Saturday, May 14, 2011

Buy vs Rent Pet Peeve

News out of the US is showing prices are falling again but, on a positive inflationary note, rents look poised to rise, meaning the price-rent ratio is looking rather average. The combination of these two factors has caused the blogosphere to dust of the old rent-vs-buy calculators and show that, wonder of wonders, buying might not be such a bad financial move after all, in certain conditions, though there are still some doubters.

According to Ben Rabidoux's analysis of the data, Canada is still a ways off on this front. (Courtesy theeconomicanalyst)

There are a bunch of calculators out there, one of the more famous ones is the New York Times calculator that includes opportunity costs and other fees often glossed over by conventional buy-vs-rent calculators I've seen around. The calculator is well done, showing the number of years until owning will exceed renting from a strict financial perspective. In New York, of course, only around 55% of residents own, so there is some indication the consumer surplus (or ownership premium) is close to zero. As an investor at heart, with no ownership premium to speak of, I would recommend a more numbers-focused approach I outlined here that looks at real estate as an investment without financing costs (i.e. looking at the business case) first, then worrying about the financing later. But anyways.

I'm all for calculators -- I use one bought 20 years ago to do my day job -- but in the case of using one to calculate buy-vs-rent, one of the major pet peeves of mine is ignoring the "low probability high severity" risks in the calculations. Owning an expensive, complex and unique capital asset carries risks that are difficult to quantify on a spreadsheet. I put these low probability high severity risks into two categories: expense risk, and revenue risk.

Expense Risk

Since, for most, investing in property concentrates one's capital into a handful of assets, there is risk of some large un-hedged event occurring. For example water damage, plumbing, or other structural flaws may not be covered under insurance and many tens of thousands of dollars may need to be spent to correct them. These events will be rare but do happen from time to time.

Revenue Risk

Yes, people do get sick, die, lose their jobs, or get divorced. "It" will happen to other people until it doesn't, but we know statistically "it" will. Some of these events can be hedged against through insurance while others cannot. (Ask your spouse about buying divorce insurance if you like sleeping on the couch.) These risks are of course not unique to home owners and they can be mitigated by moving in case the expenses are too onerous. Owners face the challenge of not only moving but also selling, and this could be during a bout of market weakness; that is, the additional risk for owners is not being able to "ride out the dip" if prices fall.

Liquidity Risk

There are also risks with future "liquidity events". Housing market recessions are often accompanied by illiquid marketplaces where houses take significantly longer to sell than in normal times. If the above risks occur and cash is needed, or the house needs to be sold due to relocation or other life events, it may not be possible without selling at a steep discount. 

What can be done

Many of these items, as mentioned, can be hedged through insurance or, in the case of larger operations, diversification of holdings (which is what insurance companies do... normally). Diversification is not practical for a homeowner so he or she must absorb some of these difficult-to-hedge risks. Governments realise this to a degree, which is why they attempt to make housing more affordable for owner-occupiers through various (and often catastrophic) schemes like preferential mortgage rates, tax treatments, et cetera.

So after considering the factors in even the best buy-vs-rent calculators, there are risks that they do not account for. The nature of the risks means they are not meted out evenly and are difficult to quantify; how does one put a number on the probability of prolonged illness? The nature of low probability risks and their inability to be easily quantified means they are often simply ignored, even if they're real and potentially severe. That's a big mistake, in my opinion.

The ignoring of low probability risks is akin to a "reverse lottery". Since few will experience the fallout due to these risks, it will appear that the majority of people will have come out ahead by owning, which is true, but not necessarily in aggregate. If we sum all experiences, including the many "winners" and the few "losers", the buy-vs-rent gap narrows and may even turn negative.

The best method of mitigating low-probability high-severity risks is to demand a discount in home ownership over renting and diversify your investments. This may mean buying less primary residence and more other assets. The online calculators can only provide part of the information required to make a proper financial buy-vs-rent decision and should be used with caution.

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