Few topics in personal finance and in the early retirement community stir up emotions as nicely as the pros and cons of homeownership. Some folks in the FIRE community are renters and swear by it and others are very happy homeowners and/or real estate investors. Neither side is wrong. Those with more nomadic lifestyles probably prefer renting and the those with kids in school and strong ties to the local community are apparently happy homeowners. Normally, the two sides just coexist peacefully but discussions normally get heated and sparks fly when one side accuses the other of doing something wrong. If I had to distill the arguments of the two sides into bumper stickers it would be:
- Homeowners: Renting is just throwing away money!
- Renters: A house is not an investment at all. Or it’s a terrible investment!
But of course, both claims are just that: bumper stickers. And both claims are demonstrably false and/or crude generalizations! Let’s look more into the math of the rent vs. own tradeoff…
Debunking the “Throwing Away Money” claim
This is a free country and a capitalist market economy (for the most part, at least) and consumers have the option of either buying goods and services in the marketplace or producing them themselves. Renting is no more throwing away money than buying eggs at the grocery store or paying for a haircut. Sure, I could have cut my own hair or set up a chicken coop in our apartment (might violate our condo rules, though), but I decided to spend my time and money more productively.
A rental property is clearly an investment
Probably even the most militant homeownership opponents would have to admit that rental properties are indeed investments. You put money in an asset that pays an income stream and has the potential for some capital gains on top of that. In fact, in many ways, rental real estate is a pretty attractive asset class, especially for early retirees. With an equity index portfolio, you get a measly 2% dividend yield and you have to worry about pretty substantial price swings. With bonds, you get a pathetic sub-3% yield and no potential for capital appreciation. In contrast, rental properties have the potential to generate relatively stable income without the need of liquidating principal, which is convenient considering the illiquidity of the asset. Stable income and not having to sell the principal reduces Sequence of Return Risk in retirement! Moreover, both the income flow and the property value will likely keep up with inflation. In fact, rental prices are a large chunk of the Consumer Price Index (CPI), so by construction, rental income is a hedge against inflation.
But even owner-occupied housing in an investment!
This is one is harder to swallow! After all, shouldn’t an investment pay some sort of a return? A dividend or interest payment? Let’s go back to that example buying a chicken as an “investment.” The amount of money we save every day by not having to buy an egg at the grocery store should be part of the return calculation. It’s a dividend, even though it’s paid in-kind and not in dollars. Therefore, an owner-occupied house pays rental income, too:
“My [primary residence] is an investment for the same reason a rental property is an investment. It generates a rental service flow. As a homeowner, I save the expenditure I would have otherwise spent on rent. As a landlord, I pocket the money.” (Quote from Big ERN in the ChooseFI Facebook Group)
A dollar saved is a dollar earned! In other words, I think of a primary residence as generating rental income. It saves me the cost of renting a house in the marketplace. And keep in mind that accounting for this income from owner-occupied housing is exactly what the experts do:
The implicit rental income is counted in GDP; to the tune of $1,500,000,000,000 per year!
Yup, you heard that right; according to the Bureau of Economic Analysis, Table 2.4.5U, homeowners are generating rental income, effectively renting properties to/from themselves for a total value of over $1.5 trillion dollars per year (trillion with a “t”!!!). That amount is …
- … more than the entire annual GDP of Canada! Which is ironic because my favorite anti-homeownership bloggers are from Canada! 🙂
- … three times the amount that all non-homeowners spend on rent,
- … over five times the amount we spend on new motor vehicles (autos and light trucks),
- … and 24 times the amount consumers spend on new computers.
What does an actual expert say?
If you ask folks who actually understand real estate investing (for full disclosure, I don’t consider myself a member of that group) you’ll find that for the long-term real estate investors, income is king. For example, Coach Carson has an amazing post on how to run the numbers on real estate investments. Did you notice one thing almost completely missing from that post? Where does he factor in home price appreciation? He talks about the gross rent multiplier, net operating income, Cap Rate, etc. and none of these ever take into account the property appreciation. Income is the bread and butter of the (long-term) real estate investment. Price appreciation, because it’s mostly out of our control, is nice. It’s the cherry on top. But you don’t rely on it.
(for full disclosure: there are many other niches in the real estate investing business where capital gains are indeed king, i.e., flipping foreclosures, etc.)
An owner-occupied house can be a pretty good investment!
How much of a difference does it make when we recognize the implicit rental income from owning a house? A huge difference! Let’s take an average house in an average neighborhood in an average town in America: Omaha, Nebraska. You can’t get any more average than that! Here’s a Zillow listing I found:
Let’s run with a home value of $166,000 and assume that if we had rented this property it would have cost us $1,375 a month. Annualized that’s just under 10% of the purchase price, so probably a little less than what most of the pro-real estate investors would find attractive. But for most middle-class neighborhoods in moderately priced towns in the U.S., single-family homes will have a rental yield of somewhere between 8-10%.
Let’s also make some other pretty reasonable assumptions about the mortgage, property taxes, insurance, maintenance cost, transaction costs, a 10-year holding period, and a property appreciation of only 2% annually, i.e., just keeping up with average inflation over the last few decades:
If you like to change any of the assumptions, please check out the Google Sheet. As always, you have to save your own copy first before you make any changes! Fields in orange are the ones you specify, the rest is calculated by the sheet!
The main results:
- Despite the measly 2% property appreciation, the return numbers look quite attractive. The IRR over the entire 10-year period is almost 12%. And this is with zero tax advantage, i.e., assuming that interest and property taxes are not tax-deductible.
- The year 1 net operating income is $8,200 which implies a Cap Rate of just under 5%. The Year 1 Cash-on-Cash return, which does take into account leverage and the moderate appreciation is slightly above 12% (for full disclosure: I’m counting the 2% appreciation in this calculation).
Of course, the results are highly dependent on the parameters:
- Set the home price appreciation to 0% over the next ten years and your IRR drops to only 5.3%. But a 3% price appreciation would drive the IRR to above 14%!
- Leverage makes a big difference. If you own the house outright (set LTV=0%, i.e., no mortgage) the IRR goes down to 6.4%. For an investment that pays a stable “dividend” of housing flows that’s still a very attractive return. Much higher than today’s bond yields!
OK, I can already hear one objection:
“my $300/month roommate deal would have been even better!”
Yes, and? That’s comparing apples and oranges. We have to make two decisions here:
- (Scale): do we live with roommates or in an efficiency or in a One Bedroom apartment or in a Three-Bedroom house with a yard, etc.?
- (ownership structure): the rent vs. own decision.
If you indeed think that a 1-BR is all you need, all the more power to you. But then you should compare renting a 1-BR vs. owning that exact same (or at least comparable) 1-BR. We should not compare renting a 1-BR apartment vs. owning a 3-BR house.
What about all the other disadvantages of owning a house?
Jim Collins had a nice post, a whole laundry list of reasons why real estate is such a terrible investment. To which I can only respond: All of that is factored into the rent! Thus, you will be paying the cost of real estate transactions, the illiquidity, real estate taxes, repairs, maintenance, etc. one way or another. As a homeowner, you’ll pay that directly and as a renter you’ll pay it indirectly through higher rental costs. In other words:
Thinking that as a renter you’ll be shielded from all the disadvantages of homeownership is just as wrong as thinking that a rising crude oil price doesn’t impact you because you only buy gasoline at the gas station!
So, if we don’t want to pay for all those inconveniences of real estate then renting is not the solution. We might have to move into a tent. Or live in our car! But, just to be really clear, here are a few costs that you will be paying as a renter that a homeowner doesn’t have to pay:
- Your market rental rate will include a provision of at least 5%, maybe even 10% of the rent to account for vacancies.
- A landlord will require a premium for the risk of the tenant trashing the place and/or becoming delinquent.
- Included in the rent are all the other costs of running a business like advertising, property management, tax preparation fees, LLC setup, local business licenses, etc.
- A landlord will have to pay income tax on the (net) rental income (though there are some ways of reducing and/or delaying the tax burden). Homeowners are never taxed on any of the implicit rental income. Imagine that: $1.5 trillion every year in untaxed implicit income!
- A landlord has to pay capital gains when selling a property (though there are creative ways to defer those, e.g., 1031 exchanges). But a married couple can sell their primary residence and pocket up to $500,000 in capital gains tax-free!
I’m not saying a house is always a good investment
Just to be clear, I don’t want to talk anyone into buying real estate. It’s a personal choice and only worthwhile if price-to-rent ratios are attractive and you are likely to stay in the same location for a while. The number one reason a house, even a one with very attractive price-to-rent multiples, can become a bad financial decision is that we extrapolate the calculations above to larger and larger houses. If that $166,000 modest house is a good investment, shouldn’t an $800,000 McMansion be an even better investment? No!
Don’t get high on your own (housing) supply!
Even if that $800k house still delivers roughly $7,000/month in housing services it’s a bad financial decision. Technically speaking, the house is still a good investment but we’re overconsuming the in-kind dividend. Of course, there is one remedy: House Hacking! Buy a larger house than we need and monetize the excess housing services by renting out the extra space. I have never done this so I will refer to the expert again, namely Coach Carson and his excellent topic on the topic of House Hacking.
Conclusions
I’m not dogmatic about homeownership. I have been a renter but have also owned two homes in my life and generally enjoyed the experience. After we sell our current home early next year and move to a lower-cost-of-living area we will certainly rent for a while. If we like the new surroundings and can see ourselves living there long-term we will certainly look for a permanent home.
For us, a house is most definitely an investment because it saves the rent we would otherwise pay. An in-kind dividend payment like that is even better than a cash dividend because it’s tax-free income!
I would never bank on outsized property appreciation. Quite the opposite, in my personal calculations, I assume that a home appreciates only in line with inflation and even that appreciation is only because we spend quite a bit of money to properly maintain and repair and regularly update the house. But even without any significant home price appreciation, a house can still be an awesome investment!