Why Renting Really Is For Suckers (And What To Do About It)

Okay, you might expect a Real Estate Agent to have a post with that title, but I'm going to surprise the doubters by hauling out a spreadsheet and proving it with numbers.

The fact is that if you have moderately decent credit you can qualify for 100 percent financing. The more you have for a down payment, the better your interest rates and the lower your payments, but even so, you can make it.

The first thing to remember is that you have to live somewhere. When you buy, you place your cost of housing forevermore under your own control. Inflation means nothing to the housing costs of someone who's already bought. Rising rents means nothing - unless you've bought an investment property to rent out, also. We are currently facing a period wherein rents are likely to rise precipitously. Why? Low vacancy rates (3.4% in San Diego), and many landlords facing adjustable rate mortgages that are going to adjust upwards. It doesn't matter that your landlord has been nice up to now. They were banking on selling for a profit and right now, they can't. When the monthly outlay goes up, they're going to raise the rent. They will get it, too. If you won't pay it, someone else will.

Once you have bought, you step off of that one way escalator of rising rents. Rents increase at a yearly rate about comparable to inflation in most cases, and rents never drop. I have never heard of a rent decrease except in areas that were so far gone they might as well have been war zones. You only borrowed $X when you bought, and unless you take cash out (which is under your control) you should never owe more money next year than the previous one.

So buying stops your situation from getting worse. What about making your situation better? First off, I need to observe that with rising rents, your situation will always get worse until you sell. But buying really does make your situation better. Not immediately; there's always a hit for buying, and it always costs money to sell. But within a couple of years the average person will be above any reasonable return they can earn any other way, and the reason is leverage.

Fact one: you always need a place to live, and the options are to rent or to buy. Renting typically requires less cash flow, but returns nothing. Once you have bought, all that lovely appreciation belongs to you and nobody else but. Let's look at an actual scenario for San Diego, one of the highest priced places to buy.

I looked at one particular property earlier today with an asking price of $450,000. The most comparable rental in the area is $1700 per month. For people with dead average national median credit scores, I have 6.125% on a thirty year fixed rate loan for the first 80% of the loan, and 8.75% on the second mortgage. Yes, I'm assuming a 100% loan. Total loan costs, one point and approximately $3400 in closing costs. With sellers outnumbering buyers 36 to 1 right now, it's an idiotic seller who isn't willing to pay your closing costs. Your payments on the two mortgages are $2187 and $708, respectively. Call it $2896 with rounding. I'm going to assume you're married, which means you get a $10200 standard deduction on your federal taxes for 2006. Furthermore, property taxes are about $470 per month, and homeowner's insurance costs about $110 per month for an HO-3 policy, the best there is. Total cost of housing: $3476 per month. Over twice your cost of renting, yes. But $400 of that goes straight into your own pocket, in the form of principal you're paying off from month one. Furthermore, $2960 per month is a tax deduction, from which you'll get a benefit of $(2960*12)-10,200 (standard deduction), or slightly more than $25,500 per year, from which someone in the 28% tax bracket will see a tax reduction of about $7145, returning another $595 per month to your pocket. $3476-$400-$595=$2481 net costs per month to own that property. Less the $1700 rent, works out to $781 extra you're spending. Furthermore, if you turn right around and sell it, you're going to be out about 7% of that sale price. Assuming it's the same $450,000, that's $31,500 you're down.

However, property values don't stop rising just because the renters of the world would like them to. Let's assume you're going to make a slightly below average for this area 5% per year in absolute terms - not inflation adjusted. Most of California has been averaging seven percent per year for the long term, over cycles and cycles of pricing. The CMA for the first property I bought, at the peak of the last cycle fifteen years ago says $320,000, an 8.8 percent per year average increase. So 5% is definitely on the low side. Let's assume you have a twin who continues to rent, and invests that $781 per month, tax free, while you take it and buy a property. Actually, let's go ahead and give your twin the full net cash differential of $1143 per month.

One year later, he's got about $14,400, while your property is worth $472,500. You've got about $27,000 in equity. On paper, you're ahead of him, but remember that real estate isn't liquid and there are always selling expenses. You're really still down by about $20,000 as opposed to your twin. Darn! Just when you had a really good brag going. But wait! Now your twin's rent is raised to $1768 - right in line with 4% inflation. But your mortgage costs are fixed.

Run it out another year. Your twin has about $29,700 in that account. Looking pretty good, right? Well, you've now got a value of a little over $496,000 and you have about $56,000 in equity. You're not really ahead yet, but deducting the 7% costs of selling net you about $461,400. You've made over $11,000, net, not counting the equity you paid down! But your twin has almost $30,000. Why is renting for suckers, you ask?

Go out one more year. Your twin's rent has gone to $1838 per month, but even so his investment account still has a tad over $46,000 in it. Looks like he's pulling away! Or is he? Your property value has gone to almost $521,000, and you only owe $434,000. You're up almost $87,000, and even allowing the standard 7% for costs of selling, you're would now have over $50,000 in your pocket, several thousand dollars more than your twin.

Every year from then on, you pull further ahead. After ten years, when his monthly rent is over $2500 per month, you've got $350,000 in equity, and even after the costs of selling, are over $100,000 ahead of your dimwitted twin.

Lest you think that if your twin started with $45,000 due to a ten percent down payment it would make a difference, the answer is not really. It cuts the lead, but not the essential facts. I could cut the rate on the second mortgage a bit, but let's leave it at 8.75% for the purposes of this exercise. True, after three years you're still lagging your twin in this scenario, as that investment account is $95,000, but only by a few hundred bucks. Your equity is $130,000, of which $94,300 would be left after the expenses of selling. After ten years, he's $80,000 behind you, net of the cost of selling.

Suppose you start with a full 20% down payment? You're still $55,000 net ahead of the game after ten years. Your twin started with $90,000 earning ten percent, but not only do you not have that expensive second mortgage, you've got $450,000 earning 5%, and it's all yours and then some. This is the concept of leverage. That loan turns out to have been a good thing, as it enabled you to leverage your down payment into a much larger appreciating asset. So you only earned half the return - it was on five times the principal! It translated into a much bigger number. By the way, your twin only has the edge on you in cash flow by about $120 per month at this point, and he's going to be negative next month.

Now the real estate market doesn't earn nice smooth returns like this. Neither does the stock market, or anything except maybe bank CDs or the money market, at a fraction of the return illustrated here. Furthermore, it reliably and unavoidably takes about three years to come out ahead on a real estate investment. There are always the twenty percent per year markets, but those don't happen very often and never predictably. What I'm talking about are is making money in the slightly below average market years also. Note that you'll still make twenty percent in the years the market does. Sometimes you get lucky. But "time in" is so much more important than timing that they don't even play in the same league.

You don't have to be a genius, you don't have to have perfect credit, and you don't have to make a mint. You do have to pick properties that you can afford to make the payments on, and you do have to make the decision to accept a couple of tough years for cash flow. There just is no avoiding this hard fact. There are loans that promise otherwise, but they have bitten everyone I've ever met who tried them. Once you have made the decision to accept those lean times, however, the good times seem to flow from them for the rest of your life. The sooner you make the choice to accept them, the better off you will be.

Caveat Emptor