- September 11, 2020
- Posted by: Editor
- Category: Uncategorized
Having control of real estate can be in two ways. One way being having permanent control, which is buying the property. This has its own advantages as it allows for capital appreciation and also eliminates the option of paying rent in the future. The other way being paying rents and using the property whenever it is required.
The question now is, which of these decisions makes better sense as compared from a personal finance point of view in the rent vs. buy decision making. This article provides a description of the rent vs. buy decision.
Comparison of Annual Expenses
There is a conventional knowledge which claims that buying is always better than renting. Even the average person has the tendency to think of buying a home as an emotional decision. However, when it comes to real estate investors or pretty much anyone who’s concerned about how their money is being spent, the conventional knowledge does not hold true.
However, it is advisable to assess whether it is more profitable to buy a given house or would it make more economic sense to rent a house. That’s when the comparison of annual expenses arises. We do not compare cash flows instead we are comparing expenses.
When we buy a house, we have a mortgage to pay. The mortgage is made up of two components. One of those components is interest, and the other is principal. The interest component is purely an expense. Simply put it is money that is leaving your pocket today and the money that you will never see at a future date. Hence, this is the amount that we will use in our calculation. On the other hand, the principal component of the mortgage payment is your savings. Hence, it is like taking money out of one pocket and then putting it into another pocket. Since this money is savings, we will not include this in our calculation.
Hence, our expenses for owing the house will include interest (after deducting tax shield), property taxes, insurance and maintenance. This would be the amount of money that is consumed during the period.
On the other hand, the expenses pertaining to rent are pretty simple and straightforward. Firstly, there might be a one-time expense of paying a deposit to the landlord. However, this is not an expense it is just an interest-free loan as one will receive the same money back when vacating the house. Apart from that, there is also the monthly rental that has to be paid. Some people also factor in the opportunity cost of the down payment that has to be made to acquire a house. This means that if you did not buy a house, you would end up earning a certain amount of interest from your down payment money. This must be reduced from your monthly rental.
The risk appetite of the individual affects the rent vs buy decision making process . Some people have no issue with the risk that a mortgage brings along. A mortgage increases the risk because there is interest to be paid and also the investor becomes highly sensitive to price changes in the market. Hence, the personal net worth of an individual can change dramatically if they have a mortgage because mortgage essentially is an extremely leveraged bet.
Risk averse people prefer renting. This is because rents do not fluctuate nearly as wildly as property prices do. Even if the rents do change dramatically in a given neighbourhood, the person has an option to move into a different neighbourhoods or even a different city if required!
Estimation of Future Annual Expenses
Also, it needs to be understood that neither buying nor renting are one-day decisions. These decisions require commitment and have to be executed over a period of many years. Therefore, while comparing annual figures is the right thing to do, one must ensure that they do not compare data for only the current year. Rather, the cash flow and expense projections should look several years into the future.
This is the part where the rent vs. buy decision gets complicated because the decision is extremely sensitive to the capital appreciation that we assume in the future. If we change the capital appreciation by one percentage point, we would end up changing the net present value by a huge amount. To top it up, predicting future real estate prices is extremely difficult. Therefore, one needs to be very careful of the future assumptions that one is building into the model as they can literally turn the decision upside down.
Stability vs. Flexibility
When we buy real estate, our lives become more stable. Most people usually decorate their homes based on their preferences and when they own the house they can do so. Also, renting involves frequently moving to different houses periodically. Buying a home cuts out this movement and as such provides stability.
On the other hand, renting provides a person with the flexibility to experiment with different neighbourhoods, different apartment sizes at different costs to see what fits them best. People whose jobs require them to move regularly are also better off renting.
In conclusion, the buy vs rent analysis of a home in real estate is partly financial and partly emotional.
The financial part of the analysis is difficult to work out because of the uncertainty on future assumptions. However, one also needs to look at the emotional point of view which involves understanding the level of risk and flexibility that they desire before making a decision.