A BS-Free Approach Finally Answers This Much Debated Question
Part 3 – Results and Conclusions
If you haven't checked out Part 1 – Intro, Approach, and Assumptions, or Part 2 Estimating rR & rB and Building the Spreadsheet, click the links.
Note - ATIRR stands for per period After-Tax Internal Rate of Return, and is a “core component of capital budgeting and corporate finance.” In all of the tables that follow, ATIRR is per year for number of years specified.
A home is purchased at the end of Year 0 (Dec 31), and a sale would take place on Dec 31 in the specified year. A renter would instead place the same amount the home buyer would spend on a down-payment and closing costs on Dec 31 Yr 0, and sell the investment on Dec 31 in the specified year. Both would pay any applicable closings costs, plus taxes and fees. Investment related slippage and broker fees were not considered (hard to estimate and minor).
My analysis starts with median prices. As of 6/01/21, the median home price in NYC is $678K, and 3.125% is the approximate rate for a 30 year conventional mortgage. $2,698 is the median rent for a 2 bedroom apartment, and is similar enough to what one may buy for 678K.
In the left table below, year 1 Advantage [Buyer Return – Renter Return] for the 10.3% investment model is -40.3%, a crushing blow for the homeowner. This is because the homeowner’s costs of buying and selling are much higher than capital gains taxes for the investor. Note in year 2 the advantage is reduced, and in year 5 the owner takes the lead, with a 2.3%/year after-tax return advantage. The lead grows every year until year 11, and then starts to go down.
The owner’s rate of return goes down because the maximum tax exemption from the purchase is reached in year 10 (250K for a single person), and the mortgage amortization schedule results in lower interest payments as the loan matures. Once the profit from the sale exceeds 250K, capital gains taxes reduce after-tax returns...which could mean it’s time to move, or perhaps refinance.
Bear in mind 4 things:
- A sustained 10.3% return is Madoff money…not realistic.
- The ATIRR in the tables represents the homeowner’s after tax annualized return minus the renter’s after tax annualized return.
- In year 5 of the first table, this would mean the renter is averaging a 9.1% after tax return/ year for for 5 years – which means they would double their money - after tax- every 7.95 years.
- The homeowner is beating that by 2.3%/year – with an 11.4% after tax return – double the money in 6.42 years after tax!
The middle table is a significantly more realistic Buy vs Rent analysis. Expecting a gain of 7% (before-tax) from investments is on the high side, but not insane. In this case the homeowner starts winning in year 4, and goes on to achieve after-tax returns that are significantly higher than before-tax expected returns of the renter.
The last table considers investment from the perspective of joint ownership, which as one can see does not pan out as well. This is because the returns from the home never get high enough that the 500K exclusion creates more benefit, whereas the the capital gains rate drops from 20% to 15% for joint renters. Additionally, the increased standard deduction for partners means less of an advantage for itemizers looking to write off mortgage interest, and for the purposes of this analysis I only considered the tax savings of the excess over the standard deduction as a benefit, not the whole thing.
What Happens at Higher Prices?
A $999,000 dollar purchase price (1% mansion tax narrowly avoided) vs $3700/month rental…a 47% increase in purchase price and only a 37% increase in rent seems like a bit of a steal in favor of the renter. Perhaps the renter moved from Manhattan to Brooklyn looking for more space…pretty typical so let’s go with it.
At higher price points, even with a (relative) steal of a rental deal, the homeowner still has a decided advantage over Madoff, and the better-than-average mutual fund. Note also the joint owners are not faring better than the single owner, due to the reduced benefit of mortgage interest over the standard deduction, and because the mortgage benefit is capped at a loan size of 750K.
Even Higher Prices
$2.5M vs 11K rental…that feels about right. In places like Manhattan where rentals like this are found, and are not uncommon, the balance starts to shift towards pricey. Take note:
- A $2.5M purchase price would likely require a 25% down-payment.
- 1.25% mansion tax = $31,250.
- Total closing costs of appx $86,093.75.
- A mortgage of $1.875M (of which only 750K is deductible)
- Appx $714,093.75 due at closing
At 11K/mo, it’s very likely the renter would have to cover a broker fee in the 16K range, which would reduce the initial investment from $714K by about 2.2%...not trivial, but to the renter’s benefit not included in the calculations.
What About Coops & Townhouses?
Coops are different because buyer’s closing costs are lower, but seller’s closing costs are higher due to a flip tax, which is often 1.5% of the selling price. This results in lower initial returns, but as the holding period increases, coops seem to have an advantage over condos and houses, that is, with similar monthly holding costs.
NYC Townhouses can have significantly lower monthly taxes vs condos with the same amount of space, though maintenance costs such as replacing a roof, fixing the façade, and replacing electrical, plumbing, and HVAC systems can be very high from time to time. Proper budgeting and refinancing to account for these expenses will not only lower the burden of huge one time costs, but can be tax advantageous.
Conclusions: Buyer Beats Renter Hands Down
This exhaustive exercise shows how big of an advantage buyers have over renters, even if renters are extremely disciplined and re-invest every dollar they did not spend on the higher initial costs of homeownership. The homeowner capital gains and interest exemptions, coupled with slow but steady rates of appreciation in the NYC housing market exceed even unrealistic expected returns from stock speculation.
Even with significant reductions in tax deductibility due to recent changes in the tax laws, which many expect to improve over the next few years, buyers are the clear winners over renters in just every case considered, with a margin of return that increases significantly over time, and tops out once profits exceed the homeownership capital gains exemption.
Real estate is most often a leveraged investment, and unlike brokerage accounts, it’s relatively easy to borrow 80% or more of the cost of a house with limited risk. Going back to our original purchase for 678K, let’s compare the buyer’s advantage over a renter that invests with a 7% annualized expected return if the down-payment is less than 20%:
Note with each successive reduction in down-payment, the returns in the first and second years deteriorate (undefined in the last two tables). In year 4, the 20% down purchase is showing a 3.3% expected advantage over renting, whereas the 3.5% loan (FHA) shows a 9.3% advantage over a 7% investment. By year 7, the FHA loan has a 15.6% after-tax advantage over renting and investment. All of the calculations include PMI payments, which drop away once homeowner equity reaches 22% of the purchase price through appreciation.
If you remain un-convinced, here’s one last thing: consider mortgage rates would have to rise to 8.25% to eliminate the advantage homeowners enjoy over renter/investors getting a 7% annualized return from the equities.
Based on current rates, it will be a good market to purchase for many years, as interest rates are not likely to increase any time soon.