How to Know that you are NOT Overpaying for a Home

A lot of people, me included, are sitting on the sidelines and waiting for a good opportunity to buy a home. There’s been an unrelenting stream of bad news in the financial markets and millions of foreclosures, so realtors are telling us (as they have for a while) that “now is the time to buy”. But is it?

 

 

Let’s take a step back first. Why would you want to buy a house? For most Americans, owning a home is the realization of the American Dream. It means you’ve made it. But think about it. A house is really an asset, just like a stock or a car. It’s something you buy if the price is right and you need it. If it’s too expensive, you shouldn’t buy it and instead shop elsewhere (or rent).

 

The housing mania in the early part of this decade was unfortunate for many reasons, but mainly because it taught millions of Americans that it didn’t matter what they paid for their houses, because someone else would always come along and pay more. In essence, what the “real estate can’t go down” mantra meant was: Even if you pay way too much, you are OK if you just hold for the long term.

 

But this belief is false. If you buy at the wrong time (or even if you buy at a good time but simply pay too much), breaking even by “holding for the long term” can literally mean holding for decades, if not half a century.

 

Think about Japan. At the peak of the stock market bubble the Japanese index stood at 38,000 (that was back in 1990). Now, 19 years later, it’s around 8000. Even if it appreciated at the average rate of return for stock markets over the past two centuries (about 7% a year, after inflation), you’d have to wait 23 years to break even. Add that to the 19 years you’ve already waited and you’re looking at 42 years to break even on an investment made at the peak of the market.

 

There’s no reason to think real estate should be any different. True, in the long run, real estate prices go up, just as stock prices go up. However, at 1% the average real appreciation for residential real estate is significantly lower than for stocks. Buying at the wrong time – and in the recent market frenzy that meant paying two or three times what the house is actually worth – can be a very costly mistake.

 

So what is the right price for a house? The best way is to use a rule of thumb that says your purchase price should be at most three times your annual household income. So if your household makes $80,000 a year, you should pay at most $240,000 for the house. In most parts of the country that will allow you to purchase a good home, but in the higher priced coastal areas you won’t get much for a quarter of a million.

 

 

A good question to ask is: Which markets are overpriced and which are more reasonable? The best way to figure that out is to check the current Case Shiller house price index in an area similar to yours (go to Standard and Poors) and download the most recent data (two months delayed).

 

Here’s how I use the data: Since I live in the San Francisco Bay Area, I check the most recent reading here. The Case Shiller data covers 20 metro areas in the U.S. and is normalized so all metro areas are pegged at index 100 in January 1, 2000. It turns out that time coincides with pre-bubble pricing, so if you can buy a home at 2000 prices (adjusted for inflation), you’ll be in decent shape. House prices could still overshoot to the downside (as they have done for Detroit, where prices are now lower than they were in 2000 – even in nominal terms) but at least you would be close to the long run average.

 

The current reading for the San Francisco Bay Area is 135 (November 2008). Given that house prices in this area are falling at a monthly rate of 3%. That should put the February data somewhere in the 125 range. This means that house prices in the SF Bay Area are now approximately 25% higher than they were in 2000, for an annualized appreciation of around 2.5% over the past 9 years. In inflation adjusted terms, this means house prices are now back to 2000 levels in the Bay Area.

 

After you’ve concluded that your area is reasonably priced according to Case Shiller, the next step is to study your particular neighborhood. The Bay Area may be close to the long run price average, but that doesn’t mean houses in your neck of the wood are well priced. In fact, while certain parts of the Bay Area have seen 50-60% price declines, and are now close to bottoming, other areas have seen only modest 10-20% declines.

 

Some realtors will tell you that prices in the more desirable neighborhoods will hold up well, even in this environment. So if a neighborhood is “only” down 10-20%, that may be because it is “immune” to the current crisis. Don’t believe it. The best way to figure this out is to go back to affordability. If a lot of people bought more house than they could afford (using no-money down, interest only loans etc), then prices are probably too high and need to come down. And that’s true even for desirable areas.

 

Take Sunnyvale, where I live, as an example. The average household income in Sunnyvale is around $100,000 (you can find this type of data for your city on http://www.city-data.com/). That means that the average house in Sunnyvale should sell for at most 3 times 100,000, or $300,000.

 

Houses in Sunnyvale tend to be smaller, so let’s be conservative and put the square footage at 1500. That puts the square footage price at $200 ($300,000 / 1500). In other words, when you shop for a house, you should aim to pay no more than $200 / square foot. You can do the same calculation for your area.

 

Unfortunately, square footage prices in Sunnyvale are still in the $4-500 range. In nearby San Jose, they have come down much more and are closer to $200. But they are holding up in Sunnyvale. My conclusion: Too early to buy in Sunnyvale. Prices are bound to fall significantly more.

 

Rule 1#: A house is an asset that you purchase at a certain price. Paying too much can harm you for a long time (and “a long time” can mean decades).

 

Rule #2: Check out Case Shiller data to gauge house prices and don’t start looking until prices are back to 2000 levels, inflation adjusted.

 

Rule #3: Look up household incomes and average square footages in your neighborhood. Then compute the average price per square foot as 3 x household income / square footage. Go by this number and try not to pay more per square foot.

 

I hope that you found this article to be informative. Keep in mind that these rules are intended as a supplement to the rules mentioned in the Personal Finance course. The rules mentioned here are not ironclad but they tend to err on the side of caution which is the prudent approach in this market. Hopefully they can help you avoid costly mistakes.

 

 

P.S. – Speaking of housing…If you want to learn more about asset bubbles, then read Bob’s great articles on the topic: Bursting Your Own Bubble and Be Open to Market Timing!