San Diego renters often express frustration at having missed the housing boom of a lifetime and fear that they will now never be able to purchase a home.
Well, I think they ought to buck up. Relatively speaking, they are getting an amazing deal.
Even as San Diego home prices headed to the stratosphere these last few years, local rents grew at a fairly subdued pace. (This fact should, but apparently does not, cause people to doubt the fundamental underpinnings of the housing boom – but I digress!) The end result is that it costs quite a bit more to buy a given home than to rent that same home.
I am fortunate to have some good data on this very topic, as friends of mine recently moved into a single family home that was purchased just a few months back. They pay $1,900 per month to rent a home that was purchased for $535,000. Both these figures are typical for the area, so I believe this to be a fairly representative case.
Let’s crunch those numbers.
First we will assume that, had our friends purchased the home themselves, they would have financed the entire purchase price with a 30-year mortgage at the most recent average rate of 6.6 percent. They could not do this, of course; they would have to get a second “piggyback loan” at a higher rate. For simplicity’s sake, however, let’s just say they got that great rate on the full loan amount. If you are wondering why our hypothetical buyers didn’t get one of those hip new loans that allow them to lower their monthly payments, read this article.
Some other assumptions must be made as well. We will assume they purchased a very reasonable homeowner’s insurance policy, for example. And in order to calculate the beloved mortgage interest tax deduction, we will give home ownership the benefit of the doubt and assume that our friends pay a fairly high tax rate of 35 percent overall.
If these folks had purchased the home in the manner described above, they would have been responsible for the following monthly outlays:
– Mortgage principal: $474
– Mortgage interest: $2,943
– Property tax: $490
– Insurance: $100
Mortgage principal shouldn’t be counted as a cost, because the buyer is effectively paying that to himself. And of course we must subtract the 35 percent deduction on mortgage interest.
Overall, once we make those final tweaks, we see that the purchaser of this home would be divesting himself of just a bit over $2,500 per month. In addition to the assumption of very favorable tax and insurance rates, this $2,500 per month figure is predicated on the idea that the 80-year-old home will require no maintenance.
The renter who is shelling out only $1,900 each month seems to be getting a deal. Even under our unrealistically cheerful assumptions, it would cost 32 percent more each month to own the place than to rent it. Put another way, the buyer would be out an extra $7,200 each year.
The standard objections to renting make little sense in a situation like this. Take the old saw that “renters are just paying their landlord’s mortgage.” In fact, they are not coming close. They are only paying enough to cover the after-tax mortgage interest – hardly the renter-to-landlord transfer of wealth that the saying would imply.
Similarly, renters are often told that they “should be building equity.” But who is the one building equity in this situation? I would posit that it’s the renter who saves $7,200 each year by choosing not to own. A yearly savings of $7,200, wisely invested, will make for a nice little down payment when home prices finally move back into line with rents. (Remember down payments? Yeah, they’ll be back eventually.)
What arguments of this type fail to take into account is that homebuyers are themselves renters – it’s just that instead of renting homes, they are renting money from the bank. And when homes cost so much that the “rent” on the money required to purchase a home – otherwise known as the mortgage interest – is more than the rent required to simply live in that same home, aphorisms like these cease to apply.
Of course, when used in the manner above, the word “equity” does not refer to wealth that is saved by avoiding excessive carrying costs. It refers to wealth gained by owning a home that is increasing in price. That’s a great plan, as long as homes are actually increasing in price – but they are not, nor should they be expected to for years to come.
People who bought homes five years ago ended up gaining a tremendous amount of money through price appreciation, but that train has left the station.
This isn’t 2001, it’s 2006 – and from a purely financial perspective, renters here in 2006 are making out like bandits.
But there is more to life than money. Homeowners enjoy non-financial benefits like the ability to do whatever they want with the place, such as change out the cabinets, plant their own gladiolas, or, as in the house I am renting, inexplicably festoon the back yard with concrete and rebar garden gnomes. Owners can also have as many pets as they want and don’t have to worry about their landlords selling their homes out from under them.
At the same time, it’s important to understand the cost of those softer benefits. Just how much do you want those garden gnomes? Unless it’s an awful lot, you may be better off renting in a market like this.
Rich Toscano is an independent real estate analyst residing in Hillcrest and working in La Jolla. He writes extensively about San Diego housing at Piggington’s Econo-Almanac.