In Part 1 of this article series we looked at some of the general points about buying versus renting a home. If, however, we wanted to look at it from a strictly financial perspective, how could this be approached?
We try to use two metrics when trying to assess if rental rates or house prices are reasonable, which can therefore help when deciding whether renting or buying is more beneficial.
The major problem with trying to apply the metrics in the Caribbean is the lack of easily accessible public information to allow you to compare different properties. This does not mean no information is available; you just have to do a little digging to uncover it.
For those familiar with financial investments terminology, you’ll realize these metrics are similar to a stock’s dividend yield and P/E ratio; the metrics broadly convey similar information as they do for stocks.
This is referred to by different names (e.g. rent-to-price ratio), but we like our description. It’s basically the annual rental for the property divided by the current property valuation. For example, if a property worth $1,000,000 can be rented for $70,000 per year, the rental yield is ($70,000 / $1,000,000 =) 7%.
Pretend you are a real estate investor. The yield means you’ll earn 7% on your investment in the property. You can then compare this to other investments, financial investments, other property investments, etc. If the return is attractive, then you’d probably invest.
For the prospective homeowner or renter, if the rent yield is attractive, buying may be the better option. If the yield is unattractive, you may be better off renting.
This ratio is the inverse of the rental yield. Using the previous example, the price-to-rent ratio will be ($1,000,000 / $70,000 =) 14.3.
This ratio has tremendous value if you have an idea what the historical ratio has been for properties in the particular location. For example, if the average has generally been around 10, then it indicates the properties are likely to be currently overvalued, or at least future price appreciation may be more muted than in the past.
The rule of thumb is a lower ratio favours buying a home, while a higher ratio suggests renting may be a better option.
It would be useful to compare your prospective property’s ratio against similar properties on the market. If the property you are interested in has a higher ratio than comparable properties, then it may be overpriced. Of course, you’ll need to compare property features, age, and selling points to assess if the higher price may be warranted.
Another useful way of interpreting this ratio is it suggests the number of years you could live in a property (14 years and 4 months – 14.3 in our example) and still pay less than the property’s selling price (ignoring rental increases). The lower the ratio, the fewer years it would take to pay for the property’s selling price – this is disadvantageous to the renter, so buying is the better choice.
Costs of Homeownership
Homeowners have several costs that need to be paid upfront as well as ongoing expenses.
The initial cost most individuals focus on would be the downpayment to obtain the mortgage loan – usually between 5-10% of the property value. There are, however, additional costs, for example:
- Transfer taxes
- Loan fees
- Legal fees
- Valuation fees
In contrast, the renter would not have any major upfront costs, with the possible exception of a security deposit, which is returned when he stops renting once the property is not damaged.
Homeowners also have various ongoing costs that need to be budgeted for, the top-of-mind one being the mortgage loan instalment. Others include:
- Life insurance premiums if you are not insured
- Property taxes
- Property insurance
- Repairs and maintenance costs
In contrast, renters only have to consider monthly rent, renters insurance (this does not appear to be very popular in the Caribbean), and utilities (although this varies by landlord – it is sometimes included in the rent).
How much can you afford
Obviously knowing how much you can afford to spend is a major question to be answered when deciding if to buy or rent. You then use this amount to help your search for appropriate homes to buy or rent.
Buying in particular needs careful evaluation because the associated payments become Fixed expenses for you – remember we regard any expense that you cannot easily change in the short-term to be Fixed. When you rent, however, it is comparatively easier to find a cheaper rental and move than when you own a home.
If you are not familiar with our concept of Fixed expenses, you should check out the article Creating Your Budget (33/33/33). In addition, we covered this question about affordability in detail in the article Buying a Home: How Much Can You Afford?, so we’ll not repeat it here. Please read that article carefully.
One of the bigger financial risks when entering a mortgage is the impact of future interest rate increases. In the Caribbean, lenders rarely offer fixed rates for mortgages i.e. the loans are mainly floating / variable rate, where lenders have the right to increase the interest rate in the future.
We also covered this in detail in the article Buying a Home: How Much Can You Afford?, so we’ll not repeat it here. Again, please read that article carefully.
As you can see, there are several financial points to consider when deciding if to buy or rent a home. In Part 3 of this article we’ll look at an example. The conventional wisdom is that you are automatically worse off from renting, but is this necessarily the case? We’ll see.
We hope you enjoyed reading and we’d love to hear from you in comments below if you have questions or comments to share!