When Should I Buy a Home? Have We Reached Bottom Yet? What Is The Right Price?

by Millionaire Mommy Next Door on June 15, 2009

in Economy,Real Estate

My question has to do with the timing of buying (a home), especially in the current market. I would like to know from your perspective when a time to buy might be. I’m not asking for you to predict a date, but rather I’m interested to know what indicators and trends you might look at to make a decision to buy a home. Any response you have is much appreciated!” ~Adam

(Ed Note: The following is a reprint of an analysis I wrote in April, 2008. My family and I have since moved into a different rental home so the numbers I used to illustrate these concepts would be different today. However, the concepts remain the same. I’ve also added an update after the conclusion of this post.)

Using three indicators and the home my family currently rents as an example, I’ll illustrate how I gauge whether (or when) the time might be “right” to buy a home.

The home I rent today might sell for $250,000. We pay $1,295 per month for rent. It is a single-family home located in Colorado with four bedrooms, three baths, a two car attached garage, a fenced yard and 2,120 square feet.

First “Price is Right” Indicator: The Price-to-Rent Ratio

Rents are a useful barometer for tracking housing markets. Like a P/E (price-to-earning) ratio for a stock, a P/R (price-to-rent) ratio can help identify relative real estate bargains. The lower the ratio the better. The current price-to-rent (P/R) ratio for my home is 16.09 ($250,000 price divided by $15,540 annual rent).

The New York Times article, Ratios of Home Prices to Rental Prices in Selected Metro Areas indicates that the P/R ratio in Denver during the first quarter of 2000 (before the US asset-based economy switched from stocks to housing) was 11.6.

Therefore, the current P/R ratio on my home is 38.7% higher today than it was in 2000 (16.09 versus 11.6). If the P/R ratio for my home was to return to year 2000 “pre-bubble” levels, my home would sell for $153,250 today rather than $250,000. Therefore, unless I find a “bargain” – a foreclosure, short-sale or bank-owned property with a reasonable P/R ratio, I’ll probably wait until my local market returns to pre-bubble price-to-rent levels.

Second “Price is Right” Indicator: When will buying real estate make sense for landlords?

I recall times when local investors could buy a house with 20% down, rent it out at market rates, and make a positive cash flow in year one. In fact, I’ve done it before. But during the real estate bubble, investors speculated. They bought homes that created a negative cash flow, then counted on home appreciation to pay them back someday in the future. As with any investment, the more speculative, the more risky. I’d rather wait until I can buy rental investment homes that create positive cash flow from the get go. Future price appreciation would be icing on the cake.

My (speculative?) landlord bought our home in 2006, near the peak of the housing bubble. Here’s an estimate of the annual costs our landlord incurs on our home:

Item Annual Cost Notes
Down Payment $2,000 20% of $250k = $50k down. $50k x4% in T-bill, CD or bond instead.
Mortgage Payment (P+I) $14,772 $200k @ 6.25% 30 yr fixed
Property Taxes $1,500 0.6% of hm value
Insurance $900
Maintenance, Repairs $2,331 15% gross annual rent (this is the minimum allowance typically recommended)
Property Management Fees $1,399 9% of gross annual rent (8-10% is typical)
Vacancies $1,295 1 month per year allowance
Marketing and Leasing Fee (by Mngmt Co.) $583 90% of 1 mo. rent every 2 yrs (80-100% is typical fee)
Auto Expense $0 (assuming owner relies 100% on mngmt company)
Total Annual Cost $24,780

+ $15,540 Annual Gross Rent Collected

- $24,780 Annual Costs

= $9,240 Annual LOSS

Obviously our landlord was betting on home price appreciation to continue at unprecedented rates. Bummer.

In order to break-even in year one, our landlord needs to increase our rent from $1,295 to $2,065 per month. Of course if he tried to do this, we’d move out, no one would move in, and his investment property would sit vacant. Not good! So he’s not likely to raise the rent.

Alternatively, if he had bought at the “right” price with the intent to create a near break-even cash flow in year one, he’d have paid only $130,000.

$130,000 is 48% less than the current value of $250,000! Ouch!

If our landlord had bought this home for $130,000, this is what the math might look like:

Item Annual Cost Notes
Down Payment $1,040 20% of $130,000 = $26k down x4% in T-bill, CD or bond instead.
Mortgage Payment (P+I) $7,680 $104k @ 6.25% 30 yr fixed
Property Taxes $780 0.6% of hm value
Insurance $900
Maintenance, Repairs $2,331 15% gross annual rent (minimum)
Property Management Fees $1,399 9% of gross annual rent (8-10% is typical)
Vacancies $1,295 1 month per year allowance
Marketing and Leasing Fee (by Mngmt Co.) $583 90% of 1 mo. rent every 2 yrs (80-100% is typical)
Auto Expense $0 (assuming owner relies 100% on mngmt company)
Total Annual Cost $16,008

+ $15,540 Annual Gross Rent Collected

- $16,008 Annual Costs

= $468 Annual LOSS (almost break-even)

Third “Price is Right” Indicator: An “old” rule of thumb for establishing fair value of rental property is to multiply the annual gross rent by 6 (in not-so-great neighborhoods) to 10 (in premium neighborhoods). This gives you a “business” estimate of the value of a rental. In my case:

$15,540 annual rent x 6 = $93,240 value of rental (in not-so-great neighborhood)

to

$15,540 annual rent x 10 = $155,400 value of rental (in premium neighborhood)

Conclusion:

In my area, house prices are still elevated relative to rents.

Using the above indicators, the price of the home I’m renting should be between $130,000 and $155,400 — rather than the current $250,000. Significant price declines are needed to bring home prices back to their historical relationship to rents (and/or rents need to increase substantially) before the P/R ratio makes sense again.

June 2009 Update:

A year ago, we moved to a 3 bedroom, 2 bath condo. We pay $1150 per month in rent and this includes our water, sewer, trash, cable TV, yard maintenance, clubhouse, swimming pool, hot tub and exercise facility. These HOA benefits cost our landlord about $200 per month. Our landlord bought our condo for $177,100 in 2002. Therefore, our P/R (price to rent) ratio is just under 13 if you include the HOA benefits in our rent; or about 15.5 without them. The most recent comparable sales price I can find for a similar unit was $160,000 in March 2007. I don’t know what our condo would sell for today, but the price would need to drop to $132,240 for the P/R ratio to match our local 11.6 pre-bubble average.

We will continue to rent for as long as it is cheaper to do so. We enjoy our modern condo with all of it’s amenities and proximity to a huge park. This said, we ARE looking to buy land or a home eventually — but only if we can find one for the right price! We are in an enviable position — we can make a low price offer sound appealing to the right seller — because we don’t require a mortgage, we can pay cash if necessary, and we don’t have any home sale contingency to delay closing. When the time and price is right, we will find (or build) our little green dream home.

Readers: What indicator(s) are you watching to access real estate values? When do you think the market will hit bottom? Please do your own math for your own local market and leave your results in the comments for comparison and discussion.

Recommended reading: US Housing Crash Continues: It’s Still A Terrible Time To Buy: Falling House Prices Are The Solution, Not The Problem

{ 14 comments… read them below or add one }

Naples rental management June 16, 2009 at 3:00 am

Knowing how much to charge

The amount of the security deposit: Setting security deposits is a function
of not only market conditions but also limitations on the amount
you can charge and whether that amount’s fully refundable. These
restrictions are determined by your state laws. Determining whether
you want to pay your tenants interest on the deposits you hold is also
subject to law, but certain advantages can warrant doing so even where
not required — especially for long-term tenants.
The best way to make these decisions is to understand your local real
estate market and conduct market surveys to see what others are doing.
If everyone else has security deposits set at approximately half of a
month’s rent, requiring your new tenants to come up with a security
deposit of two full months’ rent upon move-in is difficult.
 The type of rental contract: Another important decision that has lasting
consequences is deciding whether a lease or month-to-month rental
agreement is best for your property. Such conclusions are often reached
after conducting a market survey and understanding the pros and cons
of each type of contract.

Reply

morrison June 16, 2009 at 11:13 am

I’m going to say this is the kindest, most respectful way I can: your information is outdated. It’s a whole new world out there.

First off, people today should buy a home because they want to live in one. The rent vs ownership is a thing of the past. Homes are no longer regarded as an investment anymore. Just the way you buy a car and it’s price drops as soon as you drive it off the lot, no one really cares anymore about the ratios.

2nd. If you qualify, you can get an immediate $8000 which can be either used as a downpayment or as a tax write off towards a purchase of a home for the 1st time home buyer. If anyone wanted a house before and was priced out, this may be your golden moment.

3rd. Should you buy a home that needs repair (due to the previous owner’s neglect, foreclosure, etc.) you can qualify for low interest govt loans. My girlfriend just bought an 1865 historic home for only $67,000 and got a low cost (2%) loan to bring the home up to code. Not bad.

4. Who in their right mind would invest in a CD, T-Bond or any bond right now? They can barely pay 1% in interest and most are worthless.

5. Your repair calculation is too high. Prices have come down, so has maintenance fees, etc. (Lowes for example, lowered ALL their supply costs.)

6. What property management fees? People are doing things themselves? What vacancies? My sister has a waiting list to get into her rental properties. Same with marketing and leasing fees.

7. Mortgage rates in my area is 4.865%. If you lock in now, the banks will hold the rates for 90 days.

8. If you want to buy a home, go out an just buy it. Today, people are buying with the intention of staying put in it. In 15-30 years, depending on the mortgage, the home will be paid for. People today are opting to live in fully paid off homes as a means to secure their retirement. No investment today can guarantee you free living expenses such as complete home ownership.

As to your other posts: Debt is Slavery. Incorrect. People are facing a different threat today. It’s called ‘high taxes’. Today, the motto is: taxes are slavery. We have ahead of us a three-generation lifespan of high and higher taxes. And the VAT tax law hasn’t even been passed yet. Plus the laws have been correctly changed regarding credit cards. I think people today ‘get it’ and have stopped using credit. The Jones family has finally moved out of America.

As to becoming rich? Is there anyone out there who wants to be rich anymore? Please see above paragraph. The less money you make, the more benefits you qualify for. If the govt is going to offer free health care to those who earn $35K and below, guess what? People will be working less and collecting more. The theory to ‘spend less than you earn and save/invest the rest’ is the formula used by people today to survive. I don’t recall the Vanderbilts, the Rockefellers nor the Trumps using this theory to make themselves rich.

America is changing rapidly. Advice should follow suit.

Most jobs today are in the government sector. Most college grads are opting for government jobs. People will be earning less, will have less money to spend, will be getting Universal Health Care, etc. This is the current trend in America today.

Thank you.

PS: MMND, if you want to buy land and build a green little house, do it. What is your life worth? Enjoy yourself and throw the calculator away.

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Amy June 16, 2009 at 12:09 pm

Our house is worth about $550,000 in the DC suburbs. If we rented it out, we could probably get $2500 per month. We bought this house in 2000 for $290,000 (and at the time we thought that was very high!) and put in about $25,000 worth of renovations including a new roof. Clearly we did the right thing by buying 8 years ago because even though this house was once worth about $650,000, I don’t think it will ever drop anywhere close to what we paid for it. Our house has actually been one of our best investments.

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Anna June 16, 2009 at 1:20 pm

I like your post, but I think perhaps the home prices before the bubble are not going to come back unless the financial crisis becomes longer than expected. As you know there are some economists that fear hyper inflation and therefore a big mess.

For me to own my home is a matter of life style and where I live there are no rentals for homes only for apartments. I would like to buy an investment property and I am wondering for how long should I wait.

On another note I was looking to relocate. The 2 places I like one in PA other in GA have appreciated so much in the last year that I wonder what is happening in those towns, did people really learn the lesson from the real estate crisis? I think a lot of people have short memory.

Maybe you should write about hyper inflation and the potential problems it will create.

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Mrs. Money June 18, 2009 at 9:18 am

Wow, this is awesome! I think it’s great you calculated it like this. I’ll have to say… I am jealous you are in Colorado! :)

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Peter June 18, 2009 at 7:15 pm

Morrison, your said so many strange things that I just had to check out your blog. I thought today’s post there (“Back in Black”) was just beyond ironic. I’ll say this in the nicest possible way: don’t give life style advice to anyone. :)

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Mark in San Diego June 19, 2009 at 1:02 pm

Morrison, just curious: Are you a real estate professional or in some way working in the mortgage/finance industry? Your post sounds quite a bit like other posts I’ve read from RE people. For the RE industry, there is never a bad time to buy. That being said, if I could buy a house that made sense using Millionaire Mommy’s calculations, I would in a second. But living in San Diego, where a decent house in my neighborhood (where decent means over 1,000 square feet on a lot over 4,000 sq ft) costs over $500,000. Renting something comparable costs under $2,000. And this is in a neighborhood where just 10 years ago these same houses were arond $200,000. So, as they say, all real estate is local. Millionaire Mommy’s advice is as timely as ever.

Millionaire Mommy – your advice is invaluable, given the times. We are in the second year of the first economic depression since the 1930s. I would anticipate that your blog will draw more readers every year this lasts. Keep up the good work. Your advice will be appreciated by many in the years to come. Thanks!

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Rebecca June 20, 2009 at 10:01 am

Yep, nice work. I enjoy these posts – thanks for adding a voice of reason given the vast propensity to imagine the solution to the problem is doing more of the thing that caused the problem. We’ve collectively been telling ourselves the same stories so long it’s hard to ram home still that they *are* just stories; it’s good to keep hearing stuff like this to remind us.

Like Anna, I’d love to read your thoughts on surviving the possibility of heightened inflation over the coming years – its impact on savings and so on. I know you suggested in a previous post you were concerned with this matter. Any thoughts?

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John C June 22, 2009 at 12:48 pm

I can’t believe the arrogance and ignorance of some of the comments left here.

“Just the way you buy a car and it’s price drops as soon as you drive it off the lot, no one really cares anymore about the ratios.”

Then why are people who can afford to pay their monthly mortgage, but are underwater on their mortgages by anywhere from (20%-50%) walking away from their homes?

“Mortgage rates in my area is 4.865%. If you lock in now, the banks will hold the rates for 90 days.”

This pertinently untrue, the spread on your mortgage to the 30 year t-bill is ~ 40 bps? Not a chance in hell, conforming 30 years are coming in at 5.5% and higher right now from the quotes I see.

“If you want to buy a home, go out an just buy it. Today, people are buying with the intention of staying put in it. In 15-30 years, depending on the mortgage, the home will be paid for.”

People taking out mortgages today, in many cases, won’t be in those homes two to three years from now due to ramping job losses and rising interest rates.

“Most jobs today are in the government sector. Most college grads are opting for government jobs. People will be earning less, will have less money to spend, will be getting Universal Health Care, etc. This is the current trend in America today.”

Like robbing Peter to pay Pau and Pablito has ever been sustainable in the past right? Everyone loves socialism until the Chinese and Japanese stop paying for it. Show me your socialist paradise when the bond market dislocates and Uncle Sam is forced to live within his means or tax the productive elements of American society to death. You won’t be able to because it won’t exist because raising taxes during a period of severe economic malaise is the ultimate recipe for revolution.

“Our house is worth about $550,000 in the DC suburbs….. Clearly we did the right thing by buying 8 years ago because even though this house was once worth about $650,000, I don’t think it will ever drop anywhere close to what we paid for it.”

Your house is not worth $550k unless you can actually sell it for said amount, until the sale is finalized the arbitrary figure you wrote is an assumption of value. As for thinking it will never drop back to the price you bought it for, there are millions of people on the west coast who once thought as you did.

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morrison June 22, 2009 at 7:06 pm

Nope, I am not a Real Estate person. Just a real, honest-to-goodness multi millionaire. A frugal one at that. I admit to playing ‘games’ with myself in order to preserve my wealth. It’s called ‘living below your means’ as MMND always suggests. That’s how my rich parents did it. That’s how it’s done. I live on $35-$50K a year and most of it is from passive income. I made my money in real estate. Even in todays’ down market, there is still money to be made. I own several pieces of real estate, all paid for in cash. I dare anyone else here to make that statement. My sister owns 6 rental properties, all paid for. Nice life, if you can get it. (yes, my whole entire family are multi-multi-millionaires)

Peter, I wouldn’t waste my time giving anyone lifestyle advice. I let people live and let live.

John, my daughter just got a mortgage for 4.85%. She applied 2 months ago, locked in her rate, for 90 days and closed the other day. So did some of her friends. I speak from actuality. Not dreams.

If people are walking away from their homes it is because they are scared. I recognize the feeling. But, even if people are upside down in their car loans, they don’t walk away from them. Why is that? Just stupidity, I guess.

High Inflation is on it’s way. My opinion is that during high inflationary times, owning a home is still the best hedge. I still stand by the fact that a home, when purchased correctly, 20% down, 30 year conventional mortgage, remain in the home for at least 10 years and is affordable/within ones means are a good sure bet. I could afford a million dollar palace but I opted for a small, custom built modular home (1140 sq ft), I could drive a Mercedes but I drive a Ford Focus instead. Before I buy anything in life, I ask myself “if you were broke and poor, what would you do?” I am always amazed at my answers. I find incredible cost-effective solutions to my problems and deal with them accordingly. This is a self-imposed lifestyle and it has worked for me.

During this past economic downturn of 2007, I haven’t lost one penny. I learned from the stock market crash of 1987 and 2001 that the only sustainable lifestyle was one free of debt, including a mortgage, no credit cards, no car loans…….nothing, but cash in a bank was valuable. My aim is to maintain an enjoyable lifestyle, while still keeping money in a bank. I know it’s a bit bizarre and I do get smirked at. I’m used to it. But lately, I don’t find too many of my friends laughing at me anymore. As I watch more and more of them lose their jobs. My husband and I are self employed. We work 2-3 days per week. We are very financially agile and have been able to weather any financial crisis that comes our way. I also discovered that another good hedge was to keep some money coming in monthly. Another ‘game’ I developed was forcing DH and I to live off the salary we earned. Again, it preserves our wealth.

As to socialism, I am against it. I am saddened by the fact that this country is favoring government jobs and not honoring entrepreneurs nor the self-employed. I find the governmental attitude to be anti-business. This is a very dangerous thing. But that’s another post.

I still believe that to anyone who dreamed about someday owning your own home, if the numbers are right, just go out and do it! It’s a personal choice and I can’t be swayed from advising people to own their own place. Personally, I don’t care what the values of my properties are worth. I just love them. They give me (and my family) joy. The value is priceless. You can’t put that into any equation.

Higher taxes for all of us are on the horizon, inflation may be just around the door (personally, I predict a complete collapse)……..if this does happen, ask yourself what you will do? How will you manage? Questions like this didn’t seem possible 2-3 years ago. For my life, owning a home (outright) was a probable solution.

Thanks MMND.

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Richard Wicks July 13, 2009 at 1:09 am

I read this from “morrison “and had to comment.

> I’m going to say this is the kindest, most respectful
> way I can: your information is outdated. It’s a whole
> new world out there.
>
> First off, people today should buy a home because
> they want to live in one. The rent vs ownership is a
> thing of the past.

I’m just going to be blunt.

When people say “this time it’s different” – it never is. YOU may think it’s a whole new world out there, YOU may think rent ratios are a thing of the past, YOU may think people should buy a home simply because they want one.

You’re in the minority.

I will buy a home only when it makes sense to purchase a home. I live in Silicon Valley California, where a shoe box is still selling for north of 400K. For $400,000 I am able to buy an apartment complex in many places in the country, and rent at a profit – enough of a profit to cover the full cost of the mortgage, and the full cost of my rent back here in Silicon Valley.

Why would I waste a $400,000 investment on a white elephant? You think I’d do this because of a hazy desire to own a home? I hate to break it to you, the people that avoided being killed in this crash financially aren’t pie in the sky dreamers when it comes to money.

It’s you that has the outdated information, from about 4 years ago. I am not going to put myself in economic slavery just so I can own a piece of real estate that I have to maintain, and to which can potentially wipe out all my net wealth if things go wrong and the reason is, is that I know people who have had their lives RUINED by doing what you say is the “now” thing to do.

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Mark in San Diego July 13, 2009 at 1:46 pm

Richard:

THANK YOU. My thoughts exactly. It shows how much of the housing bubble mentality still pervades the country to hear many of the comments regarding housing. Every day that passes with tiny houses here in San Diego still sitting on the market (for months) with $500K prices, I find the idea of just renting, for the rest of my life if necessary, more comfortable. You either rent a house or you rent a mortgage. At least with renting, if we decide, or have to move, it’s just a 30-day notice to our landlord. No upside-down mortgage, open houses, or stress of selling for us.

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Deb July 21, 2009 at 8:13 pm

MMND, you just haven’t found truly motivated sellers yet. You will.

We bought a tiny 900′ house on 4 acres at $29k less than asking a few months ago because the seller was motivated. Not by desperation, not by financial ruin, but because of emotional attachment to the property. It’s been in her family for 60 years and the trees were planted by her grandfather. She turned down other higher offers because we promised we weren’t here to chop down the trees and develop. We probably could have purchased for even less now than we did 8 months ago, but not by much. Our area prices have only gone down 13% through this collapse, and are now slowly creeping back up.

We kept the home in Portland and are renting it out, and are doing just fine. It’s all relative to where you’re located.

Best of luck!

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MrLaMont September 19, 2009 at 5:53 pm

As a Real Estate Broker I must say that you give Very Good & sound Advice.
keep up the good work…..

Reply

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