Why renting just might be more financially sophisticated than everyone thinks.
How many times have we all heard the term “bitter renter”, how many times have you been called “jealous” for expousing your views on the housing bubble? Renters have always gotten the short end of the stick, stigmatized as not being financially savvy. It’s the homeowners that are the intelligent investors. The public view, fortunately for renters, is incorrect, and I’m going to tell you why. Unfortunately, the answer is complicated and may be a bit difficult for many to understand. So grab yourself a cup of coffee and a chair, this is going to be a long ride.
We first need to understand what arbitrage is. Some readers might know it already, so just bear with me. The simplest definition of arbitrate is the exploitation of market imbalances. Ok, maybe that really isn’t so simple, so lets just use an example again. Say you spend half of your day in Manhattan, and half in Jersey. While walking down the street in Manhattan, you see someone selling scarves for $10.00, you make a mental note of the price. Coming home that evening, you see a similar scarf for sale for $5.00 and a lightbulb goes off. You can buy scarves in Jersey for $5 and sell them in Manhattan for $10. So the next day, you board the train with a handful of scarves, and that evening you return home richer. You’ve exploited the imbalance in scarf pricing to profit, little did you know you’ve just become an arbitrageur.
You are probably wondering what the heck this has to do with renting or buying a home. Just hold tight, I didn’t say this was easy. You need to understand arbitrage first, otherwise this whole exercise was a waste.
Arbitrage exists in many financial markets today, in stocks, bonds, currencies, etc. In fact, arbitrage opportunities almost always exist anywhere where you have market imbalances. I’m sure by now you have already thought of one of the biggest arbitrage markets available to the average joe.. You got it, eBay. If you can buy something at Costco and sell it on eBay for more, that is arbitrage. If you can buy something at a garage sale and sell it for more on eBay, that’s arbitrage. If you can buy something on eBay for less than it sells for locally, that is arbitrage.
Now that we’ve beaten the horse to a pulp, lets understand why renting in today’s market is actually exploiting the current market imbalances. You are no longer a renter, but an arbitrageur. Let’s take a look.
Two markets exist for a single similar product, housing. Those two markets are the rental market and the purchase market. You can get the same goods, housing, through both markets. You have two options if you want housing, buy or rent. The price of the good in either market is typically driven by economic fundamentals like median income, unemployment, interest rates, supply and demand for the good, etc. Just a few short years ago, pricing in both of these markets was similar. Stop, I’m not saying it cost the same to rent and buy, the cost is not, until you begin to factor in housing appreciation or depreciation, taxes, maintenance, rental increases, and the opportunity cost of the down payment. Yes, just a few short years ago these markets were both driven by similar fundamentals, thus arbitrage opportunities did not exist. Yes, a long long time ago in a universe far far away, it might have made sense to buy, but not anymore.
Why? Because house prices have become disconnected from the fundamentals that kept both markets in check (think of it as a form of arbitrage equilibrium). But something happened, the price in the purchase market shot up dramatically since the late 1990’s, and the price on the rental market did not. A lightbulb should be going off in your head right now. Yes, a market imbalance has been developing opening the door for arbitrage. Let’s walk through it.
You have two options:
1) Purchase housing in the purchase market, and provide that good to yourself.
2) Rent housing in the rental market, and provide that good to yourself.
In either case, the end result to you is the same, you were provided with equivalent housing. Rent-buy arbitrage asks the question, if a market imbalance exists that favors renting, why buy? How do we even know that a market balance exists?
I don’t think I have to explain housing appreciation to anyone, it’s been entirely out of control, but lets take a look at median rents in New Jersey.
Gross Rents – Historical
New Jersey
1990 – $756
2000 – $751
(Inflation Adjusted)
New Jersey Housing Characteristics
New Jersey (Median Gross Rents)
2000 – $837
2001 – $844
2002 – $843
2003 – $874
2004 – $877
I’ll try to provide a graph of the relationship, but I don’t have all the data I need on hand right now to graph a long enough time series of the data. However, if I did, from 1995-1999 you would see that the movement between the two markets moved in similar fashion, from 2000-2006 the rental market increased only slightly while the purchase market price disconnected from fundamentals and skyrocketed.
Now that we’ve identified an imbalance between the two markets, how do we exploit it. Well, I can tell you that you’d just be better off renting right now, but I’m sure you want to see it worked out. So here we go.
There just so happens to be a property on the GSMLS that is available for either rent or purchase. That property is located in Clifton, NJ, in a townhouse community.
The house exists in two markets:
Purchase Market Price $489,500
Rental Market Price $1,995/mo
(Now, I’m going to argue that because it’s not currently rented, the rental price is likely higher than the market wishes to bear. Because this buyer purchased it for $450,000 recently, his carrying costs are much higher and thus must *ask* a higher rent, but let’s not get too deep into that).
So lets examine the cost in the purchase market:
Down Payment: $97,900
2005 Taxes: $8,545
PITI: $3,203 (at 6.4%, 30y fixed)
Maintenance: $175/mo
Total Monthly Outlay: $3,378
On the rental market:
Total Monthly Outlay: $1,995
Monthly Differential: $1,383
Not so simple. We need to factor in:
1) Housing Appreciation
2) Housing Upkeep
3) Tax Increases
4) Maintenance Increases
5) Tax Benefits
6) Opportunity cost of the down payment
7) Interest rates
8) Rent Increases
9) Risk premium of purchasing
etc etc etc
Instead of working out all the math here, we’re going to use one of the better rent versus buy calculators to do the work for us. I’m going to warn you, don’t use a rent/buy calculator on a realty or mortgage site, they are almost always going to come up with a “buy” recommendation. Instead, use a caolculator from the Center for Economic and Policy Research (CEPR), you can find it here:
Costs of Ownership v. Renting Calculator
I’ve gone ahead and plugged in all the numbers, but I recommend that you go through the exercise yourself (I used the 28% tax bracket, 10y timeframe). The CEPR calculator tells us that if we can rent an equivalent place for less than $3,400 a month, take it. Well wait a minute, that exact same home is available for rent at $1,995 a month, why is the rent so low? Is something wrong? No. The imbalance between the two markets is so big it should be slapping you in the face. What is causing your cognitive dissonance is the fact that $1,995 a month seems like a big number. It really seems like you are throwing away that 2 thousand a month.. Well, let me assure you, you are not throwing away anything.
Some factors to consider.
1) What would the difference between your standard and itemized deductions be? Calculate those tax benefits for yourself to see the real impact that the property and mortgage interest deductions would add.
2) Opportunity cost of the downpayment. The appropriate downpayment for this home is $97,900. Let’s just say your average return over the next 10 years would be a miniscule 5% yearly (low risk investments). In 10 years that sum would grow to approximately $160,000. If you like to live on the edge and expect a 7% yearly return, that amount would be closer to $200,000.
3) Opportunity cost of the monthly differential. Each month you would have close to $1,400 extra money. Over the course of the first year that differential adds up to $16,000 cash. If the past few years of rent increase are any indicator of future trends, that number isn’t going to add up significantly. Can one of the finance readers calculate the exact amount. I’m guessing that invested at 7%, the differential will add up to close to $200,000 in 10 years.
So, at the end of 10 years the arbitrageur will have close to $400,000 in liquid investments on hand. In order for the purchase market position to pay off in the same time period, we would need a continued appreciation of approximately 6% a year over that same time period to break even.
Are you so sure the housing market will continue to appreciate at above historic returns for the next 10 years? The purchase position is not adequately priced to reflect the risk inherent in purchasing at the top of the bubble market.
So the next time someone calls you a renter, correct them. You are an arbitrageur.
Caveat Emptor,
Grim
As much as I would like to take credit for this idea. Searching for buy-rent arbitrage comes up with many hits over the past few years. This idea has also been making it’s way around the blogs lately.
Thanks to Marinite at the Marin Bubble Blog for bringing the idea to my attention and John in VA for bringing it to his.
jb
This is a wonderful article. I love all the original analysis you do. Thank you for this article.
AmericanInventorSpot.com
Grim,
I agree with you whole heartedly, but caution against using the CEPR calculator. They forecast a return to historical mean that includes 40-50% housing price decline (inflation adjusted) in most bubble markets. I expect a decline in housing prices, followed by flat to anemic growth in the near to medium term, but not many reputable analysts expect prices to fall by half. If anyone believes that is realistic, then belive the CEPR calculator. On the other hand…
Excellent analysis, thanks for posting.
I’d really like to build my own calculator which let you vary every single variable in the model.
The problem with many buy/rent calculators is they ignore the opportunity cost of the downpayment as well as the monthly differential.
Others fail to include maintenance and fees, still others incorrectly assume tax benefits (many here are subject to AMT and can’t realize those same benefits), etc.
Anyone care to help with building a comprehensive model?
grim
You can also see the market imbalance if you look at it from a cash flow perspective.
I can’t find the exact site, but I believe that on an investment property in this area the price of the property should be approximately 12-15x the annual rent roll.
So for that property, the annual rent would be $23,940, so from a cash flow perspective the property should be priced at approximately $359,000.
The price on the property needs to fall approximately 27% to bring the price back in line with the rent price. (Remember that magic 30% number I’ve been talking about).
Or, from another perspective, rents would need to increase approximately 40% to $2,750 in the short term.
Wages and rents are very tightly related. It’s the reason rents have not seen an appreciable increase in the past few years.
Do you expect your wages to increase 40% in the next few years?
jb
I went from a bitter Homeowner unexpected repair headaches, tax increases, high utulity bills, water bills, 9 years and hardly paid down the principal- not being able to take vacation , to Renter 2 br/lr dr/ use of yard and basement for storage, heat included for 780.00 per month! Was down as low as 630.00 8 years ago. Yeah we went to disney!
Yes I want to own again, leave my children something, But not right now.
KL
Very good article. However from my experience the worst factor of renting cannot be calculated in dollars: landlords and their own agenda. They can be non responsive about the problems they suppose to fix immediately. They might want you out because of selling the house (or converting it to condo). When you’re making calculations based on “when I want to sell the house”, you presume it is your choice. While renting, you can be forced to move out, which creates problems beyond moving expenses, i.e. kids schools, commute etc.
dvd,
I agree, there are some risks that can’t be easily quantified.
However, realize the risk on the flipside. There currently exists a significant risk that housing will fall and the owner will not be able to sell without bringing cash to closing.
I believe this risk to be similar to the call option on a bond (in a simplistic way).
A callable bond can be recalled by the issuer prior to maturity. This is considered a risk in the bond market. Due to the added risk, the bond would carry a call premium to compensate the investor for that risk.
So like the bond, housing also has a call option attached. Sometimes the owner makes the call, other times outside factors force a call (job relocation, etc).
Thus, housing should carry a higher rate of return to compensate the buyer for that risk.
While the same situation might take place in a rental, the risk of significant financial loss due to it is highly unlikely.
grim
grim –
I would be interested in helping you build the calculator. I am a computer engineer with strong math background. Right now I program in visual basic 6, but I am sure we could figure something out.
Grim,
Great Work. I will play around with developing a more comprehensive model and send you know what I come up with. Excel is my one of my fortes.
I think the most obvious and undeniable sign of this arbitrage situation can be found in the number of condo conversion projects happening. This is basically the mirror image of the rent/buy decision, but for building owners. Apartment building owners are basically saying the net present value of a future stream of rent payments is less than the current sale price of the unit. In a normal market, it would be more profitable for the building owner to forgo the immediate sale and collect rent over time.
I’ve got most of the model done in Excel right now.
The only quandry I have is how to factor in savings due to the tax deductions. I can’t assume that the savings should be applied towards the mortgage principal, because nobody does that in real life. I suppose I could assume that the savings amount was saved and invested.
grim
Every rent-vs-buy calculator always has this “perfect world” scenario.
It never factors in upkeep, maintenance, emergency repairs, water issues, landscaping, etc. I guess everyone takes all that for granted when they do these rent-vs-buy comparisons.
A true comparison should take into consideration the size of the house, the geographic location, size of the property, the landscaping, environment, climate, etc. All of these things will add up over time. It’s much more to own a home in the north then it is in the south, natural gas/oil heat being the main reason. Not to mention snow removal, fall cleanup, etc etc.
-Richie
grim said…
I’ve got most of the model done in Excel right now.
The only quandry I have is how to factor in savings due to the tax deductions. I can’t assume that the savings should be applied towards the mortgage principal, because nobody does that in real life. I suppose I could assume that the savings amount was saved and invested.
grim
1:18 PM
Leave it out. Assuming you are talking about the ownership case.
The marginal savings to invest would be on the renting side.
The fewer assumptions that have to be made within the model, the more robust the conclusions.
Great article.
I was wondering how the decline in housing market would impact rental market. For last five years when the house prices were booming, rental market more or less remained flat. Now if house prices go down or slows down, will the rents increase ?
-SM
Ok, here are the model results:
Given
Purchase $489,000
Down Payment $97,800 (20%)
Principal $391,200
Interest 6.50%
Terms 30 Year Fixed
Annual Property Tax $8,500
Annual HOA, Insur., Maint. $2,600
Rent $1,995
Assume
Annual Appreciation 4%
(No decline in housing prices)
Annual Property Tax Increase 1.25%
Annual HOA/Ins/Maint Increase 1.25%
Annual Rent Increase 1.25%
At an Investment ROI of 6%, 30Y
Renting ahead by $254,000
At an Investment ROI of 7%, 30Y
Renting ahead by $678,000
At I(ROI) of 7%, Annual Rent Increase of 2%
Renting ahead by $442,000
It’s actually rather difficult to make housing come out ahead in this model. And this model assumes at housing will continue to appreciate at higher than inflation levels..
grim
grim:
Another qualitative factor in favor of renting.
I have my downpayment IN HAND – ready to go. If I go out bidding for a new home, I can potentially get a seller to take my Lowball offer as credible, rather than another bidder who needs to sell their existing home in order to have sufficient funds to close on the new purchase.
That is absolute dollar for dollar savings that no one will deny.
chicago
“I have my downpayment IN HAND – ready to go. If I go out bidding for a new home, I can potentially get a seller to take my Lowball offer as credible…”
Many sellers have starry eyes, and only see the dollar amount.
Been there — made a no-contingency offer, above comps, and it was rejected because the seller went for the highest dollar offer.
Really well written–you have a gift for financial writing.
Grim,
Would you kindly post the excel model. I would like to play with it to run some of my own scenarios.
BTW, Thanks for the great work!!
-N
“… I can potentially get a seller to take my Lowball offer as credible, rather than another bidder who needs to sell their existing home in order to have sufficient funds to close on the new purchase.”
This is exactly what happend to my sister. Her offer was $10k less than another bidder, but she came with a blank check. The other bidder had to wait unit they sold their home. BTW this was not in NNJ, it was a slower area where the market wasn’t as heated
I was wondering how the decline in housing market would impact rental market. For last five years when the house prices were booming, rental market more or less remained flat. Now if house prices go down or slows down, will the rents increase ?
SM,
The rental market more or less remained flat because wages have been stagnant in Northern NJ since 2000. Rents are very tightly coupled to wages.
I wouldn’t expect a significant change in rents unless there is a significant change in wages.
grim
Ive done this analysis for myself a while ago. Was even easier because I am already in AMT city, so the tax benefit is nil. Makes the decision to rent all the better.
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