Home Ownership Bad for Your Health

The economics of renting v homeownership are pretty simple.

Renting you pay $x per month, in return for which you get a home and some repair services.

Owning, you pay $y per month for taxes and utilities (that are included in the renters rent). You pay $z in interest (which is just as gone as rent). If you have equity, you have some money that could be earning interest if it were invested elsewhere -- that is another expense (an opportunity cost) that is just like interest. If you are calculating rationally, you should give this a value based on the alternatives you have, and it should be higher than the interest rate on your mortgage (since it is riskier). And you pay (or do) repairs and maintenance, which the renter would have included in rent.

All these are monthly expenses just like rent. Add them all up. So far, if they are lower than rent, you are better off owning. If they are higher than rent, you are better off renting.

Then, there are two additional factors, one financial and one not. One is control-the right to exercise your personal bad taste in renovating. Hard to put a price on that.

The other is future appreciation/depreciation. Owners have the risk (up and down) of future price changes; renters do their investing outside their homes. Most owners are highly leveraged (that is, they have big mortgages), which means that they will make a lot if housing prices go up and lose a lot if they go down. If you buy with a 20% downpayment, and prices drop 20%, you've lost your entire downpayment. If they go up 20$, you've doubled your downpayment. So in rising markets, owners make a lot, and in declining ones, they lose a lot.

Shiller has done research on long term price trends. Over long term, even in elite cities housing prices tend to reflect cost of construction (not land) rather precisely. That is, they go up more or less with inflation.

Right now, we are coming off of the largest housing bubble in US history; NYC prices are roughly double the trend values. It is a safe bet that over the next few years they will return to trend -- that is, drop about half in real terms (probably less in dollars, since inflation will do some of the work). Banks are not entirely dumb; assuming that they are now going to have to keep the risk of jumbo mortgages, they are going to build this expected depreciation into their loan decisions, which will make it even more likely to happen.

Moreover, mortgage rates (at least for conforming loans) are very low. When they rise to more normal levels (which will be higher than in the bubble days of CMOs), house prices will have to drop to compensate.

For both these reasons, buyers should be planning on price depreciation over the next several years, and little (real) appreciation after that (unless mortgage interest rates go below inflation). So even if your monthly costs (including the lost interest on your downpayment and the time you spend in maintenance) are less than rent, you still may be financially better off renting.

The economic way to think about appreciation/depreciation is to decide whether you think buying highly leveraged NYC real estate is a better investment than the alternatives you have. There is nothing magic about "paying off the mortgage and living rent free": it isn't free, and if you rented and invested successfully, you'd be able to live work-free too. The only issue is whether this is the best investment you have. (In rising markets, for small investors, it usually is: it forces you to save, and it is the only convenient way to use leverage, two things that amplify returns on the way up.)

Posted by: FinanceGuy at December 12, 2008 10:58 AM

On taxes and insurance. Yes, I should have included taxes (pro-ownership) and insurance (pro-renting). I did assume that renters can find comparable properties, which usually has been more or less possible in Brownstone Brooklyn except perhaps at the very highest end (Remsen St mansions). If rental properties are all in worse shape than owner-occupied, then you need to adjust for that (pro-ownership). I also almost certainly underestimated repair costs, especially for homeowners who don't enjoy doing repairs (pro-renting). And 8% is a very low rate of return for investors in a highly concentrated, high risk, high work investment in a bubble that is only partly deflated. Don't you think you should make **more** than the bank? (pro-renting)

On taxes, interest is deductible on a mortgage for up to $1m. For buyers in the prime NY markets, paying the highest tax rates, this could be worth as much as $2000 per month. Assuming that the entire benefit goes to the seller and not the buyer (historically, in NYC, the reverse was the case), that could justify adding an additional 300k to the prices I quoted.

But at current prices, there is no point trying to get all these details accurate.

The reality is that unless I'm way off in my rental estimates, current sales prices in the prime neighborhoods are way, way too high. Exactly how too high depends partly on rents and largely on whether the banks figure out a new way to avoid default risk or whether they decide that they are going to be holding the bag and therefore they need to be sure that the collateral (house) is really going to be saleable in a foreclosure for the appraised value.

If you buy at current prices, you are making a very large bet that banks will be willing to lend -- even after the crisis is over -- based on bubble values that have no relationship to investment or replacement costs or foreclosure prices.

You are also betting against the normal workings of capitalism. If houses are selling at two or three times the cost of creating them, someone is going to figure out a way of making more (e.g.: expanding the acceptable boundaries of the "nice" neighborhoods, converting rentals/warehouses into brownstone equivalents, renovating substandard houses, new construction). Sooner or later, supply will expand to meet demand and the market clearing price will reflect the actual costs of construction. That's why appraisers rely on construction costs as a ceiling and rental values as a floor for fair value in non-bubble markets.

If I were a buyer, I'd wait, unless the right to renovate is very valuable. If I were a seller, I'd sell before the market corrects more.

Posted by: FinanceGuy at December 12, 2008 2:05 PM

Benson: this is the "zoned world" meme. It hasn't worked in the rest of the zoned land: prices got too high and they are coming down.

Zoning is important, but it isn't all that hard to create more land in NYC. You just build up (as in 4th Ave or all of Manhattan), convert industrial property (DUMBO, Gowanus), evict rent stabilized tenants (everywhere), renovate old stuff (Brownstone Brooklyn), convince people that they can go beyond the old boundaries (I remember when Baltic St & Clinton St was the wilderness -- way beyond anywhere respectable people would go), build infill.

There are probably 10x as many luxury housing units in NYC as 25 years ago. I don't think that the number of people who can afford them has gone up nearly that fast.

Posted by: FinanceGuy at December 12, 2008 2:13 PM

parkedslope & benson: I agree that it is nicer to live close in, with good transit, etc. But that is the beauty of the rental/buy comparison. The benefits of the neighborhood are all picked up in the rents, aren't they?

For the "zoned land" meme to justify bubble prices, you need not just a premium for better location, but an ever-growing premium compared to rents and the competition. That isn't going to happen. Brooklyn Heights will always be more expensive than Bay Ridge, but there is a limit to how big the gap can get.

When it gets too big, the market increases supply: DUMBO/Furman St/110 Livingston/Hotel St George/Mason Mints/etc, for all their industrial wasteland aspects, have effectively doubled the size of Brooklyn Heights; Cobble Hill and Carroll Gardens have swallowed half of Gowanus/Red Hook; Park Slope is at least twice as big as it was in 1990; the Flatbush Avenue color bar fell to a combination of diminished racism and price increases; "gentrifiers" live in places they wouldn't have dreamed of a few years ago.

Parkedslope -- I wasn't advocating pushing people out. Just stating the reality: that if the financial incentives are big enough, they'll get pushed out. My parents were. That's been the history of NYC as long as I can remember. Do you think it is going to stop?

As long as owner occupants are willing to pay 2x the rental value, someone is going to see an opportunity to double their money by buying rentals and kicking people out. It doesn't really matter whether I like it. The only thing that will stop it, absent a political movement and legal change that I would welcome but see no sign of, is when rental values and ownership prices converge.

After taxes of course, but capital gains taxes are so low and so easy to avoid that they don't make much difference -- certainly saving 15% taxes 30 years from now isn't a reason to pay double today.

Posted by: FinanceGuy at December 12, 2008 3:51 PM

For the people making broad generalizations about retirement -- the point is that if you are thinking of your house as an investment you need to treat it like an investment.

Bob Marvin bought his house in the '70s, I gather. That was a good investment (stocks would have been good too then). If you had done my calculation then, you would have seen that owners were being paid good money to take on the risk of ownership.

But if you buy now in the prime neighborhoods, you are paying double fair value. Tax breaks are nice, but they are far too small to affect the basic math. If you pay double rental value, you are never going to catch up to the renter who invests in almost anything else. The point is that this is an awful investment: the anticipated returns are negative as far as you can see.

If you are incapable of saving and/or investing except by having a mortgage, it might make sense to pay something for the privilege of having someone force you to save a little bit. But most employers will create a tax sheltered forced savings plan for you (they call it a 401(k)) for free. You don't need to give up 20 years of appreciation for that.

Posted by: FinanceGuy at December 12, 2008 4:01 PM

Mopar:

1. Interest is exactly as gone as rent. Interest is just the rent you pay for money. The only difference is that when you rent a home instead of renting money, the landlord is legally obliged to pay for repairs, taxes, heat, water/sewer and insurance.

2. Whenever you buy a highly leveraged investment you make a lot of money if prices go up. But as Lehman learned to our regret, if prices go down, you lose a lot, too.

When you sell you make money IF prices have gone up. If you bought in SF at the peak, you've lost all your equity now. And remember that running a house is quite expensive -- it isn't just the purchase cost and interest.

People who bought 20 or 30 years ago didn't overpay. There is no reason to think that if you pay 2x fair value you are going to have the same result as people who paid 3/4 fair value and sold into the biggest housing bubble in history. We can all envy the people who by luck or skill made a fortune in real estate in the last generation, but to think that we will get the same result now is just dumb.

3. Retirement costs are never fixed. If you don't have a lot of money, or live in a country with a civilized retirement system (which would be essentially every advanced democracy but our own), you are screwed. Investing in real estate can be a good way to deal with this problem as an individual, if you have enough money to make the investment in the first place and if you don't overpay. Otherwise, not.

Posted by: FinanceGuy at December 12, 2008 4:16 PM

Bob Marvin, by not thinking like an investor, did exactly what good investors do: he bought at the bottom. When everyone thinks the market can do nothing but go down, all news is likely to be good.

Today, though, the prices assume that all future news is going to be good -- the sellers expect to be paid for improvements in the neighborhoods that haven't even happened yet. That means that all future news is almost automatically going to be bad: it would be basically impossible for the world to turn out as good as current prices assume. So people who want to imitate Bob Marvin should probably be looking in Lodi NJ or Sebb's Staten Island, or some other place that nobody thinks can make it. Not in Park Slope.

Mopar --
1. By rental value, I mean the price that a rational investor would pay for the house to hold it as a rental property, assuming that returns will come from rents, not from flipping the property.

2. Interest is gone. It belongs to the bank. You don't get it back. What you get, if you get anything, is the equity you put into the house (downpayment plus the part of the mortgage payment that isn't interest) plus or minus any change in the value of the house. Whether that will be profitable or not depends on how much you pay and what happens to prices.

If you pay 2x the rental value, it is hard to see how prices can keep going up unless rents suddenly start exploding. And rents can't go up faster than incomes except in very short term, because people have to be able to pay them. So it seems unlikely that rents are quickly going to go up enough to justify current prices.

3. For most of the last 75 years, NYC buyers could project making 8-10% returns on their equity investment from rents alone assuming that rents would rise no faster than expenses and there would be no price appreciation. (Owner occupants made a bit more, if they did the calculation as if they were paying themselves rent at the market rate, because of the tax subsidies). Without knowing where Bob Marvin lives or when he bought, I'm willing to bet that if he can reconstruct what market rents were when he bought, he'll confirm this. It was true everywhere in NYC from at least the 1940s until 10 years ago, with only the slightest exception at the top of the late 1980s boom.

Today, if you are finding those kinds of prices, you are looking in different neighborhoods than I am or you are looking harder. The prices I'm seeing are double that. But I have no special information about prices. Maybe there are deals out there that don't show up in HOTD or maybe I'm underestimating rents. Or maybe the correction is further along where you are looking.

4. Scholars using national figures generally show lower expected returns (purchase prices are higher relative to rental values) than I am think have been true in NYC. Usually they find historic values that are around 15x annual rents, which means profit rates of under 6% rather than 8-10%. That rate seems implausibly low to me -- it doesn't make sense that equity owners should be willing to invest for less than the bank takes. So I think something is wrong in their numbers -- most likely that in most of the country, rental property is significantly lower in quality than purchase property and it is hard for investigators to correct for this. So they are not really comparing comparables -- they are comparing nicer owner-occupied stuff to not-so-nice rentals.

In NYC, in contrast, the rental market is large, liquid, and in all price ranges, and I think that it is possible to have a pretty good idea of what the real rental values are even for nice apartments (with the possible exception of the Jennifer Connolly mansion). There are plenty of garden floor-throughs that are in the same condition as the upstairs unit, and it isn't hard to simply multiply the floor-through rent by 2 or 3 to get an estimate of the rental value of the duplex or triplex.

Since it is relatively easy (in Brownstone Brooklyn) to convert owner-occupied to rental, to change configurations, and even not impossible to change rentals to owner-occupied, normal market forces should keep all these prices pretty similar. If a building is more profitable in one form than the other, someone is likely to change it to the more profitable form -- which has the effect of driving the prices back together.

Right now we have a major imbalance, as I read the market: owner occupants are paying way more than renters. So there is lots of profit to be made converting rentals into sales. Eventually, this will mean either that rents go up or sales prices go down -- and my guess is that it's going to be sales prices coming down.

Posted by: FinanceGuy at December 13, 2008 9:29 AM

Why use rents rather than sales comps?

Sales prices can easily get out of whack if buyers are willing to overpay now because they think, like Sebb, that there is some guarantee that they can sell for more later, or, for that matter, if sellers are willing to sell for discount prices because they think, like Bob Marvin's friends in the white flight generation, that there will be no one to buy from them later. Bubbles and panics happen when the prices people are willing to pay now are based on their views about the prices someone else will be willing to pay later, which are based on the same thing. In that sort of market, any price is possible, at least for a while.

Since renters are paying current prices for current services, not speculating on the future, rents are much more tied to real factors like actual quality of life right now, current incomes, transportation, fashions, lifestyles, crime rates, and so on.

So if you want to separate out the bubble irrationality from the real improvements in NYC, look at (non-stabilized) rents. They've gone up quite a bit as neighborhoods have improved, but nothing like prices in the last decade.

Posted by: FinanceGuy at December 13, 2008 9:29 AM

bxgirl: Of course rents go up when neighborhoods get trendy. Fashion is a real -- current -- improvement in quality of life for many people.

The difference between rents and sales, though, is that it is rare that renters are willing to pay more today because they think that rents are going to go up next year. Buyers, in contrast, often do that (or the reverse).

In the last several years NY prices went up because crime went down and BK became fashionable and people realized that cities are good places to live -- that's all reflected in the rents.

But PURCHASE prices also went up because people wanted to get in now before prices went up more. That's a bubble: people paying more than they think the place is worth (to rent or live in) because they think they'll be able to sell it to someone else for even more (or they'll have to overpay even more if they wait). It leads to completely irrational prices. Eventually, though, somewhere around $3m for a Carroll Gardens special, even the irrationality ends, usually because the banks decide to stop financing.

(Bubbles can work in the other direction, as in the white flight years, when people sold at silly prices because they feared they'd get even sillier -- eventually driving prices so low that in the late 60's the City was paying people to take Upper West Side brownstones off their hands.)

We are at the end of the biggest bubble in US history. If you want to get an idea of where prices are likely to go, you need to look at something that is unaffected by the bubble. Rents are much less likely to be based on speculation about where rents are going, and much more likely to be based on how much people are making and how much they actually want to live in the neighborhood/apt right now.

Posted by: FinanceGuy at December 14, 2008 11:13 PM