John Beckett's Real Estate Blog

If you’re pondering whether to buy or rent, you know the decision is partly an emotional one. If you detest landlords and have plenty of money to put toward a house, you may prefer the pride of ownership, regardless of how low rents go. On the other hand, if you plan to leave town in a year, the transaction costs involved in owning make it a prohibitive prospect. For most people, the choice is tougher. If you’re settled in a hometown and want to make the financially smartest move, a few mathematical calculations should lead you toward an answer. First, you find a home you’d like to own and calculate its “capitalization rate.” The cap rate is the amount of rental income you would earn if you bought the house and leased it out at the market rate. You express the amount as a percentage of what you’d pay for the house. So if you plunk down $100,000 for a house that you calculate could produce $5,000 a year in rental income, you’d say the capitalization rate on the house is 5%. The higher the cap rate, the better for the buyer. If the home you wish to buy has an implied cap rate that is equal to or higher than the return you think you can safely garner in stocks or bonds, it probably makes sense to go ahead and buy. What’s nice about a cap rate is that you don’t have to guess at what housing prices will do in the coming year. You only need to know what you’d pay for a home now and what it would rent for now. It’s important to calculate the cap rate correctly. Rental income is not the same as gross rent. Get a couple of local real-estate agents to tell you realistically what the house you wish to buy would garner in annual rent. Then subtract property taxes, insurance and a reserve for routine upkeep. What’s left is your rental income. (A good rule of thumb is that rental income is two-thirds of gross annual rent.) If you do buy, of course, it’s not as though you’ll get rental checks in the mail. The rental income figure you calculate is the amount of money you’re saving by not having to rent your own home. For most of us, those savings will be directed toward mortgage payments. (For a few years, those payments will mostly go to covering interest. Eventually most of it will go toward paying down the principal on your loan, which is as good as putting money in your pocket.)

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