Buy/Rent ratios

It was just a month ago that I overheard some ladies discussing if it was still cheaper to buy than rent. They didn't mean what you think. They actually meant if they could close on a house with cash back and 0% down for less than first, last and security. Some in the group said it was still possible.

But that's not what this post is about--it's actually about real-life finances. Lorna and I found a recent "Homes and Land" magazine that had a whole lot of "for sale or for rent" listings. We fired up a calculator, and figured out that most of these listings were priced at a 250-350 multiple (measured as purchase price / monthly rent).

Housingtracker.net has computed this ratio all over the country, and it puts LA around 315, a similar range. This is extremely high, as you might know. So it's cheap to rent, but how cheap is it?

Also, I admit there are some irrational reasons to buy that don't correspond exactly to simple division. But at some point these ratios have to make sense, right?

Let's do another calculation to see. There's a rent/buy ratio assuming you're renting from the bank. This is called an "interest-only" loan, and you can estimate it pretty easily on bankrate.com. It means you pay the interest rate exactly (no principal) every month.

Here are two simple cases, and our calculations are made all the easier by assuming an interest-only loan with no equity (I'm so 2006)--the payment is the interest rate. You may not agree with my estimate that housing will decline an additional 30% in some areas of LA, but you can adjust the 6% the other direction if you don't like it. (Transaction costs are somewhat undeniable, unless you use a discount broker like Redfin.)

1. Conforming Loan, 2008-2013, excluding transaction costs

• Interest rate: 6.375%
• Taxes + Insurance + Upkeep - Tax Deduction: 1.5%
• Rent/buy base multiple ("just pay my monthly costs"): 150x (2.1x cheaper to rent)
• 5-year depreciation (annual housing crash cost): 6%
• 5-year transaction fees (buy+sell over 5 years): 2%
• Rent/buy and sell in 5 years multiple: 75x (4.2x cheaper to rent)

2. With a Jumbo Loan, same conditions (except interest rate at 8%):

• Base monthly payment: 126x (2.5x cheaper to rent)
• Full cost multiple: 68x (4.6x cheaper to rent)
  

Under current conditions (meaning: cheap but not super-cheap loans, and crashing prices), renting puts you ahead when the ratio of purchase/rent price is over 150x, and if you intend to move sooner than 10 years from now, a multiple of 100 will put you in the black, too.

So how did we get to 315? Well it's easy. The NY Times did a great Flash app that lets you compare the costs of renting vs. buying. If appreciation in prices are 5, 10, or maybe 20% annually, you shouldn't rent. If reality sets in...

My estimate is that Option ARMs in high-priced areas saved people nearly half the monthly payment (allowing prices to rise so far in comparison to incomes), and when one ignores transaction costs and expects 20% annual appreciation, then things start to look even better.

And all of this...will change soon.