Conventional wisdom states the three most important things in real estate are: location, location, location. This wisdom is especially true today since market fundamentals and local conditions vary greatly across the US. Thus, not surprisingly, the answer depends on location.
Nationally, homes look overpriced, but there can be great variations on a regional or even neighborhood level. To gauge the sustainability of home prices within a metropolitan area generally, I suggest looking at measurements of market fundamentals such as unemployment, job growth, income, rental values, population levels, and mortgage rates. For example, Fitch Ratings measures how well a given metropolitan area’s home prices are doing relative to fundamentals such as these. Its ratings range from undervalued (examples: Atlanta, Chicago, and Cincinnati), to sustainable (examples: Boston, Cleveland, and Dallas), to unsustainable (Los Angeles, San Francisco, and Washington, DC). For more information on Fitch Ratings metro area ratings click here.
To gauge the sustainability of home prices at a neighborhood level, compare the home’s sale price to what it would cost to rent. In the past, rental estimates for individual single-family homes were hard to find. Today, a prospective buyer may go to Zillow.com and look up a Rent Zestimate for tens of millions of individual properties. By dividing the annual rent estimate by the home price you are able to calculate a home’s gross yield. For example, a $250,000 home with a rent estimate of $1,500 a month, would have a yield of about 7.2%, before home ownership costs. As a rule of thumb, a yield of 8% or more means the home is a relative bargain, below 5% and the home is overpriced, and for between 5% and 8% a buyer should plan to stay in the home for at least five or six years and either put a little more down or pay the loan down faster.
For a more in depth look, you might do an analysis that considers the costs of buying versus renting over time. For example, The New York Times has an on-line Interactive buy-rent calculator. It allows you to input a number of cost and benefit variables for buying and renting and calculates whether you will be up or down after six years. Of course, this is a projection and is heavily dependent on your assumed annual home price appreciation rate. Also keep in mind that combined transactions costs involved in buying and selling a home will likely total 10 percent of the purchase price. While the NYT calculator considers these costs, it is assumed you will own the home for at least 6 years. A shorter ownership period will negatively impact the benefits of owning.
Finally, I would be careful not to buy more house than you can comfortably afford. The vast majority of home buyers take out a loan to pay for much of the purchase price. Most real estate professionals get paid a percentage of the sales price, so it is in their interest to put you into the most expensive house for which you qualify. Martin Luther King recognized the problem of living beyond one’s means in his 1968 “The Drum Major Instinct” sermon. This is still good advice today. A simple way to gauge the riskiness of a 30 year fixed rate loan you may be contemplating is to go the HousingRisk.org using this link: Table of Risk. All you need is your loan-to-value (home value minus downpayment), FICO credit score, and total debt-to-income ratio. For example, a 90 percent loan-to-value loan with a 720 FICO score (this is the median score for all individuals in the US), and a total debt ratio of 30% would have about a 5 percent chance of default under a serious real estate correction. On the other hand, a 95 percent loan-to-value loan with a 660 FICO score, and a total debt ratio of 42 percent would have about a 22 percent chance of default under a serious real estate correction.
In general, I would expect home prices to be more volatile going forward than during the period 1950-1995. Today’s buyer can’t expect to buy now and get an equity windfall in only a few years. Prospective buyers looking to purchase a property, which will serve as a home for years to come, should do their homework on the true value of the home and the home price volatility in the region before making what is likely to be one of the major financial decisions of their lifetime.