Rent versus own: financial and lifestyle considerations

Rent vs. Own

Housing serves as a shelter for all the people and their family, satisfying their main physical need and holding the equipment people need for their daily routines. Although the necessity of having a housing unit is clear, owning a house has become fashionable and is looked upon nowadays as a long-run investment decision which provides stable and rather good return. In this scope, the tenure choice, or the decision whether to own a house or to rent, is a personal choice, which depends on personal financial situation as well as socio-cultural factors as the desire for independence and security connected with owning a house rather than renting.

This issue has raised many discussions among scholars on the factors that influence the tenure decision and whether the decision is rational. Especially such works have become important after several amazing rises in the house prices, which were then followed, but not less amazing falls. In this research I shall try to concentrate on the purchasing a house as an investment decision and try to recapitulate the underlying fundamentals affecting tenure choice in preference for renting or owning.

If to consider housing as an investment, it is necessary to single out the qualities of the investment asset, which any investor will evaluate when making the investment decision. These qualities are the 'divisibility of holdings, security of real capital value and income, volatility of returns, liquidity of capital, the cost of purchase and sale and capital appreciation prospects'

. Thus, the main financial characteristics of an investment are whether the income and capital values are fixed or whether they are variable, and if they are variable, to what is the variation linked.

Applying these investment characteristics to property, the real estate investment will have the following features. First, heterogeneity implies that in contrast with other financial assets, such as stocks and bonds, which are the same for particular company and particular issue, all the housing units are unique and differ in size, location, age, construction, maintenance, tenant, surroundings and other features. The fixed location of the property adds another important factor for consideration, as sometimes it will be the determining underlying feature for the value of the property as an investment. The location of the property together with the surroundings is the central players in appraising the property value as they can change it dramatically. As the property is immobile, the change for demand in one location due to varying urban region development trends may lead to the fall or a big rise in the price (value) of the specific residential, commercial, retail of warehouse property.

The size of the property will imply a specific use for it which can be the highest and best use and the demand for this particular use in a certain point of time will also lead to add or decrease the value of this piece of property. For some real estate market segments, age would be a big plus, but for office space, for example, taking into consideration the ever changing technological conditions and preferences for commercial space interior, the age of the building would decrease its' value if the building is old. As Wheaton argues in his famous article

"The Persistence of Real Estate Cycles', it is exactly the fact of the big readjusting costs of the commercial space for new tenants or due to changing demand, that leads to the vacancy rates and then to the cycles within property markets. As the fashion is a very capricious, and the technology boom leads to completely new requirements and fashion standards, the construction is vitally important as the demand for this very building may depend exactly on it.

Sometimes development companies create specific development projects for target groups because some households 'are willing to pay more than is justified by a rational analysis of the future income stream' for a unit which a better location or a very favorable design

. As these psychological features are very important for buyers, the tenants would be also willing to pay higher rents for such a unit which gives companies incentives to create such 'niched projects' for target groups of households (firms) with specific preferences. Several cases have been present in the history when the development companies suffered enormous losses, as their development projects were a complete failure due to badly predicted for the specific target group construction preferences.

Ownership of a bond or a stock are rather passive investments and require little management, while property needs to be managed and maintained very well to generate profits for the holder. Especially for commercial, retail and warehouse space, maintenance costs, rent collections, rent reviews and lease negotiations are very important as rents serve as the source of profits and must be set carefully.

Another very important fundamental is the housing unit value, which implies that very big cash outlays together with borrowing are connected to investing in real estate. One can buy a set of shares or bonds for $100, but from 300 and even more times finances are required to become the holder of a real estate asset. This increases the significance of thorough evaluation of the gains and benefits from purchasing this asset. This is also the explanation why only big investment funds hold properties in their portfolios and why the transaction times on the property markets are much longer than on any other asset markets. The seller of the property, if not a broker, is involved in marketing and then selling his property only several times in life which brings difficulties for him when trying to sell the property. The same can be said about the purchaser, for whom the buying decision also needs much time for careful investigation and consideration. Furthermore, for stocks and bonds a regularly functioning market exists and all the transaction prices and trends are easy to follow and trace, while for the property there is no such a market. The information on the transactions in the markets is rather limited and also cannot serve as the benchmark for setting a price for another property due to its' heterogeneity. All these factors make it rather difficult for ordinary households to trace the property market movements and realize what their residential property is actually worth. Property valuations and forecasts are usually done by the realtors or consultancy firms, but they are likely to be biased by their wish to increase their profits and each valuation technique has its' pitfalls. This also arises from the fact that property is an illiquid asset and trading and capital gain tax limit liquidity even more.

An important consequence of high value is that borrowing becomes the only possible way to purchase housing for households and the credit constraints can limit the desirable property size or can postpone the purchase decision at all. Family must carefully estimate the future income in order to take a loan to purchase a property, but with very volatile economic situation in the U.S.A. this decision may be very hard to give careful estimation correctly.

The financial return from housing, just like from the majority of other financial assets, takes the form of income or the capital gains or losses. The income for a landlord will be the rents received from tenants, and the income from property for home-owners are the cash outlays that the owner would have paid in renting if not having owned this unit. The capital growth is the change of the housing value due to the inflationary gains or losses or due to the increased/decreased demand for this very property, which will lead to the increase/decrease in the transaction price, which could have been received for it in the market. But, real estate is a long-term holding asset and the 'value gains' are rather 'virtual' due to the fact that the family will not be likely to sell the property as soon as the price goes up just because the price for an alternative substitute property where family will live after the deal will be likely also to go up, releasing the assumption that the property that the family owns is unique.

On the negative side of owning a property is the depreciation 'as a result of wear and tear and the effects of elements' which results in the 'decline of the income earning capacity of an investment over time when compared to an identical new investment'.

Due to the importance of home ownership to the households, property is one segment where government interventions such as planning and environmental control, building regulations, rent controls on housing, subsidized industrial and housing rents, development incentives and restrictions on ownership are very frequent.

Even though so many pitfalls when investing in real estate exist, still, according to MARS study in 2003, nearly 71% of American adults own their homes as opposed to renting or other arrangements

. Among married couples, 85% own a home and for households with as low income as below $20,000 still 50% own a house, while for households with incomes $100,000-$150,000 88% own a house. An interesting finding is that for households with incomes above $150,000, a lower amount of households accounting to 86% own a home. Norman Hutchinson in his research claims that households headed by professionals, employers or managers are the most likely to own a house with a mortgage while the unskilled or manual workers are five times more likely to be renting a housing unit

Lori Taylor in his study 'Does the United States Still Over invest in Housing'

nevertheless argues and proves with empirical evidence that risk-adjusted social rate of return is much lower for housing than other types of investment, especially non-fixed capital assets and higher education. The social return to housing is benefit to the society from investment in housing and is measured by rents received and capital gains. Furthermore, he proves that the U.S. economy could grow much faster if the resources would be rather allocated in education and other non-fixed assets than housing. The conclusion that can be inferred from the empirical evidence of enormous owning preferences vs. renting, is that owning home is a better investment decision than renting or any other choice due to unobserved psychological factors and as during the long run property 'tends to appreciate with time and income yields are higher than those from other forms of investment, such as shares'

. The home owner can build up equity which refers to the value of the home less the debt and use this equity as the collateral for further loans, as the home loan is paid up, the equity increases. The next loan with the home as the collateral usually carries a lower interest rate, which is also a benefit for a homeowner. Mortgage interest and property taxes are deductible and thus home ownership reduces the amount of income tax the homeowner owes to pay. Once the loan is paid and the home becomes yours, you can pass it on to your family.

On the other hand, owning a home has several challenges, such as property maintenance and upkeep become owner's responsibility. The owner is also entitled to pay the costs of homeowner's insurance and real estate taxes. The homeowner becomes 'immobile' in terms that it will be difficult for him to move to another place once having purchased the house. But with changing economy some regions may become prosperous while some may be depressing which will force the homeowner decide to sell the home and move. But as stated before, selling time and transaction costs are rather high which enforces the immobility of the homeowner.

Purchasing a house decision is explained by a life-cycle theory, which states that a person must establish a stable career, accumulate certain savings to make a down payment and have a good credit history before considering the choice of owning a house. Several economic models were developed that explain the fundamentals behind the ownership decision vs. The renting decision.

The simple model of housing tenure choice, presented by J.V. Henderson and Y.M. Ionnides assumes that the opportunity cost of owning is less than the cost of renting and housing consumption is perfectly divisible and income and price responsive, the uncertainty about prices and returns is introduced also. There is a basic externality connected with exploiting services from a durable good, which implies that in perfect market owning a durable good is always preferable to renting. The services h that can be gained from using a durable good are a function of a stock of this good, or capacity hc, and the rate of utilization u, the total services are thus are:

h = hc f (u) (1)

This means that at the same rate of utilization the total services from a durable good will double if the capacity is doubled, but the total services will less than double if the utilization rate is doubled at the same capacity. The greater rates of utilization require greater maintenance costs and the total utilization costs are hcT (u) (2)

The renting externality occurs due to the problem of maintenance costs. An owner-occupier bears all the hcT (u) utilization costs, but the landlord can gather from the tenant only a part of these costs hct (u) under the rent level agreed upon, thus hcT (u) > hct (u) at all levels of utilization because it is impossible for the landlord to observe all the damages or other overutilization by the tenant and then charge for them. The hcT (u) homeowner costs include opportunity costs (foregone after-tax return of housing equity on alternative asset), part cash expenses (mortgage interest payments, maintenance costs, local housing taxes), value appreciation (depreciation and capital losses associated to house price fluctuations)

. This is the rental problem because the tenants do not face the social marginal cost of their utilization rates, but the owner-occupier does and this is the critical factor in determining the opportunity cost of renting vs. owning and occupying

Furthermore, under perfect certainty, when making a renting vs. owning decision, the consumer maximizes his multiperiod utility function. If the consumer owns, his task is to find values of x*, hc*, S*, u* that maximize

U (x, hc f (u)) + V (w),

Subject to y1 = x + Phc + S

w = y2 + S (1+r) + Phc - hcT (u)

The function U (.) is the utility that the consumer derives from the period 1 consumption of both housing and all the other goods; and function V (.) is indirect utility function of wealth remaining after period 1; y1 is income in period one; x is the consumption of all the other goods in period 1; hc f (u) is the function of total services from purchased house stock and utilization rate of one unit; S. is period 1 savings which earns r interest rate in period 2, P is the constant purchase price of a unit of housing stock, and y2 is income received by consumer in period two. Thus, an owner tries to maximize the stock of all the other goods except for housing, the housing units, savings and utilization rate. Let v* be the maximum value of consumer's lifetime utility if he owns.

If the consumer owns, then his maximization function is as follows:

U (x, hc f (u)) + V (w),

Subject to y1 = x + Rhc + S

w = y2 + S (1+r) - hct (u)

And the consumer will try to find the values of x, hc, S, u that maximize his utility, where R. is the rental price for housing and v will denote the maximum utility that consumer will generate during the lifetime if he rents. For there to be any owners of rental housing in the market, the interest foregone on the equity in housing must equal housing profits.

rP/(1+r) = R -- (T (u) - t (u)) / (1+r) (3)

For the landlord to buy a house as an income-generating source with the particular market-equilibrium price of a housing unit, the rents will be set at a level that will cover the financial opportunity cost plus the costs of utilization, which are not directly paid by the tenants, all property discounted. This means that though tenants pay directly only hct (u) costs for their level of utilization, they indirectly pay the balance in terms of higher rents.

Thus, from equation 3 the conclusion is that investment in housing is the perfect substitute to investment in financial assets. For a homeowner, the marginal benefits of increasing utilization are the increase in the f (u*) (rate of services from capacity) multiplied by the marginal utility of capacity. For a tenant, the marginal benefits of increasing utilization are the same. The marginal benefits decrease as the utilization rates increase and the marginal costs incurred by increased utilization rates increase. The Figure 1 shows the equilibrium rates of utilization for homeowners and renters, where the marginal benefit equals the marginal cost for each. It is clear that the optimum utilization rate for the renter (at which marginal benefit from increasing utilization equals marginal cost of this increase) is higher than for an owner, which is called the over utilization of capacity by renters and is known as rental externality.

The conclusion is that the optimum utilization rate for the renter will be chosen on the basis of the utilization costs, paid by him, t (u), but not the true costs of utilizing the house. But the tenant will pay indirectly these costs in the form of higher rents as if it was not the case, there would be no landlords holding rental property as an asset, while owners will not cause these higher costs and thus will not pay for them. This implies that owning is better than renting. The proof economically traced through estimating the difference between the maximum life-long value of utility for a renter and an owner. After numerous mathematical calculations, authors Henderson and Ioannides prove that the difference is negative and thus the maximum value of lifetime utility of owning is bigger than from renting.

Owning is superior to renting for both people with high utilities and low utilities. For example, a household with high utilization rates might try to rent in order to shift the high utilization costs to the landlord. But, in order for the landlords to exist in the market, the rents must be sufficient enough to cover the maintenance costs and the opportunity cost of investment. Thus, the rents will increase to recover these high utilization costs. But people who have low or equal to potential utilization rates will not agree to pay such high rents comparing to their utilization of housing. This will be financially irrational for them and such equilibrium will not hold in the market. This issue was considered by Thomas J. Miceli, where he stresses that due to rental externality and inability by landlords to obtain perfect information and trace the actual utilization rates, inefficient market equilibrium exist with higher rental levels and the low utilization households suffer the most as they under consume housing services compared with the optimum consumption level in the equilibrium with perfect information obtained by landlords and rents based on it.

Nevertheless, Peter Linneman argues that because of high competition, landlords will increase their efficiency derived from superior credit ratings, lower tax assessment, maintenance cost efficiencies and other, the home ownership will become less desirable as the efficiency will be translated into lower rents.

Thus, purchasing a house is a problem of optimal time of housing consumption and optimal portfolio. Housing consumption is set at the level where the marginal benefit from an additional housing unit equals its' marginal cost. The purchase decision also depends on the total wealth of the consumer, which consists of the initial income wealth and second-period wealth. For a given level of initial wealth, the renters are likely the people who expect their incomes to be decreasing in the future. For example, among the young people, the renters are most likely to be the people with higher education, as their incomes will start growing in the future. Those who have more inherited financial wealth comparing with human capital will be likely to own as their income in the present is larger than future income streams.

Thus, there are three main trade-offs in the decision whether to own or rent. First, the owner avoids paying for higher maintenance due to the fact that renters tend to over utilize the space and then are charged higher rents by landlords to compensate for this over utilization. The second, changing from renting a house to owning is expensive and incurs transaction costs as well as direct purchasing costs. The third feature is that landlords cannot directly observe the utilization level of the tenants and thus cannot charge them the exact maintenance costs that they cause. Thus, with no perfect information for landlords, for high utilization tenants renting would be more advantageous.