Friday, May 06, 2005

Why I'm Not Buying A House..

As I've graduated, and now have a stable job and income, I'm supposed to think about buying a house, rather than continuing to pay rent. But with Bay Area home prices at dizzying levels, I have to ask whether it makes sense to buy or keep renting. Being logical, I decided to use everyone's favorite financial "what if" tool, a spreadsheet, to construct a model of the various costs.

But before I get to the spreadsheet, what are the costs? There's the obvious mortage payment, but there are also property taxes, insurance, maintenance, and homeowners association dues. There are also tax savings, both with and without AMT to consider. Rather than just one cost for ownership, I consider 3 costs: the raw cash-flow, the tax-neutral cost, and the tax-neutral nonsavings cost. The first is obvious: how big per month are the checks. The second value is the first reduced by the tax savings from deducting interest and property tax. The final, tax-neutral nonsavings, also excludes payments on principle.[1] It is the last two which are the key values: what you pay (some of which you get back as principle when you sell the house), and what you pay and don't expect to ever get back.

You would expect that the tax-neutral nonsavings cost to be less then rent. After all, you should be able to buy a dwelling, rent it out, and make at least some profit. And, assuming you have the cash and cash flow, if tax-neutral nonsavings is less than rent, you need to buy.

Unfortunatly, with the current prices, this is not the case. Lets use the real numbers. I live in the Richmond Marina Bay area (aka the Yuppie Prison Complexes). My rent is $1325/month for a 2 bedroom apartment [2]. Recently, another, almost identical complex with the same floorplans and the same construction started being converted to condominiums, at $450,000 to $480,000 for the 2-bedroom units. The only major difference is that the other complex has some fake lakes, which only serve to attract the migrating geese and the rotting fecal matter they produce.

There are a few other assumptions needed: tax rates, loan terms, insurance HOA costs and inflation. This spreadsheet assumes a very healthy income, with a 28% marginal federal tax rate, a 9.3% state tax rate, and a 1.2% property tax rate. The loan I assume as 6% fixed, 30 years, with 10% down: a good loan for the long haul. Insurance I assume as .2%, which is actually low: earthquake insurance in the area costs .3-.4% depending on coverage level. I set the HOA fees/maintenance to $250/month. Finally, I assume that both rent and HOA fees increase by 3% annually. Toss the numbers into the handy spreadsheet and out pop some terrifying numbers.

Buying instead of renting simply costs a fortune. Beyond the $3200 a month of cash flow (hello Top Ramen dinners), the tax-neutral cost is still an outrageous $2200 a month. The real shocker is the tax-neutral nonsavings cost: $1880 a month, or over $550 more than renting. That's a real loss of $550 a month, for the privilidge of owning a glorified 2 bedroom apartment (err, "condominium home"). I can buy a nice car for $550 a month. It takes 7 years of inflation (by which time I would save $34,000) before my monthly non-savings cost would be equal to rent. It would take 18 years! until the net cost is the same.

Note that I did not consider asset appreciation in this analysis. Mostly because I feel that this is a dangerous bubble, and over the next 5-10 years, prices are going to be, emm, interesting (more details in a subsequent post). But lets say I want to sell after 7 years. Prices will have to have gone up by another 13% to even break even compared to renting, considering the 6% cost of transaction when selling a house.

It simply does not make sense to buy in this housing market. With shacks in the Richmond 'hood going for $300k, I'm going to stick with renting. For others considering buying, in other markets, use the spreadsheet yourself.

[1] An important note: I do not consider asset appreciation in the model. When there is such a feeling of speculative bubble, I don't want to include speculative gains in the calculation. But I do assume, by considering the money paid to principle as savings, that the value won't drop below the down payment.

[2] Two other factors I'm also excluding: the complexes considered are in Richmond California (a truely atrocious school district) and are built on bay fill. In the event of a major earthquake, every dwelling in the area is going to be red tagged. As a renter, that just means I need to move my stuff. If I was an owner, even with insurance, its a catastrophe.


David said...

Fascinating stuff. That spreadsheet could be used to help a lot of people save a lot of money. After they see this, *then* show them what it would look like if interest rates went up, to show them what the resale market is likely to look like in a few years. It's easy to convince folks that interest rates are on the way up, but not that house prices are vulnerable to them.

Just out of curiosity, where do maintenance fees figure into this? I assume they're the HOA fees? Here in NYC, it's impossible to imagine a condo like the one in your example with maintenance of less than $400/month, with $550+ being a lot more likely. At $400, the AMT and regular savings don't go into positive territory for 13 and 15 years, respectively.

Nicholas Weaver said...

HOA/Maintinence is assumed to be $250-350. Its a lot cheaper here than the NYC prices, but still significant. The last one I queried on was $350, but included some level of earthquake insurance.

But HOA costs are one of those things that worry me when buying, because they are unpredictable.

nsk said...

A good idea is to build a house or buy one in a low-price rural area, and live in a rented house in the city. This way you will have the best of both worlds :)

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