If you have been following the Mortgage Mania saga on 3Oceans which looks at how fallout from the increasing numbers of homes bought with subprime loans are going into foreclosure, you might enjoy this tidbit from an article posted on Inman News on Tuesday. . .

Speaking via satellite to the International Money Managers Conference in Capetown, South Africa on Tuesday, Fed Chairman Ben Bernanke forecasts a slowdown on the nationwide housing industry as a result of tightening lending restrictions.

Excerpt from article:

“Tighter standards in subprime lending — along with bad publicity that may keep eligible borrowers from applying for loans — will continue to restrain demand for housing, Federal Reserve Chairman Ben Bernanke told international bankers Tuesday.”

Click here to read the complete article.

We are seeing it here as well. A couple of loan instruments that were available to an investor that I work with a couple of months ago are now gone. That hasn’t prevented him from being able to buy that million dollar fixer upper, but the increased carrying costs of his purchase are cutting into his profit, making “deals” harder to come by.

If you have been planning to purchase a home, and you are now finding that you qualify for less, or that you can’t qualify, post a comment and let me know.

Thanks for reading . . .

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I long ago put together a buy vs. rent calculator and it served as the basis for my buy vs. rent series.

The New York times has just come out with a pretty good buy vs. rent calculator of their own (might soon disappear behind a paid firewall.)

Its conclusions are basically the same as mine:  Assuming roughly the same rental cost vs. property price ratio as we have here in the Bay Area, you’re better off owning than renting over a 4 year or greater period if property prices appreciate by 5% per year or more.

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Let’s continue the saga of Bob and Betty, our hypothetical first-time home buyers who were introduced in the first of a series of articles I’ll be writing.

We met at 9am sharp on Saturday morning at my broker’s office in downtown Palo Alto. Though it’s easier to view homes with clients during open house times, I prefer to do first time tours when nobody else is around.

I had an ambitious tour planned: 12 homes in 4 towns along the 101 corridor. Always exhausting for everybody involved — every time I do this I have more liking for the part of the Redfin business model where clients do this bit themselves! — but nonetheless an important part of the whole process.

While driving, I pointed out important things about the neighborhoods we were in: The typical types of homes, the price ranges, which school district it belonged to, whether it was unincorporated or not, whether it was in a flood zone, where the nearest parks and public services were. I asked them to comment on what they liked and didn’t like in each neighborhood.

At each home we went through the same process, slowly at the first couple of homes, and then more quickly. “What did you like? What did you not like? What did you think of that kitchen? Do you like skylights? Fireplaces?”

By the 5th home I’m usually able to “get it” about what clients are looking for, and with this new knowledge, I crossed out 3 of the remaining 7 homes we had to see.

Suitably tired, we pulled back up to the office around 1pm to review what we had seen, what they had liked, and what they had not liked. I explained the next bit of the process: getting pre-approved. I’m happy to spend a few hours as a sort of “interview” with prospective buying clients, but before I invest too much more, I need them to put some skin in the game too by getting pre-approved. I generally find that if they’re not ready to dig up their financial records and go talk to a mortgage broker, then most likely they’re not ready quite yet to buy a home.

Betty was quite excited about three of the homes we had seen, but it was clear that Bob was losing interest pretty quickly. “Yeah…but nine hundred thousand dollars?” was his most common refrain.

We pressed in on that. Bob had been doing his homework the last week and pulled out all the discouraging figures he had found. Housing starts are down. Interest rates are up. Affordability is down. Condo developments in Las Vegas and Miami are being cancelled. How in the world could prices stay where they are here?

Prices in the Bay Area are indeed a pretty head-scratching discussion topic as they continue to defy gravity, pessimism, and seemingly the laws of economics year after year. I told them bluntly that neither I nor anybody else could guarantee anything about prices here. It is indeed possible that prices could collapse…by 40%…overnight…immediately after they bought a place. Possible? Yes. Probable? No.

I pulled up my secret weapon, Google Earth, on the flat screen wall monitor in the conference room. I zoomed in on the Peninsula and asked two questions: 1) How much land is technically available to build on? 2) How much land is actually available to build on.

The answer to the first question is: tons! From the Bay going west pretty much to Highway 280, nearly every square inch of land is already filled in. From the 280 west to the ocean, there are only a smattering of towns, like Half Moon Bay, Pescadero, and La Honda. The mountains make it difficult to build in that area, but we could certainly fit several hundred thousand more homes there.

However…it ain’t gonna happen! Most of that land is owned and/or protected by Federal, State, County, or City governments, private trusts, conservatorships, parks, and so forth, and not much building is going on.

If you can’t go West, then you have to use the Manhattan strategy: go up. Again, that ain’t gonna happen. San Francisco and San Jose have modest but growing skylines of high-rise buildings, but in between it’s rare to find any structure taller than 8 or 10 stories, and for the most part it’s only up to 3 stories tall. Those zoning restrictions aren’t going to be changing any time soon.

Essentially, 50% of the classic economic supply/demand equation is pretty much fixed, so the real question is what will happen with demand?

Again, at least for the short and medium term, the answer to that is pretty clear: demand is, and will likely remain, robust. Google and other local tech companies are doing well. Venture capitalists are pulling out their wallets again. Start-up nirvana 2.0 is here. Immigrants from across the country, and indeed the whole world, continue to move here.

So, could prices fall by 40% overnight?  Absolutely! But in the only scenario I can come up with in which that happens — a scenario which involves an earthquake, a terrorist attack, and bankruptcies of the top 5 tech employers in the area…all within 3 months of eachother — falling equity may not even make the top 10 list of concerns for many people.

We parted company, and they promised to get back to me within a few days about whether they were ready to proceed. I had my doubts, mostly about Bob.

Sure enough, a few days later I got a phone call from him. “We’ve decided to wait it out,” he said. “We’re just a bit nervous about these prices, and we’re not in a big hurry to buy.”

We agreed to keep in touch every few weeks and see how things developed.
Welcome to real estate in the Bay Area.  Prices are high, and you need a certain amount of faith and intestinal fortitude to dive in for the first time.

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Let me introduce you to the two newest stars of this blog: Bob and Betty, a fictional family, sort of a composite blend of numerous past clients. In this x-part series, where “x” is currently an unknown number, I’ll walk you through how we got them into a home, despite the heroic efforts of a cantankerous market, an incompetent mortgage broker (soon fired), and a sleazy Realtor or two to thwart our plans. Enjoy the ride…

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I first met Bob and Betty about a year ago at a social event hosted by mutual friends. They had moved up to the Bay Area from Los Angeles two years previously after finishing their graduate studies at UCLA — Betty an MBA, and Bob a PhD in bio-something-or-other.

We got talking about the real estate market — a common topic these days — and their sticker shock, only now wearing off, about Bay Area real estate prices. LA prices aren’t exactly cheap either, but the Bay Area certainly has it beat. Bob and Betty were doing what most young recently arrived Bay Area transplants do: renting. Though in no particular hurry to own their own place, they had begun to think about it, but were, quite naturally, concerned about what might happen to home prices. Their angst wasn’t helped much by a constant barrage of doom-and-gloom articles in the media.

We traded emails and spreadsheets a few times, then met for coffee a few weeks later. Since they were both interested in the numbers, I walked them through my “buy vs. rent” analysis, which basically shows that in the short run, it’s definitely cheaper to rent than to buy, but in the long run, with even modest growth assumptions, it’s definitely better to buy than to rent. They appreciated the analysis, but were still skeptical.

Fair enough. The primary motivator for buying a personal residence is usually emotional — stability, putting down roots, raising a family — and the analysis at which I excel (pun intended) is usually just the icing on the cake once they’ve made the emotional commitment to home ownership.

We spent some time talking about what their ideal home might be. They love entertaining, and Bob loves cooking, so a nicely done-up kitchen opening up to an entertaining area would be ideal. Not being much in the handyman department, they prefer a home that’s move-in ready, not a fixer. Bob works in South San Francisco for a biotech company, and Betty in Sunnyvale for a tech startup, so anywhere in between the two — preferably along the 101 corridor — would work. Three bedrooms or more, 1.5 baths or more, roughly 1600 square feet. Betty is somewhat noise sensitive, so too near the highway, a busy road, or the train might not be good. They don’t have kids, and probably won’t for a few years, so being in a good school district isn’t that important.

We talked about their budget, and ran some quick numbers. It seemed that a $950,000 home would be well within their reach.

We made arrangements to meet again the next weekend, when I would show them a half-dozen or so homes that might work, and start to get them acquainted with the neighborhoods.

An excellent first meeting, I thought, though I sensed a certain amount of hesitation in them. I made a note to explore that hesitation further the next time we met.

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In my previous post on this topic, we confirmed people’s intuition that in the Bay Area, it’s usually quite a bit cheaper in the short run to rent than to buy — even with aggressive financing options such as interest-only loans. So why would any sane person actually buy a property here?

Turns out it’s the financial benefit, and not insanity, that drives people to buy, bubblistas’ theories to the contrary notwithstanding. Continuing with our saga about our Mountain View home with a rental value of $2400 per month and a purchase tag of $825,000, let’s continue running the numbers, this time over a five-year period instead of just a month. If you were to buy the home today, you’d be out your 10% down payment of $82,500. During your first year of owning the home, you’d be out another $55,000 in combined mortgage, tax, maintenance, and insurance payments — that’s after deducting your substantial tax savings. Your first year’s rent, however, would be only $28,00. Ding ding. Round 1 to the renters.

Let’s assume that rents are increasing by 5% per year. (Again, purists may object that that hasn’t been the case over the last half decade. True point…but go further back in time to the late 90’s dot.com era when rents were increasing literally around 15% to 20% per year. Over the long term, 5% is probably a reasonable approximation.) In year 2, you’d pay $30,240 in rent but be out over $50,000 if you owned the property. Ding ding. Round 2 to the renters.

It’s looking like a one-sided contest so far, but let’s wait till the end of year 5 where you’ll see the the owners, pride intact, perform a solid KO over the renters. By the end of year 5, you’d have spent a total of $159,00 to rent the property. Your total ownership expenses, after considering your tax benefits, would be nearly $343,000. Let’s say you sell at the end of year 5. Further, let’s assume properties have been appreciating by 5% per year during that time, and that your selling costs are 6% for realtor fees and 1% for miscellaneous other fees. Keeping in mind Uncle Sam’s generous $250,000 capital gains tax exemption ($500,000 for married couples), you would end up pocketing $286,000, meaning that over your five year ownership period you’d have spent $56,000 out of pocket instead of $159,000 if you’d rented. (If you’re a hard-core numbers type and want to see the math behind these numbers, let me know.) Let’s update our graph:

“But…but…but” sputter the renters, reeling from their blow, “that’s not fair! Owners may end up paying less in the long run, but surely it’s got to count for something that in every single year we renters paid less? Isn’t there something about the time value of money?”

Fair point.

To account for the fact that a dollar spent today is more painful than a dollar spent tomorrow, we use a neat Finance 101 trick called “Net Present Value” (NPV) which enables you to compare two completely different sets of expenses — like five years of ~$30K per year in rent vs. five years of ~$50K per year in ownership expenses followed by a windfall of nearly $300K.

The NPV, as it turns out, evens the players up a bit…but the owners still win, hands down, by about $50,000 in NPV. (Again, for folks interested in the numbers, I used a discount rate of 5.8%, which again I’m happy to explain to anybody who asks.)

Rounds 1 through 5 go to the renters…but the final KO, and a solid one at that, goes to the owners.

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In my first post on this topic, the “aha” insight was that, even with today’s wacky ratio between home prices and rents in the Bay Area, you’re likely to be better off in the long run — five years or so — buying than renting, even if you assume fairly modest property appreciation. This “killer” chart, based on how long you’ll be in the house and what you expect the housing market to do in that time, helps you figure out the tradeoff.

Now let’s play with some numbers and see where this graph came from.

Since we’re comparing renting and owning, it makes sense to start with a sample home and figure out what it would cost to rent and what it would cost to buy.

Let’s imagine your standard ranch-style 3-bedroom, 2-bath, 1400 square foot home, in good condition, in an average neighorhood in, say, Mountain View, for which you would expect to pay around $825,000. Renting the same home would set you back around $2400 per month.

Let’s assume you buy the home with 10% down and finance the rest with a 6% 30-year fixed loan. (Current interest rates are actually a bit higher, but that doesn’t materially change the answer.) Let’s assume property taxes are 1.25% per year, and that maintenance and insurance cost you around 0.5% per year each — figures very much in line with my own experience as a landlord. Though technically only mortgage payments — not taxes, maintenance, and insurance — get paid monthly, let’s smooth things out and pretend all of these are monthly expenses.

Punch these numbers into your calculator, and you’ll end up with just under $6000 per month in expenses — a hefty premium over the $2400 you would pay to rent. But…as we real estate professionals never tire of telling you…don’t forget the tax benefits of home ownership.

Uncle Sam, and his counterpart in Sacramento “Uncle Arnold”, often let you write off your local property taxes plus the interest portion of your mortgage payment. Assuming you’re in a 30% federal and 10% state marginal tax bracket — and in this area it’s hard not to be — that gives you a tax break of about $2000 per month. You end up with a net monthly cost of just under $4000, a lot better than $6000, but still uncomfortably higher than your $2400 rental bill.

Ouch! What if you go with an interest-only loan to reduce your monthly payments? Keep the other assumptions the same, but let’s change your mortgage into a five-year interest-only product at 5.25% (again, the real rates are higher, but this doesn’t materially change the answer). Now you end up with monthly expenses of only $2900 per month, closer to but still higher than your monthly rental expenses of $2400.

In the short run, you are indisputably better off renting than buying. In the long run, however, the opposite becomes true.

Stay tuned…

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