By the end of 2012, the total value of the U.S. housing stock was $23.7 trillion. During the housing recession after the bubble burst in 2007, we lost roughly $7 trillion – almost a third of today’s U.S. housing stock’s value. Some metropolitan areas saw their home values drop by more than 50 percent, Las Vegas and Phoenix among them.
After the housing market bottomed in the first quarter of 2012, few would have predicted we would already be talking about home values being too high or affordability being an issue. Home values have been steadily increasing and are up 5.8 percent nationally in June. Many regions on the West Coast and in the South have seen even greater increases. For example, home values in Sacramento are up 29.5 percent, in San Francisco they are up 25.5 percent, and Las Vegas has seen 29.4 percent home value appreciation from a year ago. Some of these markets, like Las Vegas, dropped so far that they have a lot of room to grow before they start looking expensive again. However, home values in the city of San Francisco are the most expensive they have ever been, surpassing their bubble peak and still appreciating. While home values are still below their peak values in most markets, there are some markets in which home values are higher than historical averages when viewed relative to income levels and mortgage rates (especially with rising mortgage rates).
Relatively stagnant incomes haven’t been as much of a problem for housing due to low mortgage rates, which afford home buyers higher purchasing power than they might otherwise have. Simply put, with low mortgage rates, home buyers can afford more home. To measure this more accurately, we turn to the price-to-income ratio. The ratio compares the median price of homes to the median level of household income in a given area. Specifically, we used the metro-level Zillow Home Value Index, which is a measure of home values for a given metro, together with that metro’s median household income. Median household income is currently available through 2011. For years following 2011, we calculated the median household income by estimating it via the Bureau of Labor Statistics’ wage growth rates.
During the housing boom, the United States’ price-to-income ratio had increased to a high of 4.0 from a historical average (measured from the first quarter of 1985 to the fourth quarter of 1999) of 2.6. After the market peaked in May 2007, home values fell and so did the price-to-income ratio. Interestingly, the ratio never returned to the historical average and in recent quarters has actually started to increase once again as home values have been appreciating at higher than historically normal rates (see figure below).
To get a more accurate look at the relationship between purchasing power and home values, we turn to affordability. As mentioned, mortgage rates play a key role in this. With mortgage rates well below 4 percent for roughly the last two years, consumers had an incredible purchasing power boost, as home affordability was at an all-time high. To calculate an affordability index, we first calculate the mortgage payment for the median house price in a metropolitan area by using the metro-level Zillow Home Value Index for a given quarter and the 30-year fixed mortgage rate during that time period, which is provided by the Freddie Mac Primary Mortgage Market Survey (based on a 20 percent down payment). Then we consider what portion of the monthly median household income goes toward this monthly mortgage payment. This is our affordability measure.
In the nation as a whole, for example, this share ranges from 13 to 27 percent, meaning at its lowest and most affordable point – the current 2013 Q1 observation – the mortgage payment for a median house in the U.S. makes up 13 percent of the monthly median household income. In the second quarter of 2006 – at the height of the housing bubble – a monthly mortgage payment made up 24 percent of median household income. Individual metros such as Miami or San Jose have a much wider spread between the lowest and highest values. Low mortgage rates have allowed home shoppers to afford more home for their buck. This greater affordability has in turn also helped to increase home values.
Rising rates could affect home values
While income levels are not expected to grow significantly beyond their normal rate in the next years, mortgage rates will continue increasing as the Federal Reserve decreases its quantitative easing efforts. Currently mortgage rates for a 30-year fixed are close to 4.5 percent. With increasing mortgage rates, buying power decreases and affordability levels will move closer to their historical averages. In turn, the price-to-income relationship will once again be too high as home values are no longer sustained by demand fueled by low mortgage rates. Home values will have to either remain stagnant, while incomes catch up, or – the more likely scenario – home values will decrease. This will especially be the case in those markets that have seen strong home value appreciation.
Consider a market like San Francisco, where homeowners have historically spent 38 percent of their monthly income on a mortgage. In the first quarter of this year they spent 32 percent, however if home values continue to increase over the next year (we assume the rate specified by our 2013 Q1 Zillow Home Value Forecast) and mortgage rates increase to 5 percent, home buyers in San Francisco will spend 42 percent of their monthly income on housing by the end of the first quarter 2014. If rates go to 6 percent, they will spend 47 percent of their monthly income on housing. Across all markets, at mortgage rates of 5 percent, 30 metros covered in our analysis of 250 metros and the United States as a whole will be less affordable than they have been historically. At 6 percent, 67 metros will be less affordable than they had been. Finally, at 7 percent 143 of the 250 metros will be less affordable.
We continue to believe that current home value appreciation is not sustainable in many markets because it is driven by inventory shortages and, more importantly, still low mortgage rates. In the future, we expect that these markets will experience stagnant or depreciating home values and a price-to-income ratio that is more in line with its historical average.