Should I Buy or Rent a Home?

Hor ki chalda,

"Mandeep, what's that gibberish?" That's Punjabi for "Hi, how are you?" I thought I'd inject a little bit of my culture into these posts. 😊

That aside, this post is part two of the three-part real estate series. Today, we are going to be evaluating the rent vs. buy decision.

Home purchases are NOT always a home run financial decision.

The real estate crowd, over the last 5 years, has been talking about how houses are better than stocks, but the data indicates otherwise.

Returns on global real estate trail returns on global stocks by about 3.5% after adjusting for inflation (Source: https://www.youtube.com/watch?v=Uwl3-jBNEd4); this means stocks outperform real estate. You may want to check out the aforementioned video for a “Rent vs. Buy” rule of thumb as well.

But Mandeep, I live in the US. It’s different here.

You’re right. Stocks have done MUCH better than real estate in the US.

According to ChatGPT:

“Historically, the US stock market has delivered higher returns compared to the US housing market. According to data from the Federal Reserve Economic Data (FRED), the average annualized return of the S&P 500 index (a commonly used benchmark for the US stock market) from 1970 to 2021 was approximately 10.9%, while the average annualized return of the US housing market (as measured by the Case-Shiller US National Home Price Index) from 1987 to 2021 was approximately 3.7%.”

Here’s an excerpt from an article from investopedia: (Source: https://www.investopedia.com/ask/answers/052015/which-has-performed-better-historically-stock-market-or-real-estate.asp)

“Or, consider the 47 years between 1975 and 2022. A $100 investment in the average home (as tracked by the Home Price Index from the Federal Housing Finance Agency [FHFA]) in the fourth quarter of 1975 would have grown to about $928 by the first quarter of 2022. A similar $100 investment in the S&P 500 at the beginning of 1975 would yield approximately $19,351 in 2022, provided all dividends were reinvested.”

Home buying requires a careful analysis before proceeding. It takes more math and several considerations in buying a house as a primary residence compared to purchasing index funds. Some backwards rationalize that the home purchase was an investment. In most cases, homeownership for personal use is a suboptimal investment.

Rental property investing is a different story altogether.

Even a well-trained chimpanzee can buy index funds that outperform global real estate. The skill level and effort required for purchasing stock market index funds is really low. I digress; back to the topic at hand.

There are a lot of critical flaws that the real estate crowd makes.

1. They compare renting vs buying a house by comparing the cost of a mortgage against the cost of rent. This is mathematical blasphemy – it’s laughable in the best case scenario and malicious in the worst case scenario. Let me take a moment to explain:

The cost of renting = rent + utilities (gas, power, water, sewer, trash, internet)

The cost of buying = mortgage + utilities (gas, power, water, sewer, trash, internet) + property taxes + homeowners insurance + HOA fees + private mortgage insurance (if your down payment is less than 20%) + maintenance and repairs, etc.

1. They compare non-inflation adjusted numbers of housing to inflation-adjusted numbers of stock market returns. Either you have to adjust both for inflation or leave both unadjusted.

2. They compare their local real estate market (San Francisco, Los Angeles, New York) to the national stock market or compare what the housing market has done over the last 3 years during a Black Swan event (COVID-19) to national stock market returns over the last 60 years. They’re comparing 3 years to 60 years and a Black Swan event to many events and non-events.

3. To their point, you can’t live in a stock. You can live in a house, though. However, your stocks don’t require you to pay property taxes, tie you down to a geographic location, or leak water on your face when the roof is damaged. One is an asset that returns money and costs you no money other than the expense ratio. The other provides housing and may appreciate but does require maintenance. It’s not really an apples-to-apples comparison.

The reason I explained all of this is to undo the degeneracy of the real estate TikTok and YouTube crowd. Now, this does not mean buying real estate is a bad idea. It just means you can’t expect to make money with any house you place your gaze upon as a primary residence and/or investment.

As with anything, you’ll want to come to a well thought-out decision. Buying a house is the largest purchase most people make. It would be wise to take your time and not let anyone (especially, your real estate agent) bully you into buying a particular house or any house. You might even go out there and decide right now is not the right time - and that’s OK! It’s better to not rush into a huge amount of debt on a whim than regret your decision. Don’t think of it as time wasted since you’ll probably have learned a lot of important things during the process that you can use next time you start your search!

Let’s review one way to assess the rent v. buy decision.

As stated earlier, simply comparing the cost of a mortgage to rent is inaccurate and an easy way to dig yourself into a hole. This is because when you pay rent, your landlord is using a PART of your rent payment to pay for the mortgage and the REST to pay for property tax, insurance, maintenance and repairs, capital expenditures, etc. All of this is already baked into the rent. These are added costs that you will incur in addition to the mortgage when you buy. And your landlord is HOPING there is extra left over to be able to profit on his/her investment.

So should you rent or should you buy? You can ballpark this with Ben Felix’s 5% rule.

Let’s say you’re evaluating a $400,000 house. Multiply this by 5% or 0.05. This will give you $20,000. Then divide this by 12. This results in $1,666.67. Let’s round it off at $1,670 per month. If you can rent this house for less than this amount ($1,670), you are getting a deal (assuming you can afford the payment - rule of thumb is that your gross monthly income is 3 times the rent at $5,000).

Where does the 5% come from?

Essentially, it comes from three components that add up to 5%. The cost of equity/debt capital is 3%. Property tax is roughly 1%. Maintenance and repairs are also roughly 1%.

Property tax and maintenance and repairs are 1% each, and this is something we can easily wrap our head around.

The cost of equity/debt capital comes from the opportunity cost of not being able to invest the cash into stocks which lead real estate by 3%. The cost of debt is also estimated at roughly 3% (outside of extraordinary situations like the one we are in currently). While many think home loan interest rates are driven by the federal reserve interest rate, this is actually incorrect. They are associated with 10 year treasury notes.

In any case, this is just a rule of thumb. This is inexact. I think we can do one better and add up the different line items to get the true cost of owning a house.

Please see this link for a calculator (click me) that accounts for these additional expenses, which is a bit more precise than the 5% rule. Also, you can modify this to your home search and local geography.

What are all of the line items that are associated with home ownership?

They are as follows:

1. Mortgage

2. Utilities: Gas, Power, Water, Sewer, Trash, Internet

3. Property Tax

4. Homeowners insurance

5. Maintenance and repairs

6. Homeowners Association (HOA) dues: These vary widely depending on HOA.

7. Private Mortgage Insurance (PMI): this is something you pay for if you didn’t make a 20% down payment. If you didn’t (and I didn’t either), this falls off once your loan-to-value (LTV) ratio hits about 80%.

The cost of renting is as follows:

1. Rent

2. Utilities

If you add up all the numbers for buying and these significantly exceed the cost of renting, you may want to rent or continue to rent. However, if they are reasonably close, you may want to buy. This is because if you have a fixed rate conventional loan, your mortgage won’t go up. However, the rent could go up - quite significantly, in some geographies. However, since so many wannabe landlords are flooding the property marketplace, there could also be an excess supply of rentals in your geography (if there isn’t already), driving rents down since they are competing with each other on price.

I hope this post gives you a bit to think about as you navigate the rent vs. buy decision, and let me know if you find the calculator to be useful.

While buying or renting a home is one of the biggest decisions you'll make, it's important to have a strong foundation in personal finance education. How can you get all of the battle-tested, tried and true knowledge as quickly as possible? I wrote a book explaining exactly this; it's short; it's cheap, and it's written in plain English. You can find it here: https://amzn.to/32PLB3x. You may also want to consider subscribing to this blog by entering your email on the homepage next to the “Never Miss a Post” section and following the podcast “Nondelusional Investing” wherever you get your podcasts.

Is there anything you found useful or that I missed above? If so, please leave a comment in the comment box below.

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Disclaimer: The article above is an opinion and is for informational/educational purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice. The author has taken care in writing this post but makes no expressed or implied warranty of any kind and assumes no responsibility for errors or omissions. No liability is assumed for incidental or consequential damages in connection with or arising out of the use of this information.