A successful entrepreneur shares her thoughts on business success and failure.

When Should You Buy Real Estate — And When Is It Better to Rent?

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:

  1. 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.

  2. 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.

  1. 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.

  2. 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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I'm Erica Douglass.
After selling my online business at age 26 for over $1 million, I created this blog to help you grow your own business quickly.

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