In 2006, I wrote about how my fiancee (my wife now) got a great job promotion in San Francisco. Somewhat reluctantly, I agreed to live more than 10 miles away from my birthplace for the first time in my life. I was 30 years old. I considered it a short-term move. After two years, we’d be eligible to move back and my wife would qualify for some of the top jobs in her field that Boston would have to offer. Sometimes it’s funny how life turns out.
Somewhere along the line, we began to love what is known as “the peninsula” – an area 10-15 miles south of San Francisco. When we first moved here, I remember having an application on my cell phone that would send me a text message of the week’s weather. It was convenient in Boston when you had to know whether it was going to snow or if you’d have a sudden heat wave. I deleted that application after about a month of living in the peninsula – I didn’t need to be reminded that it was going to be 75-85 and sunny every day.
Given the change of heart, we decided to look into whether it makes sense to rent or buy in the bay area. Real estate prices have dropped a lot recently. With mortgage rates low, it sure seems like the time to take advantage and buy. My wife thought it might be the right the time… how much could things continue to drop? I said, “I think I remember seeing some math on this once, let me see what I can dig up.” Fortunately, I remembered that Erica had written an article about whether it is better to buy or rent. In it she gave a couple of metrics:
- The average house should cost between 100x-150x monthly rent
- The average house should cost between 3-5x median annual income
Looking at the first metric, our $2100 rent now should buy a home between $210,000 and $315,000. However, in my area, it seems that townhouses equivalent to our apartment still run around $600,000. Granted that’s significantly less than the $783,888 asking price of this 1100 sq. ft. “fixer-upper” I found a year ago – it’s still not what I’d call a bargain by this metric.
Moving to the second metric… City-Data says my zip code has a median house $83,809 – projecting to a home price between $251,427 and $419,045. That’s a little closer to the $600,000, but it is still far from the national average. Again buying a house doesn’t make sense with this metric.
Why are these two ratios important?
If the cost of buying a house is much more than the cost to rent one, people will likely realize the value of renting. Some people have bought into the myth that “renting is throwing away money”, but I always say that I’d rent a mansion in my preferred location for one dollar a year without batting an eye. Throwing away that dollar allows me to save and invest my other dollars. I think it’s only a matter of time before everyone realizes that and discards the conventional wisdom.
The second metric could be an indication of how people potentially paid too much for a house that their income couldn’t support. In other words, if a $83,000 income in other parts of the country supports a $350,000 home, what makes my location in California different?
What about affordability?
There’s another ratio called the affordability index. From what I’ve found it measures the actual monthly cost of the mortgage to take-home income. A number over 100 typically means that people have more than enough money for a median price home. A number less than a 100 typically means that they don’t have enough. According to the California Building Industry Association San Francisco and the peninsula have an affordability index of 16.6 as of Q3 2008 (PDF). But it’s on an uptrend… and in about 20 more quarters of similar gains, it might approach “affordability.”
It’s very possible that the rent vs. buy in this area of California never get back to the national levels. It seems that people are simply willing to pay more to live in this area of the country. Nonetheless, I can’t see the value of buying in this local market – yet. I’ll continue to evaluate the numbers, perhaps using this handy calculator of Buy or Rent from the New York Times.
What about you? Did you do this kind of analysis before you decided whether it was worth buying or not? I realize in much of the country the exercise won’t lead to the big difference I found. It’s still good practice to run the numbers to make sure.
kosmo @ The Casual Observer says
– How long do you plan to stay in the bay area?
– What is the long term financial outlook for your area – is it heavily dependent on an industry that is on shaky ground? For example, prices may be low, but certain areas of the country may still go lower (imagine the impact on the Detroit area if one of more of the automakers goes bankrupt)
– How much would it cost to BUILD as opposed to buy?
My house (1200 sq feet up, 600 finished sq feet down) cost about 1.6X our household income. Gotta love the midwest housing costs :)
Lazy Man says
Using the calculator I referenced at the end of the article (and a whole pile of guesses to the market) it will never make sense to buy regardless how long I plan to stay.
It’s a good point about the shaky ground theory. I think there are areas of Detroit that are already very low via these metrics – and have been for some time. It can be difficult to say an industry is on shaky ground for the next 15 years. If you look at the bay area one would say it was on shaky ground in 2001 and now with it’s focus on technology. In the next 20 years, I think there will be two or more other “shaky ground” times. Even in this “shaky ground” time the metrics are way off.
I’m not sure that building is a cost savings over buying in areas where land is scarce and expensive. In areas where that isn’t true, perhaps there is a gain to building your own home (at the expense of a lot of work I would think). I haven’t looked into that.
kosmo @ The Casual Observer says
My point about length was whether or not you’d be there long enough to take advantage of a possible rebound in the housing market.
Buy/build was based on builders who are possibly under-utilized (and thus might work for lower rates than usual).
You could also, um, prey on the misfortunes of others … if a local company goes bankrupt and thousands of people lose their jobs, there could be a lot of houses for sale in particular neighborhoods where they live (causing the supply/demand to get out of balance). That sounds bad … but the reality is that your entry into that market would increase demand a bit, and maybe cause those folks to make a few extra bucks on their home.
I’m going to go wash my hands – I feel a bit dirty after making that suggestion.
Erica Douglass says
Hi Lazy Man,
Glad to see you got around to writing this post! Thanks for including a link.
You wrote: “It seems that people are simply willing to pay more to live in this area of the country.”
I buy that about as much as I buy the “rent is throwing money away” argument. i.e. I think both were cooked up by people wanting to sell you houses.
It may be a bit more expensive to live here than, say, Indiana (where I grew up), but it shouldn’t be 4x more expensive. Also, there were more people living in San Francisco in 1950 than there are now!
Every year since 1999, more people have moved out of California than in.
Immigrants have been moving here and keeping California afloat, but there won’t be any jobs for immigrants soon and they will all move back. With higher taxes than nearly any other state, CA is already quite undesirable. I think we’re in for quite a drop in the next 3 years. We may overshoot inflation-adjusted 1997 pricing — which is considered to be the bottom by many experts.
I’m really glad you chose not to buy a home. When I wrote that post in June 08, I’m sure the folks who bought those $499K houses in my zip code that I referenced in that article thought they were getting a great deal. Now, not even a year later, those same houses are selling for $399K. Those who bought into the “great deal” of 2008 are already underwater by nearly 20% just 8 months later.
Back in your old stomping ground of Boston things are pretty much the same for me. I’ve been watching from the sidelines for the past couple of years. Content with renting but willing to buy if a good enough deal came along. Even with this horrible economy the houses/condos haven’t lost value like other parts of the country. It is going to take a much bigger drop in housing values to get me in the game. While the metrics you outline above don’t look as bad here as they do in San Fransico they still suck.
I think the people that own propery in the cities need to brace for a lot more pain in terms of lost equity. Things getting back to affordable levels is the only things to jump start the industry. Even with low mortgage rates we’ve got a long way to go before they are affordable again.
The foreclosure preventions in the works won’t help housing costs come down either. Am I horrible to think we need to let people get forclosed on? If we don’t deal with the problem now its going to be back down the road.
Lazy Man says
I was going to go more into the statement of “It seems that people are simply willing to pay more to live in this area of the country”, but I couldn’t fit in with what I was saying in the post.
I didn’t look into it, but I thought perhaps people make their money elsewhere and use that high net worth buck the house-buying/income ratio. I can see how more people move out of California, but if lots of high net worth people move into CA prices can still go up.
I think you are right about California’s prospects. The whole budget deficit stuff going on right now makes it difficult. Sales tax looks like it may go up to 9.5%. They’ve proposed another 12 cent gas tax, where we already have some of the most expensive gas.
Still, I can think of few other places where you are an hour away from the ocean and wine country, and 2-3 hours away from skiing and casinos (at Tahoe).
I’m in a smaller city in the midwest, and our prices actually went UP on average last year. Of course people are still saying the housing prices are falling and WHY AREN’T I BUYING?!? Lol. I’ll buy when I’m good and ready, and convinced that I don’t want to move in five years!
Lazy Man says
Jay, I think the theory is to prevent the damage from foreclosures, and hope the economy recovers in such a way that they can now afford to pay things.
The other hope is that people have learned that they were lucky this time and it won’t be the problem down the road.
Whether that’s all true or not is open quite a bit of debate I would say.
I think we made financial mistake buying, because while it was cheaper for us to Buy versus Rent a comparable unit, we could have Rented for $1k less a month a much smaller place!
We could be renting a 1 bedroom for $1600-1800 instead of $2200/month 3 bedroom mortgage.
So how to reconcile that? It is a lifestyle choice. We no longer wanted to rent a small place. We wanted to rent a larger unit. However, even 2 bedrooms in our area run around $2k so then it became more of a moot point.
A friend bought a Chicago condo in 2002. I located its estimated price at the height of the bubble (I think from Zillow), and found that even with abnormal appreciation, she would’ve just broken even thanks to ASSESSMENTS. That stopped me in my tracks. I think I”ll wait for a single family home.
Further proof that Chicago real estate has farther to fall: she’s trying to rent it, now, for less than her monthly expense, and hasn’t had a single bite in the 3 months it’s been listed.
We relocated from the Boston area to the mid-west and thought the rent/buy decision was a no-brainer since houses were so inexpensive here. We rented just long enough to get to know the area, then bought a new house for 1.25x our annual income. We love our house and feel we made the right decision for other reasons, but from financial perspective, I’m not so sure. If we stayed here for a long time it probably would have been worth it. But with the birth of our first child, we’re ready to move back to the East Coast to be closer to family. Short time frames almost always favor renting (even when houses are cheap) and in this down housing market, it’s especially true.
Some other good rent/buy posts that I enjoyed were:
SmartMoney: Why Rent, to Get Richer
Millionaire Mommy Next Door: Rent, Grow Rich, Be Free
I just went through the buy/rent issue about 8 months ago! It’s always tough!
I understand that things are very scary with regard to real estate on the Left Coast right now, and I’m not one of those knee-jerk buy a house types, but I think you are really overstating the case for renting.
Median house prices relative to median income just isn’t constant enough through time or across geographies. It’s always been high in SF and Boston (where it has just started snowing again, BTW) and probably always will be.
And even 150 times rent is a screaming bargain as a purchase price. It works out to a locked in 8% return on your money. Yes, there are property taxes and maintainance, but the income tax benefits are substantial. And there’s always inflation to consider: renters pay more and owners own more.
Sadly, you won’t make any money off any investments these days. Are you really investing the difference?
Double Journey says
I just wrote a blog about a similar topic. Anyone who tells you that housing is going to go up from here in any sort of rapid fashion just doesn’t understand history, economics, or demographics. These are the same people who said it was a great time to buy a year ago and prices have dropped 20% from there.
California is still nowhere near where it needs to be. Don’t give into the pressure. It was just a decade ago where the metrics you site were true and we are in a WORSE economic situation then before. What on earth justifies the numbers staying that hi?
i’m in a suburb of boston and just turned 26 and have been thinking about buying down the line. but it’s kind of an overwhelming prospect. it’s odd but i feel like i can barely afford my 600 dollar a month rent so the thought of having a mortgage payment seems daunting and scary. plus real estate prices here are so astronomical and i don’t have a car so i’d have to live somewhere in metro boston. oh well. it might not be in the cards right now but maybe some day. i think my next step after sharing the 2BR apartment i’m in right now will be moving to a 1BR on the red line for somewhere between 1200 and 1400 a month. but that seems to be a long way away.
MY wife and I will be the owners of a new home in about 2 months. We did not use any formula other than the one our lender gave us. After seeing how much they would lend we went home and figured up what the payments would be and whether we could afford them. That’s about it.
This is a thought-provoking article, Lazy Man. Ratios can provide some general guidelines and serve to keep you out of dire financial straits. However, as illustrated by the Bay Area real estate market, ratios are very often not realistic in certain areas of the country. Long term supply and demand trends skew the numbers dramatically.
The first question you have to ask yourself is, “Where do I want to live?” I think this question should be answered first without financial considerations. It’s a lifestyle choice. With that answer in mind, then decide if it makes more sense to rent or own.
The only ratio that has served me well over the years is to keep my housing costs lower than 30% (preferably 25%) of our household take home pay.
As a friend of LazyMan I personally believe that renting in his case is the better option. Prices might be lower than they were 2 years ago…but compared to the rest of the country they are really high. More importantly, I think if LazyMan and his counterpart LazyWoman ever intend to have children, they will find that having close friends and family nearby (even if they are a wee bit crazy at times) is important. If LazyMan buys a home in the Bay area now and comes to that conclusion within the first 2-3 years of his purchase, there is a good chance he will find himself in a sticky situation.
So, I guess the big question on the table for LazyMan in my eyes isn’t just buy vs. rent, it is children vs. no children. I think that decision will drive the buy vs. rent decision in the proper direction.
Cost of owning home vs renting:
Is renting the place = interest payments on your home loan + HOA fees + Home Insurance – inflation +(-) home appreciation + (difference between the standard deduction and itemized deduction since you will itemize due to interest * your tax bracket) – Interest you loose on your down payment (money market interest). If the right hand side is lesser than you made a deal.
Check out the all in one calculate at dinkytown.net and select buy vs rent.
My Life ROI says
When I moved to my current city in the north east I looked at both rentals and houses/condos for ownership.
From what I found… in an area where rentals are $1,200 the housing prices are about $300,000-350,000. So with those prices it made absolutely no sense to own. And I like being more relocation-able :)
As the housing market has continued to slide I would say the rentals seem to be around the same and the housing prices have come down about 10%. Still not worth it for me.
Erica said: “Every year since 1999, more people have moved out of California than in.”
Yet the population of California has grown every hear from 34M in 2000 to 36.7M in 2008.
People do migrate from California to other states, but the states population growth more than makes up for that outflow. Birth rate outpaced deaths more than 2 to 1. Also international (legal) immigration to CA outpaced emigration to other states. Even with 0% international immigration there would still be population increase since 2000.
Also the Census underestimated San Francisco population by about 35K so theres actually 799k people there, more than 1950:
But yes there is very low growth rate in population within city limits. That doesn’t mean people won’t pay more to live there or that housing costs should stay flat or something.
As has been alluded to you live in one of the most beautiful areas in the world, so this is one place where traditional ratios may not get you very far.
I live in the UK and I’d move to San Francisco if I could afford it, and figure out my job later! (Friends did in their twenties).
Didn’t I read once that half the city’s population was non-native?
Good post though, am linking in my weekly roundup. :)
Steve Nguyen says
I once created a spreadsheet of my own to aid in the decision of buying vs. renting. Pretty much no matter the parameters you assume (unless you assume astronomical home appreciation), renting always came out the better deal. This held true for all time horizons. I concluded that on a pure financial basis, renting is better than buying.
Many people have always believed the fallacy that renting is “throwing your money away” when in actuality it’s not when you consider all of the extra expenses and transaction costs that go with buying and maintaining a house that renting would otherwise allow one to not worry about. It’s a shame that many people belive it. It’s a fallacy that’s been passed on from generation to generation to the point that many folks (and we know that most folks truly don’t have the financial savvy to crunch the numbers) take it as truth.
However, I know that someday I’ll buy a house, and that’s because I see other benefits of owning. When I get married and start a family, I’ll generally want a place to call my own for my family. It’ll be a place where I have ultimate control over the premises and not have to worry about being evicted and whatnot. Plus, it’s at that time of starting a family where I’ll feel more tied to an area in where I’ll settle for a pretty long term to realize some semblance of financial benefit (relatively speaking, of course). Furthermore, by this time, especially when I start to have children, I’d want a larger place, and it’s generally a lot easier to find a home of, say, four bedrooms, than a rental.
Peter lewis says
You have made a very sound arguments here.
Here is one situation I did with this calculator.
I enter 800k house, this is common in the area you live. 4.5 interest, 10 percent down, house appreciation -1%. of course 30 years term and live there for 30 years. rent $2100. I have to admit this is in the middle to high range rent, you can live a decent place with this kind of rent. rent increase 2%. It comes out buying a house is ahead.
People may argue interest is low. My primary is 4.5% (3/1 ARM), second is 4%. so Interest can be a little bit lower if you have good credit. Of course, there is risk with rate sky rocket in a few years. I will not argue that.
Anyway, hope all goes well with you.
My Life ROI says
Curious, how often do you think people live in their houses for 30 years? I think that is slanting the favor towards owning.
Once you cut it down to 10 years (in the calc) you find that renting is actually more beneficial.
So the situation varies…
peter lewis says
Many retirees choose to live in this area until they die. This is because the weather here is nice and Prop 13. If you don’t live here is CA, you probably don’t know what Prop 13 is.
The situation is my area, many 4-6 bed room house, only 1 very old couple live there. Their kids already worked and live someplace else. They still stay there. The direct result is high school is seeing student population start to decline.
The bottom line is, I don’t mind live here for 30 years. I think you are right about nobody live in their home for 30 years. In the past few years, many people got to move up. Now we all stunk in the current home and will not be able to move up.
Thanks for checking out my post.
Rob - EasyLandSell says
Buying or renting ultimately depends on an individual’s or couple’s short-term and long-term plans.
It depends on variables, the quality of life, career plans, etc.