Wednesday, June 15, 2005

Real Estate Hot Potato...Buy versus Rent & Invest


I just rented the first floor of a two unit building in Newton, Massachusetts. The building just sold two weeks ago and so I could see all of the property specs.

The top unit rents for $1,700 a month and I rented the lower one for $2,300 a month. The building sold for $1 million. Best case scenario – the new landlord will be getting $4,000 per month, or $48,000 per year in gross rent. So 48k on $1 million represents a gross 4.8% yield.

The local property taxes are $7,500 and $2,000 is listed as the insurance premium (I have not checked how realistic that number is.) So now, the net annual rent is down to $38,500 for a yield of 3.85%, already below the ten year Treasury note yield of 4.1%.

From that $38,500 one still has to deduct general maintenance costs, lawn care, water bill, legal/accounting costs, etc.

Also the new owner is losing rent on our unit for both June and July (We start August 1st) – a not so slight $4,600.

Since they never go down, taxes will probably go up. The landlord can’t realistically count on 100% occupancy and rent collection for the life of the building. Tenants may break their lease or he may have a few months between successive tenants. Pipes may burst. The roof may leak. An exterminator may have to be called. Plumbers will extort money from this landlord too. Real estate management is not a sit-and-collect sinecure.

Any way you shake it, the new owner is getting a paltry yield (around 3.7%) on this “investment”. Good luck to him.

My unit represents 57.5% of the rent but I will round up to at least 60% since the upstairs unit is not renovated or as real estate types say, “updated”.

So compare me buying this $600,000 unit versus renting it for $2,300 a month.

If I put $100,000 down, a 5.75% fixed rate mortgage would make my payments around $2,900 a month. After subtracting the federal mortgage tax deduction and adding back in property taxes, insurance, and maintenance, at best my total payment would reduce by $100 a month. By at best, I mean assuming the highest federal income tax rate for myself, flat property taxes, and minimal expenses. So compare the “at best” figure of $2,800 per month to my rent of $2,300. So after one year, I will have $6,000 more in the bank by renting, but if I bought, I would own a little more than that in home equity.

In fact, if I save $6,000 a year for 30 years (the life of the mortgage comparison) and compound it at 4% (today’s ten year rate), I will end up with…


To that you have to add the original $100,000 deposit that I did not put up and compound that over 30 years at 4%.

=100,000*(1.04)^30 = $324,340

So adding my annual payment savings (compounded) to the future value of the 100k deposit that I did not have to give up ….

$349,221 + $324,340 = $673,561.

Conclusion, in this very limited example, after 30 years, the renter would have about $674,000 in cash, and the buyer would own the $600,000 apartment. (and lest anyone forget, the homeowner would lose around $30,000 in real estate commissions if he wanted to move.)

NOW HOLD ON. I know that right now, thousands of my blog readers are saying I am an idiot if I think that apartment will be still be worth 600k in 30 years. I am not saying that at all. This is a very sensitive multivariate exercise and I will tweak the variables one at a time.

CaptiousNut will now PROVE that renting is a no-brainer.

First of all, the above comparison has extremely favorable assumptions for the homebuyer and RENTING STILL WINS.


Local property taxes stay the same. It has never happened and never will.


The buyer is in and will stay in the highest federal income tax bracket. The IRS lets homeowners deduct mortgage interest payments from their gross income. The dollar savings to the borrower are then:

Dollar savings = annual mortgage interest paid * marginal federal tax rate

For example, the total interest paid in Year 1 of the example is $28,582. If the borrower in is the 35% federal tax bracket, he will be effectively entitled to an $834 monthly rebate. But if the borrower is in the 30% bracket, the monthly tax savings is only $715.

( computational note: 834=28,582*.35 / 12 )

I was amazed at how much marginal tax rates affected the Rent versus Buy equations. That $119 monthly difference between borrowers of different tax brackets becomes huge over time. It is actually one of the few tax laws that favor high income earners.

Remember to compare the $2,900 per month mortgage payment to the $2,300 monthly rental payment, I had to subtract from $2,900 the mortgage interest benefit and then add back in the costs (property taxes, maintenance, etc). Doing so, with a $119 lower monthly mortgage deduction benefit will widen the cost gap between the $2,300 and adjusted mortgage payment. Let’s be conservative again and round $119 to $100. So that brings the adjusted mortgage payment back to its original $2,900 per month.

It also means that instead of the renter saving $500 per month over the buyer, he now saves $600 or a total of $7,200 for the entire year. Let’s replace the $6,000 annual savings figure above with $7,200 and see how much it will compound to over 30 years at 4%.

= $419,065

That is $70k more. Add that to $324k from the compounded deposit and the renter’s total cash after thirty years jumps to $744,000 compared the homeowner’s 600k house.


Most people don’t realize that the mortgage interest deduction fades over time. In fact, it is straight downhill after the first year. Look below to see how in this example, the annual mortgage interest paid decreases. The second and third columns show the decreasing monthly tax deductions for the 30% and 35% tax brackets (that is total interest multiplied by the tax rate and divided by 12). Remember this is a 30 year fixed mortgage on $500,000 at 5.75 %.

Total Interest Paid ....... 30%............ 35%

Year 1........$28,582.24........$714.56........$833.65
Year 2........$28,202.49........$705.06........$822.57
Year 3........$27,800.32........$695.01........$810.84
Year 4........$27,374.40........$684.36........$798.42
Year 5........$26,923.34........$673.08........$785.26
Year 6........$26,445.65........$661.14........$771.33
Year 7........$25,939.75........$648.49........$756.58
Year 8........$25,403.99........$635.10........$740.95
Year 9........$24,836.59........$620.91........$724.40
Year 10........$24,235.70........$605.89........$706.87
Year 11........$23,599.32........$589.98........$688.31
Year 12........$22,925.38........$573.13........$668.66
Year 13........$22,211.65........$555.29........$647.84
Year 14........$21,455.78........$536.39........$625.79
Year 15........$20,655.28........$516.38........$602.45
Year 16........$19,807.52........$495.19........$577.72
Year 17........$18,909.71........$472.74........$551.53
Year 18........$17,958.90........$448.97........$523.80
Year 19........$16,951.95........$423.80........$494.43
Year 20........$15,885.54........$397.14........$463.33
Year 21........$14,756.18........$368.90........$430.39
Year 22........$13,560.14........$339.00........$395.50
Year 23........$12,293.49........$307.34........$358.56
Year 24........$10,952.05........$273.80........$319.43
Year 25........$9,531.41.........$238.29........$278.00
Year 26........$8,026.90.........$200.67........$234.12
Year 27........$6,433.57.........$160.84........$187.65
Year 28........$4,746.16.........$118.65........$138.43
Year 29........$2,959.13.........$73.98.........$86.31
Year 30........$1,066.60.........$26.67.........$31.11

It is easy to see that by year 10, the 35% tax bracket owner will see his monthly interest deduction fall from $834 to $706 and the 30% tax bracket owner will similarly see his monthly deduction savings fall $105 as well. Also, in the last few years, there is almost no mortgage interest deduction at all. The homeowner may claim that he is gaining pure equity at this point; however, the renter is gaining even more cash over the buyer’s equity. In other words, the renter is still paying $2300 a month but since the mortgage deduction has shrunk, the homeowner will effectively be paying easily over $1000 a month more than the renter.

Earlier I assumed that the renter would be saving $6,000 (35% bracket) or $7,200 (30% bracket) a year more in cash and that this amount would remain constant. But due to the declining mortgage interest deduction, this is not true and bolsters the renting argument further.

I assume that the renter is only earning 4% annually on his excess capital (i.e. the 100k deposit that he invests and $6,000-$7,200 in monthly cash savings). 4% is way below historical rates of return in both the equity and bond markets. Consider the massive jumps in the 30 year return on 100k invested:

At 4% $349,000
At 5% $432,000
At 6% $574,000
At 7% $761,000
At 8% $1,006,266
At 9% $1,326,768
At 10% $1,744,940

Myopic naysayers are bellowing, “Where am I going to get 7%?”

Well, a mere five years ago you could have gotten that from long term government bonds. One thing is for sure, if you put all of your cash into a mortgage down payment, when interest rates do rise, you won’t be able to capitalize on it. And of course your “investment”/house will plummet in value.

Take a good look at those big numbers above and don’t forget that they only represent one half of the renter’s growing cash, that of the 100k deposit.

When I summed up the renter’s monthly cash savings that started at $6,0000 and $7,200 for the 35% and 30% tax brackets, I compounded the money at a mere 4% over the thirty year period. Consider these monthly savings earning higher annual returns over 30 years.

At 4%......$364,897......$432,502
At 5%......$417,329......$500,796
At 6%......$500,859......$601,031
At 7%......$603,450......$724,140
At 8%......$729,602......$875,523
At 9%......$884,878......$1,061,854
At 10%.....$1,076,143....$1,291,371

So if Johnny Renter is in the 30% tax bracket and earns 6% annually on his money (100k lump sum and annual cash savings), after 30 years he will amass $1,175,000 !!!!!!!!!

Some of my readers are saying that I am crazy if I think that house won’t appreciate over 30 years. And I am also crazy for assuming that the $2,300 rent won’t rise. I don’t really want to draw those conclusions, I just wanted to illustrate that if a house is an “investment”, one should not compare it to Renting – it has to be compared to Renting and Investing the cash savings.

Plus I could throw those historical arguments back as well. You claim that housing has never had a 30 year period of price stagnation? Well I will fire back that never in economic history have interest rates been so low… you have to assume they are going to rise. Also, never in economic history have borrowers been so leveraged as they are with half of the country borrowing at adjustable rates. And let’s not forget the interest-only borrowers who are basically renters with major interest rate risk.

Borrowers are nuts to not lock in today’s low rates. But as today’s blog demonstrates even fixed rate borrowers have major interest rate risk in both the value of their home and in the opportunity cost of lost investment income.


Anonymous said...

One thing that even strengthens this argument - if your house does appreciate in value, you pay taxes on that appreciation. So you don't just lose 6% to the realtor, you lose another 30% or whatever it is to the govt

Anonymous said...

actually i don't think you pay capital gains on a primary residence if you stay there 2 years, at least not on the first 500k of capital gain or something.

actually taxes hurt the renting argument because when i assume certain investment returns i let them compound without regard to distributed capital gains in the investment period.

that is why to be fair, one cannot assume too great (8-10%) of an investment return.

also, long term capital gains taxes are lower than 30% now.

Anonymous said...

I thank you for being fair with your assumptions, but what you did not mention is that your scenario favors renting in YOUR BUILDING, in YOUR NEIGHBORHOOD. You failed to point out that the math will not work the same in geographic all areas. In some markets the cost to rent vs' the cost to own is far different. Thus favoring the buyers. Although your comments about the general American public being too far leveraged is absolutely FACT.

Also- you did appropriately write about the "investment" of the savings for the renter. This is key! Inversly, you also have to realize that some real estate markets WILL appreciate even if rates do rise. This "speculation" in "investing" in real estate is in lou of more equity/fixed income investments. Like in most situations, a general "rule-of-thumb" can be used, but I feel that in the rent vs' buy question, must be pragmatic and know their own specific situation within their geographic location. Also, you have to realize that many baby boomers and the older generations feel that brick and mortar is the way to go. A stock can go to zero, but barring a national/global catastrophy, a house never will. I am not saying that this is the REASON to buy, but it is a reason why some people feel warm and fuzzy about owning something that is tangible and cannot go to $0.

CaptiousNut said...

Appreciate the comment Anon,

In the last 1.5 years I have lived in Brooklyn, Charlotte, and now Boston. All three cities had the same wide price disparity between renting and buying.

In Charlotte we rented a 2 BR condo for $1150 a month that was selling for $275,000. (The rental price implied a price of $200k.)

New York was the same. See my prior post.

It may seem like it, but my analysis is not overly anecdotal since I have seen this pricing phenomena in multiple locales.

Apartment buildings trade on well defined metrics like a multiple of Rent Roll. In other words the market is not a complete hodge-podge of prices. Sure some properties will trade at a slightly higher or lower multiple of rent roll based on age of building, location, etc., but it would be like 22 times rent roll instead of 19 times it.

Call any decent broker, ask, and they will tell you where stuff is trading.

Once you move to areas that lack well developed rental markets (rural,etc) , obviously one's housing options decrease. In some tony towns, there may be no apartments and very few homes available to rent.

As for homes being a tangible investment, remember that most people borrow to buy a home. When you buy a stock, at a minimum you have half of the money down. But a home can be bought with no money down and very often is these days.

Since one borrows to buy a home, you NEED appreciation to justify that. Mere price stagnation, never mind depreciation, will be crippling enough for tons of people when it happens.

In the last real estate decline (1988-1992), many people ended up owing more money on the home than they were currently worth. More than a few decided to just walk away from their homes, default, and basically destroy their credit.