The Craziness of Real Estate in LA

So, I had lunch yesterday with some friends.  These are close friends that we’ve known for quite a while.  It was nice, I haven’t seen them in a while, and they are moving into an apartment together. (CONGRATS!) Moving is just such a painful, excruciating time.  But, it came up that they want to buy a place and they are looking to buy something so that they can build equity and all this other blah, blah, blah.

The Mrs and I have our own thoughts on buying vs renting, especially around these parts.  Everyone that I talk to says

You have to buy around here, you’re throwing your money away by renting.  Real Estate ALWAYS goes up!!!

I mentioned that it just doesn’t make any sense to buy a house where we live, and I was scoffed at.  So, I figured I’d look into it and see if I was right.  So, here we go, Fun With Math:

Rule of 15:

This is just a rule of thumb (and as such doesn’t do a lot of detailed analysis), but it is a back of the napkin calculation of whether you should rent or buy in an area.  The basics say, if you take the annualized rent (12 * the monthly rent) and multiply it by 15 (or simpler take the monthly rent * 180) you get the approximate break even value of a home purchase between renting and buying.

Example:

You’re torn between renting a condo or buying one.  You can rent a place for $1,000 a month.  So:

$1,000 monthly rent * 180 = $180,000

So if you can buy something equivalent for less than $180K, it’s cheaper to buy.  If you can’t, it’s cheaper to rent.  Simple.

Back to our friends:

I asked for their address, punched it into Redfin to find this gem:

“This 1,400 square foot condo features 2 bedrooms and 3 bathrooms. This property was built in 1972 and last sold for $595,000 in July 2007. Based on Redfin’s data, we estimate the home’s value is now $650,476, which is 9.3% more than when it was last sold.”

I didn’t think this was possible seeing that every other property in this zip code is well into the 7 figure range.  Alas, there were other condos that sold right around this value in the same area, purchased as recently as a month ago.  So, there you have it, I don’t usually put stock in Redfin and Zillow’s property values, but seems reasonable, especially since this is higher than the comparison properties.

I didn’t ask what they are paying in rent, but I’d have to imagine it’s somewhere in the neighborhood of ~$2,000.  Sure, I’m guessing, but I know the area fairly well, and that seems reasonable.  So, the sniff test, the good ol rule of 15, how does that work on here:

$2,000/month * 12 = $24,000 annual rent
$650,000/ $24,000 = 27 (WHOA!)

That right there tells you there’s some more number crunching that needs to go on here.

Let’s play make-believe:

So, me and the Mrs. buy a lovely condo on the hill in July of 2007.  We’re so excited to move into our new condo.  HOORAY!!!! So what did we need to put down for this thing?  Let’s put down 15% like a good rational human being (not that there were many of these at that point in time) so that’s $89,250.  And we continue to pay our $2,130 mortgage payment, and our $386/month HOA (yes, this is from one that sold a month ago).  And we decide to sell it now, for the value that our friends at Redfin say it’s worth.

So what does this mean?  Well, we made $55,476 in appreciation on the house.  For a $89,250 initial outlay.  Not bad.  But wait…

What about the HOA?  $55,476 – $46,320 ($386 * 120 months) = $9,126 Profit.
What about our lovely agents to sell the house?  $650,476 * 5% = $32,523 Commissions = -$23,367 Profit
What about the interest paid during this time? $134,458 = -$157,826 Profit
What about the repairs (1% of the value per year)? $5,500 * 10 years = -$55,000 = -$212,826 Profit

But for simplicity’s sake, let’s just take the appreciation and compare it to something else.  So: $55,476.

So, what do we do instead?

How about we just take our money and rent?  Let’s take the $89K and just put it into VTI in July 2007 (right before the crash mind you):

Graph of VTI

The value in July 2007 is $72.05.  Today it’s at $120.23.  So, just that alone gives us growth on our $89,250 of $59,500.

Wait What??? I thought real estate was the way to go?  What happened to the leverage?

$59,500 > $55,576 – both of which are taxed at capital gains rates, btw.

This is without any other of the fancy math that goes along with it.  It also doesn’t include any of the auxiliary benefits of not having to hassle with property tax or repairs or any of it.

Yes, you could argue that there are Mortgage Interest tax credits that would offset this a little.  But, you could also argue that the rent would be substantially lower than the mortgage payment, so we invest that and it would grow considerably more, especially buying through the dip in 2008/2009.

 I think we’ll stay put

I just did a quick calc on our place, and we have a price/rent ratio of about 29.  Which basically means our rent payment is half of what the mortgage payment would be.  The real estate prices here are insane.

In fact, if you use Paula’s One Percent Rule, you would need 340 months to recoup the cost being a landlord.  That’s basically a 30 year mortgage, just to break even on buying our little house as a rental investment.  WTF?!?!  Something is crazy outta whack here.

I know… I know, this is just one example, and there are 50 others that would go the other way.  But, considering that is one of the more expensive areas in LA, I was kind of shocked. I don’t know if this is a one-off thing, or what is going on, but just thought I would share.  But, it’s definitely worth considering, if a primary home is considered a good investment.