Appreciating Appreciation

Recently I talked with a client who is considering buying a house in Sonoma County. As you might know, the housing market here in the Bay Area is variously described as “crazy,” “red hot,” “ridiculous,” and “divorced from reality.” A similar situation prevails in many cities and towns across the country. Should a smart home buyer take the leap now or wait and hope for prices to drop? How do you evaluate whether renting or buying is the best strategy?

The comment sections of innumerable personal finance blogs are strewn with the wreckage of the battle—no, the war—around this question. It’s nearly as hot as the debate over whether to pre-pay a mortgage or not (don’t get me started). As a math major, I like to look at the numbers myself, play with calculators, build my own spreadsheets. After hours of work on this my definitive answer is “it depends.” Seriously. It depends on a bunch of factors, but actually pivots on one big factor.

For starters, spend some time looking at buy vs. rent calculators. Michael Bluejay’s How to Buy a House website offers a powerful overview of every possible factor, though the profusion of graphs and charts really requires your time and attention. One thing you can’t see in Bluejay’s calculators is which factors are most relevant, something that the New York Times’ brilliant buy-rent calculator shows you immediately: the slider for each factor includes an integrated chart that helps visualize how important the factor is to the overall outcome. Their calculator has 21 factors, including the obvious like inflation rate and investment rate of return; it also includes rental costs and homeowner’s insurance. But the truly stand-apart feature is the importance charts. For example, your marginal tax rate doesn’t influence the decision to buy or rent very much, but the home appreciation rate does. The less important factors are inflation rate, tax rate, monthly utilities cost, and the extent of your down payment (surprisingly). In order, the factors that make the biggest difference are how long you plan to stay (it’s a big deal if you only plan to stay a couple years, then it tapers off), the home appreciation rate, the rate of return on investments, and how expensive the house is. Homeowner’s insurance could play a big part in your decision-making if it was really expensive, but it rarely is (flood and fire zones are the exception). And if ongoing maintenance and renovation costs are expected to be high for many years, that can really shift the balance away from buying to renting; this could be a factor if the home inspection reveals issues, or if you’ve got big upgrade or energy retrofit plans.

But how does all this help you make the decision and what’s that most important factor I dangled out there a few hundred words ago? Having spent several hours with this calculator and played out numerous scenarios, I see the home appreciation rate as the big pivot—along with with investment return rates. Those are clearly intertwined, and both are bedeviled by requiring glimpses into the murky future. As I have written here many times, there are no crystal balls, no one can predict the future, and if you meet someone who insists they can, smile politely, put your hand on your wallet and back slowly out of the room. But estimating and planning for future investment returns is much more difficult than “merely” seeing the future!

For this exercise we’ll assume you have a cautiously balanced portfolio with modest expected gains. There’s much more to say about why we’ll make this assumption, so you’ll just have to trust me and read my next article! This assumption removes investment returns as a pivotal factor, and leaves us looking for some insight about what influences home appreciation rates in your locale. There are numerous demand-side factors such as area employment and economic prospects; general economic outlook for the state, region, and country; ease of access to credit; possible upcoming IPOs (this is a big factor in tech epicenters); and outside buyers (the Chinese on the west coast and in New York City for example). And of course there are supply side factors that can drive or sustain appreciation rates: limited supply, growth boundaries, planning goals that discourage development, etc. Coastal regions have built in geographical limitations (see San Francisco, Seattle, and Manhattan); peninsulas are especially pricey.

The broader economic outlook for the country or a region is often considered the most powerful driver. But many prime locations in coastal cities never saw price drops during the Great Recession; other factors were more important. If you have a chance to buy a home in Sausalito for example, you should take it (hills or houseboat of course, don’t forget climate change).

Let’s look at a simplified analysis to get an idea of what I’m talking about. In the graphic I’ve plotted five factors, and laid them out according to my evaluation of their likelihood to continue over the next 5-10 years. This is not a precise system; remember to have a clear idea that there’s a fuzzy boundary instead of a fuzzy idea that there’s a clear boundary. The dotted line is a hurdle, a threshold past which it’s likely that the factor will drive home prices upward. In this example four of the five clear the hurdle, and this would strongly suggest that prices will continue to rise. Even if interest rates rise and the national economy is weak, the strength of the local economy and the awesomeness of the neighborhood will drive prices up. A more sophisticated analysis would probably include 15 or more factors, but the five in this example are likely the biggest drivers.

This is a good moment to remember the worrying possibility that the next black swan is floating around the bend, waiting to take us down the falls. A black swan is one of those unpredictable and unforeseen events that shakes markets and economies. It’s the subprime housing debacle we just lived through, it could be a trade war with China. The nature of the black swan event is that you didn’t predict it happening—but that doesn’t mean you don’t consider what a big disruption might mean for your plans. What happens if real estate prices drop 50% in a year and stay flat for several after that? What does that do to your wealth? How likely is such a catastrophic event? Think very carefully about this set of questions. Careful thought and planning to avoid catastrophe is one of the best investments you can make.

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Christopher Peck

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