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:

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.

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