In this episode of The REconomy Podcast™ from First American, the fifth in the Summer School series, Chief Economist Mark Fleming and Deputy Chief Economist Odeta Kushi dissect the various methodologies for measuring housing affordability and discuss why traditional measures often get it wrong.

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Listen to the REconomy Podcast™ Episode 96:

“To properly measure the change in consumer house-buying power, one has to account for changes in income, like in the milk example, as well as mortgage rates. This is why we created our proprietary Real House Price Index, the RHPI, as we call it, which adjusts the repeat-sales house price index for purchasing power by considering how income levels and interest rates influence the amount one can borrow.” – Mark Fleming, chief economist at First American

Transcript:

Odeta Kushi - Hello and welcome to episode 96 of The REconomy Podcast, our fifth session of the Summer School series, where we discuss economic issues that impact real estate, housing and affordability. I am Odeta Kushi, deputy chief economist at First American and here with me is Mark Fleming, chief economist at First American. Hey, Mark. Today's episode's topic is making me a little bit nostalgic for the days when we were all in the office together, commiserating about some article we read or some analysis that we were picking apart. 

Mark Fleming - Hi, Odeta, I know exactly what you mean, and I know exactly what topic you're referring to, because it was one of those days that you described that resulted in us creating one of our proprietary indices. 

Odeta Kushi - That's right, and we'll get to that index in a moment. But to bring all of our listeners into the fold, today's lecture, I mean, episode is all about house prices and measuring affordability.

Mark Fleming - Probably one of my favorite topics in good times and in bad times. Yes, some Dickensian affordability misery is the current time and why housing affordability is top of mind for many of our listeners, and likely many American households. Leveraging the fact that we are in an election year, and that means lots and lots of polling. According to a Redfin survey, more than nine in ten, 91% to be exact, of adult Gen Zers say housing affordability is important when considering who they will vote for in the upcoming presidential election, making it the top issue for that generation. Gen Zers were more likely to rate housing affordability as an important factor in their vote than any other issue they were asked about.

Odeta Kushi - And it's not just Gen Z. According to that same survey, at least 80% of every generation said housing affordability is an important factor. But it makes sense that it's especially important to Gen Z and millennials because they're aging into homeownership.

Mark Fleming - While I understand the concern, I do feel it's a real positive of this polling that clearly homeownership remains a highly desirable objective. Otherwise, why be so concerned with housing affordability in the first place? 

Odeta Kushi - That's a great point. The dream of becoming a homeowner exists in good times and in bad.

Mark Fleming - Uh, huh. Good, good. And this is the case, even as house prices have soared by nearly 50% since February 2020, just before the start of the global pandemic, and higher mortgage rates have only made the situation worse.

Odeta Kushi - So suffice it to say that housing affordability matters, and it's top of mind for many, especially for my fellow millennials, who have aged into their prime home-buying years during this particularly difficult housing market. 

Mark Fleming - Yeah, yeah, it's always about the millennials walking around like they rent, or these days, own the place. 

Odeta Kushi - Oh, walking around like they rent the place. That was actually a good one. But hey, millennials are the largest living generation, and they are driving home-buying demand in today's market. But, you know, I digress back to house prices and affordability. Since this is a summer school lecture, let's start with the very basics. How do we measure house prices?

Mark Fleming - Well, you can do something straightforward, like just look at the median sale price of homes over time. But, if more high-priced homes sell in one period and low-priced homes in the next, then the change in median price between the two doesn't necessarily truly reflect the change in prices, but instead the change in the mix of what's selling. Would it be fair to measure the change in the price of milk by comparing the prices of two different periods, between the grocery store brand and the most organic free range crowd brand? Then next, there's a better way. It's called a repeat sales house price index.

Odeta Kushi - And it is constructed using a, you guessed it, sales-pair method, comparing the price of a house when it was sold in the current month to the price of the same house in prior transactions years ago. The advantage of this method -- constant quality. Sales-pair indices are designed to reflect changes in prices, while controlling for the fact that the mix of houses selling changes from period to period. Another way to say it is that it measures how much it would take to buy the same unit of house over time. A repeat-sales index accounts for, again, this changing mix of properties sold. So that's what we typically track. 

Mark Fleming - And using this approach, Odeta, what's going on with house prices today?

Odeta Kushi - So glad you asked. Well, according to our First American Data & Analytics House Price Index, in June home prices continued their upward trend and hit another record high, but annualized house price appreciation slowed for the sixth consecutive month, but what does that tell us about affordability?

Mark Fleming - Ah, not enough. I think this is what you meant at the top of the episode about feeling nostalgic, because our Real House Price Index, which I believe we developed all the way back in 2016 was born out of one of those in office chats where we were talking.

Odeta Kushi - Talking, ranting, tomato, tomato. 

Mark Fleming - Okay, maybe a little bit more like a rant, but let's just say we were disappointed that affordability was often measured just by looking at house price changes, or house price-to-income ratios alone.

Odeta Kushi - And that's because most home purchases are done by taking out a mortgage. So many conventional affordability measures are missing a key component of the affordability equation, mortgage rates.

Mark Fleming - That's right. So back to my milk analogy here. If the constant quality price of milk, you see what I, see, what I did there.

Odeta Kushi - Okay, I see, and there's an eye roll happening here. You just can't see it. 

Mark Fleming - That's because I'm on a roll. Too much, too much. Okay, boy, if the constant quality price of milk goes up by 5% and your income also goes up by 5% then in real terms, you can buy the same amount of milk, or to say it another way, your purchasing power for milk hasn't changed. But you don't buy milk with a mortgage, and you do buy a house with one, typically, and your purchasing power can change if either your income or mortgage rates change when buying a home. So, to properly measure the change in consumer house-buying power, one has to account for changes in income, like in the milk example, as well as mortgage rates. This is why we created our proprietary Real House Price Index, the RHPI, as we call it, which adjusts the repeat sales house price index for purchasing power by considering how income levels and interest rates influence the amount one can borrow. Rent aside, a better way to measure affordability. 

Odeta Kushi - That's right. And, according to our latest RHPI, reflecting June data, affordability improved modestly on a monthly basis, driven by slightly lower mortgage rates and positive income growth. So, there you have it, right, mortgage rates and income. However, on an annual basis, affordability nationally is still about 4% lower than a year ago, and two factors really are driving that decline in affordability, a 5.6% annual increase in nominal house prices and a slight increase in the 30-year, fixed-rate mortgage compared to one year ago. So, for home buyers holding prices constant, the only way to mitigate the loss of affordability caused by higher mortgage rates is with an equivalent, if not greater, increase in household income. And, while we did see an annual increase in household income, it was not enough to offset the affordability loss from higher rates and rising nominal prices. 

Mark Fleming - And, while average mortgage rates are similar everywhere, house prices, obviously, and income dynamics will vary by market. So, you can go to our Data Center at firstam.com/economics to check out affordability in your state, and you can check out our RHPI blog posts for more information at a market level, we refresh the RHPI posts every month. So, if you subscribe to the Econ Center, you will receive an email every month with the updated numbers and analysis. Sounds so enticing.

Odeta Kushi - It sure is, and this would also be a great time to grab the handout for this episode, if you have it handy, and turn to the third page for episode five. Here you'll see a chart that breaks down our Real House Price Index. All right, so, I mean, that's it. Then we've cracked the code of affordability.

Mark Fleming - It's the final count. Oh, sorry, sorry. Can't start singing now. Day job, day job. Day job. But we're not done yet. 

Odeta Kushi - There it is -- the episodes '80s reference. Please add that one to the playlist.

Mark Fleming - You know, I was getting worried about whether I could keep the '80s streak going. Now, the goal is to keep it, keep the streak alive to Episode 100, not that far away.

Odeta Kushi - Don't stop believing now, Mark. Only a few more episodes. 

Mark Fleming - That is a nice one. Let's not forget to add that one as well as we continue this journey.

Odeta Kushi - But, all right, yes, we digress again. So we created a separate index to capture another affordability nuance. We said earlier that we adjust house prices by income, but whose income? 

Mark Fleming - Ah, this matters. Good question. When measuring affordability, we're often interested in the potential first-time home buyer who's sort of, by definition, a renter. I mean the first-time home buyer isn't a homeowner, so they're most likely a renter. Traditional measures of affordability often inflate affordability levels by including existing homeowners as well. When they calculate the median income, they already own homes and typically have greater, nearly double the level of income than renters. Who are those potential first-time home buyers?

Odeta Kushi - So, in order to address with this, we created the First-Time Home Buyer Outlook Report. This report is actually unique in a couple of different ways. So, Mark, can you give us a quick overview? 

Mark Fleming - Sure, I don't want to pick favorites, but I think this report, which we call renter affordability for short, is my favorite affordability measure, and the reason is, for potential first-time home buyers, affordability is a function of their house buying power and the corresponding share of homes for sale that are within their reach. In our analysis, a potential first-time home buyer's house buying power is how much home they can afford based on their renter household income, the prevailing 30-year, fixed mortgage rate, an assumption that 1/3 of their pre-tax income is used for a mortgage. We call that a sustainable mortgage debt burden and a 5% down payment. The share of homes for sale that are affordable to the median renter in any given market is estimated by comparing data on home sale transactions from our First American Data and Analytics House Price Index to the renter's house buying power.

Odeta Kushi - But here's the cool part, we don't just look at the median renter, because the inspiration for this measure of affordability was the Gini Coefficient, because the way we depict renter affordability is using a Lorenz curve. Now, for those who don't know, the Gini Coefficient is a measure of the distribution of income across a population, developed by Italian statistician Corrado Geni in 1912. It is typically represented graphically with the Lorenz curve, which was developed by Max O. Lorenz in 1905 for representing the inequality of the wealth distribution, though a Lorenz curve can really demonstrate unequal distribution in any system.

Mark Fleming - This is cool, not only '80s music reference, but economic history lessons in this summer school session. 

Odeta Kushi - We do love our history here, that's right. 

Mark Fleming - So, we have made Lorenz curves to measure the inequality of housing affordability across the rental income distribution. The X axis in this chart is the house-buying power percentile. If you're the Bill Gates of renters, you're on the far right of this axis as the 100th percentile renter, and if you're on the other opposite side, you're on the lower end of the house-buying power distribution. The Y axis is the share of homes that are affordable to you. If you're on or above the 45-degree line, that's the line of equality, then your market is affordable, but below you are unaffordable. If you picture an S shape around the 45-degree line, you will have a market where housing is less affordable for the lower-income renters, but more affordable for high-income renters. An affordable market is defined as a market where the median, or the 50th percentile renter, can afford 50% or more of the homes for sale. If a potential buyer can afford their share of homes for sale, it suggests that there is enough supply at the right price to meet demand. Now, if you probably at this point need to see a picture, go check out the First-time Home Buyer Outlook Report on our Econ Data Center and look at the interactive share of affordable homes tab, where we have the national and 50 markets of affordability Lorenz curves.

Odeta Kushi - Now, in our latest report, reflecting Q1 2024 data, the median renter, who can also be considered the median first-time home buyer, unfortunately could only afford 29% of homes for sale nationally, which is down from 34% a year ago. Now, as you recall, we're defining an affordable market as the median renter being able to afford at least 50% of homes for sale. So, affordability is not doing so well in today's market and, at a market level, only one market was affordable to the median renter, and that was Memphis, Tennessee, where 55% of homes were affordable to that median renter. There are a few markets that were on the verge of being considered affordable, including Cleveland, Louisville and Pittsburgh, but in our least affordable market, LA, even a wealthy renter in the 90th percentile with a household income of $195,000 could only afford 42% of homes for sale. If we move down that curve, we find that the 30th percentile renter in LA, making about $39,000 could only afford 1% of homes for sale. But juxtapose that to a more affordable market, Cleveland, Ohio, where the 90th percentile renter could actually afford 92% of homes for sale, making nearly $117,000 per year, the 30th percentile renter could afford 21% of homes for sale. Think we just covered a lot on affordability there. 

Mark Fleming - That was a lot, that was a lot of stats, but it really makes the point. It matters where you are in the distribution. Both of our measures are telling us that rising prices and elevated mortgage rates have resulted in a challenging market, to say the least, depending on where you are for potential first-time home buyers. But there is a light at the end of this tunnel.

Odeta Kushi - That's right, that House Price Index we mentioned earlier is showing that annual price growth has slowed for six consecutive months, and the Federal Reserve has signaled that a rate cut is likely to come, which may lead to an easing in mortgage rates. And I think I'm gonna leave it on that positive note, yes. Now, this concludes the fifth episode of The REconomy Summer School series. Join us for the next episode, where we discuss the life cycle of a mortgage. And, as always, if you can't wait, you can follow us on X. It's @OdetaKushi for me and @MFlemingEcon for Mark. Until next time.

Thank you for listening, and we hope you enjoyed this episode of The REconomy Podcast from First American. We're pleased to offer you even more economic content at firstam.com/economics. This episode is copyright 2024 by First American Financial Corporation. All rights reserved.

This transcript has been edited for clarity.