The Millionaire Next Door

Follow This “Herd”

Yesterday Colin Cowherd, ESPN Radio-The Herd, expressed his concern that many professional athletes were sending the wrong message to our country’s youth.  He outlined several case studies where some athletes who earned over $100M are now broke.

According to Mr. Cowherd, it is not only how much these people spend but the choices they make on where to spend their money.  He hammered home the theme that “cars are not assets,” especially those which are grossly over customized.  Such cars have little or no resale value.  The same can apply to overly decorated $9M homes.  Today it is difficult enough to sell such a home, but almost impossible if it contains dozens of gold adorned TVs and swimming pools inscribed on the bottom with “The Player.”  Mr. Cowherd went on to suggest that, in many cases, these athletes would be financially better off renting a home instead of buying one.

How perceptive he is!  The New York Times recently published the results of an analysis it did on a decision criterium it refers to as the “rent ratio.”  This ratio is described as: “the purchase price of a house divided by the annual cost of renting a similar one.  The number 20 provides a useful rule of thumb.  When you do the math, you discover that a ratio above 20 means you should at least consider renting, especially if you may move again in the next five years or so.  When the ratio is well below 20, the case for buying becomes a lot stronger.”

Interestingly, I have received several e-mails from people asking how they should go about purchasing a home in high priced areas such as Los Angeles and San Francisco.  Given their salary, and their respective rent ratios, they should seriously consider renting instead of buying.  For example, in 2009, the rent ratio for San Francisco was 28.4 albeit down from 40.4 in 2005.

For those who are truly interested in building lasting wealth no matter where they live, they may have to consider renting instead of owning, especially in this current economic climate. In such cases, one’s ego enhancement will come from taking affirmative action, i.e renting not owning, with the goal of becoming financially independent as a result. As I said in Stop Acting Rich, “Happy people tend to live in homes that they can easily afford.”  And, for some, renting provides a much more affordable option.

5 thoughts on “Follow This “Herd””

  1. Fred @

    Thanks for sharing the NY Times articles. I never heard of the rent ratio. With people moving as frequently as they are, I think more people need to consider renting.

    From birth we are told that you have to own a home to live the “American Dream”. But, for some, that is a real financial mistake.

  2. I, too, have never heard of the rent ratio. I do wish that everyone could own a home, but the implications are to have the finances in order to allow that. Just because your friends are buying doesn’t mean that you should (or even that they should). It’s really tough on wives to want to buy a home — seems as though they want something to call their own. (this is not bunk, I’ve talk to many who shared their opinions) Numbers don’t lie though – my wife is much more happy renting in the short term knowing that we will someday move into a home that is truly a blessing.

  3. The old investment rule of thumb for a rental property: Purchase price should be 80-100 times monthly rent. The NYT rule of 20 translates to 240, which is very high by pre-1990s standards.

    My guess is the reporter is too young to know the history of such things, which are not written down so much as conveyed by apprenticeship.

  4. I would also advise to not focus as much on ‘ratio’s’ but take a look at actual numbers. In addition to owning a home there is also upkeep, taxes, insurance and improvements. Couple that with the fact that on a typical 30 year note up to 80% of the first 5 years of payments goes towards interest. These hidden costs add up quickly.

    My wife and I have owned two homes in the last 10 years. We sold at the right time, are out of debt and are now renting for less then it would cost us to pay for the same home.

    Sometimes it’s a tough mental hurdle to overcome but it has been worth it to us.

  5. JP: “The old investment rule of thumb for a rental property: Purchase price should be 80-100 times monthly rent. The NYT rule of 20 translates to 240, which is very high by pre-1990s standards.”

    I’ll admit to not being familiar with either rule before today but I don’t think the two necessarily contradict each other. The Rule of 20 is a guideline for deciding if you should buy or rent the house you’re going to live in *yourself*, while the other rule (if I read JP correctly) is a guideline for *investors* trying to decide if a purchase price is justifiable given the rent they can expect to collect. The two scenarios are not identical. An investor has to consider vacancy rates, tenants who may damage the property, bookkeeping, rent collection, and the potential costs of evicting problem tenets. Therefore he needs a much bigger safety margin in the purchase price than someone buying a property to live in it themselves.

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