Should You Buy or Rent? Depends on How Long You Want to Stay and Where You Want to Live (Of Course)

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

The decision whether 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. For a particular region, this has been calculated typically as the ratio of the median listing price (or closed sale price) of homes available for sale to the median annual rental price of available rentals in that area. A lower ratio indicates that one is better off buying in that market instead of renting and a higher ratio indicates the opposite. A rule of thumb used in the real estate world is a cut-off of 15 years – metros and cities with price-to-rent ratio below 15 years are considered good places to buy and those above are considered good for renting.

The main problem with the conventional price-to-rent ratio is that this ratio compares two different sets of homes that have different underlying home values. To account for this issue, we computed a ‘better’ price-to-rent ratio by calculating it at the household level for all available rental listings at the metro level. The individual price-to-rent ratio for a house listed for rent is calculated using the estimated market value of that house (Zestimate) divided by the annual rental price of that house. The better price-to-rent ratio for each metro is then computed as the median value of the household level price-to-rent ratios for all rental listings in that metro.

An issue with the better price-to-rent ratio is that, it is computed only for houses listed for rent; hence, it is not a representative sample of all the houses located in a particular area. To overcome the bias in the better price-to-rent ratio due to a non-representative sample, we computed another version – the ‘best’ price-to-rent ratio – at the household level using the estimated market value of all homes (Zestimate) and the estimated rental value of all homes (Rent Zestimate). The median price-to-rent ratio for a particular metro is calculated using these individual household level price-to-rent ratios for all homes in that metro.

Even though Zillow has extended and improved the conventional price-to-rent ratio in important ways, the price-to-rent ratio is still problematic to potential buyers or renters for two reasons: it doesn’t consider all of the relevant factors in the buy-rent decision nor is it very intuitive.

In terms of comprehensiveness, the price-to-rent ratio does not include all the costs and benefits incurred when purchasing and owning a home. While the price-to-rent ratio is a potentially useful metric to an investor who is considering buying a property and renting it out , consumers are more interested in knowing how much in total they will spend when buying a home and how this compares with how much they will spend when renting. These considerations must factor in things like property taxes, transactional costs, the opportunity costs of sinking a large sum of money into a down payment, mortgage interest deductions, and maintenance, to name just a few. The conventional price-to-rent ratio doesn’t consider any of these pieces of information. A particularly glaring omission in any price-to-rent ratio is home value appreciation which can make a home purchase a profitable investment 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.

In terms of the consumer understandability, the price-to-rent ratio is also fairly opaque and non-intuitive. Most consumers are generally aware that homeownership is more financially advantageous than renting the longer one owns a home. They are also generally aware that they shouldn’t buy a house if they aren’t going to live in for at least some period of time because of non-trivial transactional costs. These two facts obviously suggest that there is some length of time at which the decision to buy versus rent flips from one answer to the other. So what is that length of time? The price-to-rent ratio doesn’t directly answer this question. It instead gives the consumer an abstract ratio that must then be compared to some rule of thumb about the general level at which the decision flips from renting to owning as the optimal answer. But seldom is there any recognition of the fact that the length of time the consumer plans to live in the home affects the threshold of the ratio that separates a buy decision from a rent decision (e.g., is the rule of thumb of 15 on a price-to-rent ratio equally appropriate for somebody planning to live in the home 2 years and somebody else planning to live there 15 years?).

To overcome these issues with the price-to-rent ratio, we’ve introduced 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). When living in a home for a shorter period of time than the breakeven horizon, renting is more advantageous than buying. We compute this number at the home level and then calculate the average and median breakeven horizons at the city and metro levels. We incorporate all possible costs and benefits associated with buying and owning a home such as the down payment, purchase costs, mortgage payments, property taxes, utilities costs, maintenance costs, tax benefit etc. as well as all the costs associated with renting the same home. We also include home value and rental price appreciation. The breakeven horizon for the house is identified by comparing the net costs of buying the house with the costs of renting the same house – it is the year when the buy costs become less than or equal to the rent costs.

Figure 1 below shows the relationship between the breakeven horizon and the best price-to-rent ratio. While the two measures are generally correlated with one another, they are obviously different because the price-to-rent ratio is not a comprehensive measure of net costs associated with buying versus renting a home and also because it excludes appreciation of home values. More details about the data and methodology used to compute this metric can be found in this research brief.

We use the estimated home value (Zestimate) and estimated rent price (Rent Zestimate) on all homes in the Zillow data footprint (more than 80 million homes) from the second quarter of 2012 for the current breakeven analysis. See the map and chart below for the breakeven horizon in all metros and cities for which we had sufficient data with which to compute the metric. We find that at the metro level, the breakeven horizon ranges from 1.6 years to 8.3 years as shown in the map below. Overall, the breakeven numbers for all the metros are quite low which may be due to huge decline in home values and record-low mortgage and inflation rates that the U.S. has experienced for the last five years as a result of the housing market crash and the global financial crisis.

Another interesting finding is that, even though the highest breakeven number at the metro level is 8.3 years, there is considerable variance observed at the city level within each metro. This is shown when we select a particular metro from the list of metros and observe the breakeven numbers for the cities within that metro as listed in the bar chart below. For example; the breakeven horizon for the New York metro is 5.1 years; however the city level breakdown of the New York metro reveals that the breakeven numbers range from 1.4 years in the city of Rossmoor to 24.1 years in the city of Mantoloking. This finding underscores the importance of computing the breakeven horizon at the household level and then aggregating to the city and metro level as opposed to taking median home values and rental values as in the case of the conventional price-to-rent ratio which obviously mask differences in location and attributes of individual homes. The wide spread in the breakeven horizon within a metro also possibly results due to large differences in property taxes at the city level which are only included in the breakeven analysis.

The breakeven horizon is a very useful metric for consumers for several reasons. First, if a consumer knows that they want to buy, it allows them to target cities and metros that are appropriate for them given the length of time that they intend to live in the home. Second, if they are unsure whether they want to buy or rent but they do know where they would like to live and how long they intend to live in their next home, the breakeven horizon offers them guidance on whether to buy or rent. For real estate investors, the breakeven horizon is a more unbiased estimate of the number of years it will take for them to recoup the cost of buying the property from the lease income as opposed to the price-to-rent ratio. For realtors, depending on the consumer segment they are catering to, this metric will enable them to focus on areas where they believe their target consumers are more likely to buy based on the average and median breakeven horizons at the city and metro levels (the breakeven analysis can also be extended to the zip code and the neighborhood levels).

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

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