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How Much Home Can I Afford?

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October 05, 2007 – Comments (2)

Spurred by a bit of debate in the post prior to this one, I've been playing with our Foolish home ownership calculators, using median, DC-area numbers, in an attempt to show just how out-of-whack home prices still are in this area, and why you need to believe in Fairy Tales to think they won't continue to tank.

Review:

Median Income: $63,000. Median Home Price: $400,000.

Use the Fool's "What Home Can I Afford?" Calculator.

Assuming a household is willing to pay 25% of income for housing (before maintenance and/or condo fees)

Result: By making a down payment of $15,000 and paying $1,325 per month, you will be able to afford a home that costs $171,289.

Hmmm. That's 43% of the median home price around here.

Assuming a household is willing to pay a full 50% of monthly income for housing (before maintenance and/or condo fees)

Result: By making a down payment of $15,000 and paying $2,625 per month, you will be able to afford a home that costs $330,739.

Hmmm. That's only 83% of the median home price. Better up my offer! Sure, that'd be more than half the monthly take-home, but after all, owning a house at any price is the American Dream! The TV and Radio and Newspaper (none of whom have anything to gain by playing carnival barker for the real estate industry, of course -- cough... advertising... cough) keeps saying so!

Or wait. Maybe I should just rent? Maybe that median price will eventually fall to match what people can afford with customary, non-toxic, mortgage loans?

Or perhaps our Foolish home calculators aren't yet calibrated to the "this time it's different" world of contemporary real estate beliefs?

Sj

2 Comments – Post Your Own

#1) On October 05, 2007 at 12:55 PM, saunafool (98.84) wrote:

The best metric I've found on whether a house is overpriced is the rental yield, outlined here. In a rational world, the rental yield should be roughly the same as the cost of capital, which is why when interest rates go down, home prices go up.

What this rational world ignores is that when home prices start going up, the lemmings begin to believe they will always go up and drive yields below the cost of capital.

In Bent's previous post, he points out that a typical home in his area costs $500,000 and someone can rent an equivalent or better space for $1700 per month. Therefore, annual rents on the property would be $20,400 and the gross rental yield would be 4.08%.

Take a look at the link. 4% rental yield is clearly overvalued. If you assume the yield should be 6.5% (roughly the cost of a 30-year fixed mortgage), the price for a property that rents at $1700 a month should be about $313,000.

Alternatively, rents could rise until the $500,000 price is justified by renting an equivalent space. In this scenario rents would have to rise to about $2700 per month before our $500,000 property would yield 6.5%. Assuming rents increase by an aggressive 5% per year, it will take almost 10 years before rents justify the $500,000 price.

My prediction: over the next 5 years, home prices continue to fall slowly and rents continue to rise. At that point, home prices will have fallen to about $400,000 and rents will have increased to about $2,000. Then, housing will be fairly valued with a yield of 6%. It might get cheaper, it might not, but at least at that level (or if you could find a deal earlier) you know you aren't totally getting fleeced.

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#2) On October 05, 2007 at 1:04 PM, TMFBent (99.82) wrote:

In this area at least, landlords are having a hard time keeping renters. There are "move-in specials" posted all over my neighborhood. I'm not sure how fat that extends, but I'll be surprised if rents rise to meet the level of mortgage payments.

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