In this episode of the REconomy podcast from First American, Chief Economist Mark Fleming and Deputy Chief Economist Odeta Kushi examine the question all potential first-time home buyers must answer, whether to rent or to buy, and explain how it’s possible for a home to pay you to live in it.
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“The major financial advantage of homeownership is the accumulation of equity in the form of house price appreciation. And, when you start to factor that in, over say the last 12 months, to just take one year of owning, what would be the benefit in that cost scenario of owning, based upon the equity gains averaged over those months? We start to find some very, very different answers. We won’t always have 17% house price appreciation, but we have to take into account the fact that the shelter that you're owning is an equity-generating or wealth-generating asset.” – Mark Fleming, chief economist at First American
Odeta: Hello, and welcome back to another episode of the REconomy podcast, where we discuss economic issues that impact real estate, housing and affordability. I'm Odeta Kushi, deputy chief economist at First American and here with me is Mark Fleming, chief economist at First American. Hey, Mark. You know, I think a lot of people out there are wondering if it's financially a better option to rent or to buy right now. That is the question. And I'm hoping today that we can help those people figure out just how to make that calculation.
Mark: Hi, Odeta. Yes, rent or buy? That is the age-old question. I think every first-time home buyer potentially asked that question of themselves. I know I did. I'm guessing you did. And, of course, now with house prices soaring at 17 plus percent, according to our data in May year over year, and breaking records in terms of appreciation, not to mention the fact that there's nothing you can buy out there, because the inventory is low and affordability has been declining, according to our Real House Price Index (RHPI), for the last three months. Why on earth would anyone want to buy in this scenario?
Odeta: And I imagine a lot of first-time home buyers, as you mentioned, are trying to make this calculation. It seems difficult out there. And so they're trying to figure out on a month-over-month basis, does it make sense for me to keep renting? Or does it make sense for me to buy a home. So, weighing that monthly cost of renting versus owning is really a key factor in making that decision. And, by the way, as we've discussed in prior episodes, the decision to buy a home is not just a financial one, but also a lifestyle decision. But today, we're actually just going to focus on the financial decision of renting versus owning.
Mark: That's right. And, you know, we might want to start with this concept of, you know, a rational economic thinker, which we know exists in all of us, right? Super rational, super rational. But what most people basically do, or at least start with, is they say, right, well, how much would it cost me per month in my mortgage and other things versus renting? So, it's the simple calculation of my rent payment versus my mortgage payment. Right?
Odeta: Exactly. So, we start off with that very basic math, we just compare the median rent to the monthly costs of owning a home. And remember, there are multiple costs that homeowners have to pay that renters do not, including taxes, repairs, homeowner’s insurance, and of course, your monthly mortgage payment. So, the analysis that we ran, and this is looking at Q1 2021, we created a monthly cost profile for a hypothetical first-time home buyer using the average 30-year, fixed-rate mortgage, and assuming a 5% down payment on a home at the 25th percentile sale price. Now, you might be asking why not the median sale price, why the 25th percentile? Well, that's because first-time home buyers are much more likely to buy a less expensive home. And so we wanted to do this analysis for that hypothetical potential first-time home buyer and what we found is that after accounting for total monthly homeownership costs for a hypothetical first-time home buyer and comparing it with the median rent by market, renting was a better financial choice in 29 out of the top 50 markets in the first quarter of 2021. Some of the markets where it was better to rent, included Austin, Boston and Chicago. And it was better to own in places like Virginia Beach and Tampa, Florida. Now, as I mentioned, an example of where it was better to rent was Austin, Texas. In Austin, the median rent was just over $1,300, while the median monthly payment to own the 25th percentile home was nearly $2,000. But, as always with us, I imagine this isn't the whole story.
Mark: No, of course not. We're not done yet. Think about if you rent a home from somebody, remember all that house price appreciation we were just referring to? Who gets all the benefits of that? It's your landlord. If you're a homeowner, though, you would get the benefit of all of that house price appreciation. So, the major financial advantage of homeownership is the accumulation of equity in the form of house price appreciation. And, when you start to factor that in, over say the last 12 months, to just take one year of owning, what would be the benefit in that cost scenario of owning, based upon the equity gains averaged over those months? We start to find some very, very different answers. We won’t always have 17% house price appreciation, but we have to take into account the fact that the shelter that you're owning is an equity-generating or wealth-generating asset.
Odeta: Absolutely. And we do have some interesting findings because once you include the equity benefit of price appreciation, we find that owning made more financial sense than renting in all of the top 50 metro areas. The last time we ran this analysis for the year 2020, there were actually still some markets where it was still to rent. And that was San Francisco and San Jose. But, faster nominal house price appreciation brought those markets on to the own side of the equation in 2021. So, going back to our Austin, Texas example, as a refresher, the median rent was just over $1,300. But now the appreciation-adjusted monthly cost to own a home goes from nearly $2,000 to negative $1,000. That's the benefit of equity. And what do we mean by a negative monthly payment Mark?
Mark: Well, how can I make a negative monthly payment, or how can the cost be negative? Yes, it's a benefit. The home is paying you to live in it. Now, we've had really good house price appreciation. So, it's not that surprising that this might be the case relative to your monthly costs. And interest rates are low, so the actual cost of ownership is much lower. But, the benefit of appreciation is outweighing the cost in so many places that it's paying you to be an owner. Now, keep in mind, rent growth has picked up in the in the second quarter of 2021. And our latest available data from April or May suggests that rents are up, so this calculation is constantly changing over time. And why is that? Because, you know, theoretically renting and owning are what we, as economists, call substitute goods. I need a roof over my head that gives me the utility of shelter. And whether I rent that roof, or I buy that home to get that roof up, I get the same utility of shelter. But, theoretically then, any differences ultimately should be adjusted out between the rental prices, or the rents per month, versus the cost of ownership per month. And that has to happen either in the form of rising rents, as we're actually seeing in many markets today, or possibly slower, or even falling house price appreciation. But, of course, that's all theoretical.
Odeta: And again, buying a home is not just a financial decision, but also a lifestyle decision. And there are certainly reasons to remain a renter, I'll just say that a couple days ago, my dishwasher broke, and I called by building maintenance and they came in and they replaced it the next day. I have no idea how to replace my dishwasher. So, that was certainly a perk of being a renter. That's not necessarily the case when you buy your home. And then of course, there are the transaction and settlement costs associated with buying a home that you have to consider. Mark Yeah, there are costs involved in facilitating that purchase transaction. There are these transaction and settlements costs, which cover all sorts of other aspects of actually becoming a homeowner, but they're all charged as one-time fees. So, if you spread those fees out over the life of ownership, which for those who've listened to our podcasts know that tenure length is now over 10 years. You spread those one-time costs of becoming a homeowner over 10 years. Remember the old adage that everyone said, as long as you live in your home for at least a few years, you will recoup those costs. And, of course, when house price appreciation is going up so much faster, like it is now, that happens even faster. So the costs of transacting are relatively small compared with the benefits that you gain of owning, particularly when your user cost is negative, or a benefit.
Odeta: Right, their home gives you equity, we can't overstate that it won't always be 17% year-over-year growth. But homeownership has proved itself to be a primary driver of wealth creation over time, and we have the data to show it.
Mark: Yeah, I think one of the most amazing stats that I've come across in my years working as a real estate economist is really measuring the benefits of wealth creation of homeownership. You have to remember that this is a leveraged asset. You buy your home, in this example with 5% down, effectively that's a 20-to-1 leverage ratio. Most Wall Street banks would die to be able to do 20-to-1 leverage ratios. If your home goes up by 5%, you've doubled your money – 100% gain – so the wealth-generating capacity is amazing. Just to put some real stats on this in 2019. In the survey of consumer finances, the median homeowner had 40 times the household wealth of a renter, that's $255,000 for the owner, compared to only $6,000 for the renter. Homeownership is one of the best sources of wealth creation.
Odeta: And I think what's even more interesting is that homeowners are wealthier than renters at every income level. And the majority of homeowner wealth comes from housing for every income category, except for the very top earners. So, again, putting some numbers to this. For the lowest income group, the median net worth of homeowner households is just over $100,000, but for renter households, it's only $1,500. At the lowest income category, 92% of total homeowner net worth is tied to the value of residential property. And between 2016 and 2019, housing wealth was the single biggest contributor to the increase in net worth across all income groups, accounting for over 30% of the overall increase. And this was especially true of lower income households. And I think this is really important to note that it's across the income spectrum.
Mark: Not only is it across the income spectrum, but as you say, it's even more dramatic at lower levels. This is why from a public policy perspective, there is often so much focus on affordable housing and homeownership, and creating the opportunity for everyone to become a homeowner because the benefits are so large. In fact, you look at housing wealth for lower income people, 75% of their total assets comes from being a homeowner, as compared to when you're in the higher income brackets, it drops down to 34%. You have other sources, in the stock market and other places, so homeownership, is almost the only source of wealth generation for lower income households.
Odeta: And of course, there are certainly risks from homeownership and its benefits are not uniform across geographies. However, it seems for the majority of households that transition into homeownership, the most recent data reinforces that housing is one of the biggest positive drivers of wealth creation. And, once you include the benefit of house price appreciation in the monthly cost of homeownership, it can make more financial sense than renting. All of this data can be found on our Economics Center. And, as always, thank you for joining us on this episode of the REconomy podcast. Be sure to subscribe on your favorite podcast platform. You can also sign up for our blog at Firstam.com/economics. And if you can't wait for the next episode, please follow us on Twitter. It's @OdetaKushi for me and @MFlemingEcon for Mark. Until next time.