Real Estate: Buy or Rent?

A city-by-city guide will help you decide.

Designer Delia Seaman wishes she'd bucked financial fashion and rented.

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."

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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's like paying a lot of money for a stock with a meager dividend. This is a bad deal in a flat market.

During the housing bull market it was easy to lose sight of the relationship between price and earnings (earnings being the rental value of a home). Assume that house prices will go up forever and you can kid yourself that earnings don't matter. But as the country has discovered in the past two years, house prices do not go up forever. Earnings matter.

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.

Expressed as a percentage of resale value, annual net rent is what an all-cash buyer of the property would clear by owning it and is comparable to a bond's yield. If your net rental yield (also called a capitalization rate) is lower than the yield on investments that are less risky and illiquid--high-grade municipal bonds, say--it's a sell signal if you're the owner. Or a signal to keep renting if you've been thinking of buying.

An important fact about bonds is that, with a few exceptions (like U.S. Treasury inflation-adjusted securities), they don't maintain their purchasing power. Houses and stocks, in contrast, have prices and earnings that tend to maintain their purchasing power over long periods. So, when comparing bond yields with earnings yields on stocks or houses, subtract inflation from the bond yield to get a real return. At the moment, inflation is around 0%, so the 4% you get on a municipal bond is close to the real return. If a muni yields 9% during a period of 5% inflation, its real yield is only 4%.

Renting tends to make the most sense in weak real estate markets. We've carped about this before in these pages (see FORBES, June 5, 2006). Last year housing prices fell, on average, about 20% nationwide. Futures trading in house price indexes says that traders expect house prices to fall another 22% in 2009.


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But you don't have to put credence in the futures market to make a rational decision about whether to rent. 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. State general obligation bonds due in 2014, rated a, yield almost 4%. These bonds may default (the state's finances are looking very shaky), but if they do the L.A. property market is in for trouble, too.

In markets where house prices didn't spike as they did in L.A., 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.

Source: Forbes Magazine May 5, 2009