Real Estate: Buy or Rent?

If there’s one major disagreement in the Early Retirement community it’s on buying vs. renting your home:

• Mr. Money Mustache apparently owned two homes at some point, lived in one and rented out the other. Both properties were paid off. He might have sold the rental property recently if I remember correctly, but still owns his primary residence. Owning real estate seems to have worked out all right for him. But he also points out that if you have to live in a large metro area, renting an apartment in town is probably better than owning a McMansion in the suburbs, with all the additional costs attached to it, see here.
• Go Curry Cracker are renters. Mr. GCC had a bit of a traumatic experience as both a homeowner and an involuntary landlord. Besides, with their busy travel schedule they seem better served renting.
• Jlcollinsnh thinks owning a house is a terrible investment.
• Yours truly, Mr. and Mrs. ERN, live in a condo. The property has appreciated quite a bit since the purchase. But had we invested the down payment in an equity index fund, we would have gained as well. I once did a careful exercise to calculate our current gain net of the equity index opportunity cost, and we did come out ahead quite a bit owning our place. But this experience may not be typical. It may certainly not be replicable going forward.

We personally believe that the pros and cons of homeownership are about balanced. The median household with the median income and wealth living in the median U.S. city should be about indifferent between renting and owning. The personal idiosyncratic factors would tip the scale in one direction or the other:

In favor of renting:

• You travel a lot and you don’t believe you can or want to AirBnB your place while traveling
• Your income is low enough that you are in a low enough tax bracket (or pay zero tax during retirement, see Go Curry Cracker!), you will not benefit from any tax deductions
• You are not sure you want to stay in your current location for at least 5 years
• Rental yields are low in your area, as they are in a lot of expensive coastal metro areas, such as NYC, SF, LA, Seattle, etc.

In favor of owning:

• You plan to stay in your current location very long term
• During your working years you may have a high income that puts you in a sufficiently high tax bracket, making ownership with a mortgage still a good deal
• You are nervous about the sustainability of cash flows from your equity net worth. Example: you spend 25% of your retirement withdrawals on rent, 75% on everything else. If your portfolio drops by 25% and you keep your withdrawal rate constant, you have to cut your non-housing expenses by 1/3 because rent is a fixed cost, at least in the short-term. If your portfolio drops by 50% you have to cut your non-housing expenses by 2/3. Ouch! Longer term you could find a smaller and cheaper place, of course, but in the short-term it could be very expensive to break your lease and move
• You are nervous about an acceleration in rental inflation and like to hedge this risk
• You already own a place. The costs associated with buying and selling are sunk costs, so it may not be worthwhile to sell and then rent. We will sell our place in 2018 but we also considered selling our place now to pocket the money and rent. It seemed more advantageous to keep owning.
• There is a certain warm glow, fuzzy feeling, whatever you want to call it when you own your place. It’s totally irrational and behavioral, but you can’t argue with fuzzy feelings

Owning your primary residence is not an investment

[Update on 11/15/2017: I changed my mind on this point, please see this post: See that house over there? It’s an investment!]

What should never be in doubt is that your owner-occupied home is not an investment. A rental property generating passive income certainly is, and we can discuss whether it’s a better or worse investment that equities. A rental property will generate a return equal to R = rental yield + appreciation – costs.

Rental yields will likely range from about 4% in very expensive densely populated areas to 8%, maybe 10% in really small markets. Costs are expressed as a percentage of the home value and would include everything from taxes, maintenance, repairs, insurance to depreciation, even utilities if comparing this with a utilities paid rental. Costs can be as low as 2% but also easily as high as 5% of the home value, especially when you include utilities.

Now, if you live in your property yourself you forego that rental income, worth anywhere between 4% and 10% yield, making the return of ownership most definitely inferior to equities. One could argue, of course, that the first 1,000 or 1,200 square feet of the house, depending on your family size, are an investment, because you would otherwise have to pay rent. But houses above that minimum size are not an investment. Unless of course, you assume a massive expected appreciation, and in 2008/9 we saw where that ended. In fact, if you assume that home price appreciation is equal to inflation, which it has been for decades until the 2000s housing bubble, your owner occupied house has a negative expected real yield, equal to the annual costs. Your house is essentially a money-eating machine. Hence the advice: buy the smallest possible home you can get away with! It’s no wonder that people who do the opposite and buy as much house as they can (and more) never seem to get ahead financially. The portion of the investment that could potentially generate a good return, rental income, is spent on themselves. People are robbing Peter to pay Paul!

But what about the tax benefits of owning?

We would argue it’s the other way around. You heard that right, you could have more tax benefits from renting, unless you are in a very high tax bracket. How is that possible? Your landlord, whether it’s a mom and pop rental business formed as an LLC, a real estate private equity group or a large corporation (e.g. REIT), can write off every last dollar of expenses: mortgage interest, loan origination fees, appraisal fees, property taxes, maintenance, property management, insurance, repairs, landscaping, you name it.

But all of that tax advantage is pocketed by the landlord, right? Wrong. In a competitive marketplace all or at least most of these savings should be passed on to you the customer/tenant. Think about how technology transformed how much we pay for phone calls. It used to cost $1.00+ to call internationally only 20 years ago. Costs went down to essentially zero, and the phone companies cannot pocket the $1.00 per minute. They have to pass on 99% of the savings to you, the costumer. Thus, as a renter you may not literally enjoy all the tax benefits, but you effectively do.

If you own a place, you can write off mortgage interest and property taxes. But there are limitations. Married filing jointly, you get a standard deduction of $12,600 p.a. (2015), so only expenses over that amount effectively reduce your tax liability. And good luck trying to write off the expenses for the gardener or the lost weekends from refinishing your back porch. Another thing to consider: If you are still working you could be subject to the Alternative Minumum Tax (AMT). Mortgage interest is deductible under the AMT, but property tax isn’t. Of course, once you are retired, you will likely no longer be subject to the AMT unless you haul in some serious dough!

Thinking about it, the landlord/tenant tax benefits are so insanely lucrative, here would be a cool way of utilizing them: person A and person B each buy a comparable house, each held by their respective real estate holding LLC. Then person A rents person B’s house and vice versa, each at a below market rate. The respective LLCs can expense everything, even items that no homeowner can write off, like landscaping, repairs, insurance etc. Each LLC will make a small loss, which probably can only be declared passive loss. But if you have other passive income from rental property each landlord can use the losses from the house swap to offset passive income elsewhere. I wonder if people can weigh in and see if this is legal! Disclaimer: If you haven’t read the actual disclaimers please do, because if you implement this tax avoidance scheme and you get into trouble with the IRS don’t blame us!

The final verdict

Whether or not our condo was a good investment up until now, we will keep it until early 2018. The home equity will come in handy as additional cushion for our cash hoard. Once retired, we may plan to travel extensively, at least for a few years, so renting might be a good option then. Once we settle down and find a more permanent spot, we may decide to buy. If so, we would buy the smallest and cheapest place we can get away with and pay all cash.