Buy versus Rent – Breakeven Analysis Methodology

Posted by: Nalina Varanasi    Tags:      Posted date:  August 1, 2012  

The decision to buy or rent is of interest to consumers, investors and other professionals in the real estate market. Most individuals at some point in their lives have or will encounter the decision of whether they should continue renting or instead buy a home. At the aggregate level, the rent versus buy decision of households gives us a sense of trends in home values in a particular area.

Historically, to make the buy versus rent decision, consumers and investors have been using the price-to-rent ratio. A lower ratio indicates that one is better off buying in that market instead of renting and a higher ratio indicates vice-versa. We have developed our own improved version of the price-to-rent ratio, which can be found here. Despite the improvement, our price-to-rent ratio is still not very meaningful to a potential buyer who is considering buying a home versus renting, because it does not include all the costs incurred when purchasing and owning a home. The price-to-rent ratio is probably at best a useful metric to an investor who is considering buying a property and renting it out. It gives investors an estimate of the number of years after which their property investment may become profitable[i]. However, the price-to-rent ratio does not inform potential buyers on how much it costs to own a home versus renting the same home at any given point in time.

Additionally, the price-to-rent ratio ignores appreciation of home values which makes the home purchase a profitable investment for the home owner after a certain number of years as opposed to renting the home. Hence, the number of years after which buying a house becomes financially beneficial compared to renting the house is a function of the number of years one plans to stay in the house and the price-to-rent ratio calculation does not take this into account.

We introduce a new approach to make the buy versus rent decision and compute a metric called the ‘breakeven horizon’. The breakeven horizon is the number of years after which buying is more financially advantageous than renting (at the precise breakeven horizon one can be indifferent between buying and renting). We compute the breakeven horizon for each household by comparing the costs of owning a home versus renting a home at the end of each year for 30 years (since we assume the house is purchased using a 30 year fixed mortgage) by following the steps below-

  1. Obtain a random sample of homes for each city/metro depending on the level of aggregation.
  2. Compute the yearly costs of buying and owning a home.
  3. Compute the net costs of buying a home.
  4. Compute the costs of renting the same home.
  5. Compute the cumulative net costs of owning a home and costs of renting a home for all previous periods up until current year.
  6. Compute the difference between the net costs of owning a home and costs of renting a home.
  7. Calculate the breakeven horizon as the year when the difference is negative or zero, in other words, the number of years after which renting is more or equally expensive compared to buying a house.
  8. Compute the average and the median breakeven horizon for each city/metro using the household level breakeven numbers.

The next section describes the data used for the buy versus rent breakeven analysis.

Data

We use Zillow’s estimate of home value (Zestimate) and rental price (Rent Zestimate) for each home to compute the breakeven horizon at the property level for all homes in the United States by calculating the total costs of buying versus renting the same home. The analysis is done for all properties at the metro level for 224 metros and at the city level for 7846 cities. Only cities and metros with at least 100 properties are included in the breakeven analysis.

Net costs of buying a home

This section describes the data used to compute the net costs of buying a home. We assume that the home is purchased using a 30-year fixed mortgage with 20% down payment and a mortgage rate of 3.56%[ii]. To account for the appreciation of home values each year, we use the one-year-out Zillow Home Value Forecast (ZHVF) forecasts from April 2012 (capped at 5%) for properties located in the 30 largest metros for the first year and then for the subsequent 29 years we assume a constant rate of home appreciation of 2%. For all other metros, we assume a constant 2% rate of home value appreciation for 30 years. The closing costs for buyers are 3% of the estimated home value. We use the most recent amount paid in property taxes by the current home owners of each property[iii]. We assume owner’s insurance, maintenance and renovation costs to be 0.5% of the home value. The utilities cost is set to zero as it is the same irrespective of whether the property is owned or rented. We use a marginal tax rate of 25% which is approximately the average federal tax bracket as indicated by the National Bureau of Economic Research[iv] and this tax rate is used to compute the tax benefit accrued from writing off interest payments and property taxes. The opportunity cost of buying a house is the monetary returns one can gain by investing the cumulative yearly costs of owning a home in the financial market and we assume the rate of return on this investment to be 5% to calculate opportunity costs of buying a house. To compute the net costs of owning a home, we calculate the profit a homeowner could make by selling the home and by assuming selling costs to be 8% of the sale price; $500,000 in capital gains exclusion and capital gains tax rate of 15%. For properties that are condominiums, we include an additional cost of condominium fees of 1.2% of home value per annum. We inflate the maintenance, utility, renovation costs and condominium fees every year by assuming an initial inflation rate of 1% and 2.5% increase in inflation rate per year.

Net costs of renting a home

We use the Rent Zestimate and a rental appreciation rate of 3% per year[v] to compute the annual rental payment for each year for 30 years. Other rental costs include the rental deposit which is a month of rent, rental broker fee which is 1% of the annual rent and rental insurance which is 1.32% of the annual rental. Rental costs also incorporate rental opportunity cost which is the returns one can expect if the rental costs were invested in a financial market.

Methodology

We first start with a random sample of at least 100 homes and at most 3000 homes for each city/metro. To calculate the initial cost of buying a house, we first compute the down payment, purchasing cost and the amortization schedule which gives us the annual mortgage payments and interest payments for the next 30 years. We then add to this the yearly cost of owning a house which includes annual owners insurance, property taxes, maintenance cost, renovation cost and utility costs. We then evaluate the opportunity cost of owning a home which is the financial returns one can acquire by investing the initial and yearly costs. Since homeowners can write off the property taxes and interest payments we calculate the yearly tax benefit using the marginal tax rate. Finally, we compute the financial gains from owning a home which is the profit one could make by selling the home if the home value appreciates net of the mortgage balance, selling costs and the tax on the profit. We then compute the cumulative net costs of owning a home up until the current year. The net costs of owning a home in a particular year ‘t’ is given by (all amounts are yearly except those without the time subscripts)-

Cost of owning the home (t) =  The computation of the costs of renting a home is far simpler than that of owning a home – we add up the rental deposit, rental broker fee, cumulative annual rental insurance, annual rental payments and opportunity costs of renting for all periods prior to a particular year ‘t’ as shown below-

Costs of renting the home (t) =We then calculate the difference between costs of owning and renting the home as follows-

Difference (t) = Cost of owning the home (t) – Costs of renting the home (t)

The breakeven year is computed as the year ‘t’ when the Difference (t) is negative, that is, the cost of owning a home becomes cheaper than renting the home and hence, buying a home is more beneficial than renting from that year onwards. So if one wants to buy a home, they should plan to stay at least for as many years as indicated by the breakeven horizon for that home.

Zillow will publish the average and median breakeven numbers at the metro and city levels, and update these numbers each quarter.


[i] We can think of price-rent ratio as the inverse of capitalization rate or ‘cap rate’ of investing in a home which is the ratio of the net lease income from renting the home out to its current market value.

[ii] As indicated by National average for 30-year fixed from Zillow Mortgage Marketplace and Freddie Mac http://www.zillow.com/mortgage-rates; http://www.freddiemac.com/

[iii]  This value is a percentage of the home and land value assessment done each year by the county where the property is located

[iv] http://www.nber.org/~taxsim/state-marginal.html

[v] This is based on the average and median annual increase in rental prices of primary residences provided by the Bureau of Labor Statistics.


About the author
Nalina Varanasi
Nalina was an Economist at Zillow.