Where to Rent, Where to Buy

I had the pleasure of living in Orange County, Calif., during the housing bubble. It's a place of great weather, beautiful beaches, and an inordinate number of people eager to ruin their financial lives.

A fellow I knew had been renting a condo in Laguna Beach. I don't remember the exact numbers, but his rent was something like $1,500 a month. In 2006, the landlord offered to sell him the condo. After watching his friends get rich flipping homes, he bit.

He put virtually nothing down, had an interest-only mortgage, and was suddenly responsible for taxes, HOA fees, and repairs. His new mortgage was $2,800 a month -- a staggering premium over the rental rate. This for an asset that, historically, has produced a real return near zero.

Five years and a 40% crash later, his decision left him hurting. And it could have been avoided with a quick analysis of price-to-rent ratios.

Above all else, homes are places to live. Since renting can be a substitute to owning, a relationship between rental rates and home prices exists that can't be ignored. As a rough rule of thumb, renting is preferable to owning when the price-to-rent ratio -- or the home's selling price divided by 12 months' rent -- is above 15. Owning makes sense when it drops below 15.

Here's how price-to-rent ratios now look in major regions across the country:

City

Current Rent Ratio

Rent Ratio, 2005

Average, 1986-2000

San Francisco 27 40 24
Seattle 27 32 15
Orange County 26 40 18
Charlotte 26 25 15
Denver 22 26 15
Richmond 22 23 13
San Diego 22 37 15
Washington, D.C. 19 29 12
Boston 18 22 15
Bridgeport 17 21 17
Baltimore 17 21 10
Houston 16 17 12
Philadelphia 16 17 11
Sacramento 15 33 15
Chicago 15 24 16
Los Angeles 15 27 14
Minneapolis 15 21 12
Inland Empire 14 30 16
Tampa 13 24 12
Orlando 13 27 12
Atlanta 13 20 13
Phoenix 12 25 11

Source: New York Times via Moody's Analytics.

Prices have fallen enough in some regions that owning now makes a lot of sense. That's great news!

Others haven't. Notice that all regions, save for San Francisco, have a prebubble average near 15. The 1986-2000 ratio might not present a true long-term average, since 14 years isn't a long time and the early 1990s' housing bust might skew the figure lower. But it seems likely that most regions will eventually settle at a balance between renting and owning that isn't overly burdensome to one side.

That can happen one of two ways. Either home prices fall, or rent prices rise. Both are happening right now. While home prices nationwide continue to slide, nationwide rental rates are perking up, and likely to rise further. The vacancy rate on apartment rentals nationwide is now less than 6%, down from 8% last year, and actually below 2005 levels. Combine that with a comatose construction market, and landlords suddenly have pricing power. In my current town of Seattle, home prices have fallen 7% over the past year, yet my rent was recently raised 9%. The same is happening across America -- average rental prices are up about 7% over the past year.

Several factors are pushing this trend. Perhaps the largest is a post-bubble appreciation that homeownership isn't what it was cracked up to be. Homeownership rates have fallen significantly in recent years as owners revert back to being renters. Recent foreclosure snafus at big banks like Bank of America (NYSE: BAC  ) , Wells Fargo (NYSE: WFC  ) , and Citigroup (NYSE: C  ) have added to the sense that ownership is a hassle worth avoiding.

Particularly important in today's economy is ownership's impact on mobility. With about a quarter of all American homes underwater on their mortgages, millions are effectively tied to their current communities. When finding a job means having to move, the predicament these folks find themselves in can be devastating. For those not underwater, the average time it takes to sell a home has risen from 72 days in 2007 to 104 days in 2010.

Another factor in the rent-versus-buy decision that often goes misunderstood is how mortgages amortize. Many choose to own because they don't like the idea of throwing their money away on rent. Owning, they believe, is superior because monthly payments build equity. But in the early years of a mortgage, substantially all of the monthly payment goes toward interest, not principal (here's an amortization schedule). On a 30-year mortgage, monthly payments don't become majority principal until year 19. Most homeowners sell long before then.

There are several other variables not discussed here. Tax breaks. Social standing. Neighborhood quality. The availability of adequate rentals. The list goes on. A better part of the past two decades has been devoted to convincing Americans that ownership is for everyone -- and at any price. Recent events have proved this agonizingly wrong, but some people, and some entire regions, seem to be hanging onto the past.

What do you think? Use the comments box below to let your fellow Fools know.

Fool contributor Morgan Housel owns B of A preferred. Follow him on Twitter @TMFHousel. The Motley Fool owns shares of Bank of America and Citigroup. The Fool owns shares of and has created a ratio put spread position on Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (4) | Recommend This Article (13)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 29, 2011, at 12:29 PM, bluesguy84 wrote:

    I think more people will end up in our situation. We currently have a home in one state which we could not sell after a year (dropping the price ~$30k), so we are renting it to get our family back together. I have been living in another state for almost a year. We are not renting a house in the new state.

    I don't see our situation changing for a long time.

    I can see a lot of people renting homes to other people who are renting their homes to other people. Kind of like a bad chain letter.

  • Report this Comment On August 29, 2011, at 1:11 PM, cdd924 wrote:

    I think now that I am growing older, I would like to have the freedom to relocate to a home with less steps, better climate, etc. but I cannot because my home's value has taken a serious plunge. I don't care about the idea of "throwing my money away" on a rental now. It's worth it to me to not have to be responsible for maintenance and repairs. As soon as I get out of this jam, I'm headed to the rental agent.

    But I too don't see my situation changing for while.

  • Report this Comment On August 29, 2011, at 3:19 PM, Harker207 wrote:

    I don't know how useful an article about whether to rent or to own can be in addressing solely price-to-rent ratios can be without seriously exploring the other factors merely mentioned in the last paragraph, especially when assessing major urban markets, or with the markets listed above, looking at rates of unemployment at the same times.

  • Report this Comment On August 30, 2011, at 9:37 AM, jmlerche wrote:

    I agree landlords have more pricing power these days however I wonder how much of the 7% average increase in rent was due to higher property taxes, insurance, etc.? I'm sure not all of it, but at some point that needs to be taken into consideration as well.

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 1545440, ~/Articles/ArticleHandler.aspx, 10/25/2014 12:10:51 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement