House Prices and Transaction Costs
The New York Times offers a nifty rent-vs.-buy calculator to go with a David Leonhardt piece on whether or not is a good time to buy a home. Under the “advanced settings,” I eliminated the transaction costs from buying a home. The baseline setting was a 4 percent cost of buying a home and a 6 percent cost of selling a home. If you set those to zero, then under the rest of their assumptions it clearly pays to buy.
I use a simple formula to determine rent vs. buy:
profitability = rental rate + appreciation rate – interest cost
In the example in the Times calculator, the monthly rent is $1112, for an annual rate of $13,344. Dividing that by the purchase price of $220,000 gives a rental rate of roughly .06. Adding this to the appreciation rate of .02 (2 percent per year) and subtracting the interest cost (.0625 for a 6.25 percent mortgage rate) gives a positive number, indicating that you should buy. On the minus side, there are property taxes for the buyer. On the plus side, there is the tax deductibility of the mortgage interest as well as the property taxes.
An even simpler rule that I use is the rule of 300. If the price is less than 300 times the monthly rent on an equivalent house, it is ok to buy. I figure that if the real interest rate (i.e., the after-tax interest rate minus the inflation rate) is 4 percent, then the ratio of price to annual rent should be 1/.04 = 25, which means that the ratio of price to monthly rent should be 300. In the example, they give, the ratio of price to monthly rent is well below 300, so my simple rule says “buy.”
The real killer, relative to my formulas, is the transactions costs. I think that an unheralded part of the housing boom of the past decade has been a reduction in transaction costs, as the costs of mortgage origination have fallen. Real estate commissions still wipe out a lot of the profit from buying a home, though, which is why it usually only pays to own a home if you plan to keep it a long time.