Rent or Buy – The Verdict Is In

Purchasers of property, particularly first time home buyers, often face the question of whether they should rent or buy.  Historically, rent was thought of as a cheaper alternative to purchasing a home and paying a monthly mortgage.  However, recent drops in median sale price of homes as well as interest rates have driven down the monthly cost of a mortgage, while median monthly rents have gradually increased.  As a result, the current market heavily favors purchasing a home over renting.

Rent or Buy – Historical Trends

Prior to the housing market crash of 2007, consistently increasing home prices and interest rates above six percent resulted in a significant disparity between the monthly cost of home ownership as opposed to rent.  In Los Angeles, the annual median home sale price and interest rate dropped from its peak of $589,170 and 6.34% in 2007 to $327,470 and 3.66% in 2012.  Meanwhile, during the same period, median monthly rent increased from $1,036 to $1,175.  The below graph, containing the most recent available information between 2005 and 2012, clearly displays the downward trend in the cost of owning a home as opposed to the slight upward trend in the cost of renting.

Median Monthly Rent Data Source – United States Census Bureau
Median Monthly Mortgage Data Source – California Association of Realtors

Thus, the decision to rent or buy from a historical perspective heavily favors buying.  There are, of course, other costs of owning a home that are not accounted for in the above graph, but those costs are significantly outweighed by the benefits of home ownership.  The additional costs include homeowners’ insurance, which adds approximately $50 per month to the cost of owning a home according to homeinsurance.com.  Another additional cost is property tax of 1.22% in Los Angeles, which amounts to approximately $332.93 per month based on the median sale price in 2012.  The benefits, however, are significant.  Most significant is that a portion of the mortgage payment is not truly an “expense” when compared to rent, because a portion of the payment is allocated to paying down the principal amount of the loan, i.e. building equity.  Another benefit is the tax deductibility of mortgage interest and property tax payments, effectively reducing the monthly expense of a mortgage.  Lastly is the investment aspect of home ownership, which allows home owners to realize a gain on their purchase, whereas renters do not build equity and have no potential for investment income.

Thus, the current market heavily favors home ownership rather than renting.  This trend, however, may not last long, as prices have steadily increased since 2012, and interest rates have nowhere to go but up.

Current Trends And What Others Are Saying About Rent Or Buy

The consensus is relatively unanimous that the current market favors home ownership rather than renting.  Deptofnumbers.com reports that renters in Los Angeles are gradually spending a larger fraction of their income on rent.  Zillow recently concluded from a study that “[b]uying a home remains a real bargain compared to renting in most areas nationwide.”  A separate Zillow study also concluded “[r]ental affordability is currently much worse than mortgage affordability, largely because rents didn’t experience the huge drop seen in home values during the recession, and instead have just kept their upward trajectory.”  Those conclusions are also consistent with a study conducted by the UCLA Ziman Center for Real Estate, which concluded that “rents have risen faster in Los Angeles than in the nation as a whole” and “the gap between rent and renter incomes has widening [siq], and that rent growth in Los Angeles has outpaced growth elsewhere in the U.S. despite declining incomes.”  Thus, recent trends and market analysis heavily favor buying in the decision to rent or buy.

Determining Whether You Should Rent Or Buy

Of course, each specific buyer’s circumstances are different, and so general market trends do not necessarily determine whether a particular individual should rent or buy.  In order to answer that question, buyers will need to dust off their algebra books and do some math to figure out how the cost of home ownership compares to renting.  Thankfully, we have pulled together the following equation to assist you with the process:

x – x * y – x * z * t + h + p * .0122 / 12 * (1 – t) = r

x = Monthly Mortgage Payment
y = Percentage of Monthly Mortgage Payment Attributable to Reduction of Principal
z = Percentage of Monthly Mortgage Payment Attributable to Interest
t = Marginal Tax Rate
h = Monthly Cost of Homeowners’ Insurance
p = Property Purchase Price
r = Monthly Rent

For those of you not already sufficiently confused, the following is an example applying the above concept.  Let us assume an individual purchases a home for $600,000, making a downpayment of $120,000 (20%) and obtaining a 30-year fixed rate loan of $480,000 at 4.00%.  Using this online monthly mortgage calculator, we see that the monthly mortgage is $2,291.59, approximately 42% of the total payments are attributable to interest, and approximately 58% of the total payments are attributable to principal.  If we assume the monthly cost of homeowners’ insurance is $50, based on the median in Los Angeles, and the purchaser’s marginal tax rate is 33%, we come to the following conclusion:

2,291.59 – 2,291.59 * .58 – 2,291.59 * .48 * .33 + 50 + 600,000 * .0122 / 12 * (1 – .33) = $1,058.18

This means that a monthly mortgage of $2,291.59 is equivalent to paying a monthly rent of $1,058.18.  In other words, a well qualified individual spending $1,058.18 per month on rent would be just as well off purchasing a home with a 30-year fixed rate loan of $480,000 at 4.00%.  There are other factors, such as maintenance costs incurred by home owners, that may slightly affect the calculation, but those factors are likely outweighed by the potential investment income purchasing a home provides.

Conclusion – Buying Probably Currently A Better Option Than Renting

The current state of the market heavily favors purchasing a home over renting.  While rents are at historically high levels and are continuing to rise, the historically low interest rates and relatively deflated real estate market have significantly decreased the cost of home ownership.  Renters who are considering entering the market should seriously consider whether it makes sense to delay the decision given impending increases in interest rates.  Of course, each individual’s decision will depend on their particular circumstances, but the decision to rent or buy is probably easier now than it will be in the near future.

If you would like to further discuss how Esquire Real Estate Brokerage, Inc. can help you in the Los Angeles real estate market, feel free to give us a call at 213-973-9439 or send us an email at info@esquirereb.com.