According to this analysis, homes are more affordable than they have been in 20 years.
How’s that for a cheap trick to get you to read more?
There was quite a bit of response to my previous post, Location, location, location…and a reversion to the mean?, which compared the home price histories of two Oakland neighborhoods at opposite ends (but certainly not the extremes) of the economic spectrum. One purpose of that post was to provide a basis to anticipate how these markets might behave in the future, if not in an absolute sense at least relative to one another.
I’d like to expand that post to consider one important concern for someone who is thinking of buying a home: affordability.
There are certainly many factors that go into such a decision, starting with whether this is going to be a place to live or an investment property. Some other factors include:
- Reliability of income (Is my job secure?)
- Rent vs Own Consideration (Do I really want to tie myself down?)
- First-time or move-up buyer (Will I be selling my current home?)
Some of these are subjective and others are difficult to measure, but one factor that is both measurable and meaningful for someone buying a home as a residence is the portion of household income that will go toward monthly payments. This is what I refer to as affordability.
Let’s start by looking at a chart from the previous post.
At first glance it looks like the 94621 neighborhood home prices are back at a late 1990’s level and those in 94611 are at 2002 prices. But these are in nominal (current) dollars and we all know that inflation exists, eating into our purchasing power but simultaneously raising our incomes (at least on average). If we modify this chart to include inflation (real dollars), we get:
Now we see that using 1990 as the starting point, home prices haven’t fared too well. Strikingly, the real 94621 neighborhood prices are 26% below those in 1990, and well below that of any year since then. Those in 94611 are still 40% above 1990 prices (an annualized real return on investment of only 1.6%), and currently at 2001 prices.
Now we add another factor. For many home buyers there is one key number: the monthly payment. Overall monthly cost of home ownership can be complicated as it includes taxes, insurance, maintenance, utilities, etc. But for many potential buyers these fade into the background and the loan payment due every month as shown on the HUD-1 document overshadows all.
While during the early-to-mid 2000’s mortgage loan products went off the deep end (and became a major contributor to the bubble), the anchor point of mortgage loans has been the 30-year fixed-rate fully amortized loan. During the early part of this century the loan market was severely distorted by interest-only and negative amortization loans. But interest rates and the resultant monthly payments for 30-year loans are still a useful measure of affordability. In the next chart I factor in the monthly payment on a median home in these neighborhoods at the prevailing 30-year fixed loan interest rate.
Here we see the normalized monthly payment in real dollars required to purchase a median home in these neighborhoods. The lower the index, the more affordable the home purchase will seem.
Now we have an entirely different perspective on the affordability of a home purchase, at least as measured by the fraction of a paycheck going toward loan payments. By this measure, the cost of a home in 94621 is only half what it was in 1990, and is by far the lowest since then. In 94611, loan costs are about the same as they were at the low in the mid 1990’s, and only about 60% of what they were at the 2006 peak.
THE BOTTOM LINE
While there is still a substantial shadow inventory of underwater properties, at today’s prices and mortgage interest rates, overall there is a large financial capacity to buy. There remain questions such as:
- When will the economic recovery translate into the necessary buyer confidence?
- Are there ongoing structural changes that will impact the distribution of income, creating more wealth but in fewer (homebuying) hands?
- How will demographic changes affect national and local markets?
- When interest rates do rise (as they will), how will higher payments change demand?
I’m sure there are many other factors and questions. But from a pure affordability standpoint, the cost of buying a home is at or near a 20-year low.
1. ZIP codes are used here for identification purposes only; the neighborhoods are defined in Location, location, location…and a reversion to the mean?. In an attempt to isolate a group of similar homes the properties are in fairly small neighborhoods of 600-800 homes.
2. I have compared my data with those of Zillow (going back only 10 years) and they are very similar, although Zillow’s data shows the pricing peaks occurring a year later. Zillow’s data is less noisy as they look at more properties, but it appears that they exclude the impact of distressed sales. I understand the reasoning, but since in some areas distressed sales are the market it makes sense to me to include them.