Tuesday, January 29, 2008

What Median Home Prices would look like if the Bubble Never Happened

How much should you be paying for a home? The answer is easy to calculate if you understand the connection between median home prices and median incomes.

Historically, median home prices and median incomes have always shared a close relationship. From the mid-1970s to 2001, the historical ratio of median housing value vs. median household income was consistently between 2.6 and 3.0.

What this essentially means is that median home prices were (on average) 2.8x the median household income for the last 30 years. Using this 2.8 formula, it is very easy to estimate what median home prices would be if the most recent bubble never happened.

U.S. Median Home Prices

Current Median* What the Median Should Be % Difference
$208,400 $134,692 35%

Median household income information is not yet available for 2007, so we will be using median household income data for 2006 in this example and in the following examples. It should make very little difference since household incomes increased by 4 percent at the most (and that's a very generous estimate) in 2007.

The median U.S. household income is $48,201, according to the U.S. Census Bureau. When we multiply that number by 2.8, we get $134,692. That's what the U.S. median home price should be right now. The actual median home price is about 35 percent higher that that.

Median Home Prices by Region

Region Current Median* What the Median Should Be % Difference
Northeast $258,600 $145,760 44%
Midwest $159,800 $133,941 16%
South $173,400 $122,875 29%
West $309,800 $146,297 53%

It is obvious to most people that we are in the midst of a national housing bubble. Nevertheless, there are still plenty of naysayers who are telling anyone who will listen that there are local bubbles only.

Using the 2.8 formula, it is clear that local bubbles aren't the problem. Median home prices are inflated in every U.S. region. In the West, where the median household income is $52,249, median home prices are more than double what they should be. The situation is similar in the Northeast, where the median household income is $52,057.

Median home prices are not quite as high in the South and the Midwest, where median household incomes are $43,884 and $47,836 respectively. Even so, prices are still 30 percent higher than what they should be in the South and 16 percent higher than what they should be in the Midwest.

California Median Home Prices

Current Median* What the Median Should Be % Difference
$402,000 $158,606 61%

There is no doubt about it. California was hit hardest by the housing bubble. Although prices have always been slightly elevated in the state, they grew by leaps and bounds during the housing boom.

The result is that home prices are 61 percent higher than they should be given California's media household income of $56,645. In some areas of the state, such as San Francisco and Oakland, median home prices are so inflated that they are more than 11 times the median household income.

Will Home Prices Fall?

Absolutely. Prices have already fallen by six percent nationally and by more than 11 percent in the West in a year over year comparison. Home prices must continue to fall for the average American to be able to afford a home.

The real question is: how long will it take?

The U.S. government seems to be doing everything they can to prop up prices. Before you applaud their efforts, it is worth noting that while this could work short term, all it will really do is insure we have a slow fall.

The truth is that propping up prices and prolonging the correction will not solve anything. The Japan Ministry tried to do it during the Japan correction and it was a complete disaster.

All we can really do now is prepare for the fall. It will come and it will hurt. But that's the price that must be paid for allowing the market to become artificially inflated.

*Current median refers to the median prices of existing homes in December 2007. All current median figures were taken from National Association of Realtors' EHS data.

Source: Homeguide123


Blimp66 said...

Been following this story for quite a while and was inspired to write a song about it:


Anonymous said...

The ratio of median home price to median income is not as simple as one might suspect, nor has it always hovered in the 2.8+/- range.

The average new home built in 1950 was 983 square feet. In the 1970s it was a little over 1500 square feet, and by 2005 or so it was 2350 square feet. Even considering that the median size of all homes sold has not experienced as dramatic an increase as that of new homes, overall prices nonetheless should have increased more than any simple ratio test would predict (and, in fact, the ratio was about 2.2 in 1950, well below the 2.8 figure).

It is interesting that the median US new home, when priced per square foot, has only appreciated at about 0.64% per year (net of inflation). This is very close to the Case-Shiller trend line of 0.40% for all US homes.

Areas with higher incomes can allow for much higher property prices than simple ratios would predict, since the people living there can maintain the same standard of living and spend a much larger portion of their income on housing expenses. In fact, about 75% of additional salary (over the US median) can be allocated to housing expenses.

A median household income of $95,000 (San Jose) can afford a home worth more than $600,000, while a median income of $64,000 (Portland) can afford less than $300,000, a difference of over $300,000 (the 2.8 ratio test would predict $266,000 for San Jose and $179,200 for Portland). Except for housing, most things cost about the same in Portland as they do in San Jose (although San Jose prices are, I admit, a bit higher, the difference is not very significant).

The main problem with the relationship between housing prices and incomes in the recent boom is that income net of inflation has been decreasing slightly, while home prices (net of inflation) increased quite handsomely during the same period.

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