While many older relatives, friends, and real estate agents may assure you that buying a house is always a good idea, the relative merits of buying and renting depend on a large number of variables, financial and otherwise. Run the numbers yourself and consider the arguments below when making your decision.
Don’t get distracted by the ‘buy vs. rent’ debate—the cost difference in most scenarios is modest. To save significant money, buy or rent a smaller, less expensive place!
Real estate is a historically terrible long-term investment, yielding just over 0% inflation-adjusted return over the last 100 years. Imputed rent rarely compensates for 0] debt service, 1] property taxes, 2] maintenance and repairs, 3] transaction taxes and fees, 4] lack of diversification, 5] ultra-high leverage, and 6] illiquidity. In lifestyle engineering terms, tying oneself to a physical location via a highly-leveraged financial contract (‘mortgage’) greatly reduces the personal flexibility to change locations, and carries with it a difficult-to-avoid temptation to accumulate a vast collection of unnecessary junk.
Real estate upkeep and upgrades soak up significant time and money, and little you can do to a property will improve its resale value. There is also uncertainty whether the federal mortgage deduction will continue to exist for the 20-30 year duration of a modern mortgage.
While it’s true that “you can’t live in a mutual fund,” you can live in an apartment, pay rent, transfer all of the nasty speculative risks of real estate to zillionaires who can afford to pay for the privilege in cash, invest the rest in the stock (historical returns: 5-7%) and bond (historical returns: 1-3%) markets, and come out ahead. The bursting of speculative real estate bubbles offers a unique opportunity to buy below market value, but the game is less than zero-sum after transaction costs are considered, and buying after a crash doesn’t negate the other negative properties of real-estate-as-financial-investment.
This isn’t to say that real estate speculation (by definition, that’s what it is) doesn’t have winners—all casinos have their victory photos. This is to say that, in general, on average, historically, real estate hasn’t paid off. Having real estate may be desirable or enjoyable to many people, but it is rightly viewed as a a privilege with a cost, not as a money-making endeavor.
Many books and articles have been written on this topic, so I won’t repeat it all here. Watch for a full real estate article on my site later this month.
http://www.jamesaltucher.com/2011/03/why-i-am-never-going-to-own-a-home-again/
It can be argued that indiscriminate homeownership is a cornerstone of modern self-inflicted wage slavery. Upper management at major companies regularly joke that “get ‘em a house, get ‘em a spouse” is the surest way to retain employees. If you want to buy, tread carefully, crunch the numbers, and consider these potential downsides:
Downside #1: Assuming you own only one property, your real estate holdings are not in any way diversified. A large portion of your net worth—and any desires you might have to relocate—are at the mercy of the local housing market. Renters can diversify their investments across many types of assets and completely ignore local real estate fluctuations when making the decision to relocate.
Downside #2: Real estate transactions are expensive and time-consuming. If you hire a real estate agent to sell your home, expect to pay them 6% of the sale value. Renters need only give one month’s notice and put their old security deposit toward a new lease in order to move.
Downside #3: Property maintenance is your problem. As a renter, you can defer upkeep to the owner or management company.
Downside #4: Property ownership permanently increases complexity and reduces flexibility to deal with major life events (job loss, divorce, death), neighborhood environmental changes, and shifts in personal preference. Renters are free to move for any reason with low transaction costs and limited planning.
Downside #5: Home equity can’t be partially cashed in (without paying interest on a HELOC or eventually losing the property with a reverse mortgage); if you insist on owning a home for the rest of your life, that portion of your net worth is permanently locked away in an inaccessible form. Renters can easily liquidate some of the investments they purchased instead to cover expenses or start a new venture.
Downside #6: Homebuyers may be driven to overbuy by a psychological propensity to believe that they “may want the space later.” Renters can rent larger when they need it and rent smaller when they don’t.
Downside #7: Owning may encourage significant additional expenditure on property improvements and “things to line the nest”.
Downside #8: The cost of renting is right on the box; the cost of owning is complicated by debt service, property taxes, maintenance, insurance, transaction costs, opportunity costs, tax incentives, and home appreciation. Average long-term rates of return on housing have historically lagged the stock market by a significant margin.
Many people believe that they can significantly increase the resale value of their homes by remodeling. This is not necessarily true.
Hanely Wood Remodling publishes an annual Cost Vs Value report, which compares the average cost of paying a contractor to perform 35 remodeling projects with the value those projects add to the resale price when sold within one year of remodeling: http://www.remodeling.hw.net/cost-vs-value/2014/
None of these projects adds more than 100% of the cost to the resale value, meaning that none of them have a positive financial return. In fact, most of these projects increase resale value by only 50-75% of the cost—a financial return of -25% to -50%.
What if you skip the contractor and build ‘sweat equity’ by doing it yourself? This depends on whether you already possess the skills and tools and how you would account for the time invested: would you enjoy it, or would it ruin your free time, strain your relationships, and stress you out? Even if you DIY, some improvements—HVAC, high-end fixtures, landscaping, special-use rooms, overbuilding for the neighborhood—usually add little value and even make it more difficult to sell: http://www.forbes.com/sites/investopedia/2013/05/19/6-things-you-think-add-value-to-your-home-but-really-dont/
Buying smart and renting can make money. But make no mistake: being a landlord is a business that requires significant work, planning, knowledge and assets; it is in no way comparable to the alternative of renting, tossing money into the stock market, and forgetting about it.
“Dampening property prices hurts one of the few routes to wealth-accumulation still available to the middle classes.”
“But land-use rules have evolved into something more pernicious: a mechanism through which landowners are handed both unwarranted windfalls and the means to prevent others from exercising control over their property.”
“Second, governments should impose higher taxes on the value of land. In most rich countries, land-value taxes account for a small share of total revenues. Land taxes are efficient. They are difficult to dodge; you cannot stuff land into a bank-vault in Luxembourg. Whereas a high tax on property can discourage investment, a high tax on land creates an incentive to develop unused sites. Land-value taxes can also help cater for newcomers. New infrastructure raises the value of nearby land, automatically feeding through into revenues—which helps to pay for the improvements.”
http://www.economist.com/blogs/freeexchange/2015/04/land-value-tax
“Landowners, in other words, enjoy unearned income from the benefits bestowed by good transport links, and proximity to customers, suppliers and other businesses. Once they have bought their land, they keep this money. “
“Most taxes do not just depress economic activity; they also displace it—for example to offshore financial centres. The faster that tax collectors crack down on loopholes, the more clever accountants find new ones.
Land-value taxes, on the other hand, lack these perverse effects. They cannot reduce the supply of land, or distort decisionmaking. Instead they may even stimulate economic activity, by penalising those who hoard land and keep it idle (a big plus in desolate post-industrial cities where much land is vacant). The tax drives the land price down by the capitalised value of the future levies—theoretically even to zero—until someone finds a use for the land. Collection is cheap. Unlike profit, you cannot massage land away or move it to Luxembourg. If you do not pay, it can be seized and sold. Though nobody likes extra taxes, new land-value levies could be matched by cuts in other taxes, especially those paid by poor people.”
“Rich people tend to own a lot of land, poor people very little. For that reason it wins favour with economists who worry about inequality, such as the Nobel-prize winner Joseph Stiglitz. He argued in a recent paper that land and housing, rather than the distribution of income and productive capital, are the key to a fairer economy. When public investment improves the value of a site—for example by building a new road nearby—the benefit comes back to the community in the form of higher tax receipts, rather than ending up as a windfall in the pockets of the owners. Taxing the unearned income that landowners enjoy should curb the boom and bust cycle in land prices. Environmentalists like it because it limits urban sprawl: better to build upwards than outwards. In the New York metropolitan area, the price of land has risen five-fold between 1986 and 2014, according to research by the Lincoln Institute, a think-tank.
Other economists like it too. Adam Smith said “nothing could be more reasonable”; Milton Friedman termed it “the least bad tax”. Winston Churchill said scornfully that a landlord “contributes nothing to the process from which his own enrichment is derived”.”
Have American Homes Changed Much Over the Years? Take a Look.
The American Dream: Seven Decades of Housing Trends
http://www.mrmoneymustache.com/2012/01/25/reader-case-study-student-loans-or-saving-for-a-home/
http://www.mrmoneymustache.com/2012/02/24/pay-down-the-mortgage-or-invest-more-a-winwin-question/
http://www.mrmoneymustache.com/2011/05/23/get-rich-with-owning-rental-houses/
http://www.mrmoneymustache.com/2012/04/25/unlocking-your-home-equity-for-profitable-investments/
http://www.mrmoneymustache.com/2013/08/18/reader-case-study-the-black-hole-second-home/
http://www.mrmoneymustache.com/2011/05/11/the-elephant-in-the-room-housing/
http://www.mrmoneymustache.com/2013/09/04/how-and-how-not-to-buy-a-house/
http://www.mrmoneymustache.com/2011/05/24/mmm-challenge-get-yourself-a-lower-mortgage-rate/
http://www.mrmoneymustache.com/2012/02/24/pay-down-the-mortgage-or-invest-more-a-winwin-question/
http://www.mrmoneymustache.com/2011/07/20/get-rich-with-carpentry-and-home-renovation/
http://www.mrmoneymustache.com/2011/11/18/first-understand-then-destroy-your-home-heating-bill/
http://www.mrmoneymustache.com/2012/07/02/hacking-home-depot-to-save-big-bucks-on-renovations/
http://www.mrmoneymustache.com/2013/01/04/shit-happens-to-mr-money-mustaches-house/
http://jlcollinsnh.com/2012/02/23/rent-v-owning-your-home-opportunity-cost-and-running-some-numbers/
http://jlcollinsnh.com/2013/03/20/roots-v-wings-considering-home-ownership/
http://jlcollinsnh.com/2013/05/29/why-your-house-is-a-terrible-investment/
http://jlcollinsnh.com/2013/04/06/homeless-and-a-bit-on-the-strategy-of-dollar-cost-averaging/
http://rootofgood.com/budget-home-repairs-billion-dollar-project/
http://jlcollinsnh.com/2013/05/09/how-we-finally-got-the-house-sold/
http://jlcollinsnh.com/2014/02/20/case-study-10-should-josiah-buy-his-parents-a-house/
a) to lock people in a new and very interesting form of wage slavery
b) to encourage them to spend all sorts of money they don't have on upgrades and accouterments for their new nest
because the fact is, for the vast majority of American households, the home is by far their largest investment
and for an uncomfortably large fraction, it's basically their _only_ investment
many households with net assets near or below zero still own homes!
and it represents a massive asset sink that (historically) may or many not appreciate faster than inflation
and even when it does... that appreciation is still locked in the asset itself
you can't pay your electricity bill with the appreciation on the home you're living in
(unlike, say, the dividends and capital appreciation of a mutual fund)
so, you're stuck
for as long as you're paying that mortgage, you _need_ that job
and even after, you now own a gigantic, completely non-diversified asset with annual fees and very high transaction costs
and you still _need_ that job to pay the bills
especially with my stated goals of using my assets to cover all of my expenses
because an increase in home valuation is only a _virtual_ increase in wealth
it's not like a stock dividend or capital appreciation
you can't take your excess home valuation and pay your bills with it
I could have a million dollars
and look like I'm ready to retire
but if half of it is locked up in a home...
I can't access that value to actually _do_ anything with it
unless my 'plan' is to treat the house entirely like an investment
to sell and downsize
so really, _because_ of the fact that I do need somewhere to live
owning a home only makes sense if imputed rent > maintenance + insurance + property taxes
totally disregarding any valuation increase on the house
unless I can magically sell the house at some future time and take up residence nowhere
then it's a big gamble
because the valuation could go down just as likely as it could go up
totally dependent on the housing market in your region
and a million factors you can't really predict long-term
case in point: due to the US Air / United merger, Philly might lose its hub status
which would be rather bad news for the businesses (and the land values) in the region
they've already announced they're cutting Cleveland, and looking at cutting other places to reduce costs
I am one of those people who would very much like a more detailed analysis of MMM's assets-vs-time
he's doing the landlord thing, obviously
which totally changes the game
it's a pretty major commitment, in terms of capital, effort, and expertise
in any case, this idea that "it's insane not to buy a house" is definitely flawed
in the past fifty years, houses in the US have also increased in size by a factor of four
by which I mean, the average person has four times more square footage than someone in the 50's
(which ironically explains much of the increases in home sale prices—today's homes are much larger than yesterday's!)
and oh by the way
once you own this lovely structure
you must heat it
clean it
landscape it
fill it with shit
average American spends over a third of their post-tax income on direct housing costs
you're somewhat at the mercy of the local housing market
it could be that you want to move, but too bad
prices have slumped or no one is buying
it also ignores the complicating factors, for instance whether home ownership encourages junk accumulation more than renting
and the time cost of managing your own maintenance, renovation, etc
and yeah, all of those curves assume that housing value changes smoothly
which it doesn't
and selling a house is a non-trivial exercise
exactly
whereas I can call the landlord and say 'I'm moving next month, see you later'
I would also bet that most people overbuy
because 'we might want the space later'
the opportunity cost of overbuying could be very significant
as opposed to scaling up when you need the space, and scaling back down when you don't
if you think about it, the mortgage makes sure you 'need' your job
and it cripples your geographic mobility
I feel like that's in a company's interest
let's say your home accumulates in value a bunch
versus let's say your other investments accumulate in value a bunch
in the latter case, I can move the money into bonds, retire, and use the dividends to pay the bills
but you can't use home equity to pay the bills
you can't sell off slivers of your house to finance other things
it's all or nothing, and the money is stuck in a single giant asset unless you sell it and start renting or downsize
I feel like it works out great IF you have huge amounts of capital to play with
if you don't, you still have the diversification problem
and all of the other problems
but if you can pay in cash and skip the debt service on the mortgage...
and better yet, if you can buy multiple properties...
especially if you can spread them out geographically...
that's a completely different story
but now you're a landlord, and that's a job
you can pay someone else to manage it for you, and now you're a business owner
but that's a serious investment of time, expertise, and capital
and not really comparable to the 'buy a McMansion' approach of most people
which may be why people get confused about real estate, and how good of an investment it is
It's probably a great investment if you already own the universe
for most people, it's their biggest asset
for many people, it's their _only_ major asset
and they're not renting
out the extras rooms
playing landlord isn't comparable to the alternative
investing the money and forgetting about it