Home Affordability: Prices Are Still 40% Higher Than 'Normal'

According to the old truism, the only arbiter of price is what a buyer is willing to pay. But when it comes to the biggest purchase and investment in most people's lives -- a home -- there's another time-tested way to reckon fair value: the home's cost divided by the buyer's income. This ratio is a broad measure of home affordability.Of course there are innumerable variables in the pricing of specific homes: location ("The three most important factors are location, location and location," as the old joke goes), home loan interest rates, the availability of mortgages, the "animal spirits" of a rising economy, and so on.

Despite the inherent complexities of calculating an individual home's value, we can discern large-scale changes in affordability over time by comparing U.S. Census Bureau data on median and average income and home costs.

The Census Bureau provides data for both median and average income, and it's important to understand the distinction.

The median is the actual number at the 50% line: Half of all households earn less than the median household income and the other half earn more. Mean income (average) is the amount obtained by dividing the total income of all U.S. households by the number of households. For example, the median income of U.S. households in 2008 was \$50,303 while the average income was \$68,424, according to the U.S. Census Bureau.

Why is there such a big difference between median and average income? The reason is that the top 20% of households earn a much greater income than the lower 80% of households. That skewing of income causes the average income to be much higher than the median income.

The Census Bureau divides the income data into quintiles -- five groups of 20% each from the lowest income group to the highest. It further breaks out the top 5% from the top quintile. The Census Bureau also provides median and average historical house price data.

Digging Into the Numbers

Let's start by examining the cost of homes from 1975 to 2008. Our statistics are drawn directly from U.S. Census Bureau data. The average house price in 1975 was \$39,500. Using the Bureau of Labor Statistics inflation calculator, we find that comes to \$158,000 in 2008 dollars.

The average (mean) house price in December 2008 was \$301,200 -- almost twice the 1975 cost. To be exact, 90.7% higher. In other words, in an "apples to apples" comparison adjusted for inflation, homes cost almost twice as much as they did in 1975.

Next, let's look at the standard measure of affordability described above: household income compared to the cost of a house. Here is an analysis of the Census data 1975-2008.

* 1975: median income \$42,936, median house price \$148,800
Home price/income ratio: 3.46

* 1975: average income \$50,137, average house price \$158,000
Home price/income ratio: 3.15

* 2008: median income \$50,303, median house price \$245,300
Home price/income ratio: 4.87

* 2008: average income \$68,424, average house price \$301,200
Home price/income ratio: 4.4

In other words, a house cost 3.15 years of average income in 1975, and 4.4 years of average income in 2008. By that measure, homes in 2008 were 39.6% costlier when measured in income than they were in 1975.

The numbers are remarkably similar if we look at median incomes and home costs: the 2008 ratio (4.87) is 40% higher than the 1975 ratio (3.46). These numbers reveal that affordability as measured by average income has dropped significantly since 1975.

Supply and Demand Are Completely Out of Balance

According to Census data, the average house price hasn't dropped much recently: the December 2009 average was \$290,000 -- a mere 3.7% decline from the 2008 price of \$301,200.

Though homeowners and real estate agents may well argue that location, condition, size, amenities, highly regarded school districts, etc. all justify the high cost of a particular property, the fact remains that the national ratio of average home costs to average income is far higher than historical norms.

As for the balance of supply and demand, the Census Bureau recently counted a staggering 18.8 million vacant homes in the U.S.

While there may well be housing shortages in certain high-demand locales, the fact that almost 15% of the nation's housing stock is vacant suggests a massive oversupply, which in classic free-market economic theory should depress prices to the point that demand rises to meet supply.

If average house prices were to return to the 1975 ratio of approximately 3 times average household income, the average price would drop from \$290,000 to around \$195,000.

Of course, the Census Bureau has not yet released 2009 income statistics yet, so I'm making that calculation assuming that real average household income has only declined from \$68,424 to around \$65,000. That number may well be optimistic given the huge hit that average household incomes have taken since the global economy fell into the dumpster in late 2008.

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