Realities of Real Estate: Is it better to rent or buy?

These days, many people think that renting might be a better deal than making the leap to home ownership.

Much of the decision is a function of your financial condition and overall ability to buy. For some, a poor credit rating or lack of cash on hand might put buying a home momentarily out of reach. For others, opting to rent might be a reflection of a stage in life, where professional or personal needs make the commitment associated with buying inappropriate. And, some may think, given the recent price declines in real estate, renting could very well be a better financial decision.

We can’t address the quality of life issues, or personal side of the equation. Those are individual choices. However, we can look at the numbers and give you a feel for the financial consequences associated with renting versus buying.

We look through the Multiple List System for updates several times a day. As a result, over 10 or 15 years, you get a pretty good feel for what’s going on with the market, simply based on trends that become visible in the composition of those MLS updates.

For a while now, we’ve seen more rentals appearing in the MLS. That would be consistent with the general belief that more people are opting to rent. So, we thought it would be good to run the numbers and see if the amount of rental activity is indeed on the rise.

Take Anne Arundel County for instance. It’s a market that weathered the housing crisis with less damage than many other Maryland counties. Nevertheless, there’s been a clear move toward renting.

In 2011, there were 2,392 Anne Arundel County properties rented through the MLS. During 2005, there were only 1,351, representing an increase of 77 percent for the number of rentals. Conversely, the number of homes sold declined 45 percent, from 9,276 in 2005 to 5,142 in 2011.

During the same period, prices for renting and buying also went in different directions. In 2005, the average cost of a rental in Anne Arundel was $1,560 a month. By 2011, that had jumped to $1,892, an increase of 21 percent. However, the average cost of purchasing a home in 2005 was $399,705. By 2011, that had fallen to $346,720, down 13 percent.

So, what does that mean for the financial ramifications associated with renting versus buying?

There are several ways to look at it. First, there’s something called the “price-to-rent ratio.” Generally, this is a comparison of monthly rental rates and sales prices.

For example, in 2005 the average cost to rent a home in Anne Arundel County was $1,560 a month, and the average sales price was $399,705. To get the price-rent ratio, you multiply $1,560 times 12 for the annual rental cost. In this case, that would be $18,720. Then, you divide that number into the average sales price to get the price-rent ratio. In our example, it would be $399,705 divided by $18,720, for a 2005 ratio of 21. By 2011, that ratio had fallen to 15.

Now that the math is done, what do the numbers mean? It is widely accepted that when the price-rent ratio is from 1 to 15, it makes more sense to buy. When the ratio is 16 to 20, it’s a bit of a toss-up, and when the ratio is over 21, it might make more sense to rent. With Anne Arundel County’s ratio dropping from 21 to 15, this indicator would suggest that buying is better than renting.

The price-rent ratio can give you a cursory, top-line look at the cost of renting and buying in a particular area, but there are several more sophisticated mathematical models for quantifying the financial consequences of renting versus buying. One of our favorites is provided by the New York Times. Just Google NY Times Rent vs Buy, and you’ll find a link to their interactive chart.

This tool allows you to not only consider the purchase price of a house against the monthly cost of rent, you can also, include a myriad of other variables, things like your tax bracket, property taxes, interest rates, down payment, investment value of money, appreciation, maintenance costs, utilities and much more.

Like any computer program, it still amounts to garbage in and garbage out. Plus, it also requires a bit of crystal ball gazing, like knowing the future growth in home prices, rental rates and investment income. Regardless, it’s easy to quickly change your assumptions and see how that will affect the results. Once you load all your data in, it spits out a nifty graph and all the numbers needed to show you how much you save or spend under the options of buying and renting. Furthermore, it gives you this information on an annual basis for 30 years.

Let’s say the purchase price of a house is $400,000, but the cost to rent the same house is $2,000 a month, and you make the other following assumptions: 20 percent down payment to purchase, 4.5 percent 30-year fixed mortgage rate, 28 percent income tax bracket, 3 percent growth in the value of the house (which is the historical average), 2 percent rate of inflation and $4,600 in real estate taxes. There are some other minor variables you can add in, but these will be the big drivers in determining your results.

Based on these assumptions, it would take three years before the cost of renting would start to exceed the cost of buying. If you stayed in the home for five years, the total cost of buying would be $105,000; whereas, the total cost of renting would be $135,000. After 10 years, the cost would be $185,000 to buy and $312, 000 to rent.

By the time 15 years rolled around, you would have spent $306,000 more by deciding to rent, rather than buying. Over the 30-year life of the mortgage, renting would cost almost $1 million more than buying.

Like we said, it’s all dependent on the type of assumptions you make for the different variables, but we tried to be conservative, yet realistic and fair in our comparison.

Get on the website yourself and try a few different scenarios. It’s a quick, easy way to help you understand the financial effects of renting versus buying, based on your personal financial situation and how you see the future unfolding.

Bob and Donna McWilliams are practicing real estate agents in Maryland with more than 25 years of combined experience. Their email address is [email protected].