I recently had lunch with several other random financial professionals. One, a realtor, spontaneously launched into a verbal tirade about how the media was making the economy out to be so much worse than it actually was and that this fact, more than anything else, was feeding potential home buyers unrealistic expectations. She continued that the first-time home buyer tax credit was something that, if ignored by a potential first-time home buyer, was just ludicrous. Since it expires on December 1 and “It’s $8,000 – hello what are you waiting for?!”
I had to bite my tongue to not suggest that it was certainly possible that the value of a particular home might go down by a mere $8,000 in light of the fact that homes nationally have gone down several times that over the last few months. This, after many people, especially realtors, had called a market bottom more than a year ago. But since we were all financial professionals and no one could get hurt, I left well enough alone. (Personally, I don’t think you can convince an average realtor that home prices periodically go down as part of ordinary market cycles.) This is because the average realtor started in the business during the boom. Of course a good realtor is an entirely different story.
Nonetheless, the entire episode got me thinking. With the widely reported decline, are home prices finally reasonable? Some of you may recall that my family and I rent a home in New Hampshire. I was very bearish as to real estate prices upon moving here from New Jersey in 2005 and decided not to buy. We nearly purchased a home last year upon the birth of our second child. I was set to give into non-financial concerns (primarily my wife’s happiness), but was bailed out by her real estate savvy uncle who convinved my wife to wait. (Thank you Warren. See, even non-bankers can get bailed out.)
But with the local market finally showing some strains and with that $8,000 first time home buyer credit available, is now the right time?
There are many ways to assess whether homes are priced appropriately including multiples of rent prices and recent comps (what neighboring homes have sold for recently). (Comps, or comparisons, have always been a bit of a joke since it basically says your home is worth X because a similar home is worth X. As we’ve all learned recently, that works the same way on the way down as it did on the way up. Your home is no longer with Y, because your neighbor just had to get rid of his home in a fire-sale so now yours is worth 30% less than Y.)
Affordability as a National Proxy on Home Prices
My favorite approach on home price rationally is affordability. In my mind, this means the cost of the home to the buyer. I look at the median household income and the median home price to determine if a market fairly or over-valued. By 2005, almost no one could afford their homes based on traditional metrics, meaning a mortgage of approximately 28% of their gross income and a 20% down-payment. As we now know, people were buying homes and feeding this frenzy with no-money-down mortgages, teaser interest rates. Furthermore, many lied about their incomes simply to show lenders they could afford the teaser payment. As long as home prices went up and one could sell or refinance his property before his payments increased, all was blissful. But it didn’t take a brain surgeon to figure out that this wouldn’t work in perpetuity.
Is the United States Affordable?
So now we must return to affordability. Is the United States home market reasonably affordable? To me that’s the question for the blog. For me personally, the question is “Is the seacoast area of New Hampshire reasonably affordable?” If it is, it might be a good time for me to buy, especially with the incentive of the first time home buyer credit. For you, the best question is “Is your neighborhood affordable?” If it is, most people will be able to (and will choose to) make their monthly mortgage payments even if there home is worth less than their mortgage (the condition widely reported of being “under water.”) But if people can’t afford to make their payments regardless of market conditions, eventually they walk away from their properties and drag down the comps with them. (See, Las Vegas, Miami, Phoenix as notable examples of this sad phenomenon.)
One Approach to Calculating National Home Affordability
Here’s how I approached calculating home affordability nationally:
National Median Household Income rounded: $50,000
(Source: If I were Michael Scott, I’d say wikipedia, which lists it at $50,233. The census bureau file I found has it at $49,900 for 2007. So, $50,000 seems reasonable today. Note that the census bureau lists median household income by state. So a more useful exercise for you is to use this file. Find your state. Or, for extra credit, go crazy on google to find your county, city or town. The more local, the better.)
If the average household makes $50,000 gross, they earn $4,167 per month. Traditional metrics allow for between 28% (conservative) and 36% (aggressive) of your gross income to be used for your housing payments, including real estate taxes and homeowners insurance. I use 31%. The midpoint is 32% but lenders are tightening and then there’s the problem of all the other debt people owe.
When you multiply 31% by the $4,167 gross monthly income, you see that the average American, according to reasonable affordability standards, can pay approximately $1,292 a month in housing expenses. But remember, not all of that goes to the mortgage payment; some must be used for property tax and homeowners’ insurance. The 2007 median national real estate tax paid was $1,838. Sure, I’d like a more recent number but I’m pretty confident it isn’t too much less than this figure on a national basis. For a county by county analysis which shows shocking variability, view this file.
The median household homeowners insurance is $800, according to the Insurance Information Institute. Add $800 to the $1,838 annual real estate tax and you’ve got $2,638 in annual non-mortgage related housing expenses, or $220 per month.
Since I like round numbers, the homeowner’s number is a bit dated (we’ve had some hurricanes since then), and some states are still raising property taxes thanks to dated assessments, I’ll subtract a total of $292 from the $1,292 affordable figure. This leaves $1,000 a month for the median household to spend on their mortgage.
Bankrate.com currently lists a 5.1% average rate for a traditional 30 year fixed conforming loan. At 5% (since rates change daily and I like round numbers), this implies the median American can afford a mortgage of $186,000. With a down-payment, they can afford a bit more.
Guess what the median home sales price was for Q4 2008?
Are home prices affordable? I believe, on a national basis, that they are. Note: home prices aren’t on some crazy discount. Furthermore, homes can just as easily sell for far less than what people can afford the same way they once, quite recently, sold for far more. In my opinion, home prices have simply returned to being affordable.
2005 was crazy. 2008 was not. 2009? I’ll ll tell you about that when it’s over.
All Real Estate is Local
Make sure you look at your situation since, as any good realtor will tell you, all real estate local.
Here’s what I found for Rockingham County New Hampshire:
Median Monthly Income: $7,400
Median Real Estate Tax: $5,000
Average Homeowners Insurance: $700
Implied Amount available for mortgage: $1,800
At 5%, the amount of an affordable mortgage: $335,000
Median Home price in Rockingham County (as of Q3 2008): $270,000 and I know, anecdotally, that it’s fallen further since.
So it looks like we may have reached a good buying time here locally. Other cities and states may be less certain.
Do your research, follow the links above for your own county or state and share the results below. Let others know of valuable links and any ideas for improving this methodology!