Last year we published a price to income ratio brief and, given some recent developments in this measure, thought now would be a good time to update that brief , as well as discuss how it compares to a measure of affordability.
To recap, the price-to-income ratio is a useful metric when gauging where current home values stand in relation to their historic norms, and when comparing the affordability of housing across different cities in the United States. 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, as well as median household income for that metro. Median household income is currently available through 2010. After that year we calculated the median household income by estimating it via Bureau of Labor Statistics wage growth rates. In this research brief we consider 133 metros and the United States as a whole.
Compared to their historical averages, measured from the first quarter of 1985 to the fourth quarter of 1999, 23 metros are below their historical average, while 106 metros and the United States as a whole are above their historical average. Four of the metros are exactly at their historical mean. The United States currently has a price-to-income ratio that is equal to 2.8, which puts it at 11% over its historical average. Eighty-two metros are still more than 10% over their historic average. Six metros have overshot their historical average by more than 10%.
Surprisingly, more metros are currently over their historical average than last year at the time of our last brief. Some of that can be explained by home prices appreciating a bit and some can be explained by sluggish income growth. Both of these factors will increase the price-to-income ratio.
The price-to-income ratio, however, is only looking at the price dimension itself and not the overall affordability which encompasses both price and financing costs. When looking at overall affordability, mortgage rates well below 4% for a 30-year fixed mortgage have created levels of affordability not seen in many decades. 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 from the Freddie Mac Primary Mortgage Market Survey. Then we consider what portion of the monthly median household income goes towards this monthly mortgage payment. In the Miami metro, for example, affordability ranges from 17% to 51%, meaning at its lowest and most affordable point – the current observation 2012 Q1, the mortgage payment for a median house in the Miami metro made up 17% 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 just over half of the monthly median household income at 51%, making it the least affordable quarter.
When considering the price-to-income ratio, Las Vegas (-22%) and Detroit (-26%) remain extreme outliers, while on the other end of the price-to-income spectrum, there are many more markets that are still very high compared to their historical averages, such as Eugene (55%), Boulder (69%), and Honolulu (76%). However, all but two markets (Boulder, CO and Honolulu, HI) are currently more affordable compared to their historical average due to the historically low mortgage rates.
Remember, interpreting price-to-income ratios is part art and part science. The price-to-income ratio is useful in visualizing the historical anomaly of the real estate bubble that occurred in many markets between 2000 and 2006. Generally, for markets which have had some stability in price-to-income ratios, deviations from long-term trends tend to be followed by a return to historical levels. This has clearly occurred in all markets that experienced a pronounced housing bubble. As we’ve seen, this correction can also go too far for a variety of reasons, leaving price-to-income levels below historical norms. In this case, it does suggest that home values in such markets represent a compelling value relative to the amount of income that residents have typically spent on housing. This, in turn, might suggest that demand for housing in these markets will increase as buyers take advantage of this value proposition, thus producing a stabilization in home values near-term and, longer term, the potential for price appreciation.
Conversely, markets in which the price-to-income level is still substantially above historical levels may see further declines in home values before stabilizing. Or, instead of home values falling in order to reach equilibrium with income levels, home values in these markets may stabilize sooner but stay flat for a longer period of time until future income growth brings the price-to-income ratio back into alignment with historical levels.