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I was reading this: http://patrick.net/housing/crash1.html and found this statement by Patrick:

3% annual cost of renting is less than the 9% annual cost of owning the same thing

Source: http://patrick.net/forum/?p=16284

I understand the statement but how did he come up with 3% and 9% values? I am not sure how can I reason about this statement.

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The 3% and 9% figures are based on the cost of borrowing money and all the other ownership costs associated with real estate.

From the same article: http://patrick.net/housing/crash1.html

Because it's usually still much cheaper to rent than to own the same size and quality house, in the same school district. In rich neighborhoods, annual rents are typically only 3% of purchase price while mortgage rates are 4% with fees, so it costs more to borrow the money as it does to borrow the house. Renters win and owners lose! Worse, total owner costs including taxes, maintenance, and insurance come to about 8% of purchase price, which is more than twice the cost of renting and wipes out any income tax benefit.

Imagine you are renting a house. If the cost of your annual rent is lower than X then renting is obviously the best idea from a monetary calculation. If rent is greater than Y being a landlord makes more sense. In the middle it is debatable, and the non-monetary reasons need to be considered.

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The house that sells for $200,000 might rent for a range of monthly numbers. 3% would be $6000/yr or $500/mo. This is absurdly low, and favors renting, not buying. 9% is $1500/mo in which case buying the house to live in or rent out (as a landlord) is the better choice. At this level "paying rent" should be avoided. I'm simply explaining the author's view, not advocating it.

A quote from the article -

annual rent / purchase price = 3% means do not buy, prices are too high

annual rent / purchase price = 6% means borderline

annual rent / purchase price = 9% means ok to buy, prices are reasonable

Edit to respond to Chuck's comment - Mortgage rates for qualified applicants are pretty tight from low to high, the 30 year is about 4.4% and the 15, 3.45%. Of course, a number of factors might mean paying more, but this is the average rate. And it changes over time. But the rent and purchase price in a given area will be different. Very different based on location. See what you'd pay for 2000 sq feet in Manhattan vs a nice town in the Mid-West.

One can imagine a 'heat' map, when an area might show an $800 rent on a house selling for $40,000 as a "4.16" (The home price divided by annual rent) and another area as a "20", where the $200K house might rent for $1667/mo. It's not homogeneous through the US. As I said, I'm not taking a position, just discussing how the author formulated his approach.

The author makes some assertions that can be debatable, e.g. that low rates are a bad time to buy because they already pushed the price too high. In my opinion, the US has had the crash, but the rates are still low. Buying is a personal decision, and the own/rent ratios are only one tool to be added to a list of factors in making the decision.

Of course the article, as written, does the math based on the rates at time of publication (4%/30years). And the ratio of income to mortgage one can afford is tied to the current rate. The $60K couple, at 4%, can afford just over a $260K mortgage, but at 6%, $208K, and 8%, $170K. The struggle isn't with the payment, but the downpayment.

The analysis isn't too different for a purchase to invest. If the rent exceeds 1% of the home price, an investor should be able to turn a profit after expenses.

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    This answer is just wrong. Patrick is advocating renting a house to live in, not comparing buying to rent with buying to live in. – DJClayworth Oct 3 '13 at 13:54
  • @DJClayworth - I said the comparison was buying a home to live in vs renting. I did not mean to imply otherwise. – JoeTaxpayer Oct 3 '13 at 19:53
  • These percentages seem useful, but they do not reflect prevailing mortgage interest rates. The assumption in the referenced article seems to suggest approx 4% for mortgage rate. But rates are low now compared to historical values; should rates rise, that should affect the purchase decision. The article claimed that house prices would fall when rates rise, and also did not consider changes in rent prices. – ChuckCottrill Jan 17 '14 at 21:33
  • @ChuckCottrill - I've edited to respond to your comment. – JoeTaxpayer Jan 18 '14 at 13:44

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