How to Buy a House at the Right Price

The housing market is making a comeback in many parts of the country.

According to the U.S. Department of Commerce, sales of new houses increased by nearly 12% overall during 2014—the most since 2008—as interest rates remain at historic lows. RealtyTrac, a company that analyzes national housing data, also notes that 2015 marks the first wave of boomerang buyers—those who served their time in the damaged-credit diaspora after losing homes to foreclosure seven years before.

As hopeful as all that seems, though, harsh memories endure of a real estate crash that saw some property values decline by 50% or more. So it’s not surprising that two fundamentally important questions are on the minds of an understandably cautious public: Can home ownership once again be viewed as a “good investment?” And, if so, what constitutes a “fair price” when values are on the upswing?

First things first: If your principal goal is to generate a rate of return—say from renting out the property and/or its appreciating value over time—then your decision deserves to be made with as much care as it would for any other financial investment. But if your motivation for buying a house is to set down roots, it makes more sense to base your decision on the relative value of the property, and its potential to keep pace with—if not to surpass—the rate of inflation, all future upgrades taken into account. Here’s what I mean by that.

What Is a Good Investment?

Eight years ago, my mother reached the point where she required around-the-clock care in an institutional setting. Given the high cost, my siblings and I concluded that the best course of action was to sell her house —the same house she and my dad bought 38 years before.

Fortunately for my mom, the market hadn’t yet turned, and the sale yielded a significant amount of cash profit—a little more than seven times the property’s basis (i.e. what my folks paid for the place plus the improvements they made over time).

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After finalizing the sale, one of my brothers shook his head in wonder and said, “Boy, Mom and Dad sure made a great investment.” But was that really the case?

As it turns out, the rate of return on that so-called investment amounted to 5.19%—roughly on par with the yield on then-current 30-year Treasury bonds and only about a half percent better than the Consumer Price Index rate of inflation over the same period. Certainly not the level at which you would expect an investment to perform but, then again, there was nothing speculative about my folks’ decision to buy that house—their goal was to find a place for us to live.

The key consideration for my parents, however, was no different from what it is today for house-hunting consumers: to strike a deal at the right price.

A Straightforward Way to Compare

Real estate agents often talk about comparative values, or “comps,” where the prices of recently sold and currently listed properties within close proximity are used to justify a particular house’s asking price. Although that can help give you a sense for a community’s general affordability, it’s not nearly as precise as you should want for a big-dollar expenditure.

Fortunately, there is a better way to assess relative values.

Start by separating all the outlays that are associated with home ownership into three categories: acquisition, ownership and operating.

The acquisition cost is just that—the purchase price plus any fees or charges that are unique to the transaction. Ownership costs are annually recurring expenses, such as for property taxes and homeowners insurance. Operating costs include for utilities (electric and non-electric fuels), water (if publically supplied) and, to the extent that it may vary between properties, for cable, trash pickup (if privately arranged) and property management (if you plan on subcontracting that). The real estate agent or broker should be able to provide most of this information.

Then, divide the sum totals for each of these three categories by the square footages of the various structures under consideration (factoring in the size of the lot may complicate matters) and you’ll be in a position to evenly compare their relative values, three thought-provoking ways.

Not only will that help you to negotiate for a “right” price for the property you want, but you’ll also have a head start on creating a monthly budget once you’ve included the principal and interest components of your monthly mortgage payment (don’t double-count the escrowed real estate taxes and insurance) and provide for routine repairs and service contracts.

Incidentally, this approach works equally as well for rentals. Simply swap out rental payments for the purchase price and divide by square feet. And, as always, take care to limit rental and mortgage payments to no more than 25% of gross income so that you have enough left over to furnish the place. There are free online calculators such as this one that can help you to estimate how much house you can afford.