In this episode of the REconomy podcast from First American, Chief Economist Mark Fleming and Deputy Chief Economist Odeta Kushi break down housing affordability trends, discuss the economic forces that influence house-buying power and explain why housing is actually more affordable today, even amid the pandemic, than it was at the peak of the housing bubble.

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Transcript

Odeta Kushi: Hello, and welcome back to another episode of the Reconomy podcast where we discuss economic issues that impact real estate, housing and affordability. I am Odeta Kushi, deputy chief economist at First American.

Mark Fleming: And I'm Mark Fleming, the chief economist at First American.

Odeta Kushi: And today we're going to tackle a topic that is top of mind for most potential homebuyers. And that's housing affordability. How do you measure it? How do you not measure it? And where does it stand today? And we'll just start out with why traditional measures of affordability can be misleading. From our most recent real house price index report, we found that nominal house price appreciation increased by 9%. In August, on a year over year basis. While, household incomes for those employed only increased by 6%. Now, Mark, that's telling us that housing is very unaffordable in August, right?

Mark Fleming: Right. Of course it is yes. Yeah. house prices go up more than incomes and clearly you're falling behind. But is that the whole story?

Odeta Kushi: I'm guessing not?

Mark Fleming: No, it's not. I think it's important to talk about, you know, what kind of income to measure. And let's start let's start there. Before we talk about the secret extra special thing that we're missing in the equation.

Odeta Kushi: Let's do it. So there's multiple ways to measure income. So you have per capita income, you have household income, to use the average income, do us median income, or do you use renters or owners income. And let's focus on that for a moment because there's a huge discrepancy between owner household income and renter household income. In 2019, a homeowner's household income was on average $88,000 while renter income was $47,000. That's nearly double for homeowner households. This has pretty big implications on affordability.

Mark Fleming: Right. And first of all, it's important to note that we focus on household income as our important measure in the affordability equation, mostly because people who are either homeowners already or people who want to be homeowners that potential first time homebuyer, what drives them to that decision, those foundational choices about getting married and having family and so in today's modern age, most of them have dual income. So it's household income that matters, not wages, or individual incomes or per capita income, because it's the household who makes that purchasing and buying decision. And as you said, if there's a almost a double difference between rent or average renter household income, and owner household income, it matters in the affordability equation, if you use the owner, the the renter, or the average the medium between the two, and we like to think of it as... Look, the affordability problem isn't a problem for the existing homeowner, the existing homeowner owns a home he's somehow figured out assuming he's making his mortgage payments, somehow figured out how to afford a home. The real question is, is it affordable for that potential first time homebuyer who is in all likelihood right now, a renter. So we really like to focus on rental household income when we try and analyze affordability or not.

Odeta Kushi: So renter household income, that is the key to measuring affordability for that potential first time homebuyer. That makes sense. Now, let's get to the secret sauce. What is the missing factor in affordability, we've got income, and we've got nominal house price appreciation, why isn't that enough to tell us about affordability?

Mark Fleming: Well back to where you started at the beginning. If house prices go up by 9% and incomes only go up by six we must be worse off right there's an inflation relationship is making house prices more expensive relative to your income growth. Another way to think about this is buying a gallon of milk at the grocery store. If the gallon of milk goes up by 9% and my income is only going up by 6%. I can afford to buy less milk my purchasing power has gone down and that analysis is good up to this single point. I buy milk with income in hand with cash in hand I buy a home with a mortgage. Or to say it another way, I don't get a loan to buy milk. And the combination of income and interest rate or the mortgage rate is really what drives your buying power, that purchasing power that I just talked about. In housing, purchasing power isn't just about income growth, it's about how you can leverage that income into the amount of loan you can borrow. And for that, we have to look at the mortgage rate, because the lower the rate goes, even if your income doesn't change at all, the more you can afford to borrow.

Odeta Kushi: And ultimately, you can only buy what you can afford to pay per month. So let's just do some math. That's what we like to do here. So let's make some assumptions and do some math, which is also a pretty good definition for the field of economics, assumptions and math. Let's assume that you make $100,000 a year in household income, right? Let's also assume you have a 33% debt to income ratio. Mark, do you want to explain what that is? Quickly?

Mark Fleming: Yeah, what's the debt to income ratio? Basically, that is how much of your income is going to pay your mortgage on either a monthly or an annual basis, they talk often about the concept of sustainability or ability to pay one might have heard that term out of the global financial crisis. Clearly, you're not in a very sustainable position, if you're going to put 70 or 80% of your income towards your mortgage, there's not a lot left over for clothes and food and other things. A rough rule is about one third of your income goes towards your shelter, your housing costs or your mortgage. And that includes this is before tax income. So that includes the fact that you're going to have to pay some taxes, it roughly turns out for most income levels that a 33% or one third debt to income ratio, after you take out taxes is a disposable income ratio of about a half. In other words, half of your paychecks per month, go to mortgage, the other half of your paychecks goes to everything else.

Odeta Kushi: That's a very thorough explanation of debt to income and a really important concept to understand. So we have a 33% debt to income ratio. We have we make $100,000 a year and let's say we're going to put down 5% on a home, which is reasonable for a first time homebuyer we know from our answer.

Mark Fleming: Yes, why not? 20% Why only five

Odeta Kushi: Well, most first time homebuyers don't have the equity from an existing home to bring to the closing table. And so we find that most first time homebuyers put less down on a home than a repeat buyer. And since we're worried about that potential first time homebuyer, we're going to assume they're putting down 5% on that home.

Mark Fleming: But also, you only have to put down 5%. There are loan products that allow you particularly targeted at the first time homebuyer to put even as little as 3% down in some cases, it's important to note first time homebuyers don't need 20% to become a homeowner five or less will do it.

Odeta Kushi: And that is a really common misconception. I'm glad you brought that up. If you ask most people what they think they need in order to buy a home, the answer is usually 20%. That's what we grew up knowing. But to your point, that is not the case. And in fact, you can sometimes put down as little as 3% for some loans. But here we're going to put down 5%. And let's say that mortgage rates are 4%, which is actually above what they're at now, believe it or not.

Mark Fleming: 4%. That's astronomically high!

Odeta Kushi: It seems astronomically high right now, but in fact, is still quite low relative to historical average for mortgage rates. So our 30 year fixed rate mortgage is 4%. That means you have a purchasing power of $600,000, roughly $600,000. Now let's say that rates fell to 3%, which again is still higher than rates are currently that means your house buying power jumps by $80,000. From that one percentage point decline in the mortgage rate you gain $80,000 of house buying power you can buy $80,000 more home, if you will. So that is the power of mortgage rates and affordability.

Mark Fleming: So as we know, while incomes are not keeping pace with house prices, the combination of incomes rising at that slower level than house price growth. But in addition, the falling mortgage rates that we've experienced now for almost a decade and absolute rock bottom historic lows well, even below 3% now, and some forecasted to even go lower next year into 2021. One that increases that house buying power. And in many cases, we find that the combination of rising income and falling interest rates boosts house buying power at a faster pace than even that high level of house price growth. And so all of a sudden, back to the milk analogy, it says, if I walk into the store, and I can afford to buy more milk than I was able to buy before, in fact, $80,000 more than I was able to buy before, that's a lot of milk. That is a lot of milk. Well, that house is $80,000, maybe has a bigger fridge.

Odeta Kushi: There you go. There you go. And so with that, we know that house buying power is higher relative to one year ago. That's because for those that have a job, their incomes have risen modestly relative to one year ago, and mortgage rates have come down significantly, in fact, about point seven percentage points relative to a year ago. But we also know in that timeframe that nominal house price appreciation, appreciation has increased but to what we were saying before house buying power outpaced the gains in nominal house price appreciation, making it more affordable to buy home today than one year ago. And really, the lesson here is that affordability has to include these three things, nominal house price appreciation, household income, and mortgage rates. And that's what we do in our real house price index. That is how we calculate the affordability in the United States and by market. Now another thing to note is if you look at nominal house prices, relative to real house prices, you find that nominal house prices are about 15% higher than the housing boom peak in 2006. Right now, but when you do the house buying power adjusted house price, according to our real house price index, we still remain about 49% lower than the housing boom peak in 2006. That is very different, I would say.

Mark Fleming: And the main difference is simply rates. Because prior to the in the housing boom, and prior to the Great Recession, mortgage rates were averaging six and 7%. Now they're averaging 2.9%. And while incomes did grow in the long expansion post, the global financial crisis, the impact of falling rates has driven house buying power significantly up. That is well outpaced even the fast pace of house price growth. And I think it's also important to note, these things don't operate in a vacuum. The reason why house prices are going up at such a fast pace is because house buying power has gone up by so much. Think about it. If I can afford to buy more that additional $80,000. What most likely happens is I go out and I spend it. And in a market with tight inventories of homes for sale. I'm competing with other home buyers, I bid up that price with that additional house buying power that I got because of the decline in interest rates. And that's what's driving house price growth. buying power is the cause in large part of the pace of house price appreciation today, relative to a short supply of homes for sale.

Odeta Kushi: That's a great point, Mark. And it really brings us to what do we expect? So we said affordability today is is better than one year ago. But do we anticipate that to persist going forward? I mean, we have house price appreciation, we have inventory. That's that's kind of resulting in the faster house price appreciation, and then you have the income piece. What will happen with that? What do you think Looking ahead, will happen to affordability.

Mark Fleming: Let's cross the easy one off the list here first, and that's actually mortgage rates shy. It's amusing to say because typically forecasting mortgage rates are practically impossible. But at the moment, I think it's pretty clear, based upon what Jerome Powell and the Fed and others are saying and what we know about the path of the likely recovery from this recession right now, mortgage rates are being telegraphed to remain low, if not even go lower next year. So forecasts for rates is where they are or even better from a purchasing power perspective. The bigger challenge is, incomes and income growth clearly will have a lot to do with the performance of the economy and the labor market as we go through this quarter and into next year. That has to do with the pandemic and the virus. And so it's a lot harder to tell, but I think we could reasonably argue that while unlikely to put up point estimate on it, there are headwinds, if you will to you know fast income appreciation or income growth. And so we would expect soft or or even softer income growth going forward, that it becomes the tug of war. You get the benefit of rates. We Maybe slower income growth. It's unclear necessarily whether or not that house buying power will go up or down as a function of those two, relative to house prices. Lastly, house prices. We suspect that even if you do have a little bit less demand because house buying power doesn't go up by so much. The fact that there's so little inventory clearly continues to put pressure upward pressure on house prices, even relative to a little less potential demand in the future.

Odeta Kushi: So the big question mark here is really the labor market. We anticipate rates to remain low for some time, the feds made that pretty clear. They continue to purchase more mortgage backed securities yields remain low. And so we anticipate rates to remain low house price appreciation is likely to continue to go up because of the of the inventory challenges. But the big question mark is the labor market and how that will impact demand going forward. So I think we've covered a lot today, so we'll end it there. We could probably go on forever on this topic alone. So remember, when considering housing affordability, it's important to include mortgage rates in your calculation. Thank you for joining us on our second episode, and be sure to subscribe to the economy podcast on Apple, Google, Spotify, or your favorite podcast platform. You can also subscribe to our blog at first m.com slash economics. And if you can't wait for our next podcast, you can follow us on Twitter @MFlemingEcon and @OdetaKushi. Until next time.