Your Home: Rent vs. Buy Decision
Control of real estate can be taken in two ways. One is to take permanent control i.e. take the ownership of the property. This has its own advantages as this allows for capital appreciation and also eliminates the need to pay rent in the future. On the other hand, one can pay rents and use the property as and when they require. Now, which of these decisions makes better sense as compared from a personal finance point of view is what is included in the rent vs. buy decision. This article provides a description of the rent vs. buy decision.
Compare Annual Expenses
The average person has the tendency to think of home buying as an emotional decision. Then, also there is the conventional wisdom out there, which claims that buying is always better than renting. However, when it comes to sophisticated real estate investors or pretty much anyone who’s concerned about how their money is being spent, the conventional wisdom does not hold true.
Instead, it is advisable to think about whether it is more profitable to buy a given house or would it make more economic sense to rent a house. The trick here is to compare the annual expenses. Pay careful attention to the word expenses. We are not comparing cash flows. Instead, we are comparing expenses.
When we buy a house, we have a mortgage to pay. The mortgage is made up of two components. One of those components is interest, and the other is principal. The interest component is purely an expense. Simply put it is money that is leaving your pocket today and the money that you will never see at a future date. Hence, this is the amount that we will use in our calculation. On the other hand, the principal component of the mortgage payment is your savings. Hence, it is like taking money out of one pocket and then putting it into another pocket. Since this money is savings, we will not include this in our calculation.
Hence, our expenses for owing the house will include interest (after deducting tax shield), property taxes, insurance and maintenance. This would be the amount of money that is consumed during the period.
On the other hand, the expenses pertaining to rent are pretty simple and straightforward. Firstly, there might be a one-time expense of paying a deposit to the landlord. However, this is not an expense it is just an interest-free loan as one will receive the same money back when vacating the house. Apart from that, there is also the monthly rental that has to be paid. Some people also factor in the opportunity cost of the down payment that has to be made to acquire a house. This means that if you did not buy a house, you would end up earning a certain amount of interest from your down payment money. This must be reduced from your monthly rental.
Hence, a basic version of the rent vs. buy decision would be to compare the annual expenses that would arise as a result of either buying or renting the house.
Future Annual Expenses
Also, it needs to be understood that neither buying nor renting are one-day decisions. These decisions require commitment and have to be executed over a period of many years. Therefore, while comparing annual figures is the right thing to do, one must ensure that they do not compare fdata for only the current year. Rather, the cash flow and expense projections should look several years into the future.
This is the part where the rent vs. buy decision gets complicated. This is because the decision is extremely sensitive to the capital appreciation that we assume in the future. If we change the capital appreciation by one percentage point, we would end up changing the net present value by a huge amount, for example $50,000. To top it up, predicting future real estate prices is extremely difficult. Therefore, one needs to be very careful of the future assumptions that one is building into the model as they can literally turn the decision upside down.
The rent vs. buy decision is also dependent on the risk appetite of a given individual. Some people have no qualms with the risk that a mortgage brings along. A mortgage increases the risk because there is interest to be paid and also the investor becomes highly sensitive to price changes in the market. Hence, the personal net worth of an individual can change dramatically if they have a mortgage because mortgage essentially is an extremely leveraged bet.
More risk averse people prefer renting. This is because rents do not fluctuate nearly as wildly as property prices do. Even if the rents do change dramatically in a given neighbourhood, the person has an option to move into a different neighbourhood or even a different city if required!
Stability vs. Flexibility
When we buy real estate, it’s like throwing anchor in a particular place. Our lives become stable. Usually, people decorate their homes based on their preferences and when they own the house they can do so. Also, renting involves frequently moving to different houses periodically. Buying a home cuts out this movement and as such provides stability.
On the other hand, renting provides a person with the flexibility to experiment with different neighbourhoods, different apartment sizes at different costs to see what fits them best. People whose jobs require them to move regularly are also better off renting.
To sum it up, the buy vs. rent analysis is partially financial and partially emotional. The financial part of the analysis is difficult to work out because of the future assumptions. However, one also needs to understand the level of risk and flexibility that they desire before jumping into such a decision.
|❮❮ Previous||Next ❯❯|
Authorship/Referencing - About the Author(s)
The article is Written By Prachi Juneja and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.
- Types of Real Estate Investors
- Real Estate Investing Myths
- Real Estate Investments: As Safe as Houses ?
- Real Estate and Money Supply
- Basic Ratio Analysis of Real Estate Investing
- Transaction Costs in the Real Estate Market
- Information Asymmetry in Real Estate Market
- The True Cost of Owning a Property
- Behavioral Aspects: Real Estate Investing
- Real Estate Investing vs Investing For Cash Flows
- Real Estate Investment Trusts (REITs)
- Advantages to Investing in REITs
- How to Predict Real Estate Market ?
- Why Properties Sell for Less Than Their Worth ?
- Your Home: Rent vs. Buy Decision
- Japanese Real Estate Market
- The American Real Estate Market
- Chinas Real Estate Market
- The Indian Real Estate Market
- The Gloomy outlook for the real estate sector in India and its impact on first time buyers
- Performance Measurement for Real Estate Investments
- The Link between Credit Growth and Real Estate Bubbles
- The Subvention Scheme Trap
- Are Increasing Housing Prices Good for the Economy?
- Co-Working Spaces: The New Trend in Real Estate
- The Process of Making a Real Estate Price Index
- Five Reasons Why Real Estate Increases in Value
- Why the Indian Real Estate Sector is Down in the Dumps and How it can be Revived
- Should More Houses be Built?
- The Hong Kong Housing Problem
- Proptech: The Future of Real Estate
- The “Invitation Homes” Model For Real Estate
- Why The Indian Real Estate Market Will Not Appreciate Any Longer?
- Can Governments Ever Provide Affordable Housing?
- The Impact of Real Estate Bankruptcies
- 7 Reasons Why Real Estate Is the Worst Investment
- Bankruptcy Code and Indian Real Estate
- Why Property Prices are Crashing in Every Major City in the World?
- Is the Canadian Government Creating a new Real Estate Bubble?
- The Problem with REITs
- Managing the Affordable Housing Problem