Why you shouldn’t buy a home in the Bay Area right now

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 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.