The debate of should you buy or rent a house comes up often.
I’ll admit, my view of money, investing, and real estate is not in line with mainstream thinking.
But that’s who I am.
It’s the point of my entire website and my entire mission.
To teach that traditional thinking on money, investing, and real estate is flawed.
If you take your advice from the best-selling books, most popular magazines, and mainstream media, you are going to make some financial mistakes. You’ll miss some important points.
You’ve probably heard “experts” say owning a home over the long term gives the opportunity for significant earnings from appreciation. I will make the counter-argument that buying a house for appreciation is a bad idea.
You’ve undoubtedly heard that renting is throwing money away, and buying a house is a way of building equity.
Well maybe not.
I’ll make my case.
Next, I’ll talk about the only situations where I would buy a house, which are:
- When the purchase price of the house allows it to perform well as a rental property
- When you plan on living in the property long term, want to own it, and understand it isn’t that great of an investment
Whether or not you should buy a house or not is a simple question to me:
Is buying this house a good investment?
In other words:
What is the opportunity cost of investing in this house over other similar options?
I have a decent background in investments, having been a licensed stockbroker before I came into the military. I speak (or write I guess) with a background both in real estate and investments.
The S&P 500 Index has grown at a rate of approximately 7% a year since 1928. You can stick money in this fund, and let it compound and grow for you. There is no work, almost no fees, and it’s the easiest money you’ll ever make. Essentially, it’s money you earn for doing NOTHING.
If I can get 7% growth for doing nothing, I want to make sure any venture in real estate, which requires active management, time, and money, makes at least this much.
For that reason, I don’t consider buying a house a good investment unless it will make more than 7% per year.
Should I Buy or Rent – The Appreciation Myth
In certain markets during certain years, real estate can appreciate at rates better than 7%.
But there is a catch.
Nobody knows when, where, or for how long that appreciation will happen.
No one knows when it will end, and when it will reverse on us.
I’m already hearing real estate investors talking about a bubble again!
To understand whether you should buy or rent a house, we need to first understand the main argument many people make for this decision.
I will attempt to dispel the appreciation myth here.
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!
I’ll back this up with a real-life example from my first property.
We all likely know somebody who made a lot of money buying real estate at the right time and watched it grow astronomically year-over-year. This happened to a lot of people who bought homes in certain hot areas between 2001-2005. It happened to me in Alexandria, VA with a townhouse I bought in 2003.
Conversely, having all lived through the burst of the bubble in the late 2000s, the lesson of having the market go down on you when you are highly leveraged is probably not that hard to comprehend, and we understand how it financially ruined many people. It almost ruined me on new construction I purchased in 2005, and the $900,000 2bed / 1 bath I almost bought in Monterey, CA in that same year.
That was a close one!
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 inflation rate of 3% over the same time period.
The best you can say about appreciation in housing is that it will keep up with inflation, but unlikely to do much better.
The idea that you are going to buy your house at the right time and location and take advantage of that huge jump in the market that everyone is talking about is naïve.
Once you hear about those wild appreciation jumps in the news, and hear about your friends that bought in Florida at just the right time, guess what?
It’s too late!
And how did your friends know?
They happened to buy at the right time.
It was luck.
Maybe they bought and it went down. Now it’s not luck.
It’s bad luck!
The hype about making big money off appreciation in real estate is just that.
It sells magazines and promotes clicks on websites.
It sells books and seminars and infomercials.
It makes the people that provide that content wealthy.
But don’t believe the hype.
It’s all smoke and mirrors.
There are lots of magazines, real estate agents, and other so called “professionals” that make their living off pretending they can predict where appreciation will occur, but they are guessing.
Some of them might think they know, but they don’t. It’s just like those people that think they can pick stocks that are going to be winners.
Or those people that think they can day trade (the scariest of them all).
When and where massive appreciation will occur, just like and when and where stocks will skyrocket, are all matters that are far more left to chance than most people want to believe.
It’s out of our control. It relies of variables that are impossible to predict until it actually happens. There is a massive industry devoted to this type of guessing, but at the end of the day, it’s all just prediction.
Even weathermen will be far more accurate.
If someone tells you they are buying real estate in a certain city because they think it will raise quickly in value, you need to understand this is a risky strategy.
It is a gamble.
This is what got people in trouble in Miami and Las Vegas at the end of the real estate bubble. It’s what got me in trouble with the new construction I bought in Washington D.C. at the same time.
To me, it is not financially sound to buy real estate with the desire to cash in big on a large amount of appreciation. The odds are against you. The odds say you’ll get on average 3% per year. Going for more than that is just like playing craps in Vegas.
You’re just rollin’ the dice.
I think I’ve beat that dead horse enough.
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.
I didn’t sleep for weeks and was worried I was overpaying.
Boy was I wrong!
Two years later, my house was worth $450,000.
That’s 60% appreciation.
Obviously, I’m pretty good at this real estate thing.
Everyone should invest in real estate. Appreciation will make us all rich!
Hold on a sec…
I’m in the military, and I ended up moving away and turning that house into rental.
I rented it out for $2000-$2400 a month over the next 13 years. It made 3-4% ROI. Very high taxes, HOA fees, lots of upkeep. Not a great investment as a rental property.
I sold that property in 2016 for $400,000.
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.
I actually paid off the 30-year mortgage early. I did it in 7 years. But let’s consider this. What if instead of paying off that mortgage early, I would have invested all that money in the S&P 500.
As you remember, the increase in the price of the house for 13 years was 42%
For that same period (Jan 2003 – June 2016), the total S&P 500 Index return with dividends reinvested was 129%. (https://dqydj.com/sp-500-return-calculator) That means theoretically, $280,000 would have turned into $641,200. That’s quite a bit better than the $400,000 I got from appreciation.
This is not a perfect comparison, but I am illustrating the point that buying a house has opportunity costs. When you use your money to buy a house it means you are not using that money for other things. It’s tied up in that investment and not a better one.
Money invested in a house making 3% a year in appreciation is not invested in the market making 7% in the S&P 500 or maybe in another investment opportunity making more.
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).
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 instead of paying off my mortgage early.
Well, at least that’s what the experts say. That’s what mainstream media is always screaming at us.
After all, home ownership is the American dream, right?
Let’s take a closer look at this.
We’ll assume that Rob the Renter is renting a property for $1000 a month.
Bob the Buyer is buying an identical property and his mortgage payment is $1000 a month.
We need to understand a few important things about Bob the Buyer’s mortgage payments.
People like to say when you make mortgage payments, you are building equity each month. What you don’t realize is for the first several years of the loan, building equity happens at a much slower rate that you imagine.
If you look at the example below from a $100,000, 30-year loan, the first payment only has about $100 dollars of the $600 payment going towards the principal. 84% of the payment goes to interest. The 12th payment is only slightly higher. It inches up slowly from there.
Even after 15 years of payments, more than half of each month’s payment still goes to interest instead of principal. Look at payment 180, which is at the halfway point.
If you end up buying a house and then selling it after 5 years, the amount you’ve paid down in principal combined with the amount you’ve gained in appreciation 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 compared to renting. It depends heavily on how much appreciation you got in that five years. Maybe those weren’t a great five years for that particular location.
Buying is by no means a clear winner financially.
Also, even though Rob the Renter and Bob the Buyer’s expenses appear to be equal on the surface (both $1000 a month to live in the house), renting turns out to be much cheaper.
Rob the Renter has no additional expenses beyond his rent each month. He maybe pays a small fee for renter’s insurance, but everything else is included.
If his dishwasher breaks, he calls his landlord. If his roof starts leaking, landlord. He doesn’t pay taxes on the property and he doesn’t pay HOA fees.
The same is not true for Bob the Buyer. Even though his mortgage payment is $1000, there are LOTS of other expenses ABOVE AND BEYOND this amount. This is not necessarily all-inclusive:
- capital improvements
Verdict: A renter may have lower expenses over a buyer and be able to invest the surplus or do whatever else he wants with that money.
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:
- Appreciation historically barely keeps up with inflation (only 3% per year)
- Chasing the wild appreciation that everyone keeps talking about is a fool’s errand
- Principal pays down on mortgages far slower than you realize
- There are large hidden costs on top of the mortgage payment
- There are advantages to renting because no costs on top of rent
So Rich, does it EVER make sense to buy a house?
Hell yes it does.
I own several properties.
But I don’t always buy the house I’m living in. In fact, hardly ever.
Let me illustrate this point by explaining what I did when I moved to Montgomery, Alabama for a military assignment.
I don’t buy a house unless the purchase price would make it a good rental property. That goes for a primary residence or investment property.
For me, that means it would need to make at least an 8% return on investment. I would want it to be a better investment than just sticking my money in the S&P 500 Index fund I discussed earlier.
I use the 1% rule to give me an idea if a property will make a good rental or not.
The 1% rule essentially means if a property will rent for 1% per month or more of the acquisition price, you can consider it for a rental.
The house my wife liked in Montgomery was in a decent school district and a safe neighborhood where many other military families lived. It listed for about $179,000, but rented for about $1350 a month.
To pass the 1% rule, this house would have to rent for 1% of $179,000, or $1,790 a month. $1,350 is not enough.
It didn’t pass the 1% rule, so we rented it instead of buying it.
Why? 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. I was better off renting.
I later realized there were other neighborhoods in Montgomery, Alabama where I could buy houses for $45-$60,000 and rent for $750-$900 a month. These surpassed the 1% rule and would make good rental investments.
The problem was, these were in neighborhoods we wouldn’t be comfortable living. This is how I could end up renting in one neighborhood, but buying investment properties in another neighborhood in the same city.
These investment properties passed the 1% rule, and I ended up buying six properties over the following eight months. I did this even though I was renting the property I was living in.
It made financial sense to rent the property we wanted to live in, because it wouldn’t do well as rental. We knew this by first applying the 1% rule. It made sense to purchase the investment properties in a different part of town because they would perform well as rental properties.
Here is my detailed post on the 1% rule and how to estimate how much money your rental property will make.
I only lived in Montgomery for a year. I continue to buy houses in Montgomery to this day, even though I don’t live there. As long as I can make the numbers work, I’ll keep buying!
I have a real estate agent, property manager, and other necessary people on the ground in Montgomery to make my continued investment there possible from out of state.
In my case, I’ve actually been investing in real estate from out of the country for most of my career.
But I Just Want To Buy This House!
There is a final category 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.
The longer you live there, the better chances you have for decent appreciation and satisfactory mortgage pay down.
In that case, go ahead.
You’ll get no argument from me.
Enjoy this? Read my first post ever. It’s actually my most famous post.
Rich on Money