Blueprint for Buying - or Renting: Timing for a Market in Turmoil

Act today? Tomorrow? Never?
By: June Fletcher: The Wall Street Journal Online
With many consumers wondering if the decade-long housing boom is peaking, June Fletcher explores the crucial question of when is best to purchase property. Read her suggestions for gauging the effects of rates, demand and taxes.

To buy or not to buy?

That is the question facing homeowners all across the country as overall home prices reach yet another record, mortgage interest rates reach a six-year-high, and construction workers and supplies are diverted to the hurricane ravaged Gulf Coast.

As tensions mount between too much demand and too little supply, many consumers are wondering if the decade-long housing boom is peaking. Should they buy now, or wait for rising rates to depress prices? "House Poor," a new book by Wall Street Journal reporter June Fletcher, published by HarperCollins and in stores Tuesday, looks at this crucial question, and suggests strategies to survive a housing market in turmoil. Here is a condensed excerpt:

April and Adam Nichols are suffering from sticker shock. The newlywed New Yorkers would love to get out of their cramped one-bedroom rental in Manhattan, which costs them $2,325 a month, and buy a starter condo. But everything they've seen in their under-$500,000 price range is horrible, from a fifth-floor Hoboken, N.J., walk-up with a view of an ugly brick wall to a run-down building in the Bronx.

So what are the Nicholses planning to do? For now, nothing. "It's hard to throw money away on rent, but we're going to be patient," says Ms. Nichols. "Prices are bound to come down."

It's challenging to sit on the sidelines when every day, the airwaves are crammed with home fix-up shows, and bookstores push books on how to make millions as a real-estate investor. But the real trick to winning at real estate is to be contrarian and recognize just where you are in the real-estate cycle. When Doug Duncan, chief economist for the Mortgage Bankers Association, moved to Washington in 1988, the local real-estate market was sizzling and buyers got caught up in bidding wars at open houses. He decided to rent. Soon, the market took a nose dive. Five years later, he decided it would be a good time to buy. He paid about a third less than the previous owner, who'd lost his home in a foreclosure. "You have to use caution," he says.

Understandably, not many real-estate brokers share this opinion. An ad recently sent to clients by agents of the New York brokerage firm Prudential Douglas Elliman pushed ownership hard. It points out that real-estate prices, unlike stocks, adjust slowly, and that predictions that the New York market would crash after 9/11 didn't come to pass. It also told first-time home buyers that they have to "get in the elevator to ride to the penthouse," and asked: "Why do you work so hard? To live in a crummy rental for the rest of your life waiting for a bargain to emerge?"

But the real worry today isn't that you'll be stuck in a rental for the rest of your life, but that you'll buy at the peak, watch prices slide, and be stuck in the property for years, waiting for them to recover. To come out ahead as investors, consumers need to buy low and sell high, but this gets forgotten in the emotions of buying a home.

Honolulu's Bad Six Years

How often do busts occur? The Federal Deposit Insurance Corp. has identified 21 cities that experienced a housing bust over the past quarter-century. In the mid-'80s, the victims were cities in Texas, Louisiana, Oklahoma; in the early '90s, cities in the Northeast and California. Scattered throughout the country were other places that experienced price declines when they lost major employers or became overbuilt. After too many developers invaded Honolulu, for instance, the city had six straight years of price declines, ending in 2001.

How genuine is the danger of price declines today? Some economists like David Lereah, chief economist for the National Association of Realtors, argue that we're not in danger at all, because current long-term fundamentals are sound, including healthy job growth, tight supply, and continued demand.

And while nominal prices haven't fallen since the '30s, real home prices (adjusted for inflation) have tumbled from time to time, typically after a big run-up like we're seeing today. In the early '80s, real home prices fell 10%. It would take a sharp and unlikely contraction of the economy to repeat that scenario -- a doubling of current mortgage rates and a halving of home sales -- but if oil prices remain high, such a contraction is possible, according to Lawrence Yun, a forecast economist also with the National Association of Realtors.

Other factors are troubling, too. Americans are deeper in debt than ever before, many from risky interest-only and negative amortization loans they took out to take part in the all-night real-estate party. One big bump up in interest rates, coupled with a few local downturns, is another potential scenario. The effect could be serious. In 2000, when the stock market fell, the top 1% of investors controlled a third of the nation's accumulated stock wealth. Today, the top 1% of home-equity holders control only 13% of the nation's housing wealth.

So in these uncertain times, should you buy or rent? There's no one-size-fits-all answer. Generally speaking, people tend to rent when their income is the lowest, when they're young and old, and own in-between. But that's not always true, especially today, when some young people are forgoing pricey cars and weddings to make down payments, some older people are sucking the equity out of their paid-off homes through reverse-equity mortgages, and some midcareer couples are renting luxury condos rather than buying a suburban McMansion. Let's look at the cases for owning versus buying:

The Case for Owning

Uncle Sam wants you to own a house, and gives you all sorts of incentives. Though some reformers would like to see the mortgage-interest deduction phased out, it's currently one of the biggest tax breaks most homeowners have, saving $76 billion a year, according to the Office of Management and Budget.

What's more, if you sell your house after living in it for two out of the last five years, you get a tax-free gain: $250,000 for an individual, and $500,000 for a couple.

Over the past decade, 10 million new households bought homes; now seven out of 10 American households live under their own roofs. That's certainly helped increase the average family's net worth at a time of stagnant wages and a lackluster stock market. Since the boom began in 1996, homeowners nationwide have amassed more than $5.2 trillion in home equity.

The politically sanctioned push toward home-ownership, coupled with low interest rates and easy money from lenders, has caused builders to flock to for-sale housing and neglect the rental market. The supply of rental apartments is declining, as some are demolished due to age, and others are converted into condos. Construction of new rental housing fell to a 10-year low in 2004, as multifamily builders turned in droves to more lucrative condos.

Although rents are currently a bargain in some of the hottest housing markets as supply tightens, that may soon change. It's happening already in some sizzling markets like South Florida, where condos are sprouting like kudzu, but long-term rentals are becoming as rare as jungle orchids.

The Case for Renting

For those who already own a home, have built up equity, and live in the nation's hottest and most precarious housing markets, now may be a very good time to rent.

With price increases reaching the double-digits in many metro markets, housing has become increasingly unaffordable. In some markets, the flight to home ownership, spurred by low interest rates, has left units vacant, forcing landlords to make deals. In Atlanta, for instance, it's common to see giveaways of a month's rent. In Chicago, you can get two months' free rent and a $500 signing credit.

In some of the most expensive for-sale markets in the country, rents have been falling for a long time. Rents in San Francisco, for example, have fallen 19% since 2001, to $1,300. For that monthly rent, you currently can get a one-bedroom apartment on tony Nob Hill, with hardwood floors, a built-in china cabinet and a courtyard with gazebo and built-in barbecue grill. Meanwhile, buying a similar place costs about $530,000, or about $2,366 a month at a 5.34% fixed interest rate over 30 years -- and that's assuming you put down $106,000, or 20% of the purchase price.

Homeownership has other drawbacks. Because renters usually pay less, they have more money to put in the stock market, businesses and other investments. Renters also have flexibility, and can move without incurring heavy settlement costs, which typically run between 2% and 6% of the purchase price of a home.

Meanwhile, upscale owners in rising markets sometimes feel trapped in their homes by market forces. In Los Angeles, real-estate broker Anthony Marguleas says that high property taxes and limited capital-gains exclusions "severely penalize" sellers at the upper end of the market. That discourages them from listing their homes, so "inventories stay low, while demand is very high."

Buying has costs and headaches that renters don't need to think about, like homeowners' insurance, special assessments and property taxes. Even without these expenses, many families are already pushing their financial limits. A recent study by the Joint Center for Housing Studies at Harvard University found that more than one in three households spends more than 30% of its income on housing, while one in eight spends more than half.

So if you simply can't afford to buy without gambling your future, don't. "Many people are better off as lifetime renters," says Arlington, Va., housing economist John Tuccillo.

Email your comments to june.fletcher@wsj.com.