This is a follow-up to my post on calculating the buy/rent trade-off of housing, which produced a model to determine if you should:
- Buy property (with a fixed-rate, 20% down payment mortgage) OR
- Rent like-kind property and divert your saved money (from no down payment and reduced monthly payments) into the stock market.
I applied the model to higher-end (>$1.5M) houses in my home area, the San Francisco Bay Area, a market which shows signs of a speculative bubble:
- Rents are roughly flat over the last two years, but home values have jumped ~17% (source).
- After the “Tax Cuts and Jobs Act” passed, buying, relative to renting, became about 10% more expensive for a typical married buyer due to reduced tax incentives for homeowners. However, buyers seemed to have ignored this — prices continued to rise, even accelerating.
- Overall, combined with increasing mortgage rates, buying is over 30% more expensive relative to renting than it was 2 years ago!
First, let’s examine the market in more detail. The table below shows the following:
- Selected location with market information on Zillow (e.g. Millbrae)
- Median Home value (Median “Zestimate”)
- Median Rent (Median “Zillow Rent Index”)
- Median Price/rent ratio (home value divided by rent)
As noted earlier, the calculation of whether to buy or rent is highly affected by both housing and alternative investment returns; let’s determine what the market is anticipating to warrant these (rather high) price/rent ratios.
Each pair of returns in a given situation was plugged into the calculator³, with the break-even price/rent (P/R) ratio determined⁴ (with a $700/month HOA fee and no HOA fee). I added an additional row for a “weak market going forward” to showcase pessimistic stock and housing projections⁵.
Remember, you only buy if the market offers a P/R below the break-even; otherwise you rent:
All told, current P/R ratios imply the market having very rosy housing return assumptions going forward (e.g. abnormal returns of past 5 years continuing indefinitely). Under most plausible return scenarios, housing is overpriced in every examined market, from 10% (cheaper ones) to 40+% (more expensive ones).
(Given how high both stocks and home prices are right now, I view the 11 year — peak to peak — as most likely, which puts San Francisco at 20% overvalued and Palo Alto/Cupertino >90% overvalued.)
My own hypothesis is that the last few years of appreciation are being driven by a combination of low inventory (for whatever reason) resulting in the clearing price being set by would-be owners who see substantial inherent value in owning vs. renting, perhaps combined by a speculative feedback loop of “prices are shooting up; buy now or forever be locked out”. But that’s another post altogether. A few final thoughts for now:
- If you don’t place significant value on owning over renting, it’s a poor use of funds to buy in the Bay Area at current prices. You are speculating on abnormally high returns continuing and likely will perform much better renting, placing the amount saved in alternative risky investment sources (stocks, real estate investment trusts, etc.).
- Not only does housing have poorer returns than stocks, but under leverage, it’s also riskier. The S&P 500 might have fallen 50% in the Great Recession, but a home that falls 25% (typical numbers then) with a 20% down payment is a 125% (!) loss on the down payment.
- Believe the tech boom is causing price surges and that this tech boom will continue? Rent and invest your savings in tech companies; for the last 5 years, while the housing market grew 10% annually, VITAX returned 20% annually; such appreciation rates have a break-even P/R of about 20.
- My claim the market is “overpriced” shouldn’t be taken to predict that prices will fall. It just means that alternative investment allocations (of similar risk) deliver better returns than buying a single-family home; the market might hold these excessive P/R values for a very long time.
 Using the high-price tier home price S&P 500 Case-Shiller Index. Both housing and investment intervals tracked to December, 2017 (last date the Case-Shiller data is available) and annualized. These are top-line returns, not factoring in mortgage leverage (which the buy/rent calculator handles). There’s a deeper question of how plausible it is for the high historical returns (5.4%) to even continue — given all the talk of a housing crisis these days and more political action now to fix it, it seems more plausible that future rent increases will actually be lower in the future.
 Using S&P 500 returns with dividends re-invested. Both real-estate and market returns calculators aren’t accounting for taxes (real-estate returns don’t factor cost of selling, stock market returns assume portfolio is in a tax free account).
 Calculator uses default values for all inputs, unless otherwise mentioned. Notably, this means a fixed rate mortgage at 4.63% APR with 20% down payment. In all scenarios, home appreciation was set equal to rent appreciation, which should be expected in the long-run. (If you believed home returns will be faster than rent increases, as has been true recently, the break-even p/r is even lower — that is renting is more favored).
 Break-even P/R is calculated using the 1st output model of my calculator — never selling. This tends to align with the sell in a few years in the future model, except under very high house appreciation.
 The weak home returns are my own assessment; I’ve placed them a bit north of inflation (2%) and at half of investment returns, which if anything, I view as optimistic in an economy only generating 6% returns in the stock market.