I want to speak candidly to anyone who wants to buy a home.
You’re facing three problems:
- Home prices are high
- Interest rates are high
- Inventory is low
None of these are going to get better anytime soon.
But there’s good news: You can buy a home, as long as you’re smart about it. By the end of this email, I’ll demonstrate how.
First, let’s understand the problem.
High home prices: From 2020 to 2021, home values nationwide rose 17 percent on average. Prices have risen by around an additional 5 percent every year since.
Here’s a chart of home prices over the last 12 years:
Home values nationwide rose 5.8 percent annually from 2012 to 2020. Mortgage interest rates were at historic lows.
This period is known as the ZIRP Era, or zero-interest-rate-policy era, as the Federal Reserve kept short-term interest rates near zero. Those low rates fueled this steady rise in home values.
After 2020, as you can see on the chart, home values skyrocketed beyond precedent.
Why did prices rise so much?
Simple supply and demand. Inventory is low.
“The United States suffers from a severe housing shortage.” — Freddie Mac report
Why is inventory low?
Builder speculation was at a frenzy from 2000 to 2007, as evidenced by the number of new construction permits granted. Many of these speculators went bust during the Great Recession of 2008.
Lending standards tightened in the wake of the recession, making capital harder to access for speculative new construction projections. In addition, many cities enacted legislation limiting density and restricting the construction of multiunit properties in specific neighborhoods, in a NIMBY effort to preserve the values of single-family homes. And it worked. Too well.
New construction declined from 2010 to 2020, drying up to such an extent that in February 2020, a dire report issued by Freddie Mac warned that “The United States suffers from a severe housing shortage.”
The report called this a “major challenge” and estimated that 2.5 million new housing units would be needed to bridge the gap between supply and demand.
Then the pandemic struck. Massive supply chain disruptions led to the cost of underlying materials, notably copper and lumber, to skyrocket.
Since lumber, in particular, comprises a major cost of construction, building new homes became cost-prohibitive. This exacerbated the already-severe supply shortage.
Additionally, the sudden boom in corporate work-from-home policies allowed many knowledge workers to re-locate, driving up demand at the exact time that supply was already constrained.
That was the perfect cocktail for a 17 percent year-over-year rise in prices, as we saw in 2020 and 2021.
Home prices weren’t the only cost that rose during that time. Inflation peaked at 9.1 percent in June 2022, which was a 41-year high.
Inflation is often characterized by a wage-price spiral: prices rise, therefore workers demand higher wages, therefore labor costs rise, therefore prices rise further, and the spiral continues fueling itself.
(Here’s a podcast episode with a deeper explanation of inflation. If you’re into comics, here’s an illustrated series that we created at the peak of the inflationary era.)
High inflation means that the cost of building a new home — again, everything from materials to labor — is more expensive, which puts pressure on builders. But there’s another cost that disincentivizes builders from building: interest rates.
The Federal Reserve responded to inflation by issuing 11 rate hikes, culminating at an overnight benchmark rate of 5.25 to 5.5 percent, which the Fed set in July 2023.
(Nerd tangent: Interestingly, even though the U.S. Federal Reserve is — obviously — totally independent from the Bank of England, the central bank in the UK also set a 5.25 percent interest rate, which is a 16-year high across the pond. For economics watchers, that’s a fascinating data point, because econ-nerds such as myself are monitoring which central bank will indicate a rate drop first. Recently, the Bank of England’s Monetary Policy Committee predicted that the UK would reach its target 2 percent inflation rate within 2 years, which might be a hint at rate decreases on the horizon for next year. TBD.)
Ahem. Where were we? Right —
The Fed, which meets eight times per year, has held rates steady since July 2023, and the indications from their most recent meeting point to an expectation that they’ll continue to hold rates steady for the foreseeable future.
That’s not what we used to think.
Back in January 2024, investors and analysts were speculating that rates might start to decline in Q2 or Q3 of this year. Yet inflation has remained persistent. Employment is strong, and there’s no evidence of a recession.
As a result, many investors and analysts (myself included) now believe that rates won’t decline until Q4 at the earliest. Or even 2025.
While this is a useful tool for controlling inflation, it creates further constraint on the housing market
Why?
Three words: Lock-In Effect.
The majority (around 70 percent) of homeowners with mortgages have locked in rates of 4 percent or lower. This gives them an incentive to hold.
The result?
Home inventory has collapsed on two fronts: the sale of new construction AND existing homes.
There are fewer homes available. And, because supply is scarce, these homes cost more.
We’ve established how we got here.
Next, let’s address: what should we do?
Step One:
Figure out if you live in an area where it’s better to rent or own.
How? Calculate the price-to-rent ratio of your home or neighborhood.
The price/rent ratio (P/R ratio) is home price divided by annual rent. You can calculate this ratio to assess an individual property, or to assess aggregate data about a neighborhood or a city.
The smaller the zone (e.g., calculating the P/R ratio for a specific zip code rather than an entire metropolitan area), the more specific and applicable your result will be.
The lower the P/R ratio, the stronger of a case for ownership. The higher the P/R ratio, the more attractive the option of renting.
Typically, a price/rent ratio of:
- 15 or less is a fantastic purchase.
- 16-20 is grey zone.
- 21-25 or more is darker grey zone.
- 25 is don’t-buy-this-property. Rent this.
Let’s walk through three examples.
Example 1: Slam-Dunk Ownership
A duplex costs $300,000 and rents for $1,500 per month per unit. The denominator, therefore, is $1,500 * 2 * 12 = $36,000 in annual rent.
The P/R ratio is $300,000/$36,000 = 8.33, an absolute slam-dunk case for ownership.
Example 2: Grey Zone
The same $300,000 duplex rents for $750 per month per unit. Annual rent is $750 * 2 * 12 = $18,000.
The P/R ratio is $300,000/$18,000 = 16.6, which is generally good, but I’d consider this a grey zone depending on your personal circumstances (e.g. how long you plan to hold the property, etc.)
I’d dig further into this “rent vs. buy” question using a more robust calculator, like the recently updated NYTimes Rent vs. Buy Calculator.
Example 3: Slam-Dunk Please-Don’t-Buy-This
That $300,000 duplex rents for $500 per month per unit; annual rent is $12,000.
The P/R ratio is $300,000/$12,000 = 25.
If you’re renting in a neighborhood with these types of numbers, remain a renter in that location.
“I don’t understand … why? Isn’t it always better to own your own home?”
Nope. Look at it this way:
The P/R ratio shows you how much home value you can rent for $1,000.
In a neighborhood with an average P/R ratio of 25, every $1,000 in rent will get you $300,000 worth of home.
In a neighborhood with an average P/R ratio of 8.3, every $1,000 in rent will get you only $100,000 worth of home.
Therefore —
The renter in a P/R 25 neighborhood is getting triple as much value for their money as the renter in a P/R 8.3 neighborhood.
Typically, high-cost-of-living cities (HCOL’s) will have P/R ratios that strongly favor renting. In Manhattan, for example, every $1,000 of rent gets you more than $600,000 worth of home.
Here’s a YouTube livestream in which I break this down:
So —
Step One: Calculate
Figure out if you live in an area where it’s better to rent or own, by calculating the P/R ratio of either your individual home or your aggregate neighborhood.
Step Two: Choose
—> If you live where it’s better to rent, then continue renting your personal residence. Buy rental property out-of-state.
This strategy allows you to diversify your portfolio and hold real estate in the areas where it makes sense to own. This is the Invest Anywhere philosophy, which I’ve discussed on the podcast.
—> If you live where it’s better to own, then accessing homeownership is a matter of saving for a downpayment (which comes from classic personal finance principles).
If that seems out-of-reach, or if it’s taking too long, then try househacking.
Househacking allows you to buy a property with multiple units, live in one, and offset the costs by renting the others.
You could live in a single-family home with an accessory dwelling unit (ADU), casita, guesthouse, in-law suite, or basement apartment.
Or you could opt for a traditional multi-unit, such as a duplex, triplex or 4-plex.
—> If you live in a “grey zone”, OR if you live in an area that’s a slam-dunk for renting but you still desire to own for the sake of emotional and psychological benefits, househacking is also the strategy that can get you into home ownership as quickly as possible, for the smallest out-of-pocket cost as possible.
If you plan to buy (locally or out-of-state), sooner is better than later.
Why?
Marry the property, date the rate.
Lock down the property at its current price. Home prices are likely to keep climbing; many analysts expect prices in a year to rise by an additional 5 to 6 percent.
While interest rates are currently high, they’re not permanent.
Two mortgage options:
- Fixed-Rate Mortgage with One Free Refi: Some lenders entice buyers with a fixed-rate mortgage that includes one free refinance down the line. This allows you to lock in a potentially lower rate in the future.
- Adjustable-Rate Mortgage: These mortgages offer a lower initial rate that adjusts after a set period.
The Bonus of Forced Affordability
High interest rates might push you towards a lower-priced home initially. Once you refinance to a lower rate, your monthly payment can decrease significantly.
You can use this extra cash to accelerate paying off your mortgage.
During the last period of high interest rates (around 2001), one Afford Anything listener used that exact playbook.
