How Much Should I Pay for That House?

The question every buyer wants answered is “How much should I pay for that house?”

Despite the impression that Zillow, Redfin or any of the other automated valuation model tools (AVMs) may give you, determining the fair market value of a particular property is stubbornly more complex than typing an address into one of these tools. As we explain below, home purchases, and hence values, are not solely driven by financial factors. What a particular buyer is willing to pay for a home can vary wildly depending on their personal circumstances and motivations.

Doing “real estate math”, however, is always the right place to start. The most common way to calculate the value of a particular property is to compare it to other nearby properties that have recently sold (“comps”), and make value adjustments based on features that they have or are lacking as compared to the subject property.  The more similar a comp is to the subject property in terms of size, age, level of updates, acreage, etc., the fewer of these adjustments you’ll need to make and therefore the more relevant the sales price.  This analysis is called a “Comparative Market Analysis” (CMA) and is typically done by a real estate agent.  The challenge with CMA’s is that they can be quite subjective and deceptive.  How an agent selects/rejects comps and makes the corresponding adjustments can suggest materially different values.  

One way to take some of the subjectivity out of the equation is to look at the property through different lenses.  For example, you might first create a CMA using sales in just that particular neighborhood. Then you might create a CMA of similar size homes, of similar vintage (aka year built), on similar size lots in the same zip code. Then you might create a CMA of all sales within a price range in the zip code without regard to size, vintage, acreage to see what else that price range can get you. By looking at the property with multiple CMA’s, hopefully the data will start to help you triangulate on a tighter value range for that property.  We call that value range the “reasonable price range.”

Once you’ve identified a reasonable price range for a property, the real fun begins.  Here are five factors you should consider in your analysis on how much to pay for a particular property:

Market Trends.  Is the market going up, flat or coming down? If you think the market is hot and getting hotter, then you might feel more comfortable paying at or above the high end of the reasonable price range. If you think the market is cooling off, then recent sales become a ceiling, not the floor.  

Keep in mind that timing the market is extremely difficult. For what it’s worth, most prospective buyers think of “market timing” in terms of 2 factors: interest rates and home values. Let’s take a look at each, starting with interest rates. If you buy a home today and interest rates continue to rise, you will feel like a genius tomorrow because you locked in at a lower rate. If, on the other hand, interest rates fall, you can take advantage of the lower rates by refinancing. Heads you win, tails you still win.  

Now, let’s look at home values. If prices continue to rise, then again, you win. If values fall, however, you lose… but by how much? As a point of reference, the value of close-in single family homes dropped about 5-10% during the 2008-2009 financial crisis. Homes in further out suburbs crashed much more dramatically (as much as 35-40%). One of the big differences between then and now is that banks (hopefully) learned their lesson and credit standards are much more restrictive today. That, coupled with a chronic undersupply of housing suggests that a dramatic fall in values, at least in our local DMV market, is highly unlikely.  

Hold Period.  In reality, we believe a buyer’s “market timing” analysis should be less about external factors (interest rates, house values, etc) and more about that buyer’s anticipated time horizon for owning a particular property. A good rule of thumb is that if you reasonably think you’ll own a home for at least 5 years (note that can be a combination of living there and holding it as an investment), then you should buy. If you think it will be less than 3 years, then rent. Between 3 and 5 years is a gray area. The longer you think you and your family can be happy in a home, the safer an investment it will be. Don’t sacrifice your happiness just because you can negotiate 10% off the asking price.  In a strong and relatively efficient real estate market like the DMV, the reason you’re getting 10% off is likely because of a flaw (or collection of flaws) that impacts value. When it’s your turn to sell down the road, those flaws will still be there.  In addition, the “awesome” price you negotiated will be reflected in the public record as the fair market value (FMV), and the next buyer will consider your purchase price to be the benchmark for value going forward.

Substitution/Scarcity.  As a buyer, this question is critical. Are you open to a variety of neighborhoods and housing styles, or do you want to live in a very specific neighborhood? Do you want to be in the same neighborhood as your best friend or family? Over the years, we’ve even had clients limit their search to just a handful of  homes on a particular section of a street. If you’re flexible and would be happy in any number of homes and neighborhoods, you can be more patient and wait until you find a home that trades at the lower end of the reasonable range. If you are hyper-targeted and find a home that works, don‘t be cute by half.    

Liquidity. Real estate by definition is an illiquid asset, but not all homes are equally illiquid. In fact, some homes, even in tough markets, will sell in a weekend, while other homes can languish in a red-hot market. Unfortunately, your home’s liquidity rears its ugly head at the end of your ownership period, not the beginning. That’s why, regardless of how long you will be in the home, we always encourage our clients to think about liquidity upfront. Keep in mind that in a soft market, the value of an illiquid home falls farther and faster than more desirable homes.

Seller Motivation/Preferences.  Understanding why an owner is selling and what their main goals are in a sale can give you the winning edge.  Of course, price will always play a factor but it is not always determinative.  For example, we once represented a client who was looking to buy a highly sought-after piece of property in McLean that abutted our client’s residence.   The owner of the property was retired with health issues and facing major medical bills.   The owner was reluctantly selling in order to pay his bills but did not want to move.    The property received multiple offers 10% to 20% above the asking price.   We offered just the asking price but allowed the owner to remain living in his house for the remainder of his life (aka a “life estate”) at a modest rent that covered the carrying costs.   The owner accepted our offer.   

At the end of the day, determining the answer to the question “how much should I pay for that house?” is part art and part science. Use analytics for the CMA’s and market trends to determine a reasonable price range.  Use emotions and subjective views to determine your level of interest, personal situation and risk tolerance to determine what you’re willing to pay. Remember, you’re buying a home, look for a home and not for a deal.  Rarely are they the same thing.  

Being successful in the process of finding a home, determining the correct value and writing an intelligent winning offer is hard work.  Does it sound complex?  It sure is. Let’s see if ChatGPT can do all that! 

Steve & Hans Wydler, are co-leaders of Wydler Brothers of Compass the #1 Compass team in the DMV (Real Trends, 2022).   (WydlerBrothers.com).