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   ARTICLE   |   From Scotsman Guide Residential Edition   |   January 2018

Homes Are not Overpriced

Historical data provides the answer to renters’ bubble concerns

r_2018-01_nyitray_spotOne of the most frustrating aspects of the housing industry these days is the state of first-time homebuyers, who have been missing in action. According to data from the National Association of Realtors, first-time homebuyers accounted for just 31 percent of closed sales this past August. Historically, that number has been closer to 40 percent.

Despite soaring rental inflation, many potential young homebuyers are choosing to stay put in rentals instead of buying. One of their biggest concerns is affordability, along with student-loan debt — which is a separate issue. This reluctance to purchase on the part of many renters should concern mortgage originators. The big question is, are renter’s affordability fears justified?

It is true that most home-price indices have recouped their bubble-era highs, and it seems like we are hit with fear-mongering articles every other day warning of another real estate bubble — and another bust right around the corner. What should originators say to potential buyers who are on the fence about purchasing a home? Will they be stepping into a trap? Luckily, it seems their fears of another residential real estate bubble are probably overblown.

Bubble psychology

Bubbles are generally rare and unique phenomena, driven by psychology on the part of investors and bankers, along with cooperation from a central bank. Everybody needs to believe that an asset is “special” and will always experience price appreciation. We saw that psychology in action during recent real estate bubbles, when investors cried, “Buy real estate; they aren’t making any more land.” We also saw it during stock market bubbles, when experts exclaimed, “Don’t worry about price-to-earnings ratios; just buy and hold quality companies.”

Once the market comes back to earth, as it inevitably does, the psychology that drove the bubble evaporates and doesn’t return for a long time. We will probably never see another U.S. residential real estate bubble like the one that preceded the Great Recession in our lifetimes. Perhaps our grandkids will.

Even if we aren’t in another bubble, however, are property prices still too high? With home-price indices back at peak levels, it is reasonable to ask that question. Unfortunately, these indices don’t tell the whole story. They have all sorts of measurement issues.

For one thing, home-price indices generally aren’t adjusted for inflation. In addition, houses aren’t homogeneous — remodeling will make even the same house not comparable. Plus, metropolitan statistical areas with a high number of transactions tend to distort the numbers. Just as the Dow Jones Industrial average isn’t necessarily a great proxy for how an individual’s 401k performs, the Case-Shiller Index isn’t necessarily representative for how a local housing market will perform.

Income ratio

So how can originators approach the question of home prices and affordability? One way to attack the affordability question is to compare home prices to incomes. It makes sense that house prices and income levels would correlate, and it turns out that the correlation has been reasonably close. At the end of 2016, the median household income was roughly $59,000, according to the U.S. Census Bureau, while the median home price was $232,000, according to the National Association of Realtors. This correlates to a 3.9 ratio of median home price to median income.

Historically, that is a high number. If you calculate this ratio using data from the pre-bubble days back to the mid-1970s, you will find that in general, the ratio stayed between 3.1 and 3.5 before skyrocketing during the bubble years.

Homes were at their cheapest in a generation around 2012, but they are still extremely affordable today compared to historical averages. 

Taking the 2016 median income of $59,000 and applying the historical 3.1 to 3.5 ratio, the “fair value” of a median home should be between $182,900 and $206,500. In other words, the 2016 median price of $232,000 would seem overvalued by historical standards.

Note, however, that the ratio peaked at 4.8 in 2005, when the median income was $46,300 and the median home price was $222,300. So, even though home prices are a touch over their historical highs, the increase in median incomes makes homes more affordable now than they were during the housing bubble, which is good news for originators and prospective buyers.

Payment ratio

Looking at home prices versus incomes is better than looking at home prices in a vacuum, but there is still something missing: interest rates. As any car dealer will tell you, people don’t necessarily buy based on the sticker price. They buy based on the monthly payment. Similarly, the determining factor for housing affordability is the mortgage payment, which is determined by home prices plus interest rates.

The principal and interest payment on that home with a median value of $232,000 from 2016 using a 30-year fixed interest rate of 4.16 — the rate at the end of 2016 — would be $913 a month, assuming a 20 percent downpayment. The first year’s payments would total roughly $11,000, or about 18.6 percent of the 2016 median income, with $7,700 of those payments going to interest and $3,200 to principal.

At the peak of the bubble, annual principal and interest payments accounted for 24.4 percent of median income, and it was much higher in the early 1980s, when interest rates were pushing 17 percent. Back then, principal and interest payments consumed 48 percent of median incomes, and 99 of a borrower’s first-year payments went to paying interest. Compare that to today’s levels, where it is closer to 70 percent.

Historically, homeowners rarely built up much equity in the first few years of owning a house. They were lucky if they built enough equity to cover their closing costs if they had to move within a couple of years. Now, homeowners can begin building equity — and wealth — immediately. This can be a powerful message for renters, who are not building any equity.

To put these numbers into historical perspective, since 1975 the annual principal and interest payment on a home of median value has averaged about 26 percent of median income, with a maximum of 48 percent in 1981 and a minimum of 15 percent in 2011 and 2012. At the end of 2016, it stood at 18.6 percent.

By the monthly payment metric, housing affordability is just off the highs. Homes were at their cheapest in a generation around 2012, but they are still extremely affordable today compared to historical averages, even though home prices are now above the bubble peaks. Even without the tax effects of the mortgage-interest deduction, the conclusion remains the same: Affordability is about as good as it has ever been, at least based on this metric.

•  •  •

As outlined previously, the home-price-to-income and mortgage-payment-to-income ratios do seem to indicate that housing is not overvalued today, especially considering the ratios are lower today than during the bubble years. The biggest issue facing the housing market now is the lack of inventory, which is feeding the huge imbalance between supply and demand. That is not necessarily an indicator of an over-priced and/or unaffordable market.

The affordability issue will only get worse, however, as prices and interest rates move upward, so waiting to purchase a home until housing becomes more affordable may mean prospective buyers will miss out on a once-in-a-generation wealth-building opportunity. Share that outlook with first-time homebuyers whose bubble worries have kept them on the fence with respect to pursuing a home purchase.


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