This is the second part of a two-part discussion on real estate. The first part covered buying real estate as an investment, and showed that buying individual rental properties is not an optimal investment strategy. This part covers buying real estate to live in. Before I go into the analysis, let me cover two of the most common arguments I hear for buying vs renting.
"Paying rent is just throwing money away."
How did paying for shelter turn into throwing money away? And where do you draw the line, is paying for your groceries instead of growing it yourself also throwing money away? The real consideration should be whether the costs of buying is more or less than the costs of renting. Remember, buying also has costs that add up very quickly like mortgage interest, property taxes, maintenance/repairs, home insurance, commissions, and closing costs.
"If you’re going to pay more than $3,000 (or any number) in rent, might as well buy."
What makes $3,000 that magic number where buying makes more financial sense than renting no matter what? Even paying $10,000 a month in rent can make perfect financial sense if buying the same property would cost you more than $10,000 a month. What matters is the relative costs of the two options, not the absolute level.
The analysis in this post is going to be more rigorous than these types of arguments. In fact, I’d say it’s even more complete than popular rent-vs-buy calculators because in addition to return, we will also consider risk. Most of those calculators completely ignore risk, concentrating purely on return.
In the first part, we already discussed the advantages of buying a house to live in vs buying a rental property:
- Mortgages are cheaper and easier to get for owner-occupied properties
- Tax law makes owner-occupied properties more tax efficient than investment properties
- There are non-financial benefits of owning the house you live in
Considering these advantages, let’s analyze the financial characteristics of buying a home using the same methodology we used in Part 1. The following table summarizes the return and risk analysis using long-term averages. The only differences are that a lower mortgage rate of 5% is used and homeowner tax benefits are included. The implied rent is included as part of the return.
| House, No Mortgage | House, 50% Down | House, 20% Down | US Bonds | US Stocks | |
| Long-Term Return (After Inflation) | 3.6% | 6.2% | 13.8% | 2% | 6% |
| Mortgage Leverage | 1x | 2x | 5x | ||
| Price Risk (Asset Class) | 18.6% | 37.2% | 93% | 13.8% | 41.4% |
| Price Risk (Single Property) | 20.8% | 41.6% | 104% | ||
| Return-Risk Ratio | 0.175 | 0.148 | 0.133 | 0.145 | 0.145 |
It looks like owning your home with about half the house paid off is similar in risk and return to investing in stocks. Paying off the mortgage reduces the return, but in this case is still a decent investment, returning more than bonds. And since this assumes a holding period of 7-10 years, having to sell earlier than that will lower returns since transaction costs are spread over a shorter time period. Returns will also drop if you move and rent out the house due to the loss of tax benefits.
Like Part 1, let’s see how those numbers look for the 10 year period starting today. Again, I assume US stocks are about 50% overvalued, and US residential real estate about 20% overvalued. US bond returns are expected to be a little lower than usual based on current 10yr TIPS rates.
| House, No Mortgage | House, 50% Down | House, 20% Down | US Bonds | US Stocks | |
| Current 10yr Return (After Inflation) | 1.3% | 1.4% | 2.0% | 1.5% | 1.8% |
| Difference from Long-Term Average (Above) | -2.4% | -4.7% | -11.8% | -0.5% | -4.2% |
| Mortgage Leverage | 1x | 2x | 5x | ||
| Price Risk (Asset Class) | 18.6% | 37.2% | 93% | 13.8% | 41.4% |
| Price Risk (Single Property) | 20.8% | 41.6% | 104% | ||
| Return-Risk Ratio | 0.061 | 0.035 | 0.019 | 0.109 | 0.044 |
Although the return prospects for buying a home with 20% down and investing in stocks are similar (both ok, not great), the risk involved in buying a home is much greater. On a risk-return basis, only buying a house with cash exceeds stocks; no option exceeds bonds.
In deciding whether to buy or rent, you must also consider other factors, although some are mitigated by living there.
- Indivisible: You cannot easily buy or sell in small increments.
- Undiversifed: The home is a large bet on one property, in one neighborhood, in one city, in one country.
- Illiquid: Buying or selling real estate properties can take months.
- Loss of flexibility: If you change jobs, you may face longer commutes or be forced to sell the house earlier than expected, lowering returns. Or, it may even inhibit you from looking for or accepting better jobs elsewhere.
- Management: Your time and effort is required to manage the property.
Ultimately, your decision to rent or buy will depend on both financial and non-financial factors. Financially, it seems like a buying a home is a decent investment under typical conditions if you can handle the additional risks and responsibilities. However, under current conditions, buying a home would only make sense if the non-financial benefits outweigh low return prospects as well as the risks and responsibilities.
Spreadsheet for those interested.
How are the Price Risk %s derived?
For stocks, I fit an exponential trend line to inflation-adjusted price data from 1871 to 2009. 41.4% is the standard deviation around that trend line.
For real estate, I did the same thing using price data from 1890-2009. However, this data series is for real estate as a whole, so the risk for one property was calculated by assuming an 80% correlation across all home prices (you can change the correlation in the spreadsheet). For scenarios with a mortgage, I just multiplied the risk by the leverage.
For bonds, I used the average 10yr rate (4.7%) as the coupon to convert an interest rate time series from 1871-2009 into a price one. Then, I calculated the same thing: trend line and standard deviation around trend line.
One quick sanity check: Using these calculations, the risk of a 50% financed house is similar to that of stocks. REITs are typically 50-60% financed.