By Simon J. Lau, CFA
Updated June 2024
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What Does It Take to Buy a Home in San Francisco?
A lot. That’s the consensus among many of us who live and work in the city. Instead of glossing over this topic, I want to delve into it in more detail using real-world examples and financial, economic, and fixed income frameworks. I’ll also use models to illustrate important factors to consider when buying a home in San Francisco and other high cost-of-living areas.
Types of Owner-Occupied Residential Properties in San Francisco
There are generally two types of residential properties in San Francisco: (1) condominiums and (2) single-family homes (SFHs).
Condominiums
- Benefits
- Lower Price: Condominiums generally have a lower price and lower price per square foot compared to SFHs.
- Greater and Newer Inventory: Condos tend to have more available and newer units, often located closer to the city center, nightlife, and public transportation.
- Amenities and Maintenance: Many condos offer amenities such as front desk services and rooftop communal spaces. The Homeowners Association (HOA) manages all external maintenance, providing a low-maintenance lifestyle for homeowners.
- Drawbacks
- HOA Fees: Monthly dues to maintain the building and amenities, along with HOA bylaws, can be significant.
- Smaller Size: Condos are typically smaller than SFHs.
Single-Family Homes (SFHs)
- Benefits
- Larger and Family-Friendly: SFHs are generally larger and more suitable for families.
- Privacy: They offer more privacy compared to condominiums.
- Land Ownership: SFH owners have full ownership of the underlying land, a crucial factor in property value. Real estate consists of two components: raw land and the physical structure. While the physical structure usually depreciates over time, the land typically appreciates. Therefore, owning the land can significantly impact the home’s value.
- Drawbacks
- Limited New Inventory: There is little to no new SFH inventory in San Francisco. When buildings are demolished to make way for more housing units, they are usually replaced by condominiums.
- Maintenance Responsibility: Homeowners are responsible for all external maintenance.
Major Factors that Influence Home Prices
Location, location, location: Location is often cited as the most crucial factor in determining home prices. The quality of a location determines the relative volatility of home prices. For example, homes in established neighborhoods such as Pacific Heights in San Francisco tend to have lower price volatility. During a recession, properties in such areas generally do not depreciate as much compared to those in less established neighborhoods. Conversely, transitional neighborhoods such as SOMA may experience significant price volatility in economic booms and busts.
Other Considerations
- Job Growth: The local job market has a significant impact on home prices. Areas with strong job growth tend to see higher demand for housing.
- Mortgage Rates: Mortgage rates have a profound impact on home prices. Higher rates reduce the loan amounts for which buyers are approved, lowering the prices they can afford. Conversely, lower rates increase purchasing power and can drive up home prices.
The Relationship Among Loan Amounts, Interest Rates, and Home Prices
Contrary to popular opinion, the best time to buy a home may be in a high-interest rate environment. In competitive markets where most buyers finance their homes, interest rates significantly impact home prices. As interest rates rise, buyers are approved for lower loan amounts, reducing the amount they can offer and afford. The benefit of buying in a high-interest rate environment is that, as interest rates decrease, homeowners can refinance their homes at lower rates while having locked in a lower purchase price set during the high-interest rate period.
Imagine a couple with excellent credit and a family income of $250K per year applying for a loan. They are approved for a mortgage using a front-end ratio of 28%. (The front-end ratio in mortgages, also known as the housing ratio, measures the percentage of a borrower’s gross monthly income allocated to housing expenses, including the monthly mortgage payment, property taxes, homeowners insurance, and any association fees. Lenders use this ratio to assess a borrower’s ability to afford the loan, typically aiming for a front-end ratio of 28% or lower. To simplify this example, we’re assuming the only housing expenses are mortgage payments.) This results in a $5.8K/month payment for principal and interest.
A $5.8K/month mortgage translates into different mortgage amounts based on interest rates, as illustrated in the graph above. For instance, at a 5.5% interest rate, this couple would be approved for a loan of approximately $1M. Assuming a 20% down payment, they could offer up to $1.23M on a home. Conversely, if interest rates fall to 4%, this same couple would be approved for a loan of approximately $1.22M. With a 20% down payment, they could offer up to $1.47M, an increase made possible by a $200K+ increase in loan value ($1M loan at 5.5% interest rate vs. $1.22M loan at 4% interest rate).
However, it’s important to note that interest rates are not the only factor affecting home prices. In San Francisco, for example, high demand for homes often outstrips supply, which can keep prices high even when interest rates rise. As this example illustrates, it may not be worth waiting for interest rates to fall in a high-interest rate environment, as the benefits of a higher loan approval at lower rates may be offset by the continued rise in home prices due to persistent demand.
Types of Mortgages and Drivers of Mortgage Pricing
There are two common types of mortgages: (1) fixed-rate mortgages and (2) adjustable-rate mortgages (ARMs).
Fixed-Rate Mortgages
The interest rates and payments are fixed for the entire term of the loan, making them ideal for risk-averse borrowers.
- Benefits
- No exposure to future rising interest rates.
- Potential to refinance at a lower rate if interest rates decrease.
- Drawbacks
- Generally more expensive than equivalent term ARMs.
Adjustable-Rate Mortgages (ARMs)
ARMs have a fixed interest rate for an initial period, then adjust to the market rate at regular intervals. This is ideal for borrowers who plan to sell the home before the fixed rate period ends and those expecting interest rates to fall in the near-to-medium term.
- Benefits
- Generally cheaper than equivalent term fixed-rate loans.
- Drawbacks
- Exposure to the risk of rising interest rates.
Other Mortgage Pricing Drivers
- Credit Quality of Borrower(s)
- Sub-prime: FICO < 680
- Prime: FICO 680 to 780
- Super-prime: FICO >= 780
- Loan Types
- Conventional Mortgages: Typically priced more competitively.
- Non-Conforming Mortgages: Includes jumbo loans, which exceed national Federal Housing Finance Agency (FHFA) limits and cannot be purchased, guaranteed, or securitized by Fannie Mae or Freddie Mac. Despite the difficulty in approval, jumbo loan rates are often competitive due to the higher quality of borrowers.
Real Estate Valuation Methods
There are generally three real estate valuation methods: (1) comparable transaction method, (2) multiples method, and (3) discount cash flow (DCF) method.
Comparable Transaction Method
- Identify the target unit.
- Curate a cohort of comparable units that have recently transacted and are similar in neighborhood, home type, square footage, quality, and sale date.
- Calculate the average price per square foot (PPSF) for the comparable units.
- Forecast the target unit’s sale price using its square footage multiplied by the PPSF of the comparison set.
- Other considerations
- In high volatility markets, set a tight threshold for recent transactions (e.g., from 6 months to 3 months or less).
- Apply a premium/discount based on market direction to avoid underestimating current prices due to stale comparisons.
Multiples Method and Discount Cash Flow (DCF)
- Mainly used for investment purposes.
- Difficult to apply in high-cost cities like San Francisco, so often excluded from analysis of owner-occupied units.
Note: In high volatility markets, home prices can increase significantly in a short period. For instance, a 3-month difference in transaction periods might underestimate the current home price by 5% or more due to rapidly changing market conditions.
Case Example
Chris and Jennifer are recently engaged and currently rent in Hayes Valley. Chris is a 31-year-old Finance Manager at Salesforce. His total compensation last fiscal year (2018) was $149K, which includes base salary, bonus, and equity. Jennifer is a 28-year-old Product Marketing Associate at Square. Her total compensation last fiscal year (2018) was $121K, also including base salary, bonus, and equity. Their combined income is $270K. They have no car payments and no student loans. Their credit quality is excellent. After speaking with several mortgage brokers and doing their own analysis, they have established a price ceiling of approximately $1.3M for their home purchase, although they have been approved for much more. Recently, they discovered a unit at the Malt House complex at 530 Chestnut St., Unit #103 in North Beach. Chris and Jennifer love North Beach and especially enjoy its proximity to Little Italy, Chinatown, and the Financial District.
They would like to make an offer for the Malt House unit. How should they perform their independent analysis?
The first comparable property that Chris and Jennifer identify is Unit #207 at 600 Chestnut St. This unit is one block from the Malt House complex and has several similarities: it was built in 1995 compared to 2001 for the Malt House unit, it has a similar square footage (1270 sq. ft. vs. 1293 sq. ft. for the Malt House unit), and both are condominium complexes. Potential issues with this comparison include modest differences in the quality of the complexes (the Malt House complex appears to be in better condition) and the transaction dates (target offer for the Malt House in March 2019 vs. the transaction date of December 2018 for 600 Chestnut St., #207). Despite these differences, they have decided to include it as part of their comparison set.
The second comparable property that Chris and Jennifer have identified is Unit #201, located in the same complex and on the same floor as Comparable #1. Like Comparable #1, this unit is one block from the Malt House complex, was built in 1995 compared to 2001 for the Malt House unit, and is part of a condominium complex. Potential issues with this comparison include modest differences in the quality of the complexes (the Malt House complex appears to be in better condition), the transaction dates (target offer for the Malt House in March 2019 vs. the transaction date of November 2018 for 600 Chestnut St., #201), and differences in square footage (1180 sq. ft. vs. 1293 sq. ft. for the Malt House unit). Despite these differences, they have decided to include it as part of their comparison set.
The final comparable property that Chris and Jennifer have identified is 2151 Mason St. This unit is also one block from the Malt House complex and sold recently in March 2019. Potential issues with this comparison include modest differences in the quality of the units (2151 Mason appears to be in better condition than the Malt House unit), differences in square footage (1150 sq. ft. vs. 1293 sq. ft. for the Malt House unit), differences in vintage (built in 1909 vs. 2001 for the Malt House unit), and differences in complex type (2151 Mason is a TIC (a type of co-op), whereas the Malt House unit is a condominium). Despite these differences, they have decided to include it as part of their comparison set.
Comparable Transaction Method (Price Estimate)
After populating the required information into their financial model, Chris and Jennifer estimate the fair market price for the Malt House unit to be approximately $1.3M.
Cash flow analysis
As they prepare their offer, Chris and Jennifer consider three different financing terms: (1) 30-year fixed rate at 3.75% with a 20% down payment, (2) 5/1 ARM at 3.25% with a 20% down payment, and (3) 5/1 ARM at 3.25% with a 10% down payment and 0.75% PMI. Below are some highlights:
- 30 year fixed rate at 3.75% and 20% down payment.
- Initial cash outflow before mortgage interest deduction (MID): $7.3K
- Initial cash outflow after MID: $6.4K
- 5/1 ARM at 3.25% and 20% down payment.
- Initial cash outflow before MID: $7K
- Initial cash outflow after MID: $6.3K
- Savings of $300/month before MID compared to the 30-year fixed rate, but savings drop to $100/month after considering MID.
- 5/1 ARM at 3.25%, 10% down payment, and 0.75% PMI.
- Initial cash outflow before MID: $8.3K
- Initial cash outflow after MID: $7.5K
- Higher cash outflow due to the higher loan amount and PMI from the lower down payment.
- Cash outflow falls to $7.7K (before MID) and $6.9K (after MID) 2-3 years out, assuming home prices increase by 3% YoY and Chris and Jennifer refinance at the same rate when equity value >= 20% of the market value of the home.
When evaluating this model, some of the largest drivers to consider include the following:
- Max Mortgage Interest Deduction (MID) Loan Amount
- With recent tax changes, the current deductible amount is $750K for loans. For those who purchased before 2019, the deductible amount is $1M. Changes in MID over time may have a significant impact on the total cost of homeownership.
- Down Payment (% of Purchase Price)
- Determines the loan amount: A larger down payment reduces the loan amount, thereby reducing the monthly mortgage expense, and vice versa.
- Determines whether the borrower pays private mortgage insurance (PMI): PMI is generally required if the down payment is less than 20%.
- Marginal Income Tax Rate (%)
- Determines the size of the tax benefit associated with the MID. You can find your marginal tax rate at SmartAsset.
Disclaimer: The information provided is for informational purposes only and does not constitute financial, legal, medical, or professional advice. Users should consult qualified professionals for advice tailored to their specific needs. The author and publisher are not responsible for any errors, omissions, or damages arising from the use of this information. By using this content, you agree to hold the author and publisher harmless from any claims or liabilities.
