When deciding between buying a home or renting and investing the down payment, the anticipated rate of return in both choices is a major consideration. Outcomes will vary depending on a complex range of factors pertaining to the home purchase or rental and the individual's stock portfolio.
Many factors come into play when deciding whether to purchase a home or to rent instead. One factor worth considering is the anticipated rate of return on invested capital from home ownership versus renting. This article provides a “real-world" comparison of the financial gain from renting and investing any remaining cash in the stock market with the financial gain from purchasing a home. For a more simplified scenario, read “Nest or Nest Egg? Hatching Best Investment Plan" in the October 2018 issue of
By renting and investing in a stock portfolio, the household forgoes the potential to earn appreciation from homeownership but may benefit from selling the stock at a profit. Conversely, by purchasing a home, the household forgoes the future earnings from a stock portfolio as well as the potential to earn dividends.
As in the previous article, the question being examined is, if between 2000 and 2016 a Texas household had the option of either renting (and consequently investing in the stock market) or purchasing a home, which provided the greater financial gain?
Real-World Financial Comparison
Numerous differences complicate a comparison between renting and investing in the stock market and purchasing a home. The Real Estate Center's analysis controlled for the differences through a number of assumptions (see “Real-World Scenario Assumptions" sidebar).
The internal rate of return (IRR) from homeownership using statewide data as well as data for four major Texas MSAs provided a benchmark. The four metros considered are Austin, Dallas-Fort Worth, Houston, and San Antonio. Due to space considerations, metro-level results are available only online in the technical report “Purchasing a Home versus Renting and Investing" at www.recenter.tamu.edu.
The IRR from homeownership is compared with that from renting and investing any savings in the stock market. Expenses associated with buying, holding, and selling a home or a stock portfolio in a typical, real-world situation are also considered.
The amount of the initial investment varies, but it is assumed to be the same for both investment options. The household either purchases a home or rents and invests the equivalent dollar amount in a stock portfolio at the beginning of the year. The point of initial investment ranges from the beginning of 2000 to the beginning of 2016.
Net cash flow to homeowners is typically negative as the annual costs of homeownership usually outweigh the rent on a “comparable" property. However, upward pressure on rents has translated into positive cash flow for homeownership over the past several years.
Homeownership costs tended to remain more stable than rental rates over the holding period as the sum of principal and interest is constant for a fixed-rate mortgage. Property taxes and insurance and maintenance can vary each year depending on factors such as the appraised value of the home. However, the sum of these expenses was generally less than the sum of mortgage principal and interest, thus having less impact on overall homeownership costs.
Winning IRR Tally
Even if a household suffered an overall financial loss from a particular investment (as indicated by a negative IRR), the investment with the less negative IRR is assumed to provide the household with greater financial gain. In other words, a superior IRR does not necessarily translate into a positive IRR.
The results for the investment decision (i.e., the number of times a household most often captured a higher IRR from purchasing a home or renting and investing in the stock market during the study period) vary by geography. However, the IRRs from homeownership exceeded the IRRs from renters investing in the stock market in all five MSAs and in Texas overall.
The IRR from homeownership in Texas surpassed that of renters investing in the stock market 97 times, or 63.4 percent of the time (Table 1).
The results also indicate that either renting and investing in the stock market or buying a home would have produced more positive than negative returns. However, homeownership did result in a greater incidence of positive returns.
The homeownership IRR based on statewide data was positive 126 times, or 82.4 percent of the time. The IRR from renters investing in the stock market was positive in 113 instances, or 73.9 percent of the time (Table 2).
Timing is critical in the decision but obvious only with hindsight. Neither house buying nor renting and investing in the S&P 500 from 2007–09 translated into a good investment for several years.
Results under more real-world conditions vary significantly from those in the previous article. The first article found renting and investing in the stock market, on average, offered a greater IRR for households in Texas from 2000 to 2017. Conversely, this more real-world set of assumptions revealed that purchasing a home generally provided households with a superior IRR (Table 3).
A major factor in the different outcomes between scenarios was the effect of capital gains tax on a renter's investment portfolio. The introduction of capital gains tax dramatically impacted the IRR from an investment portfolio. In most cases under current tax law, avoiding paying capital gains tax on the sale of a home gives homeownership a tremendous edge.
Additionally, high rent growth over the past several years has diminished the financial gain from investing any excess funds in the stock market. An important factor to consider is the substantial up-front cost of purchasing a home versus renting and investing in the stock market. Potential homeowners should typically expect to remain in a home at least two years before the front-end costs are recouped.
Finally, renters investing in the stock market at the end of a recession and disinvesting within a few years almost always captured the superior financial investment. The stock market tends to grow at a much faster rate than home prices coming out of a recession. However, over longer periods purchasing a home has shown to be the more rewarding option.
A household's decision to rent and invest in the stock market or purchase a home will be determined by a combination of personal and investment preferences, not just the IRR the household would have received from either option. Households are likely to consider factors such as each market's historic performance and current conditions and the ease and ability of qualifying for homeownership.
Other factors include the need for flexibility in living arrangements, the obligations of homeownership, available housing stock, nearby amenities, and the social and community aspects of owning versus renting.
Dr. Hunt (email@example.com) is a research economist and Losey a research intern with the Real Estate Center at Texas A&M University.