When it comes to maximizing your lifestyle and net worth, the question “should I rent or buy” is one of the most heavily debated. Even if you already own your home or apartment, it’s a good exercise to regularly consider whether living there is the optimal move.
Taking on debt to buy is always a gamble. But if you go down that route, your goal would be to use the debt to live a nicer life than you could have afforded to if you had to pay cash. The initial years after taking out debt to buy a home are generally the riskiest.
In contrast, the return on the rent you pay is essentially zero. Yes, in exchange for paying rent, you get a place to stay. But you have little chance of building equity.
BURL: The rest estate investing rule to follow
Utility can be defined as something you absolutely need, with very little unused space. Luxury is something beyond what you need, such as a third empty bedroom, massive terrace and backyard with a swimming pool.
BURL helps you see that the true cost of living in a home that you own isn’t just the money you spent to live there. It is the opportunity cost of not renting it out at market rate.
A case study for the BURL rule
I once knew a couple in San Francisco who decided to downsize once they realized that they could rent out their 2,600-square-foot, four-bedroom, three-bathroom home for $7,500 a month.
Before the pandemic, they bought a second, smaller home in a less central location that cost 40% less than what they paid for the first house. Their new house had a mortgage of $3,000 and could have rented out for $4,500 a month.
To them, a smaller house with a rental value of $4,500 was more aligned with their budget and household size. So they rented out their old house for $7,500 a month and boosted their monthly cash flow by at least $3,000.
By following the BURL rule, they opted to buy — and live in — the slightly more utilitarian three-bedroom, two-and-half-bathroom house, and let someone else rent for luxury.
If you’ve owned for a while, it never hurts to do some research and see how much rent your home could command in the current market. You might be surprised. As of June 2022, the national median rent price has increased by 14.1%, according to data from Apartment List.
And thanks to inflation, population growth and demographics, rent will likely continue to go up indefinitely.
What smart real estate investors do
In my experience, the question of “rent or buy” boils down to this:
- If you have the cash for a down payment on a luxury home and want to avoid economic waste, buy and live in a property only if you’d be willing to pay its fair market rent.
- If you want to go luxury but don’t have the down payment, you can rest easy as a renter knowing that you’re getting a better deal on your rented home or apartment than its owner is.
Savvy real estate investors often pay no more than 100 times the monthly rent to purchase a property. In the case of the couple above, an investor following the 100 times monthly rent rule wouldn’t pay more than $750,000 because the monthly market rent was $7,500.
Spending $7,500 per month ($90,000 a year) on rent may sound expensive, but paying $7,500 a month in rent is actually relatively good value, since you’d have needed to spend roughly 360 times the monthly rent to buy that house at its market price of about $2.7 million at the time.
It may be harder to follow the BURL real estate investing rule in expensive cities like New York, Los Angeles and San Francisco. There are people who pay six-figures a year in rent, but are actually coming out ahead thanks to the BURL rule. These renters are investing in different properties in other parts of the country for higher rental yields.
A Honda Civic takes you around just fine, but some people like to drive Ferraris. The BURL rule says that if you can afford it, buy the Honda Civic and rent the Ferrari on weekends.
The other side of BURL
In the Midwest, there are properties for around $200,000 that could rent for $2,000 a month based on the 100 times monthly rent rule. Amazing value for investors but not so much for renters, even if the absolute dollar amount for rent is low.
If you were to buy such a home with a baseline of a $40,000 down payment, $160,000 mortgage, and 4% interest rate, the annual costs of ownership would be about:
- $6,400 mortgage interest
- $2,400 property taxes
- $1,200 insurance
- $3,000 maintenance
= $13,000
Add $800 a year in opportunity cost for not earning a 2% risk-free return on the $40,000 down payment, and it costs only $13,800 per year to own compared with $24,000 a year to rent.
Even if the owner could only charge $1,200 (versus an expected $2,000) a month in rent, bringing the $200,000 property purchase equal to 167 times the monthly rent, owning is still a better value proposition, especially if the property continues to appreciate.
If the area in which you live, or would like to live, has market prices that look like this, you should buy rather than rent, since you could get cash-flow positive immediately if you were to one day rent the property out.
Ultimately, where we choose to live is a very personal decision. We all want to live close to friends and family. We also want to live in an area with great food, wonderful entertainment, and pleasant weather.
But we can’t have it all! What we can do, however, is choose the best options with the money we have.
Sam Dogen worked in investing banking for 13 years before starting Financial Samurai, his personal finance website. He has been featured in major publications including The Wall Street Journal, The Sydney Herald, The Chicago Tribune and The L.A. Times. Sam’s new book “Buy This, Not That: How to Spend Your Way to Wealth and Financial Freedom” is out now.
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