In this episode of the REconomy Podcast™ from First American, Chief Economist Mark Fleming and Deputy Chief Economist Odeta Kushi explain why falling mortgage rates and rising income levels mean today’s soaring house prices are still significantly more affordable than they were at the peak of the housing boom in 2006.

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Listen to the REconomy Podcast™ Episode 20:

“Even though those nominal prices are well above the housing boom peak, real, house-buying power-adjusted prices are 42% below that 2006 peak. House-buying power has been benefiting us, actually, in the long run since 1981, when interest rates were over 18%. Since then, we've been on this long downward trend all the way down to below 4%. And, we've been below 4% for the last decade and that has extremely increased our purchasing power relative to house prices.” – Mark Fleming, chief economist at First American

Transcript:

Odeta: Hello, and welcome back to another episode of the REconomy podcast where we discuss economic issues that impact real estate, housing and affordability. I'm Odeta Kushi, deputy chief economist at First American. And here with me is Mark Fleming, chief economist at First American. Hi, Mark. I've been reading some headlines recently highlighting house price growth and the fact that it's surpassed the housing boom peak in the mid-2000s. So, the implication is that housing today is less affordable than in 2005 or 2006. What do you make of that?

Mark: Hi, Odeta? That's a great question. And we're gonna have fun with it in a minute, but first I think we should acknowledge a meaningful milestone. This is our 20th episode of the podcast, which I'm told is an achievement for podcasts, as they usually don't last this long. We must be having too much fun or, at least, I'm having too much fun.

Odeta: You know, I would agree. And thank you to everyone who listens, shares and engages with us. I love getting messages and questions about the podcast and engaging with the listeners. I'm so excited that listeners are finding the podcast valuable and sharing it with their network. So, with that, let's get back to the question Mark. Get it? Question mark...

Mark: Good one. This is gonna be a long podcast, I can already tell. Yeah, it's not surprising that prices and price growth have surpassed the housing boom peak. I mean, we've talked a lot about the lack of supply and all of the demand in the housing market. And you know, your Econ 101 supply and demand -- I think we did an episode on that – would say that prices should rise very quickly in response to an imbalance between supply and demand. But, there's also a fact that's out there and that is, despite house prices being so high, affordability nationally is actually more than 40% greater than when house prices peaked in 2006. In fact, across all 50 major markets that we track, houses are more affordable than at their respective housing boom peaks in 2006. The question is, "How can this be that housing is affordable – 40% more so – yet house prices are also historically high?" I'm confused...

Odeta: Right. And, if you're also confused, the answer is that housing is not like most goods. And we have discussed this in a previous episode. But, it's so important to reiterate, when you walk into a grocery store, you judge how expensive a carton of milk is based on its price. And that's it. But in housing, most people purchase their home by taking out a mortgage. That is the difference.

Mark: That's right. So, adjusting for standard inflation, a.k.a. the change in one's purchasing power, for the standard basket of goods that includes milk and eggs and other things we buy as is sometimes done when we talk about real inflation-adjusted measures. That's not the right adjustment in this market for purchasing power.

Odeta: So, what's more important than the house price – your monthly mortgage payment. Lower mortgage rates allow a potential home buyer to afford more home for the same monthly payment.

Mark: And the right adjustment factor for inflation, in this case, is the mortgage rate because the mortgage rate, combined with your income, determines your house-purchasing power.

Odeta: Let's go through an example. Let's say that you have a household with a median income of $60,000. And we'll look back at February of last year, right before the pandemic, when the average 30-year, fixed mortgage rate stood at about 3.5%. So, you are a household making $60,000. And the mortgage rate is 3.5%. We make some assumptions, assuming a 5% down payment and 33% debt-to-income ratio – that household in February of 2020 could afford a home of about $387,000. That's very specific. Now, that same household in July of this year, when rates fell to 2.9%, could afford $30,000 more home. That's with income staying the same. That's really just because of the decline in mortgage rates. They could buy a more expensive home for the same monthly payment just because rates fell 0.6 percentage points. Again, we call how much home you can afford to buy your house-buying power and it matters because most people buy homes based on how much it costs each month to make a mortgage payment, not the price of the home. So, with that said, let's revisit my first question. Home prices are more expensive than in 2006 when nominal house prices peaked, but is it less affordable now than then?

Mark: The answer is no, because, as you say, nominal prices don't matter. Even though those nominal prices are well above the housing boom peak, real, house-buying power-adjusted prices are 42% below that 2006 peak. House-buying power has been benefiting us, actually, in the long run since 1981, when interest rates were over 18%. Since then, we've been on this long downward trend all the way down to below 4%. And, we've been below 4% for the last decade and that has extremely increased our purchasing power relative to house prices. That means that the average 30-year, fixed mortgage rate of 6.3% back in 2006, which is now approximately 3%. Household incomes have increased 55%, so that's gone well for the last decade, as well. This all combines for 129% more house-buying power – more than double the house buying power than the housing boom peak. This is why housing is more affordable. This is also why house prices, in large part, are going up so much.

Odeta: Okay, I'm still stuck on the 18% mortgage rate, oh my goodness, I can't even imagine. But, that is the rate benefit. And so, accounting for low rates, housing is more affordable now than then. But many are still asking that question, will this housing boom end in housing bust? And I think when people ask this question, they're implicitly asking the question, "Is housing overvalued?" And I should mention that in Episode 11 we talk about why this time it's different from the last housing boom, and outline reasons why the housing market is unlikely to crash. So, that's a good resource for a deep dive into that topic. But, for now, let's talk specifically overvaluation, or lack thereof.

Mark: Or lack thereof indeed. Today's housing market isn't overvalued because of the impressive rate-driven gains and house-buying power. We just talked about that. If you think of it in real terms, this actually makes a lot of sense. So, a better way to measure whether or not we're overvalued is to sort of look at how much one can afford to buy, your house-buying power, relative to the median prices of homes that are out there. And when we do that comparison of how much you can afford relative to the median price – unaffordable would be you can afford less than the median-priced home and affordable would be you can afford the median-priced home or more. In the bubble years, like in 2006, house-buying power was less than the median house price, so it was overvalued. Today, house buying power is so high relative the median sale price that homes are actually still affordable. But, real estate is local, right? You know, the old adage. So, not all markets are created equal. When we do that same analysis looking at the house-buying power by market – and that's influenced by their income levels by market, as well as the prices of homes in those markets – the median-priced home of the top 50 markets we tracked – there are only four that are currently overvalued. All are located in California. But that means that there's still significantly large numbers of markets out there – 46 of them all across the country – that are actually undervalued, or more affordable today. For example, Los Angeles, was overvalued by approximately $286,000 in 2006. It's now nearly overvalued by 30% today. That's not as bad. So, even though the overvaluation is there in Los Angeles at the moment, it's not as bad as it was in the housing boom peak.

Odeta: And, by the way, this is not to say that house-price growth should sustain this pace. Because we do know from our Real House Price Index that, in June, housing affordability declined on a year-over-year basis for the fourth month in a row. And that's really because, even though we're seeing growth in house-buying power, for example, house buying power growth was about 7% in June compared with a year ago, but the nominal house price growth was about 19%. So, really outpacing the growth in house-buying power. The question from here is, are we due for a correction?

Mark: We always assume that if it's too high, it must come down. Yeah, we might assume that in certain scenarios. But, what we've actually found from our own research is that not all housing booms end in a bust. The last one did. We cannot forget that. But, most of the time, they don't. In fact, there's all kinds of combinations of things that might be driving whether or not you're successful, even if house prices are high. That might be driven by a bunch of fundamentals, like the fast-growing economy as we see today. Low mortgage rates, things like that, all driving things to make it a market that is fundamentally supported at these high-price levels, and not necessarily going to bust. You know, one of the easiest benchmarks we can look at is the supply relative to demand. We look at something like days on market. It's only 17 days right now and 88% of homes are on the market for less than a month. If that's not a good explanation for a market dynamic of supply and demand, I don't know what is. That low inventory, combined with that record-low mortgage rate, millennials aging into their prim home-buying years, tighter mortgage underwriting, not the same kind of underwriting as in the housing boom. These are all fundamental reasons why we see prices doing what they're doing. Prices are effectively a result of a market. They aren't a standalone thing. And they can be explained today by a number of factors that are fundamentally sound in the market.

Odeta: So, this time, it's different. Alright, so we talked about the fact that the housing market on average is not overvalued, but that this level of house price growth also isn't sustainable because it's starting to cut into affordability. So, if we're saying that we don't expect house prices to collapse, like they did last time around, what can we expect?

Mark: Yes, what I was taught in Econ class was this weird world where miraculously markets adjust perfectly and immediately to dynamics of supply-and-demand change. The truth of the matter is, nothing happens instantly, we call it the equilibrium point. It's really dynamic. We're rarely actually in equilibrium in the market. We're always striving for it. So, arguably, the equilibrium is off-balance right now, and house prices are responding by rising. But, as you say, the demand pressures are beginning to draw demand down out of the market, which begins to create a little bit more bounce. We're already seeing an increase in inventory modestly, beginning to create a little bit more bounce. And so, we go from 150 miles an hour, to say 100. The analogy I've often talked about, in particular with house prices, house prices are not like a Lamborghini. They do not stop on a dime, they do not go into reverse very quickly. It's more like a semi-truck. That momentum of 17%, 18%, 19% house-price growth that's behind us right now? That momentum will slow, putting the brakes on the truck. The truck will be going forward for a while. That dynamic will play out slowly over time. As the market tries to bring itself back into equilibrium. That does not mean we slam on the brakes, Lamborghini style, and throw it into reverse and actually get price declines.

Odeta: Thanks Mark. I like that analogy. So, we can expect a moderation of house prices, rather than a sharp decline. And you know, we touch on the Real House Price Index often because we do see stories about housing affordability that don't include this key component of mortgage rates. And, once you account for income and mortgage rates in the housing affordability calculation, we do find that affordability is actually better today than during the last housing boom peak. And today's house price appreciation is supported by the fundamentals and characterized by a shortage of supply relative to demand. Alright, thank you for joining us on the 20th episode of the REconomy podcast.

Mark: Woohoo!

Odeta: Be sure to subscribe on your favorite podcast platform. You can also sign up for our blog at Firstam.com/economics. And if you can't wait for the next episode, please follow us on Twitter. It's @OdetaKushi for me and @MFlemingEcon for Mark. Until next time.

This transcript has been edited for clarity.