Carrying Costs Exceed Rent

Fine to divert the thread. Just a historic fact - on average, out-of-pocket carrying costs have equaled market rents over time. Sometimes they're higher, sometimes lower, but on average the same. The reason is that if you were to buy an apartment to rent out, you would need at least to break even.

Those who drink the real-estate Kool-Aid will tell you about the purported tax benefits, etc., but all buying is is capitalizing your future rent payments and amortizing them over time. The Kool-Aid crowd have come up with no data that proves their theories - but the actual fact is that rents and purchase prices are correlated nearly 100% over time. Only in recent years has that changed, and we are now seeing how prices are crashing back to reality.

Steve, I'd think it would depend on your time horizon. If you bought a while ago you'd have more wiggle room, but in the initial years you may not break even.

Rents and carrying costs are correlated, but the ratio steve uses to measure the correlation is flawed. He insists on a 12x ratio (rent x 12(months) x 12(ratio) when it really should be 18-20 (rent x 12 x 18). steve's 12x ratio excludes important factors such as the mortgage deduction tax benefit, and has been shown to be too low when running actual numbers.

"purported tax benefits"

so are you now suggesting that those benefits don't exist?

So Steve, why have you bought in the past? Do you only buy if the out of pocket carrying costs are less then renting?

The tax benefit is very real. I doubt the out of pocket costs will ever be equal, because that means the real (post tax deduction) costs would be incredibly skewed (strongly favoring buying). Most people in the Manhattan market pay at least 40% in marginal taxes (28% federal, 6% city, 6% state) - being able to chop 40% off most of your costs is a hugely significant amount.

That said, don't forget the opportunity cost of the down payment. That needs to be counted as a hidden cost of buying.

True techguy, but what about the long-term growth of the price of your home, or the long-term growth in rents that you would not have if you owned?

It depends on your time horizon. If its 5 years, I'm not convinced there will be long-term growth. In either property prices or rents.

". . . all buying is is capitalizing your future rent payments and amortizing them over time."

Well, you also get to own the property. I mean I could enter into a long-term amortization arrangement with my landlord that looks a lot like a purchase with me paying him some initial amount (similar to a downpayment) and then having fixed payments each month for thirty years (no rent increases since that was worked into the amortiztion schedule).But at the end of say 30 years I would own nothing whereas if I had purchased a similar property I would have an asset that is worth at least something (even if possibly less than the original purchase price).

Putting aside the tax benefit which you deride, one benefit of ownership is eventually owning an asset outright whatever its eventual value may be if you buy and hold. Of course, if rents are so much less than the carrying costs of owning it may be financially favorable to just rent -- that I do not deny. But certainly over the long haul, the cost of owning has to be significantly higher than renting for it not to be better to own (BTW, I agree that we may easily be in that scenario right now). But it is wrong to imply (as your post seems to, at least to me), that if owning costs so much as a penny more per month over the equivalent cost to rent, then you are better off renting.

"capitalizing your future rent payments and amortizing them over time" I love thinking of it that way, but could you give me a hypothetical?

"He insists on a 12x ratio (rent x 12(months) x 12(ratio) when it really should be 18-20 (rent x 12 x 18). " That is the question: what is the proper ratio?

In the 1970s, my grandfather bought Manhattan investment RE (also a depressed market) & at that time, he would pay no more than 7xs gross income. In early 2008, people were still paying up to 23xs gross income, which was completely ridiculous.

It's really hard to figure out a ratio or cap rate for an apt because there's no income.

Also, how or can one calculate the value of "the opportunity cost of the down payment"?

I see that because a residence does not generate income, it's difficult to calculate value, other using comparables, and if the comparables are over priced, yer screwed. This is why I'd like to use a ratio and think in terms of capitalizing & amortizing future rent payments.

Thanks all, great ideas.

Colgin: I think the contrary view is that after thirty years, you'll own SOMETHING either way. The difference is that if you buy, the thing you own is your home. If you rent, you can own something else. Of course, a renter can easily fritter the money away on frivolous spending and wind up owning nothing; but that's also true of a homeowner who extracts equity to enable spending.

Colgin: If you own a property outright, your opportunity cost is *HUGE*. You may be happy and feel secure, but its not an optimal allocation of your assets. Far, far from it.

All the government incentives to owning are priced into real estate, meaning real estate prices are higher than they would be in a completely fair market. That means if you're not benefiting from the government incentives, you're coming in behind the curve. The biggest 2 government incentives are the mortgage deduction, and the 250k/500k tax free gains. Holding for 30 years (vs. selling and buying another place once or twice in that same time period) gives up both benefits.

["He insists on a 12x ratio (rent x 12(months) x 12(ratio) when it really should be 18-20 (rent x 12 x 18). " That is the question: what is the proper ratio?]

The ratio isn't fixed. Mortgage rates at 15% will demand a much lower ratio than mortgage rates at 6%.

"It's really hard to figure out a ratio or cap rate for an apt because there's no income."

Its easy. Find an equivalent rental and consider that as your income. However, its *tax-free* income, which you have to account for (you would pay tax if you rented your apartment to me, but you don't pay tax on the rent you're "paying yourself" for living there yourself). Just as tax-free municipal bonds have lower yields than treasuries (historically - not true today due to muni risk priced in) you have to account for this significant difference. An easy way is to figure out how much *taxable* income you'd need to get such that, after taxes, its the same as a rental. Voila, cap rate established.

[Also, how or can one calculate the value of "the opportunity cost of the down payment"?]

For everyone its different. The best is to ask yourself what you would do with the money if not for buying an apartment. For me personally, I like index funds, 50/50 stocks/bonds, and Vanguard (as well as others) have statistics showing that such a ratio has historically earned 8%. That's what I use. Others use 10 year CD prices.

"Mortgage rates at 15% will demand a much lower ratio than mortgage rates at 6%"

Of course. I made that pt to steve 6+ months ago, same thing for tax benefits, he ignored it per usual.

" That is the question: what is the proper ratio?]
That is the question, it is answered in several ways all require a fair amount of assumtions. The cap rate becomes the alternative investment ratio. You may compare it to the "risk free rate" i.e. treasuries, or high grade corporate bonds, or whatever you choose. If you are this much of a numbers person, then you need to put all options into a risk adjusted return profile and see where your cap rate fits. But don't forget liquidity as a constraint in your formulas. If the cap rate offered stills looks cheap, then buy, if not, rent.

stevejhx:
one thought, I have never really cared to think about it, but what is your opinion of lengths of rich/cheap cycles for rent/purchase? 5yrs, 10yrs, longer?

West81st: I don't disagree with what you are saying. I was only trying to respond to whatI thought were the implications of Steve's post which is that one should be indifferent between renting and owning if rent = carrying costs. But over time a large part of your carryng costs are principal and you will own an asset for having made your payments whereas the rent payments will get you nothign. Now if rent is less and you invest difference in another asset then that is another matter. My point was just that it is better to own even if carrying costs are slightly higher (although at some tipping point it would be bettrer to rent, a situation we may be in now) adn regardless of tax benefits (which is not to diminish the utility of those tax beenfits).

tech_guy: I am not suggesting that one is better of buying and holding real estate than continually trading up. That is a separate issue and I don't deny the benefits you outline (although the bottom line analysis is going to be very case dependent IMO and take into account non-fiancial considerations). All I am saying is that if you do buy and hold you are better off than someone who merely rented the equivalent apartment ona similar amortization schedule with a landlord because at the end of the day you will have an asset, not nothing as with the renter. Of course, when it is significantly cheaper to rent the comparable property, as it is now throoughout much of NY, renting may, in fact, be better (although these rent v. buy calculations are very difficult given all the long-term assumptions you need to make as well as non-financial considerations).

Is LICC talking to himself again as tech_guy? Sorry I have them ignored.

"If you bought a while ago you'd have more wiggle room, but in the initial years you may not break even."

You would NEVER buy an apartment to rent to someone else if you could not immediately cover your costs on a cash-flow basis. There is risk, for financing purposes no bank will let you count more than 11 months' income as income due to times without renting, etc. The correlation between rents and purchase prices is nearly 100%.

And the ratio in New York is 12x annual rent = purchase price. Proved over and over again using the p/e ratio method. If you were to use imputed rent and/or owners' equivalent rent, since both take potential price increases / decreases into consideration, NO ONE would buy in today's market since prices are expected to fall precipitously, as they already have.

"Putting aside the tax benefit which you deride"

I DO NOT deride it. I say it is a) discounted into the price of the property; and b) offset by the opportunity cost.

"one benefit of ownership is eventually owning an asset outright whatever its eventual value may be if you buy and hold."

Which is valid if on a discounted cash-flow basis the price of the property is less than the rent would be, to compensate for the extra risk. But when the price of the property far exceeds rent, only a fool would make such an investment.

"because there's no income."

There is income. The most common way of doing it is to use owners' equivalent rent or imputed rent, which simulate income - the theory is the owner of a property is basically renting the property to himself. They will get you slightly different results, but their correlation to the simpler p/e method is 100%.

"think the contrary view is that after thirty years, you'll own SOMETHING either way."

Right. And if you bought gold after we got rid of the gold standard you'd still own the gold, and it would still not be worth the price you paid for it even nominally, never mind adjusted for inflation, so what's the purpose of owning it?

patient09 is approximately correct - that's one way of looking at it.

"what is your opinion of lengths of rich/cheap cycles for rent/purchase? 5yrs, 10yrs, longer?"

I would NEVER buy for anything over 15x annual rent under any circumstances. According to my calculations based on a single example (when I bought in Manhattan the first time in 1998) the ratio was 8x annual rent. We may be headed there again. So right now, I wouldn't even buy someplace if I could get it cheaper than what I'm paying for rent on a cash-flow basis, because I expect my rent to fall.

"one should be indifferent between renting and owning if rent = carrying costs."

One should be indifferent between renting and owning all the time - the output is the same - a place to live - so the cost should be the same.

I agree pre-tax is the way to look at it. The "cost" of the admittedly very real tax benefits are a between 5 and 10 to 1 levered equity interest in real estate that could be wiped out in 3 months as it has for many summer 2008 buyers, or alternatively a simple interest bearing account holding your down payment. While you can't rent a coop freely, the analysis is fair. Once you need to factor in appreciation and/or tax benefits to make it make mathematical sense, you are buying at the wrong time.

PS: Steve, you said you'd buy your rental if you could at 11x rent at prevailing mortgage rates so stop exaggerating. This weekend I played with some numbers and it seems to me the only way we get back to single digit rent multiples is if we have double digit mortgage rates...which we could easily have... But if you could buy at 11x with a 7% mortgage or so it would be a pretty attractive monthly payment and a 50% discount vs. peak. It would draw people in.

"I would NEVER buy for anything over 15x annual rent under any circumstances."

Really. Ok so if you could rent a place for $10k, you wouldn't pay more then $1.8 mil under any circumstances. Ok so you wouldn't pay 2mil? what if I financed 100% for you at 2% fixed for 30 years. You just make it to easy.

"One should be indifferent between renting and owning all the time - the output is the same - a place to live - so the cost should be the same"

This has clearly been at the heart of your agenda from the very beginning. You just put no value in home ownership, you get satisfaction from it, no sense of stability, you have no desire to customize, in the end its just a place to live and you put little value on that. And all of that is fine. That is your choice. But many people disagree strongly and you simply ignore that.

"Ok so you wouldn't pay 2mil? what if I financed 100% for you at 2% fixed for 30 years. You just make it to easy"
Good point. That's why it's difficult to use a fixed number ratio as a hard & fast rule.

On the other hand, 12%-15% gives a cushion. Those who recently purchased at 20x-23x will get foreclosed when they can't refinance their 5 yr 80% LTV mtgs. Then again, if they had 2% 30 yr fixed financing, 23x might be OK.

Thank you all for helping me. What I'll do is take the Maint/CC, treat it like income & find the cap rate. Additionally, I'll see what the ratio is.

One more question: If I buy a condo, and I have my corp buy it (I'm sole SH), will I get greater tax deductions than if I buy it in my name ? Should really ask my acctnt this, but thought I'd throw it out there.

Thank you all again.

steve comes up will all sorts of misconceptions to justify his renter status and decisions. Notice how he says "proved" when he has never proved anything.

"You just make it to[o] easy."

If you would like to finance my apartment at 2% for 30 years, then we have a deal. That is not a rate that has ever existed in the mortgage market, nor will it ever, and therefore it is just a stupid comment.

How about this - you finance my apartment at 0% interest and pay my taxes, too. Will that affect my decision?

"Good point."

No. Moronic example. It is not a real market example any more than the one I just gave above.

Just to remember, I have always maintained that interest rates do affect the ratio, but they also affect rents, so I stand by my assertion.

"That is not a rate that has ever existed in the mortgage market, nor will it ever, and therefore it is just a stupid comment."

Did you or did you not say you would not buy at over 15x "under any circumstances?"

"Those who recently purchased at 20x-23x will get foreclosed when they can't refinance their 5 yr 80% LTV mtgs."

wow, ton of assumptions there.

"Did you or did you not say you would not buy at over 15x "under any circumstances?""

Yes, unless you're willing to make that commitment right now. 100% financing, 0% interest for 30 years, and pay my taxes. Then I'll retract, but until you or someone else ponies up and makes that or any other moronic example you might come up with into a real market transaction, then I stand by what I said.

"Then again, if they had 2% 30 yr fixed financing, 23x might be OK."

dwell, don't you think that that would affect the price of rents, too?

"Then again, if they had 2% 30 yr fixed financing, 23x might be OK."
dwell, don't you think that that would affect the price of rents, too?"

Yes, the 30yr 2% is not real world, unless it was desperate seller financing & yes, it would affect rents.

As you can tell, I'm not a math person, I need to keep it simple, so I just want a couple of formulas to run the numbers. I'm not good at discounting or finding future or present values. I can find a cap rate based on NOI & I like the 12-15xs.

For my purposes, I got to keep it simple.

When I purchased my forst place in 1998 - owning was the equivalent price as renting -- so if you could scratch up the down payment (20% of a much lower number!). 1BRs were $250K - and 2BRs were $500K. Rents were $1250/1BR. $3500/2BR

Wow, manhattanfw, bring back the old days.

steve get a job

I have some future in-laws up my rear to buy a house as they feel you are not a real person if you rent, tech-guy keeps it tech-I like that. We live in a large rent stabilized pre war two bedroom rent= $1409.65 I will never sweat paying that and we can live a lot more care-free(we like that) Hard to get excited about buying. I look at it this way though first I would buy as a quality of life move, something I may not be able to rent long term(generally there will be a limit to a house rental). I also look at it as "forced" savings as I don't always put that money I save on my cheap rental to work in an investment product, usually it goes toward a surf trip to Costa Rica for 6 weeks etc.I figure if we do buy at the end of say 15-30 years(God willing I'm still alive) we will have some "equity" hook or by crook. As I get older I am thinking that home ownership is much more than just axb=c and if I can buy at a price I am comfortable with and for a time frame of at least 10 years-I'm in. As long as I can be creative and continue to earn a living in this business I must say I like where home prices will be in say 1-2 years. You want to see a rapidly declining real estate market head out to Jersey...we like a town called Maplewood.

manhattanfox, when I bought my first place in 1998 it was cheaper than renting. I rented a 1-bedroom 1-bath for $1,675, bought a 2-bedroom 1-bath for $218,000, 30% larger.

theburkhardtgroup: I can't price in nagging future in-laws :) Take them out of the picture, and your stabilized apartment sounds like too amazing of a deal to give up until you need the extra room. You simply won't make out better financially, so there has to be strong non-financial reasons for you to give that up.

Learning to save without a forced savings plan is another trait the future in-laws may appreciate. Especially if that's the bulk of the reason they want you to buy - learning to save instead may appease them enough!

Steve you over-simplify with this statement-
"One should be indifferent between renting and owning all the time - the output is the same - a place to live - so the cost should be the same."
You allude to the variable of anticipated price increases/decreases. When prices are rising and might reasonably be expected to continue to rise, the profit from owning more than covers negative carrying costs from rent. This is of course unsustainable, but in the short term buying was rational despite negative carrying costs. Now prices are falling, so the rent/buy argument tends to push prices, in the short term, BELOW 12x annual rent, because anyone who buys right now has a 20% loss baked in over the next year. All speculators will be gone from the market if they are not already - except to the extent that they are still offering their units at prices that are unrealistic, putting it gently.
Finally, I've heard a lot of mention of the tax benefits of ownership, but no mention of the tax penalty of ownership, i.e. that capital gains on a primary residence, of more than $250k, are taxable, while capital losses on the same property, of any amount, are not deductible.

brodie - I didn't oversimplify. I said EXACTLY what you said.

With the caveat that over time - except in the last 5 years - owner-occupied residential real estate does not rise in value significantly on a real basis. So there should be no expectation of future price increases, as prices cannot increase more than income and leverage will allow.

I had an interesting conversation with a friend recently who bought a nice L-shaped, large studio in a luxury building in 1995. He paid $65 K. He could have rented an equivalent apartment at the time for about $13K per annum. So a price/rent ratio of 5.

Fast forward to 2008. Equivalent apartments in his building have transacted this year for about $510 K. Annual rent now for such an apartment would be about $30 K. So a price/rent ratio of 17.

1995 was a great year to buy. 2008 is a great year to rent.

All in all, I don't think rents and prices are highly correlated on a one-year basis. But over the "long" term they are correlated.

Footnote: studios were the real sweet spot of the real estate market in the last Manhattan real estate bear market with by far the lowest prices per square foot. My "impression" is that Manhattan price/rent ratios have been more volatile than the New York metro price/rent published numbers I have seen.

Smartmoney just noted that in much of the country now, its cheaper to buy. Just nobody wants to.

Even though it may be cheaper, its still a long term commitment. People who are unsure about their jobs aren't going to buy. It will probably stay that way until the economy recovers.

Haven't seen the SmartMoney article, but I'm guessing that the numbers do, indeed, compute in much of the country in favor of buying. I doubt that is the case with Manhattan real estate as the price/rent ratios are so high. (In addition, I expect owner carrying costs in New York are much higher than in much of the rest of the country.)