Buy or Rent in Northern California?
UC Davis MBAs Advise to Invest in Homeownership
By Associate Professor Anna Scherbina
Editor’s note: It’s easy to crunch a few numbers and figure that buying a home in most markets is cheaper than renting, but there several factors many people don’t take into account. In her course on Evaluation of Financial Information last spring, Associate Professor Anna Scherbina sent Bay Area MBA students out to do a buy-vs.-rent analysis. National Public Radio’s Sacramento affiliate interviewed Scherbina and student James Jennings about their findings. This is an excerpt from Scherbina’s blog about the students’ experience.
I asked students to devise a detailed valuation model to answer the question: Would you buy or rent a home in today’s market? The assignment required making a fairly realistic assumption they would live there for either 10 or 20 years before selling it and moving away, with each outcome being equally likely.
Students quickly combed through real estate listings and fanned out to open houses to find properties they would consider buying. One student already owned a condo and considered an alternative scenario of having rented his condo instead. Another student analyzed the property he had recently nearly purchased. Yet another student liked two different lofts and performed the buy-versus-rent analysis for each.
Students chose properties in cities throughout northern California, including Novato, Santa Clara, San Carlos, Oakland, Dublin, Lafayette, Livermore, Capitola, El Sobrante, Petaluma, West Sacramento, Sacramento, Mill Valley, Berkeley and Fremont. Listing prices ranged from $249,000 for a one-bedroom condo to $798,000 for a single-family home with a large backyard and a spectacular view of Mt. Diablo.
Next, students sought a mortgage contract, some enlisting the help of mortgage specialists. Those with a higher debt burden—partly due to large outstanding student loans, which would make a standard down payment of 20 percent unaffordable—and those with lower FICO scores would be paying higher mortgages rates.
They also estimated costs of buying and home ownership: closing costs, repair and maintenance, insurance, broker commissions and possible capital gains taxes. Future expenses and rents on comparable properties were adjusted for the current infla-
Students accounted for the risk associated with the uncertain sale price of the property by using an appropriately higher discount rate for the expected proceeds of the sale than for the interim cash flows. They also figured in their expected tax savings of home ownership using their personal tax rates and the estimated interest payments. Finally, it was important to account for the opportunity cost of capital invested in the down payment on a house since this capital could be earning an investment interest if the property is rented instead of bought.
The conclusions were striking. Only three students found that renting is cheaper than buying. One of them commented that he would nevertheless advise to buy in the Bay Area since he expected that the economy would continue to improve, increasing the demand for housing, which given the constraints on new construction would lead to a rapid price growth. Very prophetic as year-over-year asking prices have increased 16.1 percent in San Jose and 11.9 percent in San Francisco.
Among the students who chose other locations, one wrote: “I was surprised that owning would provide significant savings,” and another commented that the rental prices were “much too high!” Several attributed the benefit of buying to the historically low mortgage rates.
One student wrote that she felt too risk averse to consider buying a home in light of the highly uncertain sale price. This is a big shift in attitudes toward home ownership relative to the widespread belief of the late 1990s and early 2000s that house prices never fall.
Listen to Associate Professor Scherbina and student James Jennings discuss the findings on Capital Public Radio’s “Insight” program: www.gsm.ucdavis.edu/scherbina-radio