In the decades since World War II real estate prices rose with enormous consistency but now the oomph is gone. Most people are better off renting than owning, says Patrick Killelea. For him, and for millions of others, the path to financial security no longer includes real estate ownership, mortgages or the possibility of foreclosure.
Killelea is a leading seer and prophet for a financial movement which thinks traditional real estate strategies are done and over. His website — the hugely-popular Patrick.net — is a national forum for the renting-is-better trend, a place where he and thousands of others make the case for new thinking and provide example after example of local rental opportunities.
In the past it would be easy to dismiss Killelea because rising home prices made real estate attractive. Figures from the New York Times show that in 1968 the typical house was valued at $22,600, a figure which rose to $219,000 by 2006. (See: Will the Fed Reverse the Housing Slump? September 19, 2007)
But the numbers from the Times also show something else: In 1968 it would take a typical buyer 2.9 times his or her annual income to buy a house. By 2006 the same house would cost 4.5 times annual income.
Killelea believes home prices have soared to a point where they no longer make financial sense, that real estate values are likely to decline further and that in most situations renting is now a better option than owning.
The Market Slumps
After decades of good news real estate trends started to change in 2007 when large numbers of distressed homes began to appear and force down home prices. RealtyTrac reports that there were 885,468 foreclosure filings in 2005, a figure which reached 2,203,295 in 2007 and has continued to climb.
The government says that home prices in November 2010 were down an average of 14.9 percent from the 2007 peak. Some regions, of course, have had even steeper declines — think of areas in California, Florida, Nevada, Arizona and Michigan.
The result, says Killelea, is that times have changed. New conditions require new thinking and in most cases that means ownership is out and renting is in.
“Prices did inflate for a long time as the US industrialized and the population growth rate was high,” says Killelea, “but lately the US is losing its industrial base to China, and US population growth has slowed. This makes it unwise to count on similar house price inflation in the future, especially in areas where prices are already far beyond the cost of renting an identical house.”
The Case For Renting
On his site, Killelea argues that “it’s usually still much cheaper to rent than to own the same size and quality house, in the same school district.
“On rich neighborhoods, annual rents are often 2.5 percent of purchase price while mortgage rates are 5 percent, so it costs twice as much to borrow the money as it does to borrow the house. Renters win and owners lose! Worse, total owner costs including taxes, maintenance, and insurance come to about 9% of purchase price, which is more than three times the cost of renting and wipes out any income tax benefit.”
In the past, the premium many buyers saw for ownership was justified by the idea that a home was not just shelter, it was also likely to be an investment that produced consistent gains in value. In many cases the value of real estate increased more than the rate of inflation, meaning that over time additional buying power — the real measure of wealth — was being created.
The catch is that now the justification for real estate ownership is missing in many markets. Prices are not rising before inflation or after. When home values will again begin to rise is unknown and unknowable.
When to Buy
Killelea is not an absolutist, someone who believes renting is always the better choice when compared with ownership. Instead, he makes two central arguments:
First, he says consumers should stick to basics and seek to avoid debt when possible.
“The traditional banker’s rule of thumb is that a house should not cost more than three times a household’s gross annual income. On a monthly basis, I think 30% of take-home page is reasonable,” he says.
Killelea’s view is actually more liberal than traditional lending standards. Conventional loans, for example, typically require that a borrower spend no more than 28 percent of his or her monthly income for mortgage principal, mortgage interest, property taxes and property insurance (PITI). This is the so-called “front” ratio that lender use to qualify borrowers. The “back” ratio includes the front ratio plus recurring costs such as monthly payments for auto loans, credit cards and student loans. The back ratio for conventional loans is 36 percent of monthly income.
Second, Killelea argues that even if the financing numbers are right, even if a borrower can spend less than 30 percent to own, there is still a need to look at whether it’s cheaper to own or to rent over the ownership period.
“Living in California did really force the whole rent vs buy issue into my head, because the prices were and still often are so absurd, like two to three times as much to own as to rent the same thing. Had I lived elsewhere, I probably would not have thought about it as much.”
A False Bottom
When asked if real estate values have generally reached a false bottom, if prices could go lower in many areas, Killelea says “yes, I do think we reached a false bottom again, and we have done so many times since 2006. I do believe house prices in most markets will fall in 2012, but that the percentage declines will be larger in more affluent areas. The bottom will be here when it is distinctly cheaper to own than to rent the same thing.”
“I think rates will go higher in spite of the increasingly desperate manipulations of the Federal Reserve,” he says. “But that doesn’t make it a good time to get a mortgage at all. The ideal time to buy is when interest rates are at a peak, which excludes competing buyers, and to buy then with all cash. Then you get few competing buyers, a low price, and no risk of defaulting.”
Yet even if buying conditions are not ideal, Killelea expects there will be no shortage of real estate purchasers.
“The basic psychological drive to own at any price will nonetheless cause millions of people to keep making bad financial decisions. But at least some people will do the math and see why they should wait until they find a really good deal.”