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By Brian Davis
It’s a common question: “Should I buy a house or rent?” (or for landlords, “Does real estate investing in this market make sense?”). While the answer varies, there is a way of framing the question for a useful answer.
All real estate purchases require an up-front investment, but then the annual cost of owning is generally lower compared to renting (but how much lower varies dramatically). After a certain number of years, the annual savings from owning makes up for the up-front investment in cash, but for some homes this “breakeven horizon” is prohibitively long. The breakeven horizon is the amount of time it takes for a buyer to recover (in lower payments, tax benefits, etc) the up-front costs of the real estate purchase (closing costs, down payment, etc). To use easy math, if a house requires $6,000 in up-front costs, but will save the buyer $250/month over renting, then the breakeven horizon is two years ($6,000/250 = 24 months).
In reality, the calculation is far more complex, and must account for every additional cost and every additional benefit conferred onto homeowners and landlords. For example, the average annual cost of repairs, the portion of the mortgage payment going to principal and the value appreciation should be calculated in, some of which must be estimated.
Longer breakeven horizons are ultimately bad news for prospective homebuyers and investors looking to buy new rental properties, but good for existing landlords and tenants.
The breakeven horizon calculation proves more useful than the commonly used price-to-rent ratio for a given city, or the ratio between the average purchase price and one year’s average rent payments. One problem is that the average property for sale is not comparable to the average property for rent, which tends to be smaller and lower quality. There are ways of correcting for this, such as Zillow’s approach of leveraging their data to look at active For Rent listings and compare to their ZEstimate values, but this still fails to take into account the various other costs and benefits involved in owning real estate (repairs, tax benefits, amortization, etc).
Breakeven horizons are useful at both the metropolitan level and the neighborhood level, to help prospective homebuyers and rental investors identify better metro areas for buying properties, and what they can expect in specific cities and neighborhoods. Even within metro areas, individual cities, suburbs and neighborhoods have a wide variability in breakeven horizons (see the link below). Anyone moving to a new area can use breakeven horizons to determine whether they should buy or lease, based on how long they intend to live in that neighborhood.
And, of course, landlords and rental investors can get a glimpse into how long it will take for their up-front investment to start offering a return.
For Zillow’s complete list of each city’s breakeven horizon, click here.
