Should You Buy Or Rent?

Author: Stephane Fitch

Deciding whether to buy a home comes down to your expected returns.

Designer Delia Seaman is fashionable, successful and regretful. Her clothing and jewelry label, Decolette, has been catching on with celebrities such as Hilary Duff, but sales at her West Hollywood boutique are still suffering amid the recession. Eager for rainy-day funds, Seaman, 40, has put her 1920s Spanish-style bungalow up for sale at an asking price of $999,000. After Realtor fees and closing costs, she'll clear little or nothing beyond the $922,000 she paid for the property four years ago--and that assumes, optimistically, that she will get something close to the asking price.

Even more sobering, Seaman did some math showing that the $60,000 in yearly mortgage payments, insurance and property taxes she's been shelling out exceeded what she would have spent renting a similar home at $36,000 annually. The tax deductions she got for mortgage interest and property taxes don't come close to making up the $96,000 difference in cost over the four years, she says. "I feel like the whole housing dream is kind of a joke," Seaman says. "I paid in for four years and got nothing. I wish I'd never bought."

Conventional wisdom is that renting is equivalent to throwing money away. That wisdom is wrong, and not only because home prices occasionally crash. It can be wrong in a flat market too. Pay a high enough price in relation to rental value, and you're getting a raw deal, even if the price holds up.

It pays to do the math, and that means thinking in terms of net rent. That's the annual rent a house would command, minus property taxes, insurance, maintenance costs, losses from occasional vacancies and any fees paid to property managers. The house you live in has slightly higher earnings than the same one you rent out to a stranger, because you aren't paying for a property manager.

Renting tends to make the most sense in weak real estate. Just calculate the earnings yield on a house. Keep renting (or, if you own, sell) if the earnings yield is lower than 3%. Be a buyer if the earnings yield is higher than 4%. In between, be influenced by whether you think rental values will hold up over the next decade.

Seaman's property agent, John M. Barrentine, calculates that her house would yield close to $1 million in a sale but less than 3% of that (or $30,000 a year) in net annual rent if leased out. She would be better off selling and putting her money into California municipal bonds. These bonds may default (the state's finances are looking very shaky), but if they do, the LA property market is in for trouble too.

In markets where house prices didn't spike as they did in LA, cap rates tend to be a bit more generous. That's why Kristen Cevoli is buying rather than renting. In March, the 25-year-old lawyer paid $235,000 for a two-bedroom apartment in Pennsport, a gentrifying South Philadelphia neighborhood.

Cevoli came close to signing a $1,400 monthly lease for an apartment similar to the one she ultimately bought, but she ran the numbers and decided that with help from a 5% interest rate Federal Housing Administration mortgage, it made more sense to buy. Were Cevoli to turn around and lease her place, she'd earn $11,150 a year in net rent. At 4.5% of her purchase price, that's a good return. The prospect of a capital gain down the road isn't far-fetched, either. Philly's housing market fell only 2% a year over the last two years, and Pennsport rents are rising.

The numbers are less appealing for tech investor Christopher Findlater of Miami, where home prices tumbled 14% in 2007 and 27% last year. Findlater spent months scouting waterfront homes with the aim of buying a property at a fire-sale price, renovating it and cashing in on an eventual comeback. Findlater realized he had lots of competition when he kept seeing the same Aston Martin and Mercedes-Benz in front of promising homes.

Undeterred, Findlater bought a four-bedroom waterfront house in Miami's South Beach neighborhood in February for $3 million. That was 40% below what the property would have fetched at Miami's peak.

It may also be more than its value a year from now, Findlater admits. With the Miami economy a shambles, South Beach rents have been falling almost as quickly as purchase prices. The $8,000 a month that he thinks his unit would now go for on the open market translates into about $64,000 in annual net rent--a meager 2% of the purchase price. Findlater hopes the renovations will boost the property's potential rental yield and, in three to five years, its resale price. "I do not think I bought at the bottom," he says.