A BS-Free Approach Finally Answers This Much Debated Question
Part 2 – Estimating rR & rB and Building the Spreadsheet
If you haven't checked out Part 1 – Intro, Approach, and Assumptions, you can find it here:
Below is a bulleted list of assumptions used to estimate rR & rB. Unless stated otherwise, all rates are quoted before-tax. ATIRR, on the other hand, is after tax. I chose Sep 1, 1987 as starting point for historic returns to factor in the volatility of the financial and housing market booms and corrections in recent memory.
Since January 1, 1987:
- Median home prices in NYC (the entire city, not just Manhattan and Brooklyn) have gone up 4.57%/yr (source – Housing Data, Case Schiller NYC Index).
- I considered 3 realistic metrics for potential investment returns:
- S&P 500 is up 10.3% per year, including reinvested dividends (source – DQYDJ).
- I decided to assign professionally invested funds an annualized expected return of 7%, though that’s optimistic based on facts. Over 15 years, 81-87% of fund managers underperform the S&P 500 (Source – GINS Global). Mean mutual fund returns were 9.51% in 2020, 8.17%/yr over 5 years, and 5.98%/yr over 15 years (source – The Balance)
- Day-trading and stock speculation, also called retail investing returns 2.5% over time. Somewhere between 70% and 90% of retail investors lose money, depending on what one is reading. I went with optimism, and gave them appx 25% of what the S&P returns.
- I pegged rent growth and expense increases (taxes, insurance, maintenance fees, etc.) to 2.56%, the inflation average since 1987. In reality, rents in prime and emerging areas have gone up faster, so this assumption favors the renter.
- Buyer closing costs are calculated accurately, and I estimated seller closing expenses would be 9%. In reality 6% broker fee + 1.425% NYC transfer tax + .4% NYS transfer + 3K+/- attorney fee = appx. 8.3%...so9% is a conservative round-up.
- Annual maintenance is estimated at 1% of the purchase price, which is a common professional real estate investment budget for maintenance.
- The average NYC renter moves every 3 years (for lots of reasons, including rising rents and landlords selling), and moving costs $1-3K. Replacing appliances, small plumbing and electrical repairs, and minor upgrades cost about the same and happen with similar frequency, so both incidental expenses were considered a wash.
- Money saved on lower rent payments vs. homeowner expenses (mortgage + maintenance + taxes) was invested into the renter’s account, and compounded monthly. Though rising rents eventually exceed owner payments (why renters move every 3 years), savings benefitting owners were not re-invested.
- Single homeowners have a 250K taxable gain exclusion, partners have a 500k exclusion, and owe 15 - 20% capital gains tax on the remainder, adjusted by their bracket determined by income + capital gains.
- Renter(s) would owe 15 - 20% capital gains tax on their investment, adjusted by their bracket determined by income + capital gains.
- The incomes of B & R have to be estimated in order to determine brackets to adjust after-tax ROI. This was done by reverse engineering the income required to maintain a pre-tax 28% housing-related debt-to-income (DTI) ratio. 28% is the DTI used by many NYC coops to judge financial eligibility, and is a more conservative measure of financial stability than 43% DTI used by banks.
In case the reader is curious (or suspect I'm just making stuff up) here’s what the completed spreadsheet looks like. I projected and analyzed 17 years of data and returned 15 years of Buy vs Rent comparison, and performed similar analysis for coops, condos, and houses. I don't expect you to be able to read it, just to know it's out there.
Only Bernie Madoff Averaged 10.3% Returns (Google It)
Let’s be realistic. The (crazy) returns all over the news in 2020-2021 are very difficult to achieve for most people trading stocks (and coins). We are not talking about a 401K here, 20% of the median home price (the down-payment) in NYC is $135,600, and watching hard earned, after-tax savings go up and down in your face is rough.
Think about this – on a relatively good or bad day the market can be up or down 3% - so the $135K invested would change by $4K. You work 251 days per year - 5 days per week with two weeks off. $4K times 251 would correspond to an income of $1,004,000 – but don’t forget – those are after-tax dollars riding the waves. In NYC, people who take home $1,004,000 are in a 52% Fed/State/Local combined tax bracket. There are loopholes to avoid such high tax exposure, but at a 30% bracket, that would correspond with a pre-tax income of $1,434,285.71/year.
If you make that much, losing 4K is just a day’s work. But people buying 678K homes earn about 10 times less – or $400/day…before tax. Resisting the temptation to take money off the table when things are great, and staying cool when things are melting down take a toll on a person. It’s said the biggest mistake most common investors make is getting shaken out of the market, and never getting back in.
I suppose if one invested with a trusted (and skilled) professional fund manager, then the nail-biting swings that took place in 1987, 2000 & 2001, 2008-2010, 2015-2019, and 2020-2021 may have been more likely to work out favorably. So I think the most reasonable approach to this analysis is to consider average annual investment returns as a range of possibilities that fall somewhere between 7% if things go pretty well, to 10.3% if one is extremely lucky.
Unlike the stock market, you can’t knee-jerk a home sale just because the market is on fire or tanking. For that reason, homeownership has been called a “dumb way to force saving.” A home sale takes preparation and planning. On top of that, selling costs are high, the process of financing and closing takes months, and you have to live somewhere after you sell. The propensity of staying in by trading up (or down) over a long period of time makes the idea of 4.71% gains feel achievable.
Check out Part 3 – Results and Conclusions, where I analyze different expected investment returns vs different property types, price points, and different percent down, and find an answer to our question.