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Should You Buy or Rent the Second Home

Last update on: Nov 06 2017
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The real estate markets are changing, especially those in resort and vacation areas. Home prices streaked upward from 2000-2005, causing us to address the possible “housing bubble” several times in this newsletter. Those articles are on the web site Archive.

Now, the forecasts we made the last few years are looking accurate.

The hottest housing markets are slowing down. Not long ago, a buyer could sign a contract to purchase a home in a popular resort or vacation area, especially on the coasts, and sell the home for a substantial profit before closing on the purchase. Those days seem to be over. In most of these areas, inventories of homes available for sale are increasing. The average time it takes a property to sell is increasing. Prices are at least moderating and perhaps declining from their peaks. Builders are offering substantial incentives to buyers.

The firms that purport to determine proper valuations of housing markets continue to report that a large number of markets around the country still are overvalued by wide margins.

Yet, I still do not anticipate a housing bust, except in a few discrete submarkets such as condos in Miami. But many of the hot areas probably will see at best moderate price increases for the next few years. Look for stable or even slightly declining prices for three to seven years.

Suppose you sat out the boom. There is an area that you want to spend vacations or winters. Should you buy a home there now or rent one for at least a while?

In many of the hot areas, rents have not increased as rapidly as purchase prices. That is one sign that a market is too hot. It also indicates that renting now would be cheaper than buying.

One easy way to examine the issue is to look at the capitalization rate or cap rate.

First, determine both the purchase price and the potential annual rental income of a property. Be sure the rental income accounts for peak season and off-season rates, and the possibility that in some areas a home might not be rentable for parts of the year.

Determine the net operating income of the property by subtracting the costs of ownership and being a landlord, such as taxes, maintenance, advertising, and agent’s fees. Do not include any mortgage or living expense costs.

Divide the net operating income by the purchase price. The result is the initial cap rate. Now, make a conservative estimate of the price appreciation rate and add that to the initial cap rate. That gives you the cap rate.

The higher the cap rate, the more sense it makes to purchase the property. A low cap rate means rents have not kept pace with purchase prices. Normal cap rates are 5% to 10%. A rate higher than 10% is considered a strong buy by most real estate experts. A rate under 5% looks like a pricey market.

That is just a starting point. There are other factors to consider, especially if the home looks like a bargain or is in the normal range. You can make a more detailed comparison on various web sites, such as TCalc.com. These calculators include more factors such as the tax benefits of mortgage interest deductions. But be aware that the key factor in many of these calculators is the assumed appreciation. They generally assume you would sell after five years and compare how much you would be out of pocket under each scenario. I don’t think you can assume that the appreciation of the recent past will continue.

There are other factors to consider.

In vacation areas, homes generally are rented furnished. That means if you rent, you won’t incur those costs. If you buy a home, you have to furnish it. Also, there are costs to buying and selling that frequently are left out of the calculators, such as the 6% agent’s commission to sell. These additional costs can tilt a close case into a decision to rent.

While many analyses assume part of the cost of buying is recouped from renting the home when not in use, few owners actually rent their vacation homes. There are additional costs when a home is rented, and there are the uncertainties associated with having strangers living in your home. Many buyers decide that it is better not to bother with renting.

You also should take the temperature of the local market to test assumptions about price appreciation and rental increases. Are visitors having trouble finding places to rent? How much have rents appreciated? Are homes taking longer to sell? Are builders offering discounts? How is the economy? Is the area losing or gaining year-round population?

The rent vs. buy decision can be quantified. But the numbers depend on forecasts of price appreciation and rent increases. Those are the most difficult numbers to develop, yet they have the most influence on the answer given by the models. As with stocks, don’t give too much influence to recent past performance. In addition, there are subjective factors to consider.

One mistake people make is to overestimate the amount of time they will spend at a second home they purchase. If you likely will use a place only a couple of weeks a year and won’t rent it to others, the purchase makes financial sense only if you count on substantial price appreciation. Take a realistic look at how often you will use a home and whether you will rent it.

There are more opportunities to buy vacation homes today, but that doesn’t mean you should take advantage of them. Take your time, examine the numbers thoroughly, and look for a property you really want to either buy or rent.

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