Rule of Thumb: When is it Better to Rent than to Buy?

It’s true, I’m a real estate agent and I make my money helping people buy and sell homes.  However, I’ve been known on more than one occasion to talk people out of making a purchase if I didn’t think their reasons for buying were sound.   Here’s one example of where I didn’t think it made sense.  A young married couple with a baby are looking to capitalize on the fact that interest rates are at their all time low, and the fact that the market – particularly South of Market where they were looking, took a sizable hit.  Why didn’t it make sense to me?  1.  Their price range, even with the market where it is, it put them in a one bedroom, or in a rough part of SOMA that may be fine when you’re inside but not so much fun walking with a stroller.   2.  They have family come visit often  3.  And most importantly they were looking at moving overseas in a few years and renting their place out.

For first time homebuyers to live in a place too small, or a neighborhood that is going to have ‘quality of life’ issues, who think they will become landlords in a couple years managing that from overseas, where they almost certainly wont break even on their carrying costs, didn’t make sense to me.  Yes, they may lose a window to become homeowners with some very favorable perks for Buyers that we may not see again for some time to come, but I promise you they will thank me from not having the stress related with trying to manage all of that on a bet.   One bad tenant takes all the fun out of any potential appreciation anyway, assuming they manage to deal with living in a too small space in the interim.

Planet Money, one of my all time favorite money blogs from the team at NPR posted this the other day, and I felt it was well worth passing on:

If you’re trying to decide whether to rent a home or buy one, here’s a useful back-of-the-envelope calculation:

Of course, the rent ratio is just one factor, and there are (obviously) all kinds of variables to consider — how long you’re going to stay in a place, what’s going to happen in the real estate market, and all the intangibles associated with both renting and owning. Still, I’m a sucker for a rule of thumb.

1. Take the price of a home you’d be likely to buy.

2. Divide the price by 20.

3. Compare the result to the annual rent on a comparable home.

If the result is higher than the annual rent, renting is probably a better deal.

A quick example: Take a $500,000 home. If you divide the price by 20, you get $25,000. So if the annual rent is less than $25,000 — that’s a monthly rent of roughly $2,100 — there’s a good chance you’re better off renting.

A story published on Tuesday, in NYT notes, the ratio was higher than 20 in much of the country during the past decade — during the bubble, the price of buying rose a lot faster than the price of renting.

But now, the ratio has fallen below 20 in many places, suggesting that buying is now often a better deal. (Here’s a useful graph of how the cost of renting-versus-owning has changed.)

[When is it Better to Rent than to Buy]-Planet Money NPR

For the record I also see examples where the rule of thumb does not work.  I have a friend who makes very good money, although that income can be spotty, so she’s always careful and saving for a rainy day.   She rents in a fabulous part of town, in rent control, and by far would double her monthly rent were she to buy a comparable place. However she’s lived in San Francisco for well over 10 years, has no plans to leave, and really really could use the tax deduction.  Had she used just a portion of her rainy day fund, and bought 10 years ago when I purchased my first home, she would have doubled her money in appreciation and likely be close to paying her place off in 20 years, instead of having a fantastic wardrobe of clothes – which she does!

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