Introduction

Many new buyers are fearful of overpaying for real estate when purchasing a new property. Given that buying a new home will likely be one of the largest investments you make in your life, this is entirely understandable. However, the market conditions in which you are considering a purchase play a big role in determining what might be a fair value vs. overpaying.

The Context

Even with all of the recent economic turmoil, Berkeley and the surrounding areas continue to be a sellers market. What this means is that there are generally more buyers in the market than sellers. This equates to a relative lack of ‘inventory’ (the number of homes available to purchase at any given time) which typically results in buyers paying higher prices for properties, regardless of the price that the property was originally listed.

An Example

In effect, the notion of ‘overpaying’ in a seller dominated market is essentially a fallacy and here’s why: Imagine you are hoping to purchase a home that is listed for $1,000,000. You plan to make a down payment of 20% or $200,000. You expect that you’ll have to spend a bit more than the asking price, so you make arrangements with your lender to borrow $830,000 to cover the asking price plus an additional $30,000. Your goal is to offer the seller $1,030,000 (which is only 3% over the asking price).

However, your real estate agent provides you with information on comparable properties in the same neighborhood and advises you that they expect that the house is likely to sell for around 10% above asking or $1,100,000. What are you to do if you find yourself in this situation? Do you take the advice of your agent and offer $1.1 million or do you stick with your original goal and only offer $1.03 in order to avoid paying more than you feel the property is worth?

What to Consider?

There are two factors to consider in this scenario. The first is whether you will actually win the deal with your original offer. The second is how much it will cost you in additional financing expenses if interest rates are to increase before you are able to win a deal.

Let’s assume you will be financing your home purchase with a 30-year fixed rate loan. Over the term of the loan, for every $100,000 you borrow you will pay approximately $8,000 for each 0.5% increase in the interest rate. In other words, if you were to borrow $800,000 you would pay an additional $64,000 in interest over a 30-year loan term if the interest rate were to increase by one-half of one percent.

The Overview

So back to the original question – do you avoid ‘overpaying’ and stick with your original offer price, or do you take the advice of your real estate professional and offer more than you’re comfortable paying? The answer to the question is both a combination of data analytics and qualitative risk tolerance. If you stay with your original offer but lose the deal you’ll need to continue looking for a different property you can afford, and also risk that lending rates might rise, thus increasing the total loan repayment amount.

If you lose the deal in the above purchasing example and interest rates go up by just 0.5% in the interim, you will have to pay more than $64,000 in additional interest fees over a 30 year loan term to offer the same $1.03M you were originally considering. You would effectively spend the same amount of money as you would had you offered the $1.1M the comps indicated the property would sell for.

The same argument holds true for necessary repairs or deferred maintenance on a house.  For example, a structural pest report shows dry rot under stucco and the estimate or “bid” to remediate the damage is approximately $75,000. Once again, you are likely better off paying the additional cost of the repair than risking losing the deal and having to pay an equivalent amount of interest over the loan term for a later purchase.  

Conclusion

Ultimately, it is nearly always better to get into the market sooner rather than later. You will begin building wealth in the form of home equity as you begin paying off principal on your mortgage and as property values appreciate over time. In the end, the market (or rather, the number of buyers offering to purchase a home at any given time) will determine the value of a home regardless of what you feel is a reasonable price. There is ultimately no ‘overpaying,’ only winning or losing a deal – and winning early is the best recipe for long term wealth creation.