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Seeing Green: Should You Buy Or Rent A Home?

Tom Lehman designs software for a hedge fund in Manhattan. Every morning he goes into work and turns on a machine that makes other people rich; every evening he turns it off (he's looking into leaving it on overnight). In … Read More

By / May 29, 2008

Tom Lehman designs software for a hedge fund in Manhattan. Every morning he goes into work and turns on a machine that makes other people rich; every evening he turns it off (he's looking into leaving it on overnight). In his spare time, he'll be helping Jewcers navigate the economic decisions in their lives.

David Leonhardt, the New York Times economic scene writer, has been "an evangelist for renting" in recent years, but in yesterday's Times, he made the case for buying a home. The basic idea is that buying is becoming more and more attractive as home prices decline, and Leonhardt came up with a metric he calls the "rent ratio" to decide precisely when it's time to buy:

You find two similar houses, one for sale and the other for rent, and divide the sale price by the annual rent. You can call the result the rent ratio.

The concept will probably sound familiar to stock market investors. It’s the real estate market’s version of a price-earnings ratio — a measure of how expensive an asset is, relative to the underlying economic fundamentals. Like a P/E ratio, the rent ratio provides something of a reality check.

He goes on to say that a rent ratio of 20 is too high to buy, but a rent ratio of 15 is pretty good, blah blah blah.

Of course this is all total bullshit.

Just as there's no "magic formula" for picking stocks based on their P/E ratios, there's no way to pick cheap houses based on their rent ratios. To see why, consider this thought experiment: Why does the author buy only one house? If renting is such a rip, and buying is such a steal, why not buy a bunch of houses and rent them to idiots?

"But Tom!", you might object. "Seriously. You are ignoring the fact that we don't live in a frictionless world! Being a landlord is a pain in the ass — it's too costly for him to become one just because home prices are good."

Ah, but here's the thing. If you think real estate is priced too low relative to the rent it can fetch, you don't have to actually buy physical property or be a landlord to make money. You can just buy a Real Estate Investment Trust. Someone else manages the property for you and you get the return. So if Leonhardt really believes what he says, he'd greatly increase his investment in REITs. However, he's not going to because you can't time the market, you idiots.

To see why this is so complicated — and why there's no chance Leonhardt practices what he preaches — check out the buy v. rent calculator linked in the article. In order to make the correct decision about buying v. renting, you have to know (with pretty high precision): (a) annual home price appreciation, (b) annual rent increase/decrease, (c) rate of return on investments (i.e., the opportunity cost of capital), and (d) the inflation rate. Good luck with that.

And of course these factors are all intimately related to each other (even though the calculator treats them as independent variables). Any confidence you have that buying a home is a good idea can be translated into confidence in your ability to estimate the above 4 factors (and some others). If you're not confident estimating these factors (and really, who can be?), you shouldn't be confident that buying is better than renting.

I prefer a more abstract approach. On the margins, renting and buying should only differ in the sense that they are somewhat different products. When you rent you can move whenever you like and you don't need great credit. When you buy you can modify the house, you can't get kicked out, and you get satisfaction from owning a home. Moreover, everyone — even people who own their own homes — pays rent. The only difference between a renter and a buyer is that renters pay rent by cutting a check every month to their landlords, and buyers "pay rent" by forgoing the income they would get by renting their homes to someone else. Regardless, both renters and buyers will end up with $X less in their wallets every month, where X is the rent their home fetches.

Save yourself the headache and just pick whichever product appeals to you more.

(Me? I'm going to rent as a middle finger to the whole BS "culture of home ownership" we have in the US.)

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