US Housing
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14th December 2017
US HOUSING MARKET FOCUS Buying still better than renting in the long run •
Based on the current tax environment, our forecasts for house prices and rents show that buying a median-priced home is better than renting one for any holding period of six years or longer. By making the standard deduction more valuable, the tax bill working its way through Congress will change that calculation, and on the face of it could raise the net costs of buying by up to 30%. But, given most households will see an overall tax cut, and potential buyers are likely to put that saving towards their home, we doubt it will have a significant detrimental impact on the housing market.
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Since we last looked at whether it is better to buy or rent a house in the long run, house prices have risen by 45%, but rents by only 21%. More recently concerns have been raised that the tax bill will reduce the benefit of buying a property. So does it still make sense financially to buy a home in the long run, and will the tax bill change that calculation?
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There are many costs and benefits involved in a buying a home. Our buying versus renting calculator accounts for closing costs, maintenance, insurance, property tax and foregone interest on the down payment, as well as the tax deductibility of mortgage interest and property tax. We also take account of the housing equity accrued by homeowners as they repay mortgages, as well as any gains or losses in equity as a result of movements in house prices. On the rental side, we need to factor in transactions costs and future rent hikes.
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Assuming the purchase of a $250,000 home with a down payment of 20% our calculator shows that, for households who would itemise irrespective of their tenure choice, buying is a better option than renting for any holding period over six-years – the same conclusion we reached when we last ran this exercise at the start of 2012.
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But the tax bill working its way through Congress puts new limits on the property and mortgage interest deduction, and doubles the standard deduction. That will reduce the tax benefits of owning a home. Indeed, our calculator shows that by opting to take the new, larger standard deduction, over a 10-year period buyers of a $250,000 home would see their net buying costs increase by 30%.
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On the face of it, that might suggest house prices are set for a sizeable drop. However, the key point to note is that households are choosing not to itemise. Apart from their accountants, there is nothing to stop this household from continuing to itemise to enjoy the same housing-specific costs and benefits as before. Admittedly, they can now elect how they will spend their tax savings; they are no longer tied to buying a home. But most households stretch themselves when buying a home, and to the extent that the bill will cut taxes for most households, the overall change could even be positive for the housing market.
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The impact on expensive homes could be more detrimental, with a potential limit on the mortgage interest deduction raising taxes for itemisers. However, for a $1.5 million home held for 10-years, the extra cost of $5,898 a year is unlikely to have a large impact on home values. Particularly as many wealthy households will enjoy an overall tax cut. That said, some high-end markets in high-tax states will be more vulnerable, and could see some downward pressure on values.
Matthew Pointon, Property Economist, +1 646 934 6640, matthew.pointon@capitaleconomics.com Ed Stansfield, Chief Property Economist, +44 (0)20 7808 4992, ed.stansfield@capitaleconomics.com US Housing Market Focus
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Buying still better than renting in the long run It’s been almost six years since we last took a detailed look at whether it is better from a financial perspective to rent or buy a home over the long run. (See US Housing Market Focus, “Is now the time to buy?”, 23rd Jan. 2012.) Back then, we found that based on our expectation for house price growth of 16% over the next seven years, and rental growth of 25%, it would be better to own rather than rent a home. Given that house prices have risen 45% since then, compared to a 21% rise in rents, is that still true today? And what impact will the proposed tax bill have on that calculation? Median headline costs give renting the edge Annual house price growth now looks to have peaked at around 6%. (See US Housing Market Update, “Annual house price growth has peaked”, 13th Nov. 2017.) But the 45% rise in house prices since 2012 has taken nominal house prices beyond their peak at the height of the previous boom. (See Chart 1.) Chart 1: Nominal House Prices (Index) 220
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Admittedly, mortgage interest rates are still very low. But they have begun to rise. Mortgage payments have therefore also been trending up. The National Association of Realtors reports that the median monthly mortgage payment, including both interest and capital repayments, totalled $989 in the third quarter. That’s still a fair way below the peak of $1,170 seen during the height of the mid-2000s housing boom, but is up 60% compared to the start of 2012. (See Chart 2.)
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Chart 2: Median Monthly Mortgage & Rent Payments ($) 1400 1200
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Meanwhile, a surge in multifamily construction has led to rising rental vacancy rates, which has taken some of the steam out of rental growth. The CPI ‘rent of primary residence’ component rose by 3.7% y/y in November. That’s down from 4.0% at the end of 2016. The upshot of those two developments is that median monthly mortgage payments were $77 higher than median monthly rental payments in the third quarter. On the face of it, that might suggest renting is now the better option for a newly forming household. However, that calculation misses out a large number of additional factors that need to be taken into account. After all, if the initial monthly payment was the be-all and end-all of the relative benefits of renting vs. owning, Americans should have elected to rent in nearly every year since 1981. Modelling the buy vs. rent trade-off Given that they haven’t, a simple comparison of rents vs mortgage payments is clearly inadequate to answer the question of whether buying is better than renting. As we noted in our earlier Focus, monthly rent or mortgage payments are not the only costs associated with each type of tenure. Tenants are charged fees at the start of their tenancy while homeowners face closing costs, property tax, insurance, maintenance and certain utility costs that tenants do not, as well as foregone interest on their down payment. And while most homeowners lock into a fixed mortgage payment, tenants’ monthly rental payments can change. What’s more, as they repay their mortgage, homeowners build up housing Page 2
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equity. A change in house prices also delivers windfall gains or losses in housing equity. They may also be liable for capital gains tax when selling their home. Set against that, homeowners are able to offset mortgage interest and property tax against federal income tax. The changes that the tax bill will bring to the desirability and/or ability to deduct those items could therefore alter the buying decision for some households. Our buying versus renting calculator takes all of these factors into consideration. It assesses the net costs of buying and renting over a particular holding period. For the purposes of this Focus, we use 10 years, which is the average time an American homeowner currently spends in their home. The calculator assumes that, at the end of the holding period, the homeowner sells their home before moving. Table 1 sets out the assumptions we make in our first scenario, which is based on the current tax environment. Full details of the calculator are provided in the Appendix. Table 1: Assumptions In Buying vs. Renting
Calculation Assumptions for owner Purchase price $250,000 Closing costs (buying) 4.0% Down payment 20% Mortgage Rate 4.3% Annual property tax 1.38% Insurance, maintenance and utilities $320 / month House price inflation (2018-2028) 4%, 0%, 2%, 2%, 2%, 3%, 3%, 3%, 3%, 3% Closing costs (selling) 5.0% Assumptions for tenant Monthly rent Transactions costs Security deposit Rental value growth (2018 – 2028)
General assumptions Holding period Inflation Bank savings rate Marginal tax rate Mortgage interest deduction limit Property tax deduction limit
$912 $450 $912 3%, 3%, 3%, 3%, 3%, 3%, 3%, 3%, 3%, 3%
10 years 2% 2% 25% $1,00,000 None
The impact of itemising To ensure a fair comparison between the two tenures, whether this hypothetical household itemises their deductions is a key factor to consider. Based on the assumptions set out in Table 1, in 2018 this household would be paying $3,450 a year in property tax and just over $8,500 in mortgage interest payments. Those deductions total just under the current married couples standard deduction of $12,700. In a state with no income tax, and assuming no charitable deductions, it is therefore plausible that this household would simply take the standard deduction. Table 2 sets out the costs of buying and renting under that scenario, where the additional tax-specific benefits of owning are therefore rendered mute. Table 2: Buying vs. Renting Costs Over 10-Years
(Non-itemiser, Current Tax Rules, $) Owner Initial transaction costs 10,000 Net mortgage payments 118,769 Mortgage capital repayments 40,853 Mortgage interest payments 77,916 - Fed income tax deduction Net property tax 38,313 Gross property tax 38,313 - Fed income tax deduction Ins., maintenance & utilities 42,431 Rent Foregone interest 9,704 Accrued equity 110,713 Selling costs 15,993 Total costs/benefits -124,497
Renter 456 125,774 220 -126,450
Source: Capital Economics
Both tenure choices involve an overall net cost. That’s to be expected, after all the household is consuming housing services during the 10-year period. But, at $124,497, the net cost of owning the $250,000 home is just under the cost of renting it. However, non-itemising households are consistently better off renting for any holding period of less than 10-years. (See Chart 3.)
Source: Capital Economics
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Chart 3: Costs of Buying Vs. Renting $250,000 Home for Non-Itemising Household ($000) 180
Chart 4: Costs of Buying Vs. Renting $250,000 Home for Itemising Household ($000)
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Source: Capital Economics
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For households who do itemise, however, the calculation changes. Table 3 sets out the case at the other extreme, where the hypothetical household would itemise irrespective of whether they bought or rented. For example, that could be the case for households who reside in states with a high income tax. Table 3: Buying vs. Renting Costs Over 10-Years
(Itemiser, Current Tax Rules, $) Owner Initial transaction costs 10,000 Net mortgage payments 99,290 Mortgage capital repayments 40,853 Mortgage interest payments 77,916 - Fed income tax deduction 19,479 Net property tax 28,735 Gross property tax 38,313 - Fed income tax deduction 9,578 Ins., maintenance & utilities 42,431 Rent Foregone interest 9,704 Accrued equity 110,713 Selling costs 15,993 Total costs/benefits -95,439
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Renter 456 125,774 220 -126,450
Source: Capital Economics
As this household would itemise their taxes whether they bought or rented, the added benefit of being able to deduct mortgage interest payments and property taxes makes owning relatively cheaper compared to renting. Indeed, owning is now the better option for any holding period over six-years. (See Chart 4.)
Of course, for many households, they may only choose to itemise if they buy a home. That makes the comparison between buying and renting more complex. But, depending on the size of the other items they can deduct, the holding period from which buying becomes a better option than renting will be between six and 10-year years. House price sensitivity The results of the calculator are clearly dependent on the assumptions set out in Table 1. In particular, given the benefit of capital appreciation for those buying, the evolution of house prices can make a significant difference. For example, Chart 5 shows the costs and benefits for an itemising household where house prices grow at just 1% y/y in each year during the holding period. In that case, instead of six-years, buyers would need to hold onto their property for more than double that before buying begins to offer a tangible financial benefit compared to renting. Chart 5: Costs of Buying Vs. Renting $250,000 Home for Itemising Household, Low Price Growth ($000) 180
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Source: Capital Economics
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That’s a stylised example – after all in that situation you would also expect rental growth to slow. But it demonstrates that many factors, not just the tax environment, will influence the home buying decision. Impact of Tax Bill The tax bill would have a number of implications for the above calculations. Most significantly, it doubles the standard deduction for married couples to $24,000. It also puts a limit on state, local and property tax deductions of $10,000. The bill will also put a limit on the mortgage interest deduction (MID) for new buyers to the first $750,000 of mortgage debt, compared to a $1,000,000 limit in place now. For our representative household buying a home with a $200,000 mortgage, the new MID limit in the bill therefore does not apply. However, the doubling of the standard deduction will have an impact on this household’s itemising decision. With mortgage interest at $8,500 in 2018, and state, local and property tax deductions limited to $10,000, for most households it would now make sense to take the standard married couples deduction of $24,000 rather than itemise. In other words, nearly all households will now face the costs outlined in Table 2. At the extreme, compared to a household that would have itemised irrespective of their tenure choice under the current tax system, that implies the costs of owning a $250,000 home over a 10-year period would rise by 30%. That might imply a reduction in demand for homes after the tax bill comes into effect, with a corresponding drop in house prices. But note that the household is not worse off overall under the new tax system. The difference is that the household can now choose what to spend their tax deduction on – it isn’t restricted to spending the tax benefits on a home. At the margin, that may mean some Americans choose a smaller home than they otherwise would have. But we suspect most will still put the tax saving towards buying a home. After all, many households run up against debt-to-income limits when applying for a mortgage, suggesting they are stretching themselves when purchasing a property. To the US Housing Market Focus
extent that households enjoy an overall tax cut, the impact could even be positive for homes priced around $250,000. Will the high-end market suffer? For more expensive homes, the new limits on the mortgage interest, state and property tax deductions could have more of a detrimental impact. Table 4 sets out the costs under the current tax environment of buying or renting a home that costs $1.5 million, keeping the gross rental yield constant at 4.4%. Even give the limit on the MID of $1 million, this household will clearly elect to itemise. Table 4: Buying vs. Renting Costs Over 10-Years
($1.5 Million Home, Current Tax Rules, $) Owner Initial transaction costs 60,000 Net mortgage payments 595,741 Mortgage capital repayments 245,118 Mortgage interest payments 467,497 - Fed income tax deduction 107,141 Net property tax 172,409 Gross property tax 229,879 - Fed income tax deduction 57,470 Ins., maintenance & utilities 196,243 Rent Foregone interest 58,221 Accrued equity 664,278 Selling costs 95,958 Total costs/benefits -524,027
Renter 2,750 758,508 1,324 -762,582
Source: Capital Economics
The relative benefits are much the same as with a $250,000 home, although economies of scale mean insurance, maintenance and utility costs are now slightly lower when buying a home. Again, buying involves a lower net cost for any holding period of six years or longer, with renting the cheaper option for shorter time periods. Under the tax bill, this household would now be limited to claiming $10,000 a year of property tax deductions, and interest on only the first $750,000 of mortgage debt. But it would still make sense for this household to itemise even given those limits. Therefore, in Table 5 the value of the property tax deduction is now limited to $25,000 over the 10year holding period (25% marginal tax multiplied by $100,000 of deductions), down from $57,470 under current tax rules. And the mortgage interest deduction is cut from $107,141 to $80,625.
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Table 5: Buying vs. Renting Costs Over 10-Years
($1.5 Million Home, New Tax Rules, $) Initial transaction costs Net mortgage payments Mortgage capital repayments Mortgage interest payments - Fed income tax deduction Net property tax Gross property tax - Fed income tax deduction Ins., maintenance & utilities Rent Foregone interest Accrued equity Selling costs Total costs/benefits
Owner 60,000 421,327 245,118 467,497 80,625 204,879 229,879 25,000 196,243 58,221 664,278 95,958 -583,013
Renter 2,750 758,508 1,324 -762,582
Source: Capital Economics
But, over a period of 10-years, those are relatively small changes given the sums involved. Compared to the current tax environment, buying this $1.5 million home and holding on to it for 10-years would cost an additional $58,986, or $5,898 a year. To put it another way, at a mortgage interest rate of 4.3%, to achieve the same purchasing cost as before the change the size of the mortgage would have to be reduced by 9% to $1,100,000. But, that doesn’t necessarily mean expensive homes will see a drop in price of that magnitude. Even with the limits on the state and local income tax deduction, wealthy households are expected to see their overall tax bill cut, which will support home values. That said, for some very high house price, high tax cities in coastal states, home values are likely to come under downward pressure. Housing market will weather the change Overall, we doubt there will be a large adverse impact on the housing market under either version of the bill. Admittedly, a lot more middle-income households will choose to itemise, and that will reduce the value of the MID and property tax deductions. But most buyers will still stretch themselves to buy a home. And many will have more post-tax income to save for a down payment and meet their monthly mortgage payments.
expensive properties in high-tax cities on the coast. But, even there, we doubt the impact will be large. Appendix This appendix discusses our buying versus renting calculator in more detail. Starting with the calculation of the tenant’s total costs, the calculator adds up the amount of rent paid over the holding period. Rent increases are applied once a year. The calculator also takes account of a tenant’s initial transactions costs and deposit, as well as the bank interest (after deducting tax) that could have been earned on these. Transaction costs are assumed to be equal to half of one month’s rent and the deposit is equal to one month’s rent. The deposit is returned at the end of the tenancy. The calculation of the owner-occupier’s total costs starts with the buyer’s closing costs, which are a percentage of the initial price of the property. The calculator then takes account of the bank interest (after tax) that could have been earned on the down payment and the buyer’s closing costs. Added to this are the total mortgage payments made over the holding period. We assume the home is bought with a fixed-rate mortgage, meaning that payments remain constant. Mortgage interest payments on the first $1m of debt are tax deductible at the borrower’s marginal rate. The owner-occupier also faces insurance, maintenance and some utility bills, which the tenant does not. These costs increase at the rate of inflation. Added to this are the owner’s annual property tax bills, which are levied on the current value of the property, and which are tax deductible at the owner’s marginal rate. Accrued housing equity must be offset against the costs of homeownership. Equity is accrued both from the capital repayments on the mortgage and any upwards movement in house prices. If equity gains resulting from a rise in house prices are greater than the capital gains exclusion, capital gains tax is levied on the marginal amount. If house prices fall, the equity loss is added to the homeowner’s costs.
Meanwhile, the limit to the MID for wealthier households is only likely to have an impact on
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At the end of the assessment period, the homeowner sells their home, paying agents’ fees as a percentage of the sale price. The outputs of the calculator are the net costs (given as a negative number) or net benefits (a positive number) of each type of tenancy, as well as the amount by which one tenancy does better than the other.
large amount of available cash to pay the deposit and initial transaction costs), this does not skew the final result. The outputs of the calculator would be no different if we had assumed that the tenant also started with an equal amount of cash which they choose to bank rather than use as a down payment on a home.
It is worth noting that while the buyer and the tenant begin from unequal starting points (the buyer has a
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