Homeownership boosters use many arguments in favor of buying rather than renting, one of which is that purchasing a home is a key part of the path toward a lifetime of financial success. They often say that renters are helping landlords profit when they would be better off paying their own mortgage instead. But a more nuanced analysis shows that it’s possible both for landlords to profit and for renting to make more financial sense than buying for some people.
Someone purchasing a property to rent out will be purchasing an investment rather than a home — an emotionally fraught purchase often fueled with American Dream mythology. Because of the large transaction costs in buying and selling houses, people tend to buy the home they foresee wanting for many years after the purchase date. A childless couple might purchase a four-bedroom home in a good school district for the future, meaning that they end up over-consuming housing for their yet unborn children. If this hypothetical couple decided to rent until their children were school-age instead, they would likely be able to save and invest a substantial amount by spending less on housing in the near term.
Would a landlord purchase this couple’s single family dream home? Probably not. Rather, with the same money, he might purchase a small apartment building in a less desirable part of town. These differences in purchasing decisions help to explain why landlords can profit in the same cities where people may not come out ahead by buying instead of renting.
In addition to having disparate motivations when purchasing property, a potential landlord likely has other comparative advantages that make him more likely to profit from real estate relative to the average homebuyer. He may have above-average knowledge of which neighborhoods are likely to see rapid appreciation, knowledge of home repairs, and either a willingness to do repairs himself or connections to an affordable and reliable handyman. He may make improvements to the property that help it rent more easily (cheap new carpet) while perhaps foregoing improvements that homeowners want for the long run (like granite countertops).
Large-scale landlords can profit with economies of scale that individual homeowners can’t take advantage of. While per-square-foot construction costs tend to rise as apartment buildings get taller and bigger, over the long-term, large buildings provide efficiencies in maintenance as tenants share the cost of landscaping upkeep, building repairs, and paying less for utilities than owners of single-family homes. Large-scale developers also profit from their abilities to navigate development entitlement processes. They can employ a legal team to navigate zoning rules and bureaucracy of the city’s entitlement process. In jurisdictions with burdensome restrictions, large development companies rely on their political connections to navigate complex and risky approval processes. These efficiencies are shared between landlords and renters.
While some real estate investors do earn returns — sometimes greater returns than they could earn in a more passive investment like an index fund — others do not. Personal finance blogger Mr. Money Mustache explains that in his own experience as an accidental landlord, he would have been better off investing his investment property’s initial value in an index fund during the time period he owned it. Even though his property saw strong appreciation while he rented it out, he had a reliable long-term tenant, and he has exceptional knowledge of home repairs, passive investing would have beat his returns as an active real estate investor.
Some real estate investors rely on the conservative 2% rule, which says that a property’s monthly rent should be at least 2% of the value of the home to ensure positive cash flow after accounting for vacancy, maintenance, taxes, insurance, etc. This rule could be met, for example, with a $100,000 fourplex in which each unit rents for $500 per month. Finding any property that meets the 2% rule is rare, but it’s much more likely to happen in low-cost of living cities. High-cost of living cities — those places where renting is most likely to beat owning from a financial perspective — are where small-scale investors are least likely to find properties that meet this guideline and are in turn least likely to earn great investment returns.
Homeownership boosters often point out that there are plenty of non-financial returns to buying a home, like stability, neighborhood civic engagement, and the ability to customize their home. They may be right that homeownership makes some households happier in the long run relative to renting. But with respect to the argument that homeownership is a key to lifetime financial well-being, the truism that renters should buy in order to keep their landlords’ profit for themselves just isn’t so.