While the title of this article sounds like the name of a classic Tupac Shakur song or a famous 1980s cop movie, it is actually an important question that not enough people in this city (and the rest of the country) ask themselves -- but one most people should ask themselves. With homeownership rates near 20-year lows, it is clear that for one reason or another, Americans and especially Californians aren't buying houses as much as they used to. Why, you ask? A number of factors come into play: the rising price of homes, comparatively lower average income, the wanderlust effect, delayed family life of the Millennial generation, and other shifts in spending habits and priorities are all reasons that have led to a drop in homeownership. If you're one of these people who have swept the homeownership question under the rug, you could be leaving some serious money on the table.
There's Money on the Table
That being said, the decision to buy or rent is completely circumstantial and personal, and comes down to more factors than just money. However, what if I told you that under the right circumstances, buying a home is actually cheaper than renting the same house or apartment? Even if you were only planning on living there for a few years? The fact is, a lot of people shrug off the idea of buying a home because they think it will cost too much and is too much of a hassle. But the process of purchasing isn't all that hard, and a lot of the time, the savings you get from not having to pay rent combined with the appreciation of the value of your home more than offsets your homeowners' expenses! Which means that you actually make money by buying a house.
Still confused? Let's go over a simple example to get the point across.
Example: Jonny & Kate's Condo
Jonny and Kate are renting a condo in Brentwood for $4,000 per month. The condo is put up for sale by the owner at the price of $1,000,000. Jonny and Kate talk to their financial advisor, who tells them that as long as they can afford a 20% down payment (and they can, they've been saving up) their total monthly payments will still be just around $4,000! Plus, when they want to move, they can sell the place and realize a handsome capital gain from the rise in value of the home! So their monthly expenses won't change much, and they'll get a big payday when they sell. So, when you rent, you pay a steady, considerable sum of money monthly. When you buy, you invest a larger sum at the beginning, a similar amount to renting each month (in a lot of cases), and then you generally receive a fairly large sum of money when you sell down the road.
Let's examine these two distinct cash flow patterns a little more closely.
Jonny & Kate: Analysis
In the Excel analysis, you can see the top line labeled "Renting", which displays yearly cash outflows of $48,000 ($4,000/month). When you leave or move out, that's it, you stop paying the rent, and you're left with having paid a boatload of money to a landlord that you'll never see again.
Now below renting, there is the section labeled "Owning". Here, we take a look at the cash flows involved with Kate and Jonny owning the same Brentwood condo they were renting. First, we now see $48,000/year as a positive number - you can think of this as the money that Jonny and Kate are saving each year because they don't have to pay rent. It is also rent money they would actually receive if they were to move somewhere else and rent out their condo to a tenant. You can also think of it as the "rent" that Jonny and Kate pay themselves for living in the condo they own.
On the next line, we start the calculations related to the mortgage. Jonny and Kate are buying the condo with a 20% down mortgage, meaning they put down an initial investment of 20% of the purchase price, which here is $200,000. Combine that with an estimated 1% of the purchase price in closing costs, and you have an initial investment of $210,000, which is a negative cash outflow. It sounds like a lot to invest, but we'll see soon that this investment is going to yield more money than it would if it were invested in the stock market. Next, we see the annual mortgage payment breakdown. The mortgage payment is composed of a) principal reduction, and b) interest payments. Together, they combine to form the Total Mortgage Payment. Jonny and Kate pay that monthly to the bank to a) pay back some of the money they borrowed, and b) compensate the bank for their risk in loaning out the money. We take the mortgage payment, combine it with the annual insurance and tax payments, and subtract that from their "income" of free rent to get the Pre-Tax Cash Flow for each year.
Finally, we've reached the number we've been looking for -- but wait a minute. Before we compare the ownership cash flows to the renting cash flows, we have to factor in the tax savings involved in paying mortgage interest, a benefit only afforded when you buy. As of 2017, the IRS allows individuals to deduct up to $750,000 of mortgage interest payments per year from their taxable income. In effect, this directly reduces a borrower's tax bill at the end of the year by the amount of interest paid times their marginal tax rate. So, in order to accurately show the net cash flows of owning this Brentwood condo, we have to add a positive cash flow in the amount of the tax savings, which again is the interest amount paid times Kate & Jonny's marginal federal & state tax rate, which here we've estimated to be 40%. In effect, Kate and Jonny are only really paying 60% of the interest the bank requires of them, because the United States & California governments pay them back the rest! So, we finally arrive at After-Tax Cash Flows. The next line shows us the approximate amount of money they'll net after they sell the property after 10 years. And finally, we have Net Cash Flows, factoring in all investment costs, annual "operating" cash flows, and capital gains from selling the condo.
This final row is what we can use to compare buying this condo to renting it, and because we've already factored in the "NOT Paying Rent" as income in the ownership scenario, we can read it like this: "Year 1 of owning this condo costs $3,108.85 less than it would to rent it. Of course, at the purchase aka "Year 0", a sizable down payment is required to buy, where it is not required when renting. However, this is a small price to pay for the benefits, as we can see that each year, the cost of renting goes up (3% is a standard rent growth estimation), and ownership expenses go up by less than that, so the savings increase the longer K&J own the home. In addition, each year they pay their mortgage, a portion of the payment goes to reducing the principal balance, which means that they are paying down the debt, to the effect of accruing equity, or ownership, in the home. Property values also tend to grow with rent, so in addition to the accrual of equity through debt paydown, Kate & Jonny are accruing equity through the appreciation of the property, or the increase in value of the property.
All of this equity gets realized when they sell the home after their 10th year of ownership. They receive over $1.3M for the home, which, after selling costs and full repayment of the remaining loan balance, nets them $709,845.48. Holy cow. The best part about this gain? You guessed it: another tax benefit from the IRS. As of this writing, individuals are exempted from capital gains taxes up to $250,000 on the sale of their primary residence, granted that they've lived in the home for 2 of the last 5 years. Under the same qualifications, married couples filing jointly are eligible for up to $500,000 of exemptions.
Is It Worth It?
So now you must be wondering: Okay great, Kate & Jonny get to save a little money each year buying, and get a really nice payday of around $700,000 ten years from now, but that seems so far away, and they have to invest $200,000 up front! Are the time-valued returns worth it? Wouldn't Kate & Jonny be better off just keeping their $200,000 in their investment account at the bank and letting it grow there?
For this, we look to the IRR, or the Internal Rate of Return. This figure tells us how much of an annualized return we get from this house purchase when also factoring in the time-value of money. In our example, we get an IRR of 13.6%, which indicates that to achieve the same return on their money, Kate & Jonny would have to invest in something else, like a stock portfolio or mutual fund, that achieves an annualized return of 13.6%. These are hard to come by.
It depends on your particular and personal investment strategy, but I will go ahead and throw out a very loose number for the average target hedged investment portfolio at 7%. With this "required return" of 7%, the couple actually earns a 6.7% premium for buying the house instead of keeping the money in their investment account! In Kate & Jonny's case, it certainly makes more sense to buy the condo than rent it.
Try It!
Curious about your personal living situation? To learn more about the tradeoffs between renting and buying, and to try the calculations yourselves using a free, easy-to-use online calculator, check out the New York Times articles below:
Thank You
Thanks for reading, and if you have any questions or just want to chat, feel free to hit the contact form at the bottom of the homepage, or e-mail me directly at daniel@rosenwaldequities.com
P.S., Do You Want to Invest in Los Angeles Real Estate?
Rosenwald Equities will be opening its first few fundraises in the coming weeks. If you or someone you know is interested in investing in Los Angeles apartment buildings through a professional investment company, please feel free to reach out to me at daniel@rosenwaldequities.com or use the contact form at the bottom of the homepage, and I'll be happy to answer any questions and see if these projects are a good fit for your investment needs.
Sources
California's Low Homeownership Rate to Continue | journal.firsttuesday.us
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