Author Topic: The 4% Rule and the Rent vs. Buy Decision  (Read 6011 times)

aclarridge

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The 4% Rule and the Rent vs. Buy Decision
« on: December 19, 2013, 04:48:36 PM »
It occurred to me that in some situations the 4% rule dictates whether one should rent or buy.

Imagine I have 1MM invested, and require 40k a year to live in my rented apartment. I am FI. Now my landlord offers to sell me the apartment. I figure that if I buy the apartment, my overall annual expected living expenses will decrease by 10k per year. In order to maintain my FI status, I can pay as much as 250k for the apartment (10k divided by 4%). If it's significantly more or less than this number, then the decision becomes pretty easy.

There are a few assumptions here:
- having a 250k apartment is the same as having 250k invested in one's portfolio (obviously a big assumption)
- annual expected (or average) living expenses can be accurately measured (probably harder for the house case)
- 250k is paid in cash, not mortgaged - that just makes it more complicated because of the rate
- taxes are ignored

It's not a complicated idea but I'd just never thought of it that way before. Curious to see what others think.

steveo

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Re: The 4% Rule and the Rent vs. Buy Decision
« Reply #1 on: December 20, 2013, 01:53:31 AM »
I totally agree with your premise however there are a couple of caveats that I can see.

1. The future price of renting.
2. The future price of owning - taxes, fees, bills etc.
3. The future price of living where you want to live - i.e. close to family and friends etc compared to travelling to see family and friends when it suits you.

I would add that the assumption of owning a house vs investing elsewhere is a difficult one to judge. For me personally with massively expensive house prices (Sydney, Australia) and young children it is for me personally easier to own a home because it is a great lifestyle hedge. I'm not sure if it is the best financial decision over the long term but in reality who knows.


Cooperd0g

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Re: The 4% Rule and the Rent vs. Buy Decision
« Reply #2 on: December 20, 2013, 09:48:54 AM »
Overall what you say makes sense. You either need to have the income to pay the additional expense of rent or you need to be mortgage/rent free, which requires less money on an ongoing basis.

Another question to ask yourself is do you think that apartment is worth $250k? Just because your math works that way doesn't mean the property value works that way. Maybe you could get more for your money or pay less because the market value isn't $250k. Having said that it does seem like a good way to evaluate a property from a pricing standpoint.

aclarridge

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Re: The 4% Rule and the Rent vs. Buy Decision
« Reply #3 on: December 27, 2013, 08:54:55 AM »
For me personally with massively expensive house prices (Sydney, Australia) and young children it is for me personally easier to own a home because it is a great lifestyle hedge. I'm not sure if it is the best financial decision over the long term but in reality who knows.

What do you mean by lifestyle hedge? Is that like paying off a big mortgage is "forced savings"?

Overall what you say makes sense. You either need to have the income to pay the additional expense of rent or you need to be mortgage/rent free, which requires less money on an ongoing basis.

Another question to ask yourself is do you think that apartment is worth $250k? Just because your math works that way doesn't mean the property value works that way. Maybe you could get more for your money or pay less because the market value isn't $250k. Having said that it does seem like a good way to evaluate a property from a pricing standpoint.

Cool - that's what I figured.

arebelspy

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Re: The 4% Rule and the Rent vs. Buy Decision
« Reply #4 on: December 27, 2013, 09:08:58 AM »
It's a good way to think about it.

The biggest problem, IMO, is that people overestimate how much home ownership will save them.  You'd better be sure about that 10k, in other words.

When maintenance rears its ugly head, and you can't call the landlord, but are paying out of pocket for that 30k sewer line burst (and that's normally your budget for the whole year), that hurts.

I certainly wouldn't pay 25x for a house in that scenario, I'd probably divide by at least the 7% stocks will hopefully return long term.

And make sure ALL costs are accounted for, and add some padding into the numbers.

So it starts like a simple way to think of it, then gets more complex as you delve into the numbers.

But it is a good, useful, basic framework. So thanks for posting. :D

(For those that mention owning gives you the fixed housing cost while rents rise, that's true, but theoretically the investments you have paying for your rents that are there because you didn't use them to buy the house will rise, and hopefully faster than inflation, so it should easily offset that.)
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KingCoin

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Re: The 4% Rule and the Rent vs. Buy Decision
« Reply #5 on: December 27, 2013, 09:10:31 AM »
I think the lifestyle hedge argument goes something like this; "Even if housing is somewhat overpriced, I'd rather lock in at the current level than rent and be forced to move or downgrade if housing becomes even more overpriced".

This argument makes some sense, but less as prices become more and more unmoored from the cashflow these properties are able to generate. At some point, you have to have faith that housing prices will track the earning power of the populace, and any significant deviation has to be temporary. Rising prices can foster the attitude that you need to "buy now or be priced out forever" which is usually a dangerous one (with some exceptions).

aclarridge

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Re: The 4% Rule and the Rent vs. Buy Decision
« Reply #6 on: December 27, 2013, 02:43:06 PM »
The biggest problem, IMO, is that people overestimate how much home ownership will save them.  You'd better be sure about that 10k, in other words.

Point taken. It's especially difficult to estimate I think for somebody buying their first property. Aside from poor estimation of routine maintenance (some area-specific research likely required), a few cruel twists of fate like you mentioned and all bets are off.

In condo markets, the rate at which maintenance fees increase, and the possibility of future "special assessments" to fix big things are big unknowns. Personally I don't get that far in my analysis, as even with the most inexpensive assumptions about ownership costs (i.e. no surprises, ever), using a metric like this to value the property tells me I should only pay about 60-65% of what others around here are paying.

So it starts like a simple way to think of it, then gets more complex as you delve into the numbers.

But it is a good, useful, basic framework. So thanks for posting. :D

That was the intention. You're welcome :)

I think the lifestyle hedge argument goes something like this; "Even if housing is somewhat overpriced, I'd rather lock in at the current level than rent and be forced to move or downgrade if housing becomes even more overpriced".

This argument makes some sense, but less as prices become more and more unmoored from the cashflow these properties are able to generate. At some point, you have to have faith that housing prices will track the earning power of the populace, and any significant deviation has to be temporary. Rising prices can foster the attitude that you need to "buy now or be priced out forever" which is usually a dangerous one (with some exceptions).

Ah ok, that argument. I share your sentiments exactly.