Arnold Kling  

House Prices and Transaction Costs

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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.


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COMMENTS (5 to date)
Bob writes:

As usual, people are able to greately reduce transaction/regulatory costs. In CA every serious real estate investor becomes (or has their spouse become) their own agent.

Dewey Munson writes:

Short Term or Lomg term?
Short term - just another one on one trade.
Long term - payoff expensive money with increasingly cheaper money while your real asset retains its monetary value while inflation proceeds.

Justin Rietz writes:

Perhaps I misread your post, but I don't believe you took into account fluctuating changes in the value of a home over time.

Over the next few years, there is a considerable chance that the value of a home purchased today will drop. Hence, for an entry level home buyer looking to "build equity" and trade up in a few years, buying a house now could well be a bad decision.

spencer writes:

I did not look closely at the NYT model.

But, do its calculations include the impact of leverage?

If you buy a $250,000 home with a 5% downpayment your investment is $12,500. If the home appreciates in value by only 2% the return on your original investment -- the downpayment -- is 40%.

I know transaction costs will change this. But
the home mortgage is about the only way the typical middle class individual can use leverage the way the more affluent investors regularly use it.

Isn't this leverage the real reason you should buy, not rent?

Moreover, if you have a conventional or standard mortgage with a 5% downpayment you will not get a margin call if the home value falls 2%.

Arnold Kling writes:

Spencer,

I really disagree with you on the leverage issue. Looking at the profit as a percent of the down payment runs very counter to what I consider to be sound economic reasoning.

In any case, there are plenty of more efficient ways to have high leverage. Buy stock on margin. Buy a call option on the S&P 500. etc.

I don't mean to come down hard on you personally, but I feel very strongly that a lot of popular financial advice is bunk, and way up there in the bunk category is the notion that an advantage of buying a home is the low down payment.

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