Two priests who take pleasure in smoking are having difficulty reconciling their desire to smoke with their commitment to daily prayers. They decide it is best to ask their bishop for guidance. The first priest broaches the subject with the bishop at that evening’s dinner and as he feared the bishop’s response was a resounding disapproval. The next day the first priest encounters the second smoking in the courtyard while saying his morning prayers. “Didn’t you hear” enquires the first “I asked the bishop if it is okay to smoke while praying, and he told me it is not”. “Why there’s your mistake”, responded the second priest “I asked the bishop if it was okay to pray while I smoked”.

I am reminded of this story as I analyze the fall in housing prices over the past two years. After witnessing the carnage, the large number of defaults, lost equity, and the number of homes upside down on their mortgages, I asked myself “is home ownership a good investment”? Like the story, it is all about perception. Historically, home ownership has been promoted as part of the American Dream. Lately, the news about foreclosures, falling values, and lack of mortgage financing makes that dream appear to be a nightmare.

I visited many mortgage and financial planning sites that have “buy vs. rent” calculators, and as you may imagine, they all came up with different answers. Most of the calculators are very general and not robust enough to encompass all the variables that contribute to the answer. Therefore, I developed my own model that takes into consideration the following factors:
- Purchase price;
- Down Payment;
- Real Estate Taxes;
- Hazard Insurance;
- Maintenance;
- Mortgage Interest Rate;
- Mortgage Insurance;
- Adjusted Gross Income, marital status and related tax bracket;
- Return on Investment Savings;
- Home Appreciation;
- Inflation;
- Rent Expense

These variables substantially affect the findings. In my analysis, I assume a Boston area Home Value to Rent ratio of 23x, which is one of the worst in the country. I also presuppose the average real home appreciation price index since 1950 of 1.24%, the average yearly inflation rate of 3.789%, a 30 year fixed interest rate of 6%, and average yearly returns on investment savings of 6%, 8%, 10% (hard to imagine in this market). Using two different scenarios, my findings are dramatically different.

The first scenario is a $350,000 purchase with 10% down, married, earning $100,000 of adjusted gross income. At the end of 30 years, the equity in their home is 12% more than the value of their investment portfolio at a 6% investment return, but 15% and 43% less at investment returns of 8% and 10% respectively.

Scenario two, with a purchase price of $700,000, 20% down, married, and an adjusted gross income of $200,000 had a far greater purchase advantage with home equity gains 117% and 35% greater than the rental investment portfolio when assuming investment returns of 6% and 8% respectively, and only 5% less at an investment return of 10%.

Why such a large advantage for the more affluent homebuyer? The answer is the power of compound interest. Under the first scenario with only 10% down, the buyer is paying mortgage insurance for the first 6 years or until enough equity is built up to cancel the insurance. In addition, the 2nd buyer is in an effective tax bracket of 28% vs. 25%, providing an additional 3% tax shelter on interest payments – which again is more prominent in the earlier years of the mortgage. Compounding these early year savings provides the better returns.

In analyzing all the data over the 30 year time period of the mortgage, I found some very significant information that is useful in making a purchase decision.

1.) The cash flow requirement or homeownership is far more than just paying principal and interest. When the cost of real estate taxes, insurance and maintenance is included, plan on adding up to another 50% of P&I to cash flow needs.

2.) The largest component of home ownership cash outlay is principal and interest. However, this is also the greatest advantage vs. renting. If amortized over 30 years this cost is fixed and does not change while rent is subject to yearly increases. This has a dramatic effect on homeownership vs. rent cash flow break-even.

3.) The purchase cash outlay includes payment of principal, which in effect is investment or equity building. When this component is removed reflecting a “net cash” or “expense” outlay, the break-even between purchasing and renting is far shorter.

4.) When analyzing purchasing vs. renting there are 3 different break-evens that should be considered.
a.) Equity vs. Investment Value;
b.) Total Cash outlay;
c.) Net Cash outlay.

5.) “Mortgage Free”. Once the mortgage is paid off, the difference in monthly cash flow is dramatic, and only continues to improve. Perhaps we should all think differently when purchasing a home, and view it as security in our retirement years, and an asset for our estate. In deciding how much house to purchase, and what size mortgage, we should look at payments with amortization payments based upon a desired age to be “mortgage free”. This may be 30 – 35 years for a 30 year old, but 15-20 years for a 45 year old.

I have included a couple of charts that clearly illustrates both the cash flow aspects of purchasing vs. renting, as well as the home equity buildup vs. investment return.
If you are interested in developing you own personal purchase vs. rent scenarios using your personal variables and input, please feel free to email me and I will send you a template.

As usual, please feel free to forward this email along to anyone you think may have interest. Along that note, I thank all of you who passed along my blog information to your contacts who you thought may be interested in signing up for my commentary through my blog. I also received many direct email requests to simply be added to the distribution list. If your contacts prefer this method, please ask them to email me directly and I will add them.

Have a wonderful Thanksgiving.

- Greg