construction. Comparatively the supply is less than half of what it was pre-recession. Even here in the country’s strongest markets, home starts are still under 50% of pre-recession numbers. During the financial crisis many builders went away. Up to last year both public and private builders were reluctant or found it hard to obtain loans to build more homes. This helps explain why supply has not responded to perky prices: the pace of building is still far below its pre-crisis average across America. The larger builders, who have easier access to equity, have been able to increase market share.

Even if supply does improve, new homes will not be cheap ones. Construction costs have risen by 18% in the past two years. Median prices of new and existing homes have always had about a 20 to 25% value difference weighted towards new. With labor and materials increasing so quickly, that value difference is increasing, causing some to question new home values against existing. The builders cannot build for free and most are not seeing near the profit margins that were there before the bust. And realize that with the rest of the nation recovering, we have not seen demand for materials and labor really challenged.

One opportunity in today’s market is low interest rates. Recent data also make a rate rise even less likely. Falling household debt and a rising number of cash-funded sales will ease concerns at the Federal Reserve. In addition, predictions of a future rise have already made buying tougher: for every 1% rise in lending rates, the consumer looses 12% buying power. Although as of this week, rates will remain low. Realize that the near future of higher rates, lower leverage, and evidence that high prices will reflect supply constraints more than speculative demand means that the central bank has little reason to make homeowners’ lives any harder. At least, not yet.

Since 1975, housing has appreciated by an average of 4.5 percent per year. Housing seems to be a great investment in good times because it is usually leveraged to a great degree. With a 20 percent down payment, a price increase of just three percent turns into a 15 percent increase in the homeowner’s equity. Do some arithmetic with a hypothetical $100,000 home to verify that result. Real estate proponents call this the “cash-on-cash” return. However, leverage applies to the downside as well. With 20 percent down, a 20 percent price decline wipes out all of the buyer’s equity. That’s not an outlandish scenario as we’ve learned from the price declines of the recent housing bust.

Interest on home mortgages is deductible, but the deductibility doesn’t offset the fact that you are paying someone interest. It’s an expense, and you are worse off because of it. If you want a big tax deduction, you could make a contribution to charity. You’ll end up with less money than before your contribution despite the deduction. The same is true for interest expense. It may be worthwhile, all things considered, but it’s still an expense. Talk to your accountant first, because the actual benefit from a deduction varies from family to family.

When you rent, the landlord picks up the taxes, insurance, maintenance, and sometimes utilities. If you buy, plan on replacing the water heater some years, the back fence other years, the roof occasionally. Hope that you don’t need to replace all of them the same year. If you are going to hire out all of the maintenance, you’ll probably pay more than your landlord does. The landlord is in the business of maintaining properties and is probably very efficient. However, if you can do some of it yourself, your cash outlays will be much less than the landlord’s. And you can do it yourself if you’re willing to learn. Try Googling “leaky faucet” and you’ll find plenty of advice. Personally I find a professional to help maintain properties, because the ‘self learn’ cost is prohibitive (I have a history of my “DIY” attempts landing me in the emergency room).

Most people thinking about buying compare monthly payments to rent, which is a good starting point. However, some of that monthly payment goes to principal. It’s like saving. To put buying on a level playing field with renting, look at just the part of the monthly payment that will go to interest.

Example: you borrow $200,000 for a house with a 30-year mortgage at 4.25 percent. Your monthly payment would be $993, but $285 of that would be going to principal. Your parents will be surprised that you’re paying so much to principal. When they got their first mortgage, rates were much higher and only a small portion of their payments went to principal.

Transaction costs are large in housing. Real estate agents charge six to seven percent commission on sales, which will make moving expensive. You can sell the house yourself, but keep in mind, you are not a professional and that it’s a lot of work and your house may not be exposed to as many buyers, reducing the price you can get for it and taking a lot of personal time and labor. This argues against buying unless you are confident you want to stay in the house for several years, preferably even longer.

Renters should keep in mind that they do not control their housing destiny. If the landlord decides to sell the property, you’ll be looking for a new home. The landlord can also raise the rent at the end of the lease. The landlord can also decide not to rent to you, though that’s rare for people who are well behaved.

One of the benefits of owning a house is the ability to do with it what you want (subject to neighborhood rules, of course). When your daughter wants her bedroom walls black, you can be the cool parents who show her how to use a paint roller.

Owning a house gives you some flexibility, but also requires flexibility. When you get a bonus from work, you can upgrade your housing by adding a hot tub or more landscaping. Renters don’t have that option. When you lose your job, you can defer replacing the carpet. Flexibility is required of you, too. When the roof starts to leak, there’s no telling the rain that this is a bad time. You need to have reserves for unplanned repairs.

So now you’re ready for the analyst to give you a conclusion. However, there are too many emotional factors for a mathematical solution. I recommend running the numbers as best you can, then asking yourself if the psychological benefits are worth the cost.

If you are thinking of purchasing a home or investment property, one of the first things is to get with your financial planner and a home finance professional before shopping. The parameters have gotten harsher with the ‘after effect’ of the housing ‘bust’, and the implementation of Dodd Franks and all the punitive parameters it puts on lenders. That said, there are a lot of misconceptions as shown by many of the current surveys of consumers.

While nearly 70% of Americans surveyed agree that now is a good time to become a homeowner, a large number remain reluctant due to their own misguided understanding of the financing process, according to different survey results from FNMA, FHMA, Wells Fargo, and others. All the surveys have a common theme of over 70% feel that now is a good time to buy a home, and 90% percent want to own if they don’t already.

The common theme found by these surveys is people say they “know and understand” the financial process involved in buying a home, but large numbers also expressed doubt or misguided notions about home buying requirements. For example, Wells Fargo reported 30 percent of respondents expressed belief that only people with high incomes can obtain a mortgage at this point, and 64 percent said they believe only those with a “very good”” credit score can buy a home right now.

FNMA, Wells Fargo, and other surveys about consumers’ needs in the housing market showed that over 60% of respondents said they have an understanding about how much of a down payment is needed to purchase a home, nearly half said 20 percent is required. Forty-four percent also said they know little or nothing about closing costs. Is that true?

Most lenders report that lending requirements at the moment are still high as a result of enhanced regulations and reluctance to take risks, so lending standards are tighter. But the consumer and the industry would be well served to work on educating homebuyers about all programs available to them—especially the millennial crowd, most of which pointed to lack of down payment funds as one of their biggest hurdles to homeownership. It is important for consumers to ask lenders and real estate agents questions about available options, such as down payment assistance or FHA (Federal Housing Administration) or VA (Veterans Affairs) loans for veterans. Informing prospective homebuyers about their options is the first step toward helping them realize their goals of owning a home.

These same surveys find that most consumers are confident in managing their personal finances, with 82 percent saying they know how to save, invest, and work within a budget. In addition, 63 percent said they have a “rainy day fund,” including more than half of millennial-aged respondents, potentially the largest group of homebuyers over the next 5 to 10 years.

If the latter is true, then they need to get with a lender to understand how to buy, because there will never be a more affordable time to buy, whether first time, move up or move down. Should you buy in Texas? If you think I am going to say anything else but an absolute yes, then you must be new to the blog, and not watching what is happening here.

Here in Texas and in most metros across the country, the home you look at today will not be there tomorrow!

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