The debate of should you buy or rent your home comes up often.
You’ve probably heard “experts” say owning a home gives the opportunity for significant earnings from appreciation. I make the counter-argument that buying a house just for appreciation is a losing strategy.
You’ve undoubtedly heard that renting is throwing money away, and buying a house is a way of building equity.
I’m here to tell you, it is not that simple.
The following is a list of reasons buying is not always better than renting:
- Primary Residences often Don’t Cash Flow Well
- Rent does not have Additional Expenses
- There are Several Expenses to Pay on Top of a Mortgage
- Mortgage Pay-down Doesn’t Happen as Fast as you Think
- Appreciation is often Overestimated
Primary Residences Don’t Cash Flow Well
I’m a real estate investor, and I almost never buy the house I’m living in.
Unfortunately, primary residences often don’t cash flow well because they have one or some of the following attributes:
- New or Newer Home
- Nice Neighborhood
- Good School District
- Low Crime
- High Cost of Living Area
- Near Beach, Lake, or River
By having any of these attributes, they are more desirable, and cause the price to rent ratio to be off. This means rent often doesn’t cover the mortgage.
Let me illustrate this point about primary residences by explaining what I did when I moved to Montgomery, Alabama for a military assignment.
I don’t buy a house unless it will cash flow well as a rental when I move away.
That goes for a primary residence or investment property.
For me, that means it would need to make more than a 7% return on investment, which is what I believe is easy to make in the stock market.
I use the 1% rule to give me an idea if a property will make a good rental or not.
The 1% Rule
The 1% rule essentially means if a property will rent monthly for at least 1% of the purchase price, it will be a good investment.
If a $100,000 property rents for $1,000 or more a month, it passes the 1% rule.
If something passes the 1% rule, it works out to about a 6% return on investment (ROI) on your money without financing.
To get the exact ROI, you’ll need to manually calculate, but this is a great way to see if you are even close to having a profitable investment.
The house my wife liked in Montgomery was in a good school district and a safe neighborhood where many other military families lived. It listed for about $179,000, but rented for about $1,350 a month.
As I mentioned above, this neighborhood had attributes which cause it to not cash flow well because of higher prices relative to rents.
To pass the 1% rule, this house would have to rent for 1% of $179,000, or $1,790 a month.
$1,350 in rent was not enough.
It didn’t pass the 1% rule, so we rented instead of buying.
Why rent instead of buy?
I knew that if I had to move out of Montgomery soon (which was very likely because I’m in the military), this house would be a poor investment as a rental property.
After subtracting expenses and a mortgage from the rent, you were likely to have no cash flow, or even lose money each month.
I was better off renting.
I later realized there were other neighborhoods in Montgomery, Alabama where I could buy houses for roughly $50,000 that rented for approximately $850 a month.
A $50,000 house needs to rent for at least $500 a month to pass the 1% rule. This one rents from $850 a month.
These homes surpassed the 1% rule and would make good rental investments. They are likely to cash flow well, even with a mortgage.
The problem was, these were in neighborhoods we didn’t want to live.
While these weren’t horrible neighborhoods, the homes are older, school districts weren’t as good, and crime a little higher then where our primary residence was.
This is how I could end up renting in one neighborhood, but buying investment properties in another neighborhood in the same city.
Here is my detailed post on the 1% rule and how to accurately estimate how much money your rental property will make.
Wait Rich, sure it might not cash flow well, but I’d rather pay a mortgage than rent!
Renting is Throwing Money Away, Right?
It’s not that simple.
When you rent a property for $1,000, that is the most money you’ll pay every month.
Toilet breaks, call the Landlord.
Roof starts leaking. Landlord.
You don’t pay property taxes, insurance, or even HOA fees.
When you pay a mortgage of $1,000, that is the least amount of money you’ll pay every month.
In addition to a mortgage, you’ll also be paying:
- capital improvements (windows, roof, large expenses)
- HOA fees
- closing costs and commissions
What many new investors also don’t realize is expenses on a property often take up 35-65% of rent.
There is something called the 50% rule which estimates half of rents are eaten up by expenses.
NOT INCLUDING MORTGAGE!
Ok, Rich. Rent might be cheaper overall, but tenants are paying down my mortgage for me!
But at least my Tenant is Paying my Mortgage!
Yes. Well, sort of.
What you don’t realize is for the first several years of the loan, payoff or building equity happens at a much slower rate than you imagine.
If you look at the example below from a $100,000, 30-year fixed loan, the first payment only has about $100 dollars of the $600 payment going towards the principal.
84% of the mortgage payment goes to interest. The 12th payment a year later is only slightly higher. It inches up slowly from there.
Even after 15 years, more than half of each month’s payment still goes to interest instead of principal.
|180 (Halfway Point)||$243.09||$356.46||$71,048.96|
If you end up buying a house and then selling it in 5 years, the amount you’ve paid down in principal will probably underwhelm you!
I wouldn’t go shopping for a sports cars quite yet.
That combined with all the transaction costs of buying and selling will probably put you in a worse financial position than renting.
It depends heavily on how much cash flow and appreciation you got in that five years.
Buying is by no means clearly the better financial choice.
Ok Rich, but my friend bought in Hawaii and made $100,000 in a year!
Won’t I Make Money from Appreciation?
I need to break the popular misconception that lots of money is made in real estate from appreciation.
It’s far less than you think!
The average annual home price increase (appreciation) for the U.S. during the 1900-2012 period was 3.1%, which is only slightly better than the average inflation rate of 3% over the same time period.
The best you can say about appreciation in housing is that it will likely keep up with inflation.
Areas that are famous for appreciation, like Hawaii, San Francisco, or New York City often appreciate largely over short periods of time.
This can be very misleading, because over the long term, the average appreciation is only slightly better than the rest of the country.
Plus, you never know when these short periods will be.
Here’s a good example.
Appreciation on My First Property
Let’s talk about the first property I ever bought. I made a FORTUNE on appreciation when I bought this place.
Real estate rules!
I bought a townhouse in 2003 in Alexandria, VA for $280,000. This is right next to Washington, D.C.
A year and a half later, my house was worth $400,000.
That’s 42% appreciation.
Obviously, I’m pretty good at this real estate thing.
I sold that house thirteen years later in 2016.
For how much?
Essentially, over a 13-year period, I saw an increase in price of 42%.
They say inflation is roughly 3% per year. 3% X 13 years = 39%. That would mean my increase of 42% barely kept up with inflation.
This is historically the case with real estate. It keeps up with inflation, but that’s about it.
Looking back and crunching the numbers, I realized two things:
- The amount I made from appreciation was far less than I expected.
- The amount I made from having that property as a rental was far less than I realized (barely 4% ROI).
The house didn’t cash flow well because it was in a high cost of living area.
If I had it to do over again, I would have rented in Alexandria, VA instead of buying, and invested any extra money I had in the S&P 500 Index.
Take a more in-depth look of appreciation here:
Buy Properties that Cash Flow – Conclusion
I’m not saying renting is always superior to buying.
I am saying that it is not as clear cut as you previously assumed, and you should consider the following information:
- Confirm your Property will Cash Flow Well
- Renting is Not Throwing Money Away
- There are several expenses to pay on top of a Mortgage
- Mortgage Pay-down Doesn’t Happen as Fast as you Think
- Appreciation is often Overestimated
But I Just Want To Buy This House!
There is another unique situation where I believe it’s ok to buy a house instead of rent.
It’s when you understand that buying a house is not a great investment.
Knowing that, you plan on living in this house for a long time, and you want to own it.
Owning feels good, feels right, and it’s important to you.
The longer you live there, the better chances you have for decent appreciation and satisfactory mortgage pay down.
But primary homes are rarely good investments. They don’t cash flow well.
As long as you understand that, and know this isn’t the optimal use fo your money, then it’s ok.
Sometimes it’s not a purely financial decision. There are other psychological reasons for wanting to own the house you live in, and those are valid.
In that case, go ahead.
You’ll get no argument from me.
Just don’t kid yourself that it is the best use of your money.
I currently own 30 properties, most of them being paid off.
I wrote a long article explaining how I did it in my spare time.
You could too.
Read more about my approach to real estate at the link below.
Agree with my buy vs rent argument?
Think it’s B.S.?
I want to hear from you in the comments.
Rich on Money