You’ve solved one equation with one unknown a million times. For example:
$20 - 2 * $8.99 = X
where:
X = how much change you are owed after handing over an Andrew Jackson for 2 hot dogs at Wrigley Field.
In finance, this uneventful operation is dressed up with the word “implied”. Fix all the observable inputs to an option price and back out an “implied volatility”.
We imply lots of values. The probability of TSLA expiring below $250 by December 2025, “breakeven inflation”, or as my fundamental investor friend likes to refer to value stocks — “low implied forward ROIC” companies.
If you can effectively “normalize” the important inputs (not easy) so that there is only 1 implied value that acts as a statement about market expectations you are arbitrage-pilled.
My tone suggests that there’s something wrong with you, and to be clear there is, but I’m also a fan of doing this. It’s the heart of a replication mindset that is useful for isolating bets on the exact claim you want to make.
[Replication mindset is the bridge of asses that separates just-so storytellers from rigor. And even that bridge is fastened with some loose bolts, like the nuance between real-world vs risk-neutral probabilities.]
This is an obvious preamble to sharing that — I’m buying a house. I’m going to discuss the financial aspect of the decision in a moment, but I want to confront a few points of context and curiosity first.
- I’ve been renting an old but groovy house for the past 5 years since selling my old one during the pandemic.
- My in-laws (sis and bro) live next door including my niece & nephew and my MIL lives with us. The commune compound life is recommended if you love your in-laws! But we all rent so this was always gonna be temporary. The house we bought is in toy walkie-talkie distance so given one of us is moving it is a best-case scenario.
- This is the 5th home I’ve bought in my life — 4 of them have closed within a week of my birthday (and I can’t remember when I closed on the first one so maybe that was too). Weird coincidence.
- We have bid on a home probably every quarter for the past 2 years. Our agent’s effective hourly rate makes sense after what we put her through. She is heavily involved in a lot of the research and bloodhounding because every case has some weird hair on it. She sold our old house for us, sold one of my best friend’s homes the same month she sold ours, found us this rental which wasn’t even available to rent but through an old friend who was keeping it vacant, and even bought a home for a Moontower reader who asked me for a good agent when they moved to our area! I’m nonplussed by the average realtor but the real pros stand out. If you need one in the Lamorinda area, I know a gal 😉
- Qualitative reasons to buy:
- My eldest is going into 7th grade. We want to give him his own room.
- We want to be able to customize our space (we are going to build an ADU at the new place).
- A renter always lives with the sword of “we need the house back” hanging over their head.
All this said, how do we frame the finances and how does that relate back to inverting an equation to find what’s implied?
We start with this tweet:
My cost-of-living is going up with this purchase. We have accepted this in light of the qualitative benefits outlined above net of the lower-stress “renter” status. I don’t think it should have to be said but buying vs renting is mostly not a financial decision. The finances are a constraint in light of your broader goals but shouldn’t be the primary driver.
[Personal thinking: whether we rent or own, we ask ourselves “At what level do we want to consume housing at?”. Even if we can afford more, we try to be ruthless about what is a must-have vs nice-to-have and not let the nice-to-have creep out like a wolf spider hatching. Neither of us wants to find ourselves servicing interest payments to some mimetic trend. The cost is not just denominated in dollars but in utils of resilience and optionality which are key to peace of mind and lower stress.]
You should use a buy-rent calculator to understand the financial trade-offs.
- NY Times Calculator: This is an OG calculator that does a great job of identifying relevant variables and seeing the IRRs over time
- Khe Hy’s calculator: Incorporates qualitative aspects to generate how you should lean. A large aspect of the value of this calculator is also in identifying the levers.
Like real estate investors (of which I’m not) who use sanity-check math like a ratio of monthly rent to home price to get a blunt cap rate, I like to tinker with calculators and basic assumptions to find a handy compression of “what does the decision to buy cost me financially relative to renting?”
A lot of this motivation was also to frame the financial decision in terms of economic cost as opposed to just focusing on cash flows which can obscure reality just as cash flow statements don’t equal income statements.
I’ll show my math assumptions below so you can see how your local assumptions would stack up.
I also assume no mortgage as I want to see unlevered math. (In our area, the home inflation is less than current mortgage rates by a lot).
“Excess cost to own” roughly reduces to the spread of your home inflation rate vs after-tax opportunity cost of your cash.
Since I’m assuming purchase in cash, suggesting that the funds you will be using are being taken from the conservative portion of your net worth portfolio (ie bills, intermediate fixed income), it is reasonable to benchmark the risk to low-risk investments. Likewise, if you have a mortgage (ie leverage) you are fine to benchmark to after-tax risky returns.
[Note: Capital gains exclusion is $500k for primary residence, so for high value homes need to discount the home appreciation accrual by a tax penalty.]
Cost/Benefit calc and what it implies
As a high tax-bracket CA resident, these are my assumptions:
Cost to own
Taxes: 1.25%
Insurance .40%
Brokerage amortized over a decade .50%
Maintenance (including things like amortizing the cost of say 1/2 a roof over 10 years): 1.5%
After-tax opportunity cost of cash: 2.5%
Total: 6.15%
Benefit to own
Not paying market rent: 4.8%
Therefore, if you buy it costs you 1.35% per year or $13,500 per $1mm of house.
But you can re-frame that as:
The implied inflation break-even is 1.35%
If your home value appreciates by 1.35% per year, even though your cash flow is negative versus the counterfactual of renting, there is zero additional economic cost to owning. (If the home appreciates by more than the economic cost shifts to renting.)
The pros of this lens is that you can use off-the-top-of-your-head numbers to quantify the annual cost of owning vs the bet you are implicitly making — what home inflation rate am I underwriting to be financially indifferent.
Again, it’s a sanity check, not a reason to pull a trigger.
It’s also useful because it identifies important local variables:
Taxes, insurance, brokerage, maintenance
As I stepped through these numbers I estimated the rent (ie 4.8%) based upon comps I’ve seen anecdotally (rental rates are hard to find and sparse).
Our rent is closer to 3% of the price of a comparable home which means the opportunity cost to buy is higher — 3.15% implied inflation breakeven. If I’m comfortable underwriting 2% inflation then I’m “willing to incinerate 1.15%” per year” for the psychic benefit of owning the house.
A word on risk
All of this these considerations exist in the context of normalcy. If AI wipes out white-collar jobs then there are lots of expensive houses around here. If not, the East Bay bull case is San Mateo and San Mateo is Palo Alto and so on. The starting cost to build in town is about $625 per sq ft. Given that homes trade in the $800-$1,000 ft and land is not free, most existing home sales trade under replacement value and building margins are thin. Demand determines the upside, but replacement costs buffer the downside.
California
When I was in NY a couple weeks ago my friends who live in Bergen County, NJ whose eldest is heading into senior year of HS, told me how common it is in their area to see a “Congrats grad” right next to a “For Sale” stake. As soon as they have an empty nest they’re 86’ing the big house with the fat NJ property tax that reasseses with market value.
You own the house for 20 years while your kids grow up, the next owners remodel the kitchen and repeat the cycle.
Meanwhile in CA, Prop 13, born the same year as I was — 1978 — means couples age in place in a 4,000 sq ft house thus crushing housing turnover. Prop 13 is a call option on inflation and why I’ve argued that CA home prices are not as high relatively as optics would have you believe once you adjust for property taxes. This isn’t just academic. I grew up in NJ and witnessed natural experiements as some of my immigrant family settled in CA (or elsewhere). NJ with both high property taxes and income taxes is utterly wealth destroying. My mother’s house, net of property taxes, has performed about as well as inflation. If you threw a dart to pick an equivalent house in the Bay Area or LA in 1980 it’s a million if not multi-million dollar asset today.
But it’s CA that’s broken. In the lingo of economists, the “excess burden” or distorting behavior of taxes, seems much larger if you impose low property taxes and high income taxes once you reach the limits of the frontier — as opposed to places like TX which have high property taxes and no income taxes.
How does this manifest in the cost/benefit math above?
The taxes as a percent falls over time in CA so the benefit shows up strongly in a multi-period model. Our landlord’s property taxes are probably 25 bps or so. If your home is reassessed, as it is in NJ, that cost scales with your property value.
This is from my intro to On Georgism:
I love living in CA despite its fiscal framework. CA is what you’d get if you told Wario to design public finance. Let me get this straight… a young worker with a good job will pay nearly 50% in combined Federal and State taxes, while an absentee landlord living in Orange County has plenty of time (the app he uses to collect the rent is built by the young worker, by the way, saving the landlord the indignity of paperwork and trips to the local Wells Fargo branch) to scream at “lazy bums” to pick themselves up by their bootstraps, all without a shred of self-awareness about his grandparents’ fortunate decision to buy a regular house in Newport that’s now worth 8 figures and is protected by Prop 13 from high carrying costs?
My mother bought a house in NJ for $70k in 1982. It has appreciated 5x for about a 4% CAGR. She paid 2% property taxes reassessed every year. In real terms, she lost money. But she had a roof over her head.
An equivalent house in CA cost about the same in 1982. I know because she and her father tried to move us to the Bay Area 40+ years ago. They couldn’t find jobs out west, so I was raised in NJ. You could have thrown $70k at nearly any house in the Bay Area in 1982, and it’s worth seven figures today. And the property taxes can be safely rounded to zero because of Prop 13.
In CA, the reward for getting lucky once was to get to stay lucky. In other words a landed gentry. Meanwhile, family formation in Bay Area suburbs is limited to millennials or zoomers who will inherit their parents’ homes and that sweet stepped-up basis. The ladder is officially pulled up. The rentier is on top while the worker falls behind on the treadmill down below.
CA’s fiscal dysfunction likely has many causes. But the output is plain to see — it’s a state that gives preference to building wealth through capital appreciation instead of labor and the real estate market has internalized that logic. But real estate, in particular, land should be considered a reserved word to use a coding analogy. Thinking land is just another form of capital, like a computer or factory is a subtle but profound error.
To understand why, we will journey back to the late 1800s to meet the economist and philosopher, Henry George.
As an (almost) homeowner once again I feel like I’ve joined the landed CA gentry once again. At least Zak gets his own room.