“Once again large segments of the population have come to believe that they have found the way to unending wealth by doing little or no real work.” – Anonymous
When I first moved to Florida around 2005 real estate was on everyone’s mind. It seems that no matter where I went, everyone I met talked about planning to buy a property or about the property they just bought. Everyone was expounding the virtues of owning a home. They would go on about what a great investment it is, how prices on houses have never gone down and why I should buy immediately!
There were a few things I remember that really bothered me and made me believe that this would all end badly. Looking back, I was probably the only person in Florida who felt this way in 2005 but as Warren Buffett says “You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.”
The few things that really stuck out to me during that time were:
There were just too many people mouthing the same clichés about the virtues of buying a home. My question was always, “Why now?” Where were these people 10 years ago when prices were more than 25% cheaper? If today is a good time to buy, then ten years ago was even better. Where was the enthusiasm back then?
The arrogance of real estate agents. I specifically remember looking at a few properties and it seemed like the real estate agents felt they were doing me a favor by showing me the property. I have always found that whenever you buy something from someone who feels they are doing you a favor by selling to you, there is a good chance you are over paying.
The rule about investing is to be greedy when others are fearful and fearful when others are greedy. There was way too much greed in 2005, which was a sign to me to be fearful.
But the straw that broke the camels back was when I remember reading a news story about a few strippers who stopped stripping because they were making more money flipping houses. A good rule of thumb is that anytime you hear news stories about strippers getting into a new line of work be it Flipping houses or Day Trading odds are there is a bubble. That is not to say that all strippers are stupid or uninformed, (having dated a few). But it does mean that when the mainstream media starts doing stories which ties strippers with particular hot finance topic of the day chances are that we have jumped the shark.
Needless to say, I did not buy when I first moved to Florida. I chose to rent and I am still renting now. However, I’m starting to think about buying for the first time since living in Florida seeing that the prices are starting to look fair.
So how do you decide when is the right time to buy a house? How do you decide what is a fair price to pay for a property? How do you avoid a bubble? There are a number of indicators such as price to income ratios, debt to service ratios or price to rent ratios which can give you a rough idea if you are purchasing a property at a fair price. All of the above are a bit complex since they require some digging to come up with the numbers and only give you a rough approximation for the area.
Below is my simple back of the napkin 3 step formula to help determine what is a fair price to pay for a house or condo and takes less then a two minutes to determine.
Step 1: Forget all the clichés about a house being a great investment and that prices will keep going up. That is simply not true. Robert Shiller, who looked at home prices for over a century, has found that houses increase in value at roughly .2% above inflation. That is all. Assume that anything you buy will appreciate with inflation, anything above that is wishful thinking and luck.
Below is inflation adjusted Real Estate prices through 2Q 2012. As you can see prices are only now getting closer to historic averages.
Step 2: Determine the property you want to buy or something very similar in that area. Then look up historic sales prices on Zillow.com. Find the price of the property you are interested in (or similar) and look at what it sold for around 1992 to 1996 year range. This is a safe range to look at since those are U.S. pre-bubble prices and are a lot more accurate.
Step 3: Go to inflation calculator and plug the price the house sold and the year to determine what that means in today’s dollars. Assuming that no major renovations have been made to the property this is a fair price to pay for the house or condo.
It’s that easy. You are basically taking pre-bubble prices and assuming the housing appreciated with inflation. If you were to do this during the real estate bubble, you would see that prices have shot up over 25% above inflation prices in almost all the areas of the country and we are in a huge bubble. Then again, the housing bubble was like any other bubble in finance and was never about logic or reason; it was about greed and delusions.