knife1.jpgWould you dare buy a house in California today? In spite of mind-boggling prices, the short answer is, "Yes--- under certain conditions."

This is not the answer I expected to find. Those of us who don't live in one of the "super cities" look at giant price tags on the coasts and shake our heads.

"No way. Prices have to fall. This is unreal," we say.

The median home price in San Diego, for instance, was $579,800 at the close of 2006. That's a hefty premium over the median resale price in Fargo ($136,600), Kansas City ($153,100), or Cincinnati ($138,700).

For people with ordinary incomes, homeownership in the super cities is virtually impossible.

Well, it may be virtually impossible, but it can still be beneficial.

If you take the economists' consumption-smoothing approach--- which means you focus on maximizing what you consume over your lifetime rather than your net worth--- a future of flat prices is fine. A future of declining home prices is actually better.

Let's take the case of Arlo, a 35-year-old anesthesiologist in San Diego. Arlo is starting his first job in a group practice with a starting salary of $200,000. First, he can actually qualify for a house in San Diego. That's good because Arlo's wife, Amanda, is about to stop working and they want to buy a house.

Arlo and Amanda must make an enormous commitment even as headlines shriek about falling prices. In 2006, San Diego prices fell 4.5 percent. Arlo and Amanda face a simple but stark question: Do they dare to catch a falling knife? If they do, what difference can it make in their life--- now and in the future?

Intuition says they should rent. San Diego rents are about half the cost of buying and financing a comparable house. But intuition is wrong. In fact, there is a sublime beauty to falling knives. It still pays to buy, not rent, with this caveat--- Arlo and Amanda must be confident they can remain in the house for many years.

More important, Arlo and Amanda will enjoy higher lifetime consumption with homeownership compared to renting, even though renting costs far less to start. While the cost of owning the house takes $55,942 of their income in the first year--- versus $30,000 for renting--- they'll enjoy $95,560 of real annual consumption, over and above shelter expenses, for the rest of their lives. All other assumptions equal , they'd have $91,370 of consumption as renters.

Taking the risk of homeownership improves their standard of living by 4.6 percent--- for life.

How can this be?

As renters, they would pay $63,435 in taxes in the first year (federal, state, and FICA). That's $14,336 more than they would pay as homeowners. The tax gap continues throughout life, though it diminishes slightly each year. (All results were obtained using ESPlanner consumption-smoothing software.)

Late in life, when their mortgage is paid off, their cost of shelter is less than renting--- and their income tax bill is still lower than it would be if they rented.

Renters have another liability. To smooth their consumption, they need to save more because rent rises with inflation while the mortgage is fixed and shrinks in real value each year. The cash to balance that comes from other consumption. Over their lifetimes the renters accumulate $1,284,016 in investment assets from saving (not home equity). The homeowners, meanwhile, save less every year but accumulate investments of $1,060,870. In spite of this, the homeowners enjoy a higher net worth in every year due to rising home equity. Even if the house rises only with inflation, its real future value will reach $600,000 when the mortgage is paid off.

But what happens if the house loses value? Another surprise!

If the house loses value at a 2 percent real annual rate, Arlo and Amanda will enjoy an additional increase in lifetime consumption to $97,839 a year. That's an increase of 2.4 percent. This happens because they will benefit from declining real estate taxes and insurance, measured in real purchasing power. Their home equity and net worth will be less: But their lifetime consumption--- the money they can spend on things other than shelter--- will rise.

Perversely, if the value of their home rises 2 percent faster than inflation, the money available for lifetime consumption will decline to $91,251 a year--- about the same as what they would experience by renting.

So here's how rent vs. buy plays out if you use consumption-smoothing. If San Diego home values rise with inflation or decline, Arlo and Amanda will enjoy a higher lifetime standard of living than if they rented. If the real estate market continues to soar, their lifetime standard of living could be reduced to that of a renter--- but they would have the option of selling.

On the web:

The Consumption Smoothing series

April 2, 2006: Is there an economist in the house?

April 4, 2006: The Wrong Number

April 9, 2006: When Quick Is Dirty

April 11, 2006: Soliciting Risk April 15, 2006: Get Real about Retirement

April 16, 2006: Free Money, No Heavy Lifting

April 18, 2006: The Value of Everything, the Price of Nothing

April 23, 2006: Should the Poor Invest More in Stocks?

April 25, 2006: Financial Malpractice

ESPlanner consumption smoothing software