Housing Affordability: This Isn’t Normal

I want to check back in on a topic near and dear to many: housing affordability. We’ve witnessed soaring real estate prices nationwide, with many cities exceeding a 20% year-over-year growth in sales prices of homes. Is income growth keeping up? For those looking to get into the housing market for the first time, can you expect better future prices or less competition?

Well, let’s see…

You are forgiven if you find this real estate market to be bizarre, crazy, and frustrating. However, we’ll examine in this post how the seeds of this current situation were not sown at the start of the pandemic, but nearly 20 years prior.

The Subprime Mortgage Crisis: Are We Heading for a Repeat?

So, should prospective buyers be sitting on their hands waiting for a 2008-style crash and a deal on a new house? The short answer is no.

In the early 2000s, speculative investors and builders were on a tear, taking on debt and building homes that all expected would be filled. You see, sub-prime mortgage lending practices were providing loans for folks who couldn’t otherwise afford them. Builders and investors, seeing what many believed to be low-risk opportunities, began building to the moon. Eventually, supply outpaced demand, prices dropped, underwater sub-prime mortgages piled on, foreclosures surged, and unpurchased homes multiplied…

All around the cobbler’s bench

The monkey chased the weasel

The monkey thought ’twas all in fun

POP! Goes the weasel.

Housing Affordability: Supply and Demand Today

Today, the exact opposite situation exists, a simple example of supply and demand. After the collapse of the financial and housing markets in 2008, builders were hesitant like a scolded child. If you ride the snake and the snake bites back, you don’t want to ride the snake again.

Since roughly 2006, the construction of new homes has been in decline, yet demand has continued to rise. What’s the result? A lack of supply. To make things worse, a pesky bug shows up, even fewer people decide to move and/or otherwise sell their home, and, like POW (!)…fewer homes than before! What happens when supply is suddenly and drastically curtailed yet demand remains high? Prices surge.

The High-Price Market

Now we’re all fighting over that 100-year-old drafty bungalow turd with a cracked foundation, a 1987 DIY electrical wiring job, and 86 missing shingles. Larry is willing to pass on the inspection and throw down an extra $100k because come hell or high water, Larry is going to own a home. No one keeps Larry in an apartment if Larry wants his own home.

So, just because we saw surging prices in the early 2000s, and a collapse in prices during the Great Recession, it does not mean the conditions are in place for a bubble (and collapse) now. But this doesn’t seem sustainable, does it?

Clearly, folks still have the funds to make deals happen at these elevated prices. Or do they?

Related Post: And We’re Back to Home Ownership! But Why Now?

Housing Affordability: House Prices and Income

Without a doubt, housing prices have continued to rise at above-normal rates. Historically, prices increased at a rate of about 3-5% per year. But lately, we’ve seen 20+% year-over-year growth (!) in many towns and cities. This is especially true for the desirable western Mountain and Pacific regions, home to many of the nation’s favorite climbing towns.

If you watch a lot of news, you’d be led to believe that the pandemic resulted in great economic misfortune. This assertion is not wrong: Americans at the bottom of the socioeconomic ladder have been hit the hardest during the pandemic. However, the majority of workers have continued working, and median incomes at the national level have continued to rise throughout the pandemic, especially among the demographic with incomes sufficient for home ownership.

Are incomes keeping pace with home prices? Definitely not. Most folks aren’t seeing 20+% year-over-year growth in their salaries.

A Simple Guide to Housing Affordability

1. No more than 30% of gross income should be occupied by housing expenses, for homeowners and renters alike. For instance, someone making $100,000 should spend no more than $30,000 on all combined yearly housing expenses (rent/mortgage, bills, renovations, HOA fees, maintenance, etc). Personally, I’d aim for 15-20%, with 30% as an absolute upper limit.
2. An affordable home will not exceed three times annual gross salary. For instance, a family making $100,000 should make offers on homes costing $300,000 or less.

Related Post: This Just In: The Real Cost of Home Ownership

Obviously, we begin to see some discrepancies. For instance, homes in many towns and cities have long surpassed $300,000. Either folks with higher incomes are left to play ball, or lower income earners are choosing to potentially take on increasingly higher housing costs.

Related Post: Relocation: A Guide to Moving and Housing Affordability

Below is a chart of median home sale price to median household income. As the rule-of-thumb stated above would suggest, we’d ideally see this ratio hovering at or below three. Unfortunately, however, since 2002 Americans (on average) have been paying a higher portion of income towards home ownership. According to these data, this ratio peaked in 2018 (5.2), higher than levels seen prior to the housing collapse in 2006-2009 (4.1). It should be noted that most of the 2021 housing price surges are not yet captured, so this figure could now be higher.

Another dataset from the National Association of Realtors (NAR) shows a stark decrease in the monthly home affordability index in 2021. However, while housing affordability is decreasing, the NAR maintains that any value greater than or equal to 100 signifies that the median income earner has enough to qualify for a mortgage. Remember though, mortgage lenders still don’t care as much as you should about those rules-of-thumb mentioned above.

Finally, let’s take a look at overall household debt with a figure provided by the Federal Reserve Bank of New York. Concerningly, Americans are continuing to take on increasing amounts of housing debt. The level of current housing debt has surpassed the previous high observed before the 2007-2009 housing collapse.

Housing Affordability Summary:

• Housing prices have surged in recent years, particularly since the arrival of the pandemic. Supply is tight and demand remains high. Conditions for the fluctuating imbalance between supply and demand have existed since the early 2000s.
• Incomes have continued to rise, but are not keeping pace with the inflation of housing prices.
• Americans are, in general, taking on an unhealthy amount of housing debt. Instead of choosing to forego home ownership, families are taking on mortgages for properties in excess of 3x annual income. At this time, the median home price to income ratio is 4.8, 60% above “healthy” household spending levels.

Will Housing Prices Fall?

The short answer is probably not. In lieu of either a sharp decline in demand or a sharp increase in supply, prices will stabilize at best. Certainly, as prices have surged some prospective buyers have folded, unwilling to play ball. As such, demand is falling slightly, resulting in some stabilization of prices in certain markets. While builders are building (check out St. George if you don’t believe it), supply increases are slow to materialize.

At best, prospective buyers can expect perhaps less competition, which could have the end result of paying less money. As competition wanes, bidding wars are less frequent, and deals may begin to settle closer to a reasonable asking price.

I wouldn’t expect a price collapse and a 20-50% sale on home prices. While the rise in household debt is concerning, the current supply and demand picture does not set the scene for falling prices and underwater mortgages, where the balance of the mortgage is higher than the value of the property.

If homeowners continue taking on “too much house,” perhaps facilitated by loose mortgage lending practices, mounting debt is a concern. Also, if builders overcorrect the current dearth in supply, again believing “if you build it, they will come,” prices could begin to fall. Falling prices can leave over-leveraged homeowners with underwater mortgages. Neither of these scenarios exist at this moment.

But as The Onion might say, “History Sighs, Repeats Itself.”

How Can I Buy a Home I Can Afford?

It’s pretty simple: don’t take on a mortgage for a home with a sales price of greater than 3x household income. And don’t expect the mortgage lender to hold your feet to the fire either.

Know the Limits

For instance, a $500,000 house should require a household income of at least $167,000. But that doesn’t mean a mortgage lender won’t approve a loan at a lower income level. Any prospective homeowner not meeting this income threshold should be prepared to lower expenses through house hacking or look for a more affordable property. With a higher debt load, a homeowner could be at serious financial risk.

Control What Can Be Controlled

Obviously, there are two knobs to turn: (1) home selection (and therefore price) and (2) household income. Play with those two end-members and know that both are variables within our locus of control.

Hack It

Another way to tip this ratio in your favor is to rent out a room, or otherwise lower housing expenses through “house hacking.” With these tactics, housing costs can be substantially reduced or even eliminated entirely. In fact, America’s biggest spending line item could be a source of profit!

So, is home ownership out of the picture? Of course not, but you might have to get clever. Finally, ask yourself if the opportunity cost of home ownership is worth it. For us, the answer is yes.

How about you? Is home ownership worth it? What rules do you use in deciding to buy a property or rent instead? Let me know in the comments below.

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