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Thursday, February 3, 2011

Housing Affordability: Has the real estate market bottomed? (published in October of 2010 in the SB News Press)

Economists have developed a number of indexes and other indicators that can be used to evaluate whether homes in a given area are fairly valued. By comparing current levels for the index or indicator to previous levels for the same index or indicator during period of time surrounding bubbles and the resulting crash we can make an educated guess as to whether a given real estate market is experiencing a bubble. You may be saying to yourself; A lot of good this will do us… the housing market has already crashed.  True enough, but we can also compare the current data to previous periods to see if homes are affordable on a historical basis, or if we should expect more price declines.

There are two important components of a housing bubble that we can analyze: a valuation component; and a debt (or leverage) component. The valuation component measures how expensive houses are relative to what most people can afford, and the debt component measures how indebted households become when they buy them as a home or for investment.  

The price to income ratio is the basic affordability measure for housing in a given area. It is generally the ratio of median house prices to median family disposable incomes, shown as a percentage or as years of income. It is sometimes compiled separately for first time buyers and termed attainability.

The National Association of Realtors has a housing affordability index series, as does the California Association of Realtors (CAR).  I will use the CAR index, since the national median home price is so far below our local median home price ($179,300 for the national median price versus $487,500 for Santa Barbara County.  The media price in the city of Santa Barbara, as of September 2010, was $834,750, which is down 34% from the peak price in October of 2007). 

Going back to 1988, as the last real estate bubble was starting to form, the California single-family home affordability index (from CAR) was 34.  As the bubble hit its peak, the index fell to a low of 18 in May and June of 1989 (Higher numbers indicate more affordability, while lower numbers for the index indicate less affordability). This same index rose to a high of 44 in February of 1997.  If we look at the timing of these highs and lows, they very closely match the top of the bubble (1989) and the bottom of the collapse (1997).  Prices actually started bottoming around 1993, and took about 3 to 4 years to form a bottom and start to recover. (I expect the bottoming process for the current real estate collapse to take at least this long and very likely a lot longer.)

The CAR Housing Affordability Index for California got as low as 11 during the second quarter and third quarters of 2007 (right when prices peaked), and has now rebounded strongly to the high 40’s. 

Does this mean that houses are “affordable?”  The median home price for all of California fell to around $175,000 in 1996 and is about $320,000 at present.  Household incomes, according to the California Department of Finance, averaged $39,000 in 1997, and are now around $56,000.  If we do a very simple calculation, and divide the median home price by household income, we get a ratio of about 4.5 times for 1997 (the median home price was about 4.5 times household income); and 5.7 times today.  While these two ratios are relatively close, the current value is still almost twice the “rule of thumb” I have always heard for buying a home, which is that you should not pay more than 3 times your annual income for a house.

Shifting gears to the local market, CAR only shows data going back to 1990 for their Santa Barbara County Housing Affordability Index.  In January of 1990, the index was at an incredible 12.  In June of 1997, the index has risen to 37 (it was 33 in February of 1997, at the time when the California index hit its peak).  By May of 2005, the Santa Barbara Index was as low as 6, and stayed around that level through March of 2007.  The most recent reading was a 29.

For an explanation of how CAR calculates their Housing Affordability Index, visit this link:
Using data supplied by Mark Schniepp of the California Economic Forecast, our same simple ratio calculation of price to income, and with median household income of $49,300 in 1997, and the median home price in Santa Barbara County of $242,445, our ratio is 4.9 times.  The current median home price in the county is about $431,000 and household income is $71,400, so our ratio is 6 times.  Again, this is about twice the rule of thumb level of 3 times annual income for a home purchase.

For South Santa Barbara County, household income in 1997 was $59,600 and the median home price in the South County was $360,000, so our ratio is 6 times for 1997.  Currently, household income for the South County is $87,800 and the median home price is $905,000, so our current ratio is 10.3 times. 

Another commonly used ratio that can be very useful in terms of identifying bubbles and also understanding the affordability of homes is the House Price to Rent Ratio.  Rents are generally tied closely to supply and demand fundamentals, so we rarely see an unsustainable rent bubble.  Therefore, a rapid increase in home prices combined with a flat renting market can signal the onset of a bubble.  We can use the ratio of home prices to rents to track home affordability over time as well.

The ratio of median home price to annual rent back in 1997 for Santa Barbara County  was $7150 (apartment rent) per month; annual rent was $8,580.  The ratio of median home price to annual rent is therefore is 28.25 times.  Currently, rents are approximately $1,160 per month, or $13,920 annually.  Using the current median home price, our ratio is 31 times.  Based on this ratio, housing in Santa Barbara County is very close to the same affordability level as it was coming out of the last major real estate debacle.

The ratio of median home price to annual rent for South Santa Barbara County (Goleta and Santa Barbara only) was $1,010 (apartment rent) per month; annual rent was $12,120 in 1997.  The ratio of median home price to annual rent is therefore is 29.7 times.  Currently, rents are approximately $1,600 per month, or $19,200 annually.  Using the current median home price, our ratio is 47 times.  Clearly prices in the South County are still inflated, at least in comparison to where they were as we emerged from the last real estate collapse, and based on the ratio of price to annual rent. 

What does all this mean?  I think in a broader sense, and in a broader geographic area, prices have come pretty close to bottoming.  However, it appears that we may still experience some further downside in prices locally, at least to get us back to affordability levels witnessed at the bottom of the last real estate cycle.  We certainly don’t have to get back to the levels of the late 1990’s, so it is quite possible that we have already seen the lows.  However, my feeling is that the bull market we experienced in real estate, which lasted from 1997 through 2007, was probably the strongest in history.  Therefore, I believe the depth and breadth of the decline and the duration of the bottoming process will be more significant than was the case for the previous cycle, so I would anticipate more price declines and more time to get prices moving back up again.  With that stated, I do believe that we are close to a bottom, at least from a price standpoint, although I think we will see prices linger for several years before they begin to move back up.

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