Hacker|Engineer

So You're Thinking About Buying a Home, Eh?

Awesome, so here’s the deal. Now is a pretty good time to buy real estate. Even Warren Buffet said that if he could get the logistics figured out, he’d buy up a bunch of houses. The only thing stopping him is the inefficiency of dealing with actual homes!

Several friends of mine have asked about buying real estate recently, so I figured I’d put together my thoughts on the issue. I currently own a small condo in the SoMa neighborhood of San Francisco, which I purchased in 2010. I have no qualifications to speak on this topic other than that, but rest assured, I do my homework when making major life decisions. Plenty of others have written about buying vs. renting, but I’ll try to come at it from the SF tech perspective.

Owning the home you live in is on average cheaper than renting. Why? Because the government subsidizes it! Of course, the devil is in the details, and in some cases it doesn’t work this way, but on average owning is guaranteed to be cheaper than renting, thanks to government manipulation in the form of the mortgage interest tax deduction, whereby you can deduct all property taxes and mortgage interest paid from your income on your tax returns. On a 30-year mortgage, a huge percentage of your payments are interest, so you’re effectively paying 25% less on it thanks to the tax break. A landlord also gets to deduct the mortgage interest, but he’s deducting it agains the rental income, not his core income, and thus isn’t getting the same kind of discount you can.

“Sweet,” you say, “so I should buy a home right now!” Not so fast. The biggest impediment to buying is transaction costs: You’re looking at about $10k in closing costs, 3.5% down payment (20% if you don’t go FHA), and 6% commission when you sell it. That’s a lot of cash, and not everybody has the means to come by it. If you do, then awesome, you’re set. Well, not quite. There’s still investment risk in the real estate market, which I’ll get to in a bit.

To get into detail about 3.5% vs 20%…right now lending is tight, so a normal mortgage is going to require a 20% down payment. However, the Federal Housing Administration will insure the mortgage so that the lender is taking effectively zero risk. If you get an FHA-insured mortgage, you only have to put 3.5% down but you pay an extra 0.5% of the purchase price every year plus an up-front premium of around 2%. You can roll that up-front cost into the mortgage itself, but you’re paying it either way.

So, back to transaction costs. Renting generally makes more sense if you’re short-term, due to the high transaction costs. Unless you’re looking forward to being a landlord, you generally don’t want to buy unless you’re going to be there long enough for the savings and appreciation to offset your transaction costs. The #1 variable in rent vs. buy calculations is how long you’re planning on living there. The NY Times has a fantastic rent vs. buy calculator based on this.

Okay, now the investment side. Real estate is an asset. Assuming a flat economy (e.g. Switzerland), you’re looking at about a 5%/yr return on your money if you just walk up, buy a home for cash, and rent it out. Not bad, but not great either. However, if the value of the home goes up, then you get that appreciation in addition to the cash flow. Pretty good, eh? Well, it gets better: you can get some pretty serious leverage involved. Instead of buying a home for cash, you use a mortgage to finance it. The bank gets their ~5% cash flow, you put 20% down, and the rest is financed. Now, you’re 5x leveraged. If the home goes up 20% in value, you doubled your money (down payment). At 3.5% down, it’s even more leverage. Unlike some riskier leveraged bets, your downside is walking away and letting the bank foreclose on the home. You’re out the down payment and probably can’t buy another home any time soon, but you’re not on the hook for the massive loss in value. Of course, it’s still not pretty, but the asymmetry makes leveraged homebuying look pretty good.

Given the Fed’s recent policy of printing money, there’s another way to look at this: even if the real value of your home stays flat, the nominal value can go up entirely due to inflation. Since your mortgage is a fixed number of dollars at a fixed rate, you get to pocket the difference. This is, in fact, one of the big reasons that pushed me to buy my condo. I expect pretty severe inflation some time in the next 30 years, so I’m quite happy to be long a hard asset (the land and structure) while short what amounts to a 30-year bond at 5%. Interest rates can’t go much further down from here, so worst-case all I get is an increase in the real value of my home.

On average, real estate appreciation pretty much matches inflation. In specific regions, however, we can see significant gains or losses. For example, the SF Bay Area has seen something like 17%/yr for the last 20 years according to my realtor friend. Other places? Not so much. In addition to deciding whether to rent or to buy, you’re also making a decision about where to buy, and that can have a big impact. I prefer SF, NYC, or Boston because I expect a significant demographic shift back from suburbia to the cities in our generation, and those three are the most pedestrian-friendly large cities in the U.S.

So here’s the bottom line: if you really want to own a home, go for it. Condos are pretty low-maintenance (the biggest homeowner maintenance I’ve done since moving in almost 2 years ago has been tightening a nut on my bathroom faucet) and on average it’s a pretty good deal. If you lose your job, it can suck to be shelling out several grand a month to the bank instead of slipping out of your lease to live with a friend or your parents. If the real estate market tanks, as it did in 2007, you can end up paying quite a bit more for your mortgage than your neighbor pays in rent. If your HOA discovers severe building defects, you could be on the hook for tens of thousands of dollars in repairs (we’re currently suing our developer to get them to pay these costs). There are plenty of downsides, but in the end, there’s something to be said for the pride of owning your place.