Winter is coming, and the thoughts of many retirees turn to warmer climates. The next thought for those who plan to spend part of the year at a second home is whether it makes sense to buy or rent that refuge.
Not many years ago that was an easy decision. Real estate almost always appreciated at solid rates, and high tax rates cut the cost of ownership. Now the appreciation in many areas is more modest, the costs of ownership are high, and you might be in a low tax bracket. Now it is a much closer decision, and it is easy to find very bright people who disagree on the correct decision.
Let’s take a look at some intangible factors before examining the numbers.
If you buy a second home, you always have your own place with your own things. When renting, you must pack your things and haul them each year, and you take the furnishings provided by the landlord. On the other hand, when buying you have to ensure that things are taken care of all year, even when you are not there. You bear the costs of ownership all year and have to replace the major items that wear out. Renting gives you the flexibility to change your mind about where you want to stay each year.
Each option has uncertainty about future costs. If you lease in a popular area, the rent will rise each year. Over time it could rise substantially. Ownership might have a fixed mortgage. But you’ll have a number of other costs such as ownership fees, taxes, and maintenance that are likely to rise. The growth rate is hard to estimate. You’ve owned a home for years, so you know the surprises.
When the financial difference between leasing and buying is close, you’ll want to balance these intangible factors. But first take a look at the economics to see if they clearly favor one option over the other.
There are many ways to compare buying and leasing. In finance books you can learn to use a spreadsheet that considers a number of factors. You also can find a number of web sites with calculators that will help balance all the financial factors. But there’s an easier way that considers the most important of the factors. Here’s how it works.
First, determine both the purchase price of a property and its annual rental income. Rental income can be tricky for snowbird properties. The rent for prime months is likely to be much higher than rent the rest of the year. Be sure to figure that in. From the annual rental income subtract taxes and the other costs of ownership. If you want a ballpark figure, use about 30% of the rental income for expenses. (This does not include any mortgage.) You now have the net operating income of the property. Divide this by the purchase price.
The result is a percentage that is known in real estate as the capitalization rate or cap rate. This is similar to the earnings or dividend yield on a stock. The higher the cap rate, the more sense buying makes. The lower the cap rate, the more sense renting makes. If the cap rate is low, that means property prices are inflated compared to rental prices.
Before making a decision, take one more step. Estimate future appreciation of the property and add that to the cap rate. If you anticipate values rising 3% annually, add that to get your final cap rate. This is where it is easy to get in trouble. It is not always accurate to assume that the appreciation rate of the past few years will continue indefinitely. If you are looking in an area with strong appreciation, try to determine the reasons for that appreciation and if it is reasonable to assume that trend will continue indefinitely.
Cap rates in a normal real estate market generally are between 5% and 10%. If you compute a cap rate in that range, then consider tax advantages and the intangibles to make the final decision. A cap rate (including appreciation) of over 10% sounds like a good buy. A cap rate under 5% looks like an overheated real estate market in which purchase prices have outpaced rents.
Here’s an example. Suppose you determine the annual rent on a property would be $24,000, expenses would be 30% of that, and the property would cost $500,000. That gives you a capitalization rate of just over 3% ($24,000 – $7,200/$500,000). That’s clearly a market with high real estate prices relative to rents. To put the property clearly in the buy category, you have to assume it will appreciate at least 9% annually for an indefinite period. If the rent were to rise to $35,000, you get a cap rate before appreciation of 7%, which is a much more normal market.
For many people the intangibles of buying versus leasing are the key considerations. Staying at your own home versus the headaches and expense of ownership will tip most decisions. But be sure to use the rough cap rate calculation to determine if you are looking at a real bargain or a bubble ready to burst.