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Rent vs Buy on Major Steroids....You've Got the Money to Buy a Home in the Bay Area, But Should You?

Rent vs Buy: It's a topic that any financial advisor should have a clear opinion on.  A recent conversation at a dinner party with friends caused me to ponder it some more and to sharpen the pencil in terms of how I frame up the decision when speaking with families who are unsure what to do.

As the title suggests, I am assuming that you have the financial capacity to buy but you want to validate that it's the right move for your family and your situation.

I think this conversation gets more than average airtime here in the Bay Area given the insane price levels that are commonplace and the rate at which the market has appreciated in the decade since the financial crisis.   The chart below summarizes the trends over the past 35 years:

Source: bayareamarketreports.com

In the dinner party conversation that I referenced above, I would say it was fairly evenly split between those advocating buying and those that were "content to rent". 

The primary arguments from the 'buy' crowd:

  • Prices will keep going up
  • Demand will continue to significantly outpace supply
  • Is it really a good strategy to ait and hope for the market to drop to a point that feels more comfortable?

The arguments from the 'content to rent' group:

  • List prices are already at a crazy high level
  • In order to actually get the house, you'll have to pay a significant premium above list price to beat the competition
  • Given the rate at which homes have appreciated and the length of time since the end of the great recession (+90% over 8-9 years), isn't there a risk of buying at the top of the market right before the next correction or recession?

At some point in the conversation, the crowd looked in my direction to break the tie and provide them with the numbers and logic to support my position.

I'll use the town that I currently live in, Sunnyvale, CA, to walk through a comparison. And for full disclosure, my wife and I (and our 3 young kids) are currently renting a single family home (Wait...a financial advisor chose to rent....who knew?). 

Let's run through a quick comparison, starting with the cost to buy:

Average cost for a single-family home:  $1.5MM (per Zillow, the median list price $1.488M as of April'19, we'll round up to keep the math easier). 

Required down payment (@20%) $300k: There are options to close with less money down, but I would certainly never advocate for paying PMI. If you're unable to come up with 20%, the decision is easy. Lower your target price or rent until you build up the required ransom.

Current mortgage rates (30-year fixed):  As of this writing, 4.25% was the best rate on bankrate.com for this jumbo loan.

Monthly Expenses:

Principal / Interest:  $5,903

Property taxes:     $1,250    (1% x home value; probably a little light to reality)

Maintenance:        $708    (Using the average of the 1% rule and the $1/sq ft rule

Insurance            $500

Total               $8,361

Now, the comparable numbers to rent:

Rent:              $4,000    Again, using Zillow's data as of April '19; $3,995 to be precise!)

Insurance:     $100    

Total:              $4,100

The common criticism of renting is "you are just flushing money down the toilet every month". In this example, the total cost to own is more than double the monthly outflow to rent (not to mention that your liquid assets are lighter by $300k). But the owner is building equity and will benefit as the market appreciates, right? Let's breakdown the $8,361 and focus on the non-recoverable expenses to give more of an 'apples to apples' comparison with renting:

Mortgage payment components (Average during years 1-5):

Interest:                  $4,065   

Principal:                  $1,838

Total mortgage payment:   $5,903 

Why a 5-year holding period? Similar to stocks, I would approach a home purchase with a minimum 5-year holding period, and ideally much longer. If you have reason to doubt you will stay in the house even 5 years, you get the same verdict as the family that doesn't have the 20% down payment. Continue to rent until your life stabilizes to the point where you can look several years ahead with reasonable clarity.

What's notable here is the interest by itself is roughly equivalent to the cost to rent this same home. Yes, this interest can be a deduction on your income taxes, but thanks to the Tax Cuts and Jobs Act of 2017, it's only the interest on the first $750k of the loan that can be an itemized deduction. TCJA further reduces the income tax offsets by capping the property tax + state income tax deduction at $10k. If you are in the income range that makes buying a $1.5MM home is possible, you are paying well above $10k in CA income taxes alone....therefore, property taxes are completely in the "non-recoverable expense bucket".

After removing the principal payment and the benefit of itemizing the interest on your tax return, the monthly expenses now look like the following:

Interest*:         $3,404      

Property taxes:   $1,250   

Maintenance:    $708

Insurance:      $500

Total:          $5,862   

* Assuming 65% is deductible ($750/$1.15MM) and 25% effective tax rate

So, the person who is loathed to flush $4k/month down the tube on rent is doing exactly that to the tune of closer to $6k/month for the privilege of owning their home.  The buyer isn't truly flushing money down the drain since they will likely benefit from home appreciation, but they have to cough up $300k on day 1 and pay an extra ~$1,762k/month for 5 years ($105,720 in this simplified example) to get access to this upside. And even though there are no signs of the risk of loss to homeowners in the Bay Area at the moment, 2008-2011 is a stark reminder that home prices don't always go up.  

To summarize, the buyer would have to realize enough home appreciation in 5 years to cover the following expenses, above which they start to earn a true economic profit:

1) Monthly cash flow drag:  $105,720

2) 6% realtor fees:                $90,000  It's only a paper profit until you sell

3) Opportunity cost: $$$?     Money tied up in the house that can't be invested

The theory behind #3 is if you didn't tie up this money on the down payment, you could invest in the market and perhaps get better returns relative to what you will see in home appreciation. I'll call this a wash.....the stock market has solidly outperformed the housing market over the long-term*, but the Bay Area housing market is a clear outlier and has seen growth rates very much in line with the bull run in the stock market. The other important aspect is leverage. You pay 20% and borrow the other 80%, but when the house appreciates you reap the benefit on the full 100%.  While leverage in the stock market is VERY risky and not something I would ever recommend you to consider.

* According to the Case-Shiller Housing Index, the average annualized rate of return for housing increased 3.7% between 1928 and 2013. Stocks returned 9.5% annualized during the same time.

What's the final verdict? Better to rent or to buy?  

Financial decisions need to be made within the context of your unique situation. A major decision such as a home purchase requires a lot of planning and consideration. Big picture, for most families buying is a good long-term decision, but it comes with several important pre-requisites: 1) Financial: Build up the 20% down payment while still maintaining an adequate emergency fund, understand the changing dynamics in your monthly cash flow and the implications for your taxes. 2) Lifestyle: Make sure that you have reasonable clarity on your career, your marriage and family plans, and your lifestyle preferences. 3) Patience:After taking the plunge and making the down payment, be prepared to hold for several years while enduring down markets, maintenance headaches, and the other "joys of home ownership".

The better you do with pre-requisites 1&2, the higher the chance that you will be afforded the patience to enable your investment to pay you back over time.

You just said that buying is the right decision for most families. Why are you renting?

While we are currently renting, we have been homeowners on 2 separate occasions with 2 completely different outcomes. I'll summarize each and give our rationale for renting:

Home #1: We purchased a 1 BR condo shortly before getting married. This began the 9-10 years that we lived in the Rivermark neighborhood in Santa Clara. In light of today's prices, this was an incredible bargain, but signing up for a ~$400k loan felt like a major burden at the time. This was in late 2006....not too long before the tsunami of the great recession hit. As the graph above clearly shows, there was an extended period of time, easily 2-3 years, where the market value was down 20-25% (Ouch!). Very stressful, but we both had stable jobs, the home fit our lifestyle and we were able to ride out the storm. By the time we sold in 2015, the value was well above purchase price. A happy ending, but no shortage of tension along the way.

Home #2: We purchased a single family home in CT after I accepted a new job. Our view was that we had young kids that would soon be school age. I was working at the company headquarters and expected to have career stability in the area. It seemed like the right phase of life to buy. Fast forward 2 years...the situation has changed and we take an opportunity to move back to CA. In the meantime, the local housing market had materially dropped and we sold at a significant loss...in essence wiping out the entire gain on the condo. Seemed like a great decision at the time, but didn't have a fairy tale ending.

2 different properties in two completely different markets, but the moral still remains: be as certain as you can that you will have a long enough holding period to ride out market surprises. If we sold the condo after 2-3 years, the result would have been just as bad as the CT house. And while not guaranteed, if we lived in the CT house for close to a decade it might not have ended in a nice profit, but it's very reasonable to expect a better result than what happened when we hit eject after just 2 years.

Same as you shouldn't put money into the stock market that you'll need within 2-3 years, you shouldn't be dropping significant money into a home unless you feel confident you will be able to buy and hold for a long time. The right time to buy is more a function of your phase of life than the current phase of the economic cycle.

We're now living where we plan to be long-term and we want stability and access to good schools, but for the time being, renting is still the better option for us. I left a successful corporate career to launch my planning practice and in doing so had a major decline in income which will take several years to build back up. My wife changed companies and is working to establish herself and to figure out if it's the right environment to meet her career objectives. Even if we wait another 2-3 years and prices continue to climb, it's still the right decision to first sort out our careers and incomes before signing up for that huge commitment a 3rd time. No market timing, just life planning.  

I would encourage you to approach a potential home purchase with the following outlook: "If we live here for the next 15-20 years, will the property enable us to live comfortably, to raise our kids and provide a quality education, to host our family and friends, and to enjoy life....and if we sell the place at the end of 20 years for exactly what we paid for it, would we look back and say we made the right decision?" If you can confidently say "yes", buying that home may well be the best decision (life or financial) that you ever make.

If you are unsure whether buying a home is a wise decision for your family, please contact me for complimentary consultation: