Renting vs. Buying a Home: The 5% Rule

Summary

In this insightful video, Ben Felix from PWL Capital challenges the common belief that buying a home is a good decision if the mortgage payment is equal to or less than rent. Instead, he introduces the '5% rule' for a more accurate comparison between renting and buying. The rule considers the total unrecoverable costs of both, including property taxes, maintenance costs, and the cost of capital (debt and equity). By comparing these costs to rent, the video offers a clear financial perspective on the rent versus buy decision. Felix also discusses the impact of tax rates and investment portfolio mix on the rule, suggesting adjustments for different scenarios. The video concludes by emphasizing the importance of considering the opportunity cost of equity capital in the decision-making process.

Takeaways

• 🏡 Comparing mortgage payments to rent is not a direct comparison; it's essential to consider total unrecoverable costs for both renting and owning a home.
• 💭 Unrecoverable costs for renters are straightforward, equating to the amount paid in rent, whereas for homeowners, these include property taxes, maintenance costs, and the cost of capital.
• 📊 The 5% rule is a simplified method to estimate the annual unrecoverable costs of homeownership, which includes 1% for property taxes and 1% for maintenance, with the remaining 3% for the cost of capital.
• 💰 The cost of capital is divided into the cost of debt (e.g., mortgage interest at around 3%) and the cost of equity, which considers the opportunity cost of not investing the down payment elsewhere.
• 📈 Historical data suggests that the real return for real estate is lower than that for stocks, which influences the cost of equity and the decision to rent or buy.
• 🌐 Global investment returns are considered, but it's crucial to use expected returns that factor in current market conditions rather than relying solely on historical trends.
• 🏠 The opportunity cost of equity capital is a significant factor in homeownership, representing the potential returns from alternative investments that could have been made with the down payment.
• 🧮 For aggressive investors who have not maxed out their retirement savings accounts, the 5% rule can be a useful guide, but it may need adjustment for more conservative investors or those with taxable investments.
• 📉 Tax considerations and the composition of one's investment portfolio can affect the cost of equity capital, potentially leading to a modified version of the 5% rule.
• 🤔 The financial decision to rent or buy should take into account not just the direct costs but also the opportunity costs and the potential tax implications of homeownership.
• 📚 For a comprehensive understanding, considering the rent versus buy decision from a perspective of unrecoverable costs can provide clarity and a more informed choice.

Q & A

What is the common perception regarding renting versus buying a home?

The common perception is that if the mortgage payment is equal to or less than the rent, then buying is a good decision.

Why is comparing a mortgage payment to rent considered flawed?

It is flawed because a mortgage payment includes interest and principal repayment, which are not unrecoverable costs, whereas rent is an unrecoverable cost.

What does the term 'unrecoverable cost' refer to in the context of renting and buying a home?

An unrecoverable cost is a cost that you pay with no associated residual value. For renting, it's the rent paid, and for owning, it includes property taxes, maintenance costs, and the cost of capital.

What is the 5% rule mentioned by Ben Felix?

The 5% rule is a simplified calculation to compare the total unrecoverable costs of renting to the total unrecoverable costs of owning a home. It includes property taxes (1%), maintenance costs (1%), and the cost of capital (3%).

What is the typical percentage for property taxes in the context of the 5% rule?

Property taxes are generally considered to be 1% of the value of the home.

What is the suggested average percentage for annual maintenance costs?

The suggested average for annual maintenance costs is 1% of the property value.

How is the cost of equity capital calculated in the 5% rule?

The cost of equity capital is calculated based on the opportunity cost of investing the down payment in stocks instead of real estate, and it is estimated to be 3%, equal to the cost of debt capital in the example provided.

What is the significance of the historical return data for real estate and stocks in the script?

The historical return data is used to estimate expected returns for real estate and stocks, which helps in calculating the opportunity cost and the cost of equity capital in the 5% rule.

How does the expected return for stocks affect the cost of equity capital?

The expected return for stocks, which is currently 6.57% for a 100% equity portfolio at PWL Capital, is used to calculate the opportunity cost and thus the cost of equity capital, which is set at 3% in the example.

What adjustments might be needed for the 5% rule in different scenarios?

Adjustments to the 5% rule might be needed considering variables like tax rates, portfolio asset mix, and the aggressiveness of the investment portfolio. For example, the cost of equity capital could decrease for a more conservative investor or a taxable investor.

How can the 5% rule be used to determine if renting or buying is financially sensible?

The 5% rule can be used by multiplying the value of the home by 5% and dividing by 12 to get a monthly unrecoverable cost. If the rent is less than this amount, renting is financially sensible. Conversely, if the rent paid is higher, you can calculate the home value that makes the unrecoverable costs equivalent to the rent paid.

What is the opportunity cost of equity capital in the context of home ownership?

The opportunity cost of equity capital is the potential return that could have been earned if the down payment money was invested in stocks instead of being used to purchase a home. It is a real economic cost that needs to be considered in the rent versus buy decision.