My fiancée and I thought that we were so close to home ownership. After nearly two years of house hunting, countless home tours and six rejected offers, last week we were finally first time home buyers under contract. 15 months ago I expressed my frustrations with the state of the housing market when I wrote a reminder to myself and others not to fall for the home ownership FOMO that the pandemic brought. The real estate market has only gotten less hospitable since then, as mortgage rates recently breached 4% and prices are still at all-time-highs, denting affordability. But we exercised patience, kept our cool, and slowly submitted offers for what we thought homes were worth to us, knowing all it took was one to stick.
This real estate market since coronavirus hit has been defined by a new paradigm of behaviors from buyers desperate to make their offer stand out. Bidding above asking price with escalation clauses. Completely waiving their inspection and taking on the financial, health, and safety risks of whatever issues the house may have. Completely waiving the appraisal, in which case a buyer must bring as much cash to the table as is needed between what they paid for the house, and what the lender thinks it’s worth. Huge earnest money deposits to show your serious commitment to the seller by putting some skin in the game — break the contract and it’s forfeited.
One thing we’ve never been willing to do is fully waive any of these contingencies. As a result of that we lost bids time and time again to people who paid a little bit higher than comparable homes would suggest, completely waived their appraisal, and lastly (but also most importantly for sellers of the 70 to 120 year old homes common in my area) waived their inspection. These contingencies exist to protect buyers from information asymmetry; the seller knows a lot more about their home than you do after a 30 minute tour. Those people waiving contingencies and offering huge amounts over asking make their offer stand out to sellers, since they’re either definitely buying that house, or if they can’t perform and have to walk away the seller gets to keep their earnest money deposit due to the buyer waiving all options to cleanly exit the contract.
We’ve walked the line with some of these, knowing that it’s a complete waste of time to submit offers for homes in our area at asking price with full contingencies. You will never win over the 6 to 32 other offers (which is the actual minimum and maximum number of offers on the table in all seven homes we have offered on). So we’ve done things like offering over list price when we can find comparable sales to support the number, offering a $20–30k appraisal gap when we’re pretty sure it will appraise (but fully prepared to pay up if it doesn’t), and offering to cover the first $5–10k of inspection repairs out of pocket before asking the seller for a credit.
In the end this behavior degrades the integrity of the real estate market for all buyers, but we tried to find a balance between submitting competitive offers for what we felt a home was worth, while trying to make that offer fully define the risks on our end. We knew we’d probably lose offer after offer because we weren’t waiving everything, but hoping it was a numbers game and one would break through eventually.
Our winning offer
The home was priced far below comps so I mainly used price per square foot plus some other adjustments to arrive at what I thought was a fair market value, but wouldn’t make it the most expensive home in its market segment. This ended up being about 11.7% over the asking price, and we also offered an appraisal gap of $30,000. For a sanity check I compared the monthly mortgage payment and opportunity cost of the down payment plus worst case appraisal gap and it came out to a similar figure to comparable rental prices in the area. In our local market, renting is typically cheaper than owning so getting a par value deal is actually quite good, despite this offer sounding utterly insane at face value.
We also offered $20,000 in earnest money, half to be delivered upon acceptance of the offer and the rest to be delivered when signing the purchase and sales agreement.
Most importantly we kept our inspection contingency, promising to cover up to a maximum of $10,000 in total estimated repair costs potentially found during the inspection.
I was sure that since this offer made complete mathematical sense to me as a fair value and risk mitigation strategy that some other irrational market participant would come completely blow it out. To both of our surprise on Valentine’s Day 2021, we finally got the notice that our 7th offer on a home was accepted. We scheduled our home inspection for that Friday morning, trying not to get too attached to the house because it wasn’t a sure thing yet.
The home inspector reveals all
We were recommended a great inspector, this guy was seriously awesome. He explained to us everything he was doing, let us ask questions, and taught us a lot of stuff to look out for next time we tour a house. He spent 3 hours inspecting a small starter home.
The inspection started out okay in the interior spaces and then gradually got worse as he moved to the exterior and finally the crawlspace under the home. Here’s most of the big issues we encountered:
- The house had newer cedar clapboard siding, but someone had installed the new siding over the old siding rather than removing it, leading to loose boards and other potential issues.
- The gutter fascia boards were in the early stages of rotting, likely leading to moisture in the attic.
- Chimney leaking into the attic.
- Likely mold in the attic, probably from aforementioned moisture issues.
- In the crawlspace, someone had installed the insulation backwards so the vapor barrier was trapping moisture against the structure of the house.
- Rotting joists in several areas and rotting subfloor under the bathroom, requiring structural repairs and a complete tear-out of the bathroom to remediate.
- The seller lied about the age of the furnace and it was actually six years older than they claimed and very close to end of life.
- More mold in the crawlspace; inspector recommended installing a vapor barrier and pouring a foundation under there after remediating the mold to address the root cause.
- Temporary jacks appeared to have been adopted as permanent support to hold up the home in several areas, but were not properly installed for the job and just sinking into the dirt.
We’re not savvy when it comes to houses but not oblivious either. None of these issues are things we picked up on during the home tour (although half of the issues were in the crawlspace which we weren’t about to crawl around in during the tour).
Assembling quotes from the internet and from general contractors we know, we estimated around $50,000 to address all of these issues minus the siding. And this isn’t stuff like a kitchen upgrade where you can generally wait until you have the money and are ready to get around to it. Mold is a serious health risk and would need to be addressed immediately. And if you notice, all of the issues are generally related to moisture, so proper remediation of the mold involves correcting the root moisture issues at the same time. Essentially we’d be looking at paying most of that $50k bill right off the bat just to make the home habitable and structurally sound.
Imagine if we had waived inspection like so many people are doing in this market?!? $50,000 simply evaporated into thin air! Instead we were out $500 for a home inspection, cancelled the contract and walked away.
The opportunity cost of paying for somebody else’s deferred maintenance
In my mind it didn’t particularly make sense to negotiate, since money spent out of pocket today isn’t financially equivalent to a 1:1 discount of the repairs off the price of the home. We would have had to get a much better deal on that home, lower than the list price to justify sinking that kind of cash into a starter home.
Say the seller discounts the loan by the cost of the $50k repairs: we’re saving that amount plus interest amortized over 30 years, plus a few thousand dollars from the slightly smaller down payment required to hit an equivalent loan-to-value (LTV). At a 4% mortgage rate that’s $86k less in total payments over the life of the loan, plus $10k savings for what you would have put down on that additional $50k balance at an 80% LTV. You invest your $10k into an index fund yielding 5% real return which becomes $43k after 30 years. Total savings of $129k in this scenario.
We got our discount from the seller, so now we go spend $50k out of our own pockets to do the repairs when we move in. But the opportunity cost of spending that money today (compared to an equivalently priced home that doesn’t need repairs) is far higher. $50,000 invested for 30 years at a 5% real return results in $216k. If you end up getting 6% or even 7% real returns over the long-term, the gap widens even further compared to the fixed 4% mortgage rate. But let’s just use 5% for a conservative assumption.
For these $50,000 worth of repairs, we would actually need about an $84k discount on the price of the home, which results in a $144k savings in mortgage payments and interest plus the result of $16,800 in reduced down payment savings invested at 5% interest for 30 years which comes out to $72k. These two savings figures sum to the $216k opportunity cost of spending that $50k in repairs out of pocket today.
We could make the model more complex by investing and compounding the monthly mortgage savings as they are received, which would make the required home price discount slightly smaller. More simply however we can condense this down and assert that as long as one expects the real return of a stock market index fund to be larger than the interest rate on a fixed rate mortgage, logically the fair price discount on a home needing repairs is larger than the nominal cost of those repairs when compared to the price of a home which does not need such repairs.
We backed out, and someone else is probably getting screwed big time
Since our offer on the home was based on assuming it did not need significant repairs, logically we should have requested this $84k discount, minus the $10k in repairs we promised to cover. However that would have taken us about 6% below list price, and since they already had 5 other offers at or above list price (one or two of which waived inspection, their agent had slipped to ours earlier in the bidding process) we knew they’d never negotiate for even the full price of the repairs, let alone the opportunity cost premium that we should have logically demanded.
So rather than waste our time we cancelled the contract, requested the return of our first earnest money deposit and walked away. It’s been four days since we cancelled, and the property never went back listed on the MLS to solicit more offers; it’s still pending. Which makes me almost certain they went back to another bidder slightly lower than us who waived the inspection. I doubt that they have any clue what they’re in for, but that’s the risk you take when you waive a home inspection.
The housing market still sucks for first time buyers
Right now the housing market is in a weird place. Data points from sales that went under contract two months ago are coming through as comps, but those buyers got 3.25% interest rates, whereas mortgages today are around 4.15%. On a monthly payment basis, that difference is about a 10% reduction in buying power. So if you’re buying a home today based on the price of comps over the last 3 months, you’ll have about a 10% larger mortgage payment than if you had bought the same home in December 2021.
There’s a well-established inverse relationship between asset prices and interest rates. With real estate, most buyers are primarily “buying the monthly payment,” which then determines the price of the homes they can afford. When interest rates drop as they have pretty steadily for the last 4 decades, this provides a huge tailwind to home price appreciation since for the same monthly payment, buyers now have more purchasing power. Conversely for each 1% increase in interest rates, buyers have about 13% less purchasing power with a 30 year fixed rate mortgage. Servicing a $400k loan at 3% rates, has the same monthly payment as a $350k loan at 4% rates.
This graph that I plucked from a Redfin article is quite poignant:
Looks sustainable! I don’t advocate timing the stock market, but the housing market is in such a bad place for first time buyers that it’s hard to believe it can get much worse. In addition we’re seeing the winding down of an unprecedented stimulus and asset inflation program from the government and Federal reserve, much of which was either directly targeted at, or in a roundabout way ended up in housing.
Mortgage forbearance and rental eviction moratoriums artificially restricted the supply of homes. At the same time the Federal Reserve bought nearly $1.5 trillion in mortgage backed securities (MBS) since the pandemic hit, juicing lower mortgage rates than even a 0% Federal Funds Rate would support. People were getting sub-3% mortgages at the height of this scheme, and now as the MBS purchases are tapering off (though still occurring to the tune of $45B in January) we are seeing the true rate that the market will pay for these loans right now is well over 4%. Maybe even close to 5%, which is where mortgage rates peaked in mid-2018 when the Fed engaged in their short-lived balance sheet reduction and were overall net sellers of MBS.
There’s further anecdotal evidence all over housing forums right now that quite a few couples under forbearance on their student loans who remained employed during the pandemic used those savings to craft a down payment and dumped it into the housing market out of desperation that it would be their only shot. I’m no expert, just a layman economics enthusiast, but I’d have to bet that this “preemptive stimulus” play will go down as a great blunder in Federal Reserve policy.
Perhaps the biggest indicator that this housing market is overheated is a deep look at our own financial situation — we are top 10% household earners for our area and far above average (obsessive even) with saving money. Financially speaking, we shouldn’t have to think twice about buying a home that meets our goals. But here we are, and it makes little sense to me.
Waiting for home prices to decrease isn’t the right play if you can afford to buy now and it makes financial sense to do so compared to renting. But taking on huge financial risks like waiving a home inspection to win an offer isn’t the play either, unless you’ve got some particular professional expertise in evaluating the condition of homes.
We’re continuing to save up cash for a down payment in addition to our normal investing regimen of maxing out our 401k’s and Roth IRAs. We are closing in on having 20% down plus closing costs. Even if higher mortgage rates don’t cause home prices to fall as I theorize they should, having a higher down payment is one way to brute force a desired lower mortgage payment. I’m confident that with continued frugality, efforts to save, and attempting to make smart financial decisions we will come out just fine in all financial areas in the long run, including home ownership. For now, patience will have to suffice.