Today, we are honored to have Ken H. Johnson, Ph.D. — Florida International University (FIU) and Editor of the Journal of Housing Research as our guest blogger. To view other research from FIU, visit http://realestate.fiu.edu/. - The KCM Crew
Last week’s posting (Creating Wealth Through Homeownership – The Proof) concentrated on how homeowners, on average, accumulate more wealth than renters. The gist of the posting was that, in an environment where most do not save, homeownership creates a “forced piggybank” for owners through amortization of their mortgages and prepayment of principal. This conclusion comes from ongoing research being conducted by Beracha and Johnson.[i]
Additional evidence indicating that homeownership is really a savings vehicle is provided when Beracha and Johnson’s Buy vs. Rent model[ii] is employed to estimate the probability that renting is the superior economic decision and leads to greater wealth.[iii] In particular, Beracha and Johnson balance the benefits of ownership against the costs of homeownership and compare wealth accumulation through home equity against wealth accumulation through investments created by a comparable renter.[iv] The model assumes an eight year holding period.[v]
Through thousands of Monte Carlo simulations (an advanced statistical technique where past outcomes are used to predict future results), Beracha and Johnson are able to derive the probability that renting will outperform homeownership in terms of wealth accumulation for each of the 30 plus years of the study. When the probability for a given year is 50%, there is no clear winner between ownership and renting. When the probability is greater than 50%, renting wins. When the probability is less than 50%, ownership wins. The results are presented in the graph below:
The top line in RED depicts the probability that renting will outperform ownership in wealth accumulation assuming that renters reinvest rent savings (difference between rent payments and mortgage payments). Clearly, over the vast majority of the study period and under this very strict assumption of reinvestment of rent savings, renting provides the greater probability of wealth accumulation.
The bottom line in BLUE, however, depicts a different and perhaps more realistic outcome. In particular, when renters are not forced to save and reinvest their rent savings and are instead allowed to spend on consumption, ownership becomes the probability winner in all of the wealth accumulation races.
Evidence is continuing to mount that renting is a better path to wealth accumulation in a strict “horserace” between buying and renting where renters are forced to reinvest any rent savings. Therefore, for those that have the discipline to monastically reinvest rent savings, renting is probably the better path to wealth accumulation. However, in perhaps a more realistic setting where renters can spend on consumption (beer, cookies, education, healthcare, etc.), ownership is the clear winner in wealth accumulation. Said another way, homeownership is a self-imposed savings plan on the part of those that choose to own.
[i] Eli Beracha and Ken H. Johnson, 2012, Beer and Cookies Impact on Homeowners’ Wealth Accumulation, ongoing research.
[ii] Eli Beracha and Ken H. Johnson, 2012, Lessons from Over 30 Years of Buy Versus Rent Decisions: Is the American Dream Always Wise? Forthcoming in Real Estate Economics.
[iii] The model results simply need to be inverted in order to interpret the results as to when buying leads to greater wealth accumulation.
[iv] See Beracha and Johnson (2012) for exacting details of their Buy vs. Rent model.
[v] The holding period can be varied with little change to the results. This issue will be addressed in future postings.