patrick.net

Being a big fan on MS Excel, I like to toodle around in it & manage my personal finances. I got into a little debate with my fiancee the other week over the value in buying a house and decided to work out some simple projections for myself (guys, you know what happens when you try to bring logic & data into one of those arguments). I figured I'd share some of the stuff I ended up with in the analysis. "Analysis" may not be the most appropriate term since I am not in professional finance or anything, and there are some huge assumptions in the spreadsheet. Nevertheless, I'd like to share some of this. Feedback is welcome, positive & negative. Keep in mind that I am not saying that buying is ALWAYS bad. I am just trying to illustrate that it is not a great plan with pricing what it is now, which is a pretty common these in here.

American culture today dogmatically holds a number of things to be true. Some examples are voting, working hard and taking care of family. Truly, these are important facets of our culture, and are part of what built us up to be the foremost power in the world. There is another common-sense notion that is also as prevalent as ever: buying a house is essential to living the American dream and having financial stability. This brief analysis is intended to question that notion and to reveal how challenging it can be for just about any upper-middle class (or below) household in the California Bay Area to remain fiscally solvent while owning a house. The data for this analysis was gathered from internet sources providing median income and pricing data for the Silicon Valley. The greater Bay Area also has price to income ratio issues, but data for the Silicon Valley will be used since it is generally where one will find the highest median incomes due to the high tech industry.

In this analysis, inflation is held at 3% over 30 years and applied to wages, rent, home maintenance costs, commute penalties & home values. Investment returns are held at 7%. No transient events are accounted for. Home & rental prices are based on summer 2011 median data for the Silicon Valley. In both cases (renting & buying), fictional couples of age 30, with net household income of $100000 & newborn twins are being simulated. Living expenses with children are assumed to be 70% of net income, with things like school tuition & cars averaged over time. After 25 years, the children are assumed to have finished college & be out on their own, dropping living expenses to 35% of income. Upon retirement, the couple that bought will sell their house & downsize to something half of the price, investing the other half of the money they obtained in the sale. Both couples are assumed to be fiscally responsible & save/invest any remaining money at the end of the year. Mortgage interest is also used to add to the buyers’ end-of-year balance for investment (25% of mortgage interest is added to income). Property tax increases at a maximum of 2% per year, as per CA Prop 13.

To start, Figure 1 shows the spreadsheet setup & inputs set to current nominal conditions. Notice that, assuming that both parents remain employed & wages rise with inflation every year, the buyer of the nominal Silicon Valley home will have a fair period of negative net worth. In cases where the buyer’s net worth is negative, it is assumed that they obtained a HELOC. In this case, they are given an ideal situation where HELOC rates remain at 4.5% indefinitely. The result of a median-earning family buying a median house in the Silicon Valley is decades of debt, and retirement 9 years after the family that rented a median property that saw 3% inflation in rates every year. The buyers are assumed to go into debt because in this model, it is assumed that they carry the same living standard as the renters in terms of living expenses, with real estate costs being separate for the buyers.

Figure 1 - Rent vs. Buy - 20% Down Payment + 2011 Nominal Conditions Over 30 Years

It is unlikely that the couple that bought would be able to obtain HELOC money in the amount indicated above since HELOC rates were set at 4.5% and the home was allowed to appreciate with inflation at 3%. Owning wouldn’t work, and the couple that bought would have likely foreclosed & rented.

Notice the discontinuities in the lines. For the renters (blue), the first one occurs when their kids move out in 2034. The second occurs at retirement, in late 2039. The buyers have these same two points (and at retirement sell their house), plus another one in 2040 when the house is paid off. These discontinuities will also be observed in subsequent figures. Both lines end in 2065, when the couples are age 85 & assumed to die. Retirement year is determined by the net worth a couple has that allows them to reach age 85 with as close to zero worth as possible (with 1-year resolution in everything).

In the next case, depicted in Figure 2, the buyer-couple decides to plunk down 3.5% instead of 20% as in Figure 1. All other parameters are held the same. In this case, it is even less workable. Mortgage interest drains the buyers’ incomes even faster, and no responsible bank would give them a HELOC in the amount required to work this out. Assuming that they were able to get the credit though, they would retire 11 years after the renters.

Figure 2 - Rent vs. Buy - 3.5% Down Payment + 2011 Nominal Conditions Over 30 years

Setting the down payment back to 20%, but adjusting HELOC rates to 9% shows that this living situation is even less workable in a case where interest rates increase. See Figure 3 for the plot. Interest rates in the early 1980’s were well over 10%, and there is no reason to believe that they could not rise to those levels again. As can be seen, the buyers almost do not get to retire. They retire 21 years after the renters, at age 75. That assumes that they are paid constant wages the entire time, which may be somewhat of a stretch on reality.

Figure 3 - Rent vs. Buy - 9.0% HELOC Rates

As some may point out, the model is simplistic and cannot account for transient events. Pay raises in high tech fields often exceed 3% annually. With the current economic climate, and with families typically having one parent work part-time or stop working, I chose to keep wages rising with inflation, with the intent of averaging out things like underemployment, unemployment & pay raises / bonuses exceeding 3% annually.

Up to here, this analysis paints a dismal picture of ownership. Readers should note that the dismal picture is painted using current pricing & wage trends. Prices have far outpaced wages in the Silicon Valley for the last decade or so. The next case to be studied will involve a 34% reduction in the median house price. This is illustrated in Figure 4. With this being the case, purchasing a house starts to make fiscal sense for a young family. Retirement comes at about the same time as the renters, and after downsizing they can own a house where the taxes & maintenance cost less than renting, allowing them to live off of a smaller accumulation of investments. So, as some people are beginning to realize, buying under the current conditions makes little sense. Prices need to drop if young professionals are expected to be responsible long-term owners or more than just debt.

Figure 4 - Rent vs. Buy - 34% Reduction in House Price ($500k vs. $760k)

As unpopular as this final case is likely to be, I would like to add it in anyway. Figure 5 shows both couples’ net worth when they do not have children. Both couples are able to retire in their mid-40’s & live off of their savings / investments. Most people think that a house is their largest financial maneuver and spend a fair amount of time planning around it, and have kids when they “feel ready.” It would seem, for a couple that wants to manage money, that children require far more financial planning than a house.

Figure 5 - Rent vs. Buy - No Children

Hopefully this brief analysis using a simple interest/inflation model can illustrate that buying a house can make sense if prices are more in-line with real wages. The current pricing levels are nonsensical, and many buyers today will be tomorrow’s foreclosures. Fiscally savvy individuals should continue renting and saving their money. For most people, the ultimate goal in life is retirement, whether they know it or not. Younger adults generally seem to focus on home ownership, and assume that it will somehow factor in to retirement. They need to sit down, go over the numbers and see just how a house fits into the puzzle. Our current pricing situation should be a clear sign that the American home-buying dogma needs hard questioning.

If you are interested in obtaining a copy of the spreadsheet used for the calculations in this analysis, you may obtain it from the following link. Instructions are in the spreadsheet.

SPREADSHEET LINK

#housing