Combing through the questions you — my fabulous readers — ask me, I find one common thread. I write a lot of posts on real estate, but you want fewer esoteric graphs and articles and more common-sense advice. Fair enough. By the time you’re done reading this, you’ll have an excellent idea of exactly when higher-priced houses will fall in price, and you’ll have an armload of data to assist you in determining when a house is priced correctly — no matter where it is or what its price.
This is the blog post that you should send to anyone who is considering buying a house in the next 12-24 months. At the very least, it will arm you with excellent negotiating power.
Two Metrics That Show Whether ANY House is a Good Buy
Here are two facts that are well-known by a few savvy folks, but that most house buyers are unaware of. How do you tell if any house (no matter what the neighborhood or location) is a good buy? Just use these two rules of thumb:
- Housing prices historically should be 3-5x median annual income. This one is easy to calculate. Look up the median household income for your area on city-data.com. Using their guide for 95118 (my zip code), and scrolling to the bottom of the page, we find that the estimated median household income in 2005 is $73,840. That means house prices for an average house should be in the range of $221,520 to $369,200. The lowest-priced single-family home in this zip code, however, is $489,900. That means prices still have far to drop!
The great thing about the 3-5x median annual income marker is that it works for pretty much anywhere in the country. In more desirable areas, it’s more likely to be 5x annual income. In less desirable areas, you will be able to get more bang for the buck.
For instance, in 47012, the zip code I grew up in (in Indiana), the median household income for 2005 is $43,174, and the lowest-priced single-family home on the MLS is just $14,500. (Yes, in Indiana, $14,500 buys you a house with land!) A comparable house to the $489,900 house here in 95118 sells for about $70,000 in Indiana — 1.62x median annual income there vs. 6.63x median annual income here. This shows how inflated prices are here in California — as well as in many urban areas around the country.
Wait until you see many houses available in the 3-5x income range before buying.
- Housing prices should be approximately 100x-150x monthly rent. This is another indicator to see if housing is overpriced in your area. Keep in mind that ideally, your monthly mortgage payment should be less than an equivalent rent payment, since mortgage payments don’t include taxes, insurance, and maintenance, and rent payments do.
Let’s use a local example. I pointed out in 2003 that I felt the condo development where I lived at the time was overpriced. Now, recently, a condo in that development came on the market at a lower price than what I saw in 2003 — $329,900. This looks like a good deal when you consider that the same condo was selling for $342,500 in 2003, but let’s look at this through a different lens: rent prices. Here’s a nicer condo in the same development renting for $1600/month. That means you’re paying 206x rent to buy the condo (plus over $200/month as a homeowner’s association fee!)
This means this condo, even at the “reduced” price, is still not a great deal. How low will prices go? Realistically, I think these condos will be back at 125-150x rent within a few years. That means this $329,900 condo will only be worth about $240,000. Don’t buy unless you’re under 200x rent, and even then, consider (using the other facts in this blog post) that the market may drop even more. An excellent rule of thumb is to never pay more in a 30-year fixed mortgage payment than you would in rent, since that’s a great example of a bad deal.
When Will Higher-Priced Houses Fall?
Here is an estimate of exactly when higher-priced houses will fall. It’s based on research I’ve done since 2006 and hours of reading and correlating past housing bubbles to this one.
- We still haven’t seen the worst of the foreclosure crisis. Several people have commented or written to me asking when housing prices in more desirable neighborhoods such as Los Altos, Palo Alto, and Mountain View will fall. Those areas are still showing relative strength. Why are they showing strength? Simple: Foreclosures drive market prices, and there haven’t been as many foreclosures in those areas.
Why fewer foreclosures? It’s not for the reasons many think — that people who buy in those areas have better cash cushions. It’s simply because prime loans have longer reset periods — and many of them haven’t reset yet. The reason we are hearing so much about “subprime” is because subprime loans reset sooner than prime loans.
Take a look at this mortgage rate reset chart. It will allow you to “psychically” predict the news headlines for 2009. What will those headlines say? As you can see, subprime will continue to make headlines through 2009, but in 2009 and 2010, new headlines will appear: “Alt-A vulnerable too. Option ARMs resetting like mad.”
Many people think “prime” loans are safe. They’re not — as evidenced by stories like this local couple who took out a $1M “prime” loan and who will now likely default. Even “prime” homeowners couldn’t do the math to realize that a $2800 payment on a $1 million loan doesn’t pay off all the principal. Welcome to the new reality of “prime” loans. We will be hearing many more stories like this next year as more Option ARMs reset.
- Housing runs in 16-year cycles. It always amazes me when I hear people say, “The housing market is unpredictable.” Actually, unlike the day-to-day fluctuations of the stock market, the housing market is strongly predictable. Why? There are typical points in your life when you’re buying a house and typical points when you’re selling one. Since birth cycles are well-known, we can predict housing boom and bust cycles. It takes almost exactly 16 years for a housing cycle to complete a full turn. This has been true since the Great Depression.
In 2006, I made a shockingly accurate timeline of this current bust based solely on a blog that posted newspaper clippings from the previous bust in the early 1990’s. You’ll see this in a lot of newspaper articles, too — you’ll be surprised at how many times you see “since 1991″ or “16 years ago” in an article referencing when the last time this happened was.
By this methodology, the bottom should be in between late 2010 and 2013. But don’t expect housing prices to rise much if you buy then. But then again, you weren’t buying as an investment, were you?
This post gives you all of the tools you need to figure out when buying a house makes financial sense — no matter where you live. Keep in mind that no matter what housing prices look like, if you don’t plan to stay in that house for at least 5 and preferably 10 or more years, it’s not a good deal to buy. Just rent and invest instead. Even investing in bonds will likely bring you a better historical return than housing — 5-6% per year vs. 2-3% for housing.
In my opinion, it is always better to have liquid, easily-accessible cash (in mutual funds or high-yield savings accounts) than it is to have your money tied up in real estate. It’s much easier to click the “sell” button in your trading software and get a transfer to your bank account in a few days than it is to take weeks or months to sell your house. Keep yourself liquid, set up an automatic savings plan, and save for your retirement instead of expecting your house to make you rich. By following these simple steps, you will be well on your way to creating a wealthy future.
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16. June 2008 at 3:20 pm
Hi Erica,
I found your blog through your post on Brazen Careerist. Fantastic site and I love to see how you’ve progressed on your goals. Keep it up and I’m sure I will be back to visit often.
Bill
http://www.fppad.com
16. June 2008 at 3:53 pm
Useful (and intelligent) stuff here.
The only thing I have issue with is “Housing prices should be approximately 100x-150x monthly rent.”. Is this true anywhere except very small towns where real estate is cheap? It seems like in small and even medium sized cities rent is always much cheaper than the corresponding real estate. 150x times my rent here in a popular neighborhood in Chicago is less than half what a condo like my apartment would sell for.
16. June 2008 at 4:34 pm
Hi Erica,
While I don’t necessarily think that buying a house now is a good idea I did want to throw in a couple of observations here:
First is, that those of us who are older remember when interest rates were up at 10% and higher. So I need to remind myself that when I didn’t buy
that $250K house in Santa Barbara in 1997 it wasn’t just the price of the house that stopped me but rather that I couldn’t afford it because the
payment was double what a 250K loan would cost now. So when I kick myself too hard I also remind myself that I couldn’t have afforded that house
even if I could afford it now.
Also if you were planning on staying in a house for the life of a 30 year mortgage then surprisingly it is cheaper to buy a $400K house at 5.5% then to buy a 300K house at 9% when the market drops but the rates go up.
The 400K house costs you about an extra $417K in interest over the life of the loan. But the 300K house at 9% costs about an extra $569K in
interest for the life of the loan. So over the life of the loan the cheaper house can cost quite a bit more. ($152K more to be exact).
If anyone wants to play with this scenario, I love the calculators at Dinkytown.com
The other point that needs mentioning is that buying a house can be an emotional decision. One thing that I don’t miss is that for those last years that we lived in Santa Barbara, there was always a feeling that our home was temporary. We were at the mercy of our landlady. If she decided to sell or raise the rent, or even if she decided to die then we would have had to move:) And often the older you get the more important that kind of stability becomes.
So, while I agree with you that prices are too high especially in California, I have to chime in that there are many factors that come into play here.
Say hi to Richard for me, again:)
Nisha
17. June 2008 at 8:03 am
I’m with Nisha in that buying is often more of an emotional decision than a financial one. My new husband and I don’t want to be living in the townhouses that we’ve lived in up until now. Now that our “family” income has doubled, we can more comfortably afford a single family. We’d save a lot more money by just staying in the larger townhouse (we’ve already lost money on the smaller one), but for us, its the emotional decision.
17. June 2008 at 10:27 am
@Bill: Thanks for reading!
@Laura: “Always” is rather a misnomer. Here in California, the last good time to buy a house (compared to rent prices) was 1997. If a condo would sell for 300x rent in your area, look for 40-50% price drops in the next 4-5 years. 300x rent isn’t sustainable. In that case, you’ll always be better off renting and investing the difference (automatically — siphon it right out of your paycheck before it goes into your checking account).
@Nisha: Very good point regarding interest rates, but realistically, house prices in most overinflated areas will drop way more than interest rates will rise in the next 4-5 years. Mortgage rates are higher now than when the government had the Fed funds rate at over 5%…so I’m not too worried about interest rates. Plus, the longer you wait and save, the more you have interest working in your favor. The key is to actually save the difference between renting and owning — not to spend it.
@elwing: It’s a misnomer that the only places available for rent are somehow “worse” than what you could own. Here, there are many single-family homes for rent. My boyfriend and I rent a duplex with a nice back yard, hot tub, garage, etc. There isn’t much more we would get out of owning other than more square footage — which we don’t need.
I’d much rather be financially free and retire at a young age — where all my money comes in through investments — than pay more to own a house. I won’t own until the numbers make sense vs. renting.
Thank you for all of your comments!
-Erica
17. June 2008 at 10:27 pm
Fantastic summary article Erica! Why are people who tell the truth like you never referenced in the mainstream media? Fortunately we have the web now and people like you can reach a few ears.
18. June 2008 at 12:04 am
Thanks for a great blog Erica! I too saw this bubble coming and my wife and I sold our house in 2003 after it doubled in value! We are still renting and basically paying our rent with the interest from our house sale! But up until a few years ago all my “smart” friends thought I was crazy to sell in 2003. They kept asking how much appreciation I had lost by being out of the real estate market. It is too bad that so many people are getting burned by this whole fiasco. But as you have stated … when house prices are 10x median income.. there is something fishy going on with creative financing. Keep up the great postings and maybe you can help others from making a big mistake and buying in too early.. or for that matter buying at ALL!
18. June 2008 at 7:38 am
First of all I would like to know where you got your “facts” that home prices should be 3%-5% of the median income. You say a “few savvy folks” know this. Who are they? Where is the data to support it?
Secondly, I think most people would agree that they would pay more than 5% of their income, maybe even closer to 8%-10% to live in beautiful California, especially places like SoCal and NorCal vs. places like Indiana. Not to trash IN, I’m from MO. The intangible’s are the weather, the outdoor activities, and im not talking about hunting, and the ocean Californians have access to . How much is that worth vs. living in the Midwest? An extra 3%-5%? It’s hard to say, but ask yourself, would you want to move back to IN. Yea, didn’t think so.
Lastly, I believe the majority of the housing slump, in CA, is due to all of the homes that were built in the East counties of the major CA cities. There are so many people that wanted to live in CA, at what they considered affordable prices, combined with low interest rates and idea that the property would continue to go up, they bought where they could, not in the already pricey “nice” areas, but out east. I also think a majority of the coastal homes, that are facing problems, were bought by speculators, investors, and fly by night real estate gurus.
All things being equal, CA along with other coastal areas, will continue to be desirable areas to live and face increased housing prices not inflated ones.
18. June 2008 at 7:50 am
Just remember you can refinance a 9 % loan if rates drop. You can’t refinance a large principle amount into a smaller one. You will also pay less in taxes and have more appreciation (over 30 years houses will go up).
Taking your example (and I haven’t double checked your numbers) and I think the 300k is much cheaper. In your example you are paying an extra 150k in interest, but you have an extra 100k(which might be tax free) in appreciation . Factor in the tax deduction (about 1/3) and paying over 30k less in property taxes and I am guessing you are much better off buying the 300k house. Through in refinancing after 10 years or paying off principle early, the cheaper house is a much better deal. Now throw in due to an emergency if you have to move tomorrow, in one house you will owe 100k+transactions costs while in the other you will only owe transaction costs, you are much better off with the cheaper house.
18. June 2008 at 8:29 am
@chris
The data the author is referring to is publicly available historical data. You can do some research yourself, but here’s another article at marketwatch.com that talks about the ratio:
” Today, median home prices are 3.5 times the size of median annual family incomes. This may be down from the recent peak of 4.2 times incomes reached last year, but it’s way above the 2.8 times that home prices averaged during 1984-2000, when lots of homes were bought, sold and built.
And if you think 2.8 is low, check out the early 1970s. That was when home prices were only 2.3 times median family incomes, and housing was selling like gangbusters. ”
It boils down to affordability and the reason for the “housing slump,” which in my opinion is not a slump but a correction, was the housing bubble. And the reason for the housing bubble was massive purchasing of overpriced homes by people who could not afford them using alternative loans which have interest rates that reset.
This first round of foreclosures was due to interest rates resetting and we are due for more. These loan products are no longer available and most banks have learned their lessons, so we are moving back to standard loans with stringent credit score requirements.
This will result in less buyers, more homes on the market and falling prices, until an affordable median income to average home price is realized.
It’s not a magic ratio, it merely indicates affordability.
18. June 2008 at 8:36 am
Shouldn’t the price also reflect how many jobs are available. I know you probably account for this with the “median” income. But 2 cities with a median income of “x” could be completely different stories. For example, if city A has a million jobs with the median income of “x” that’s a much different dynamic with a city of 10,000 jobs with the median income of “x”, no?
18. June 2008 at 9:04 am
@burritos
Unless the number of jobs affect supply and demand, i.e. the two cities in your example have the same number of houses, the disparity between the two metrics should be negligible.
But again, it’s a way to measure affordability, so no matter the number of jobs, if the median income is the same, those job holders can afford the same home price based on that metric.
But the price of the home may be higher if there are less homes.
18. June 2008 at 1:20 pm
Two comments: 1) Real estate views are like sports / religion: Some people are born Yankees / Dodgers fans or Catholics or Agnostics: Facts and circumstances do not affect their views. Thus, some people believe in home ownership. Regardless. It’s a magical, mysterious, emotional, religious view. It has nothing to do with real world facts, finances or trends. So, some people remain Yankees fans even if they havent lived in NYC for 30 years. Nothing will change their minds / views.
2) 16 year cycle? Hmmm. Numerology. Cycles, yes, like the seasons. Chart analysis is backwards looking. So, don’t get locked into numerology but be alert to the cyclic nature of things. BOL
18. June 2008 at 1:34 pm
As a Patrick reader, I check out most articles daily. I decided to give Zip Reality a try based on your suggestion. It doesn’t seem to work. They never emailed me a 4 digit , 1 time code. You might want to rethink that link.
18. June 2008 at 3:39 pm
@Jacob: Thank you for doing my homework for me!
Yes, I should have cited an article like the Marketwatch one you posted in your comment, but I didn’t think to. I appreciate your detective work!
@Chris: California had great weather in the 1990’s too… and prices declined then, too. Don’t fool yourself. Take a look at this article from 2001: “Also, home sales in Santa Clara County dropped a whopping 39.5 percent in April (2001), 26.3 percent throughout the nine-county San Francisco Bay Area, according to the California Association of Realtors.
That’s not what happened in the late 1980s to early 1990s when Northern California fell first, followed by the rest of the state as employers fled, incomes dwindled, quakes rumbled, sales fell and prices slipped.”
Also, the state has been experiencing a net outflow of migration from 2001-2006 (2007 was the first year that reversed that.)
You’re already paying an extra 9.3% to live here anyway (assuming you earn over $40,000 a year) — it’s called California state income tax.
@Ezra: I’ve had no problems with ZipRealty and use their saved searches on a weekly basis to help me track prices. Try emailing them or calling them, and I am sure they will be glad to assist:
Email: websupport@ziprealty.com
Toll Free: 1.800 CALL ZIP
Thank you again for your comments!
-Erica
18. June 2008 at 9:54 pm
Well, I don’t know what you guys are talking about. The Real Estate in CA is on fire (literally), and I think it will all be gobbled up in no time (by the fires that is), I think you guys better all buy a home now while you still can! Now if I can just find me one of the NINJA loans, I’ll be all set.
19. June 2008 at 8:30 am
Well written and logical. Thank you.
19. June 2008 at 11:10 am
Erica,
Great article! I agree with it 100% but it sure is hard to be patient waiting for the sellers & real estate agents to accept the fact that the prices are too high! The average asking price in my area is still over 7.5 times and the average selling price is over 6.5 times the median household income. That is 250x rent! I guess that as long as there are still buyers willing to pay that amount the prices will stay inflated.
19. June 2008 at 4:00 pm
Translating Erica’s advice on “When to buy a house”: “Never.”
21. June 2008 at 4:51 am
As I don’t live in the states, I was wondering how applicable are your figures (3-5 * median annual income and 100-150 * rental costs) to other countries?
I live in London England, but am also interested in property prices in Israel.
23. June 2008 at 8:09 am
@Yosemite: Don’t give up hope. Sales may be going up in absolute terms, but there are more foreclosures coming onto the market than sales going off the market at this point. Wait a couple years and prices will be way down. A house is a long-term investment and, in a down market, you won’t regret renting for a couple of years!
@sanfrantim: Nah, 2010.
@oded: I’ve run the numbers in other countries and they always seem to be about the same. Since they’re based on median income and rent prices, they’re applicable everywhere (I ran them in Vancouver, BC and Melbourne, Aus. and they came out the same there.) Just don’t forget to use as local an area as possible — county or postal code are the best, not state/province/country.
Good luck!
-Erica
24. June 2008 at 9:19 am
Thank you for your submission for the Homesteading Carnival.
Here is the link for the Carnival.
http://homesteadblogger.com/RachelsReasoning/102220/
Come take a look!
Love,
Rachel
2. July 2008 at 4:47 pm
Hmm… I wonder how well this analysis holds up for Sydney (do you remember where you got the data for Melb?). House prices here have historically been much higher the 3-5x median income range. However, prices tend to stay within the 100x-150x rent bracket though and with rents increasing and house prices falling, houses are finally looking more affordable…
2. July 2008 at 5:40 pm
Hi Gerard,
I don’t know about Sydney specifically, but I can say that 100x rent is a pretty good indicator of a good investment no matter where you go.
Thank you,
-Erica
21. July 2008 at 10:15 am
Erica, I was interested in your comment about 16 year cycles, but you seem to have misunderstood the difference between number of sales vs median prices. Your quote above about sales being down 26% refers to number of homes sold, not the price they sold for. Go reread the article, the median price was only down 6 percent, both month over month (a stat that only dishonest agents use since real estate is so strongly seasonal) and year over year.
So when you mention 30-40% price drops, can you show the equivalent price drop (not sales drop) in the last cycle? I’m not seeing that much of a correction either in the 1990 peak to mid-90s, or the 2001 correction. Yes, there was a price correction but I believe it was 15-20% in Santa Clara County.
Outlying areas have had huge corrections already, $4.60 gas is contributing to this. But doesn’t that make close-in areas to jobs worth MORE?
24. September 2008 at 10:34 pm
So, if we bought 2 yrs ago, and prices in our neighborhood are still ticking up (but slowly)…should be bail and rent or stick it out? AND…we have 2 young kids. Looking up rental rates for houses close to work and the schools we are open to, rents are about the same as our current mortgage payment (even for smaller houses).
19. October 2008 at 10:32 pm
Erica, Interesting point of view. I think your research is flawed. I am in the Alberta Market Place where average Property Values are 5-8x our average income levels of 50-70K per year and property values are 90-250x the rent paid(depending upon the type of unit.)
I do agree with a 15 year cycle for bubbles, booms and busts. But what you fail to point out is typically Property Values double every five years since the 50’s. This is information is easy to gather from local real estate boards that track these stats. With this in mind I would advise that people consider each of thier real estate investments and put them on 2,5 and 10 year plans.
You must also consider that while you own a property and are making the mortgage payments the debt is being paid down. (When you rent you constantly have the same or worse an ever increasing debt load (Landlords increase rent as the markets will tolerate) that you gain no equity from.))
I feel that most people are better to own vs. renting provided they do not take loans that exceed the properties values.
20. October 2008 at 8:41 pm
@Sharon: You wrote “…typically Property Values double every five years since the 50’s.”
Cite needed! (I’ll help you out. You won’t find one, because this simply isn’t true.)
For the real data, take a look at this “history of home values” graph:
http://www.nytimes.com/imagepages/2006/08/26/weekinreview/27leon_graph2.html
Over the long term, housing has barely beat out inflation, growing in real terms at less than 1% a year…making it a bad investment.
Let me guess…you’re a real estate agent?
-Erica
22. January 2009 at 12:15 pm
The major problem I have run into in California. Deception. I have found near impossible to find and ‘honest’ person in real estate. After reading Erica’s process on price I find it better than any agent I have run into, I wish I was driving a car when I ran into them. But I still have more Q’s.
1) Finding an agent in LA
2) Where can you get the best loan without the scam
3) Real Sales prices. During boom the cash out refi or gifts to buyer just inflated the price. Fake data. The MLS?? Do I have to go to county records?
4) A good inspector
5) I look at REO’s but never get a call back from listing agents.
I’m so tired of the lying.
BTW… I just came back from Australia… You should absolutely go.
15. September 2009 at 3:35 pm
Erica, it’s good you moved, b/c with your metrics, it would be impossible for you to buy a place in Palo Alto/San Jose or San Francisco. We’ve been through the greatest downturn ever, and prices are only down 15%. It’s frustrating, and it’s good you voted with your feet and senses and moved.
It’s different up here in the Bay Area.
8. October 2009 at 9:31 am
Funny you should mention that… The American dream of owning a house is a sham. Well, it’s a sham if you want to do it on credit. Simply put, I agree with you – the numbers just don’t make sense. And if you make a good deal, you can save 18K – 25K per year – which, if handled properly(read – DON’T LOSE ANY OF IT), makes a much better nest egg than a house.
Good advice Erica.