Wednesday, May 28, 2008

David Leonhardt on Rent Vs. Buy

Some thoughts on the subject from David Leonhardt in today's New York Times.

Over the last several years, I’ve come to like a simple, back-of-the-envelope way to compare the costs of renting and owning. You find two similar houses, one for sale and the other for rent, and divide the sale price by the annual rent. You can call the result the rent ratio.

The concept will probably sound familiar to stock market investors. It’s the real estate market’s version of a price-earnings ratio — a measure of how expensive an asset is, relative to the underlying economic fundamentals. Like a P/E ratio, the rent ratio provides something of a reality check.

Throughout the 1970s, ’80s and ’90s, the average rent ratio nationwide hovered between 10 and 14. In the last few years, though, it broke through that historical range and hit almost 19 by the time the housing market peaked, in 2006.

I never looked at my home purchase in terms of a rent vs. buy ratio, but I estimate it was about 15 at the time when I bought. (This is the sale price of the home divided by what the annual rent would be.) Compared to the NYC ratio of 26.8 at peak, and 22.2 now, I think I did just fine. But I was more concerned about things like making my monthly expense budget work, and whether I could cover my costs by renting the place out if I ever had to move. On all fronts, I feel like I made a good choice-- my only regret is that I didn't buy something sooner. But that's just me and how my situation worked out. I'm sure for many other people, renting has probably been a wise choice these past couple of years.


Anonymous said...

I calculated ours at between 15 and 19, back when we bought in 2001 in SoCal.

Anonymous said...

That's a somewhat different approach. I've never considered it when evaluating a house purchase, instead I've looked at cash flow - which creates the biggest out flow of cash and I've considered if the rent will cover the costs should I decide to move out and rent the place.

Anonymous said...

While this link has merit .. I would just use this link.

Escape Brooklyn said...

Thanks for sharing the article -- I like the formula and never thought of it that way. I think I bought at around 10.4 in 2004.

Anonymous said...

In someways David is missing the point. It is not really a comparison of two stocks where you could invest in either and both offer the same benefit (passive economic gain). Renting is about having a home plus flexibility. Buying is about having a home plus other things like control and an economic investment (debt reduction, possible change in value).

Maybe the two are similar in that both can be a home. At the same time the flexibility that comes from renting has its greatest benefit when the occupant is unsure of the future (job change, city relo, death, divorce, marriage, house prices). The purchase decision is many times related to long term family commitments. Putting down roots.

When you buy you rent money to buy an asset. When you rent you just rent the asset. Both have a cost and both can provide shelter. If you save money renting you really should be investing the savings rather than increasing the personal consumption.

Many times when a couple buy there is a large emotional attachment. A statement about the relationship. A plan for the long term including children.

A simple calculation as to the ratio is interesting. Just like checking the weather forecast. In many cases the weather is nothing more than a distraction to what is really going on.

I have been a RE investors for over 20 years and I continue to buy or rent when that suits my situation. Even when I am renting I still own property in the same city or in other places (different states and countries).

David can calculate the ratio if that makes him feel better. Reducing the decision to a simple ratio is far from sufficient if one really cares to optimize. He might as well flip a coin as that will provide a simple answer also.

frugal zeitgeist said...

I bought somewhere between 9 and 10 in 2001. Like you, I wish I had bought earlier. My now-ex husband wasn't on the same page with me about that, though, so we didn't. Maybe it was for the best; not having any real estate made the property settlement easier. Irony of ironies, I felt like I had to buy when I did because I could no longer afford to rent.

Having said that, while buying was absolutely and positively the right decision for me, there is no single approach that is right for everyone.