"Rules of thumb" for calculation of rent v. buy?

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<p>Owen,</p>

<p>I plugged those numbers into my calcs (including 1.8% tax rate + mello roos) and I show a price of $1.03M for a 2-year time horizon and $1.08M for a 5-year horizon. So that house is about $160K to $210K overpriced in my opinion. To put it another way, you will be down about $20-25K in 2 years by buying rather than renting, assuming there are no price changes in that time. I would wait.</p>
 
gepetoh,





According the the <a href="http://www.realestateabc.com/graphs/calmedian.htm">California Association of Realtors</a>, the median in 1981 was $107,710, and in 2001 it was $262,350. An impressive jump. Is that 7.7% annual? I think the actual growth was less than 5% compounded.
 
<p>Owen,</p>

<p>I am assuming that you are married, combined income of $10,000/month.</p>

<p>You are buying a $1M home SFS in Woodbury where Mello-roos is about $5,000 year or $417/month. You are getting a 30-yr fix loan Jumbo, first 10 years Interest only. You are putting down 20%. Could you afford this home? You have no car debts. HOA dues are $175/month. Home is about 1-yr old so maintenance cost is almost neg.</p>

<p>Sale Price: $1M</p>

<p>Loan Amount: $800,000 30 yr-fix I/O at 6.25%.</p>

<p>If you are to rent, this $1M house will cost you at least $4,000/month.</p>

<p>Here is your true cost if you buy monthly</p>

<p>Mortgage: $$4,170</p>

<p>Taxes: $1,250</p>

<p>HOA: $175</p>

<p>Insurance: $80</p>

<p>Gardening $100</p>

<p>You will save at least 30% on mortgage and property taxes 30%*($4,170+$1250) = $1,626</p>

<p>Your interest income on your $200,000 after-tax = 200,000*5% int.*70% after tax = $580</p>

<p>Cost of buying = $4,170+$1,250+$175+$80+$100= $5,775/month ---- Debt ratio of 57%, you will have to go stated and pay $2,500 in loan fee.</p>

<p>After tax saving of $1,626 = $4,149</p>

<p>Add in the interest you would have earn of $580 = $4,729.</p>

<p>Conclusion: The different between buying and renting is $729/month.</p>

<p>So who fits into this scenario? You can do it, but you will have to change your life style for the first few years until your income catches up.</p>

<p>You really have to look at the whole picture to calculate effective cost.</p>

<p> </p>

<p> </p>

<p> </p>
 
<p>Owen,</p>

<p>As you see, the different between rent and buy is very small. If rent is increased by 5%/year.</p>

<p>Year 2: $4000$1.05= $4,200</p>

<p>Year 3: $4,200*1.05 = $4,400</p>

<p>Year 4: $4,400*1.05 = $4620</p>

<p>It takes a little over 3 year to get rent = buy.</p>

<p>After Year 5, you are paying less to own.</p>

<p>If you are to buy an older home, cost would be similar becasue you will not have Mello-roo and HOA. In fact, older homes may cost more for maintenance.</p>

<p>If prices drop 20% today, then all the renters should take advantage. I saw this phenon happened in 1996 when rent and buy cost the same.</p>
 
nirvinerealtor,





I see you are suggesting the 10 year interest only loans. Wouldn't you find it rather stressful if home values declined and you knew property values had to increase to save you before your ten years was up? This is a time bomb loan with a longer fuse. I suggest you read this post: <a set="yes" href="http://www.irvinehousingblog.com/2007/03/01/financially-conservative-home-financing/" rel="bookmark" title="Permanent Link to Financially Conservative Home Financing">Financially Conservative Home Financing</a>. I am not a believer in this kind of financing because the risk it entails. People who bought at the peak of the last bubble 1990 barely got their heads above water by 2000. In 1996 , six years into the ten, they were deeply underwater. I wouldn't want to go through that. Plus, this bubble is bigger.





"Debt ratio of 57%, you will have to go stated and pay $2,500 in loan fee." Are you suggesting this borrower commit mortgage fraud? Has "going stated" become such an integral part of the financing picture that nobody sees it as either risky or fraudulent? If I am not understanding what you are suggesting, please explain further. Also, don't you think a debt ratio of 57% is crazy? Has all of California lost is collective mind? Maybe we will all be making $500K a year and then we can afford these properties.





Rent isn't going to increase at 5% a year. It did during the price rally, but that rate of increase is not sustainable. If it were, we should all buy rental properties and become landlords. If you can get consistent 5% income growth on a highly levered asset, you would become very rich, very quickly. Most landlords are happy with a stable tenant and don't raise rent much.





I agree with you that in 1996, rent and buy were about the same; however, I don't agree with your assessment that only a 20% drop is required to bring these numbers back into alignment. Factor in a conventional 30 year mortgage, and see what number you get. It is more like 50% off the peak, and about 35%-40% from where we are today on new construction. Resale product pricing is still in lala land.





I appreciate that you did not fudge the numbers much (I disagree with a few of your assumptions, but nothing major). Also, I like that you included the opportunity cost of the lost income on the downpayment. Most forget or ignore that one. Prices are just too high right now. It is a difficult sell by the numbers -- no, it is an impossible sell, but I understand your need to try. Hopefully the crash will happen quickly. Good luck to you.
 
<p>IR,</p>

<p>The 7.7% annual is based on OFHEO HPI Index. I just do a growth of a dollar and then annualize, and that's what it comes out to. But as I said before, that's beside the point, since the calculation does not use house appreciation rate. It is based purely on what the rental rates are for a home, then calculating what the house price should be based on what the rental going rate is.</p>

<p>For me personally, a $1M house should be a mansion. I doubt that this house Owen is looking at is a mansion. But despite my personal thought on how overpriced housing is, the numbers bear out to be more modest. This could be because rental has inflated too much as well, I don't know. But if we're trying to calculate whether a particular price and rent price is break even, based on that and some assumptions on inflation and rental increase rates, it's fairly obvious what the price should be for a home. </p>

<p>Take a given rent price, and increase it yearly by the rental increase rate. Add that up for the time horizon and that will give you total outlay for that time period for rent. Now take the price of a comparable home and calculate the mortgage, tax, insurance, HOA, mello roos for the year based on zero down. Calculate yearly interest (don't forget to amortize) and take deductions on that based on your tax rate. Subtract the yearly deduction from the total mortgage, and this is the the annual outlay for a home. Do this for each year of the time horizon and this is the total outlay for the period for buying. You have to take the NPV of this value to calculate what the present value of these amounts would be, then compare these. If you put down payment, you'll need to account for that also. When you can match up the NPV for the two by adjusting the house price, you have an alignment on what the price should be based on the current rental rates.</p>
 
gepetoh,





Your calculations make sense. When I analyze projects at work, I use discounted cash flow to determine the internal rate of return to make sure the project exceeds our hurdle rate, but I haven't used the technique on residential real estate. I probably should, but I am usually more concerned with the crossover point where I save money by owning. I would prefer to start out ahead so owning is always cheaper, but the market does not always give that luxury. I think it will after this crash.





What assumption would you say is a reasonable holding time to reach breakeven? If you have a fixed rate mortgage and increasing rents, at some point even the most outrageously overpriced real estate becomes justifiable. I like to use 3 to 5 years because life has a way of changing one's plans. What do you think?
 
<p>IR,</p>

<p>Feww! You were really kind to me.</p>

<p>I do suggest 30/10 I/O for sake of calculation. Even at fully amortized, the first 10 year drop in principle is not that significant. A smart one would start paying principle in 3rd year.</p>

<p>57% debt ratio. When someone put down 20%, most bank would make exception (usual guideline for higher loan amount is 55%-60%). No fraud here. Left over money is 43%. 43% of $10,000 is $4,300 for other expenses. 43% of $5000 is only $2,150 for other expenses. Thank you for clarifying fraud.</p>

<p>You can tell, I help people who really want to own a home as a home. I always tell my clients that the equity in the home can fluctuate above and below home value. The important point is it does not effect your pocket, you always have your home to live in.</p>

<p>I want to tell you my story as a clueless homeowner. In 1986, as a young graduate making $24K/year, I bought my first home for $100,000. I had $10,000 for down payment. My housing cost was $800/month (debt ratio was 40%) for everything. I took in a roomate and collected $300/month. In 1988, got married, I exchange to a $240,000 home, roll over all net proceed, my payment went to $2,000/month (interest rate was 11% 30-yr fix).In 1994, this same house was worth $165K, my equity was ZERO, ALL GONE. In 2000, sold this home for $430K, I exchanged for a $500,000 home, rolling $250K equity into it, my payment has been at $2,000/month since 2000. This home now is worth $1.3M. I have a little more than over $1M of equity. I started out with $10,000 in 1986. My payment did not increase for all of these years. Since I changed homes often, they principle that I paid were no more than $30K total!!! Let me tell you, my journey of owning a home to live-in had went through about 3 crashes. None did any damages. I was lucky I guess. I am neither a bull nor bear, I just want a roof of my own. If I did not own, I would be paying $5,000 in rent for this same house that I am living in.</p>

<p>Thank you for your feedback.</p>
 
<p>IR,</p>

<p>You can tell my business is slow now that allows me to "blog", such a nice break for me. You know, when the market "crashed" you can not even give your house away, let alone sell it - remember in 1994?. When the market appreciates quickly, people push realtors to buy for them no matter what. As a real estate agent, I like to buy when it is easy to buy. I do not try hard to sell, it's very ineffective. When it comes to housing, you can not make or talk people into buying if they do not want to buy. In reality, when people want to buy, they hope to find a realtor that will keep them from backing out of buying.</p>

<p>gepetoh,</p>

<p>I think you are on the right track with your thinking.</p>
 
<p>nirvinerealtor - We do welcome you here and do appreciate your opinions. I think it shows that you are more down to earth and are willing to come back with numbers and even admit that it is slow shows a lot. However you have to remember you have stepped into a bear cave that is starting to awake from its hibernation.</p>

<p>So I have to question your level of experience with the statement of "Debt ratio of 57%, you will have to go stated and pay $2,500 in loan fee." First what is this $2500 fee? It is true depending on the lender (not the broker) stated income does come at premium pricing. But there are several lenders that with automated underwriting like Countrywide and Chase that if the borrower can "qualify" the price and rate is the same as if you were to provide income and asset documentation. So if you have a mortgage broker that is telling you there is a $2500 fee for stated income then your buyers are being bilked. A lender would not do an exception for the 57% debt ratio even in the loose lending standard days. Maybe and maybe if it were full doc and they had a significant amount of assets twice what the mortgage balance is and a FICO of 780+ but not in today's lending standards.</p>

<p>If you know of a 57% debt ratio you are knowingly and willfully committing fraud if you "go stated". This violates the Realtor codes of ethics and is a violation of the DRE. As can be seen here <a href="http://www.dre.ca.gov/relaw_pdf/Excerpts.pdf">http://www.dre.ca.gov/relaw_pdf/Excerpts.pdf</a> page 245 section F. Yes it is for "covered loans" and for "originators" but it is late and I don't feel like digging up the exact DRE code for the violation that applies here but you get the idea and you know the law is there. Maybe not as bad as the fraud for profit that we are seeing but it is fraud none the less. This also perpetuates the problem in saying you can do it and live off ramen but later you can refinance. Maybe you don't do this but many of your peers do. </p>

<p>I thank you for your personal home buying experience as it shows that with intelligence and sacrifice it proves that you can own a home. I mean that very sincerely as I am a homeowner and investment property owner myself and it does make sense to own real estate. I am curious though with your first home purchase for $100k what was your net profit from the sale?</p>
 
<p>nirvinerealtor - I really appreciate you posting here. I think its great to have different views and frankly, I would stop coming to this blog if everyone was drinking the same koolaid.</p>

<p>One thing I have to disagree with though is that rents are dropping. Your calculations assume a 5% rent increase but I am seeing the exact opposite for privately owned rentals. Look around craigslist and you will see many SFR and condos being discounted to attract renters. Actually, even the big apartment complexes are offering major discounts. Just last year, finding a 2b/2b at Villa Sienna for under $1900 was a challenge. Just last week, they had one for $1750 after discounts.</p>

<p>As far as private rentals go, my father-in-law owns a second house in Irvine and is throwing in all sorts of goodness to keep his tenants. His tenants told him point blank that other similar properties are offering discounts to lure them. I personally think there are many empty properties sitting around as the owners were banking on appreciation and now, they are renting them out as they can't bleed any longer. </p>
 
<p>grahrix,</p>

<p>Thank you for your kind words.</p>

<p>I sold my 100K home in 1986 for $170K. I put down the left over proceeds of $60K, making the loan amount of $180K. </p>

<p>Bank is very smart in their own way, they do look at the whole package. If you have assets such as 401K and the type of work you do, they do take all kind of calculated risks. My doctor client working for Cedars got a loan at 70% DTI because of the upward income potential. My CEO clients got loans funded at 70% DTI (income of $250K/year) which left them $75K a year left for non-housing expenses.</p>

<p>As an agent, I do not want any bad recourse. I calculate the expenses to the dollar for my clients so they know their financial challenge. I also talk to them about exit plans for situation such as income increase/decrease, divorce, and job loss.</p>

<p>rkp,</p>

<p>I am happy that you appreciate my posting. Rent rates were terrible and were depreciating in November last year. Then all the inventory got really low, then rent rates move upward again. This is how the rental market goes. Landlords do not want to take a house back in the slow months. </p>

<p> If you decide to become a landlord, you must choose the best market to be in. I would not want to have similar product and to have to compete with the Irvine Apartment Community. Thank you too for your kind words.</p>
 
I have decided to revamp my worksheet to actually amortize for 12 years, and got new numbers that should be more accurate. Based on that, we need to shave another $55K off of the 2-yr horizon, and $60K off of the 5-yr on Owen's place. That puts us at breakeven price of $975K or 1.02M, respectively.

I've always thought that some sort of income-related NPV (or IRR) should be part of the housing appraisal process, taking into account comparable hypothetical rental income for the house being appraised. Just like stocks and bonds, while market may move independently from this appraisal value, at least there is a discounted cash flow model that estimates what a true value of homes should be, rather than just using comps based on too much psychology. The current appraisal process is arbitrary, and is a big contributor to the current housing debacle, IMHO.

I think a reasonable holding time is around 3-5 years also, but it also depends on the down payment. If you put the standard 20% down, I think the horizon extends another 2 years or so. Of course if the house appreciates at a greater than marginal rate, it will be shorter. And if it depreciates at all, it will be longer. According to my calc, for those who bought at the peak (I am assuming a $675K for a 1600sf TH in Irvine, and a current rental rate of $2400) the breakeven is… well, longer than the 12 years I have on my spreadsheet, but looks like it will be something like 20 years. Rental rate doesn’t catch up to the NET mortgage (outlay after deduction) until year 13 at the 3.5% rental increase assumption, so you can imagine what the breakeven horizon might be. They’ve lost out on a lot of money, another words.
 
<em>"Just like stocks and bonds, while market may move independently from this appraisal value, at least there is a discounted cash flow model that estimates what a true value of homes should be, rather than just using comps based on too much psychology. The current appraisal process is arbitrary, and is a big contributor to the current housing debacle, IMHO."





</em>He sees the light <em></em>
 
gepetoh,





I don't know if you have seen <a href="http://piggington.com/risks">this, but Rich Toscano over at Piggington</a> is in full agreement with your assessment.
 
Interesting that Toscano’s income-to-price timeline is about 12 years as well. I want to emphasize that I don’t think it will take 12 years for prices to be in line. I think prices will come down, so the time horizon for buying should be considerably less than this. We’ve already seen declines, and I think you can get the TH in my example for around $600K these days. My calculations show a $480K price for this unit as a long-term residence, but we do have to attach a premium to this since a house isn’t just an investment, it is also a place of residence that gives owners greater freedom than rent tenants. There is something to be said about having a peace of mind and pride of ownership.



So to me, a $525K price seems reasonable. That works out to about 25% total decline in price from the peak market, and I had estimated for some time a 25-30% decline overall in SoCal, including downtrend psychology. If you observe the HPI index and regress the historical line, it also works out to about the same. Keep in mind that a 30% drop is equivalent to losing 60% of what you gained (for example, if a house was $500K and rose to $1M, it’s a 100% gain. If you lose 30%, it is at $700K and is equivalent to gaining only 40% of the initial value), so that is a significant drop. The gain seems reasonable also in SoCal, as it works out to about 7.4% annual gain, slightly lower than historical values. That is entirely reasonable, as market psychology may very well bring the level below the fair value. Thanks for listening to my rants.
 
"but we do have to attach a premium to this since a house isn’t just an investment, it is also a place of residence that gives owners greater freedom than rent tenants."





This premium is why I show different price support levels for Rent Savers and Cashflow Investors. People will pay more to save money on housing than they would if they looked at it as a cashflow investment requiring a return on their money. See my previous rant below:


<a title="Permanent Link to How Inflated are House Prices?" rel="bookmark" href="http://www.irvinehousingblog.com/2007/03/03/how-inflated-are-house-prices/" set="yes">How Inflated are House Prices?</a>

As for your rants, I like reading rants from people who "get it." Keep it up.
 
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