Revisiting “Buy vs. Rent”

May 31, 2008

Readers of my old blog (circa 2005-2006) know that one of my favorite topics was the “buy vs. rent” debate. One of the best writers on the subject has been David Leonhardt of the NYT – he has argued for years that it was cheaper to rent than to buy. But now, as home prices are coming down, the case for renting is less compelling: As Home Prices Drop Low Enough, a Committed Renter Decides to Buy.

Over the last several years, I’ve come to like a simple, back-of-the-envelope way to compare the costs of renting and owning. You find two similar houses, one for sale and the other for rent, and divide the sale price by the annual rent. You can call the result the rent ratio.

The concept will probably sound familiar to stock market investors. It’s the real estate market’s version of a price-earnings ratio — a measure of how expensive an asset is, relative to the underlying economic fundamentals. Like a P/E ratio, the rent ratio provides something of a reality check.

Throughout the 1970s, ’80s and ’90s, the average rent ratio nationwide hovered between 10 and 14. In the last few years, though, it broke through that historical range and hit almost 19 by the time the housing market peaked, in 2006.

And while home prices — and rent ratios — have always been higher on the coasts, they reached whole new levels recently. In the Washington area, the ratio went above 20. In Boston, New York, Los Angeles and south Florida, it topped 25. In Northern California, it approached 35, higher than it had been in any city, at any point on record.

In concrete terms, a rent ratio above 20 means that the monthly costs of ownership well exceed the cost of renting. At current mortgage rates, for example, a $500,000 house would typically bring monthly expenses of about $3,000 (taking into account taxes, repairs, a typical down payment and, yes, the mortgage deduction). When the rent ratio is 20, that same house could be rented for only about $2,000 a month.

There are two problems with buying a house in this situation. The first, plainly, is the extra $1,000 you’re paying each month for the privilege of owning, on top of the thousands of dollars you spent on closing costs. The second problem is that a rent ratio above 20 is a good indication of a bubble. When the prices of houses get out of line with the competition’s prices — that is, those in the rental market — a correction is coming.

The question facing my wife and me was whether we were entering the market before the correction had gone far enough. I really didn’t know what the answer would be. So as we looked at houses, I started calculating rent ratios.

In the neighborhoods where we were looking, two-bedroom condominiums were selling for $400,000 and being rented for about $2,100 a month, which makes for a rent ratio of 16. Four-bedroom houses were selling for $700,000 and being rented for almost $4,000, which makes for a rent ratio of 15. No matter the price range, pretty much every apples-to-apples comparison produced a similar ratio.

Historically, this is still a bit high. But it’s very different from where the market was just a couple of years ago. With house prices having fallen over the last two years and rents continuing to rise, the decision became a much closer call. We would now have to spend only a little more each month for the privilege of owning.

OER is understating CPI

May 30, 2008

I recently heard (can’t recall where) a great characterization of today’s inflation: “high frequency items are going up in price while low frequency items are going down.”

Things we buy every day – energy and food – are going up in price. Things we buy less frequently – washing machines, electronics and housing – are going down in price.

I think this phenomenon is helping to understate inflation as measured by the CPI. Or, at the least, it does not reflect the pain people are feeling as a result of the current economic environment. It’s true that housing has gotten considerably cheaper (called Owners’ Equivalent Rent in the CPI). But a large segment of the population is stuck in a house they purchased at the top of the market. For these people, housing hasn’t become any cheaper. Also, most people are not benefitting from a cheaper washing machine or ipod because they can’t afford it anyway – they’re too broke from buying food and gas.

A possible reason why low frequency items are going down in price: prices are being slashed to move inventory. This is exactly what happened to Sears this past quarter.

Inflation Anecdote:

The Laundromat in my building has raised prices substantially:

Medium Size Wash: was $3; now $3.25 – 8% increase

Dryer: was $.25 for 8 minutes; now $.25 for 6 minutes – 25% increase

We Need MAJOR Reforms to Fix the Entitlement spending crisis

May 22, 2008

Congressman Paul Ryan in Wednesday’s WSJ:

While Congress will have a partisan debate over the federal budget this week, there is a growing, bipartisan consensus about the greatest threat to our nation’s long-term economic prosperity: the explosion of entitlement spending. Unfortunately, Washington is not planning to address that problem this week, or any time soon. By doing nothing, we are shackling our future with unsustainable debt and taxes.

According to the Congressional Budget Office, Social Security, Medicare, Medicaid and the rest of government will consume nearly 40% of the economy by the time my three young children reach my age (38). This will require more than doubling the average tax burden of the past 40 years just to keep the government afloat. Continuing down this path will eventually strangle our economy.

Ryan’s reform proposals cover health insurance, Medicaid and Medicare, Social Security, and tax reform. The fact that I agree with Ryan’s policy proposals is a little beside the point of this post.

The economic challenges our country faces as a result of the coming demographic shift are huge — the longer we wait to address them, the worse they could potentially be.

Problem is, the best reforms would so drastically challenge the status quo – not to mention special interests – that it’s hard to see them happening without major change in the people running our government.

Related Posts:

Social Security Trust Fund is a Joke

My Thoughts on Gold

We Should Live More Like Europeans

May 21, 2008

Paul Krugman spells it out:

Europeans who have achieved a high standard of living in spite of very high energy prices — gas in Germany costs more than $8 a gallon — have a lot to teach us about how to deal with that world.

If Europe’s example is any guide, here are the two secrets of coping with expensive oil: own fuel-efficient cars, and don’t drive them too much.

Still, if we’re heading for a prolonged era of scarce, expensive oil, Americans will face increasingly strong incentives to start living like Europeans — maybe not today, and maybe not tomorrow, but soon, and for the rest of our lives.


Perhaps I’m biased because I live in New York City and don’t own a car, but conservation seems to be the most sensible way of dealing with high oil prices. Problem is, so much of our economy and our lifestyles are dependent on cheap energy – changing the way we live would be a massive undertaking.

Let’s get on with it then! Looking at the supply/demand fundamentals for the next 20 years suggest that oil is not likely to get any cheaper.

Cool Wellness-Porn from NYT:

May 13, 2008

A Guided Tour of Your Body

Inflation isn’t so bad

May 8, 2008

David Leonhardt thinks inflation isn’t so bad. He says we’re only focusing on the things going up in price, and not the things going down:

There is also something particular to inflation that aggravates loss aversion. Price increases are obvious. But price declines are often hidden. The cost of an item stays about the same for years, while everything else gets more expensive and nominal incomes rise.

When you dig into the Consumer Price Index, you start to realize just how many things fall into this category. The price of major appliances has been flat over the last year. Furniture is 1 percent less expensive. A decade ago, a basic four-door Toyota Corolla LE cost $16,018, according to the company. The 2009 basic model costs $16,650, and it’s a safer, more powerful, more fuel-efficient car than its predecessor.

That said, there is one way in which the official numbers were clearly understating inflation. To track housing costs, the Consumer Price Index analyzes rents, not home prices. (Why? Long story.) And rents didn’t go up anywhere near as much as house prices during the real estate boom. So the index missed the huge run-up in home values that made life harder on anyone trying to buy a first home.

Since 2006, of course, home prices have been falling. But rents have kept rising slowly, which means that, as far as the Consumer Price Index is concerned, housing has somehow gotten more expensive during the real estate crash.

So when the new inflation numbers come out next week, they will indeed be misleading. They will be artificially high.

I disagree with almost everything in this article. A few thoughts:

Sure, there will always be some things which go up in price and others that go down; there is a constant battle between inflation and deflation. Pointing to the few items in the CPI that are going down – furniture, clothing, and electronics – does not lead to overstated CPI. The point of the CPI is to track the cost of living for the average person.

Housing Costs: true, housing prices are going down and rents are going up. This is referred to as “Owners Equivalent Rent” in the CPI. Perhaps that is leading to a slightly higher CPI now, but it had the reverse effect for all those years housing prices were going up. Besides, for many people in this country, housing costs are still going higher even though home values are down. With higher interest rates, property taxes, and maintenance costs, the cost of owning a home is not going down much.

The items in the CPI which are going up the most – food, energy, and healthcare – disproportionately affect poor people. Thus, another subversive effect of this inflation is that it will lead to a widening wealth gap.

Buffett is a tax genius

May 2, 2008

The annual Berkshire Hathaway (BRK) meeting, complete with the usual Buffett-worship, is going on now in Omaha, Nebraska. As fascinating to me as Buffett’s investment success and methodology, is his tax savvy. It’s been said that Buffett “plays the tax code like a fiddle” and that he “knew more about tax law than any lawyer in the country.”

The best example is how Buffett has compounded his retained earnings by not paying out any dividends to shareholders. As with all “C-Corps”, Berkshire Hathaway pays tax at the corporate level. Then, when dividends are distributed to shareholders, the shareholders pay tax individually. This amounts to double taxation and is the reason why many people structure their businesses as flow-through entities like LLC’s and S-Corporations.

But Berkshire has never paid a dividend to shareholders – instead, Buffett has reinvested all earnings in the business. Here’s how this worked out for Buffett in 2007:

In 2007, Berkshire Hathaway earned a profit of $13.213 billion. If the company paid out dividends at the same rate as General Electric – 50% – Buffett would have personally received a dividend check of $1.86 billion. His tax rate on these earnings would be approximately 21% (15% Federal and 7% Nebraska), thus Buffett would have paid a whopping $390 million in federal and state taxes! So, by not issuing a dividend, Buffett saved himself $400 million this year. The compounded effect of not paying dividends has added many, many billions to Buffett’s net worth. Pretty smart.