How Much Further Will Housing Fall?

Using the median U.S. income, the National Association of Realtor's median home price and the national average for a 30-year, fixed rate mortgage, we’ve come up with an estimate for how much further housing prices (or mortgage rates) need to fall in order to make housing affordable, which will be where the sector can start to bottom. We show this two ways - by varying the National Association of Realtors [NAR] median home price for July ($212,400) while keeping mortgage rates constant at the current national average of 6.33% for a 30-year, fixed rate FHA loan, or by varying the mortgage rate while keeping the NAR median home price fixed at July’s level. We also suggest that a better way of gauging the housing situation is with the use of a housing “affordability index.”

For our example, we are defining affordability for a person earning the current Census Bureau median yearly income ($50,233) using a maximum 28% of monthly income devoted to  paying the mortgage, which is what many lenders call an affordable percentage. For this person, $ 1172 represents the maximum monthly mortgage payment that should be made because ($50,233/12)*.28=$1172. This implies that housing is probably still too expensive (and therefore not at a bottom) because financing a home priced on the median at the current average national 30-year fixed rate mortgage (6.33%) would cost $1318 per month, or 31.48% of the median monthly income.

When housing affordability is defined at a payment of 28% of the median monthly income, it reveals where house prices and mortgage rates need to be in order to make housing affordable. In example 1, if the current rate of mortgage interest (6.33%) were to remain constant, the current NAR median home price would need to fall an additional 11.07% to $188, 871 in order to meet the requirement of affordability. Another way to look at this is to say that if a borrower earning the current median income could make an 11.07% down payment on a home priced at the median while financing with a mortgage rate of 6.33%, the definition of affordability (a maximum 28% of monthly income) would be satisfied.

In example 2, if the median home price were to remain constant, current mortgage rates would need to fall 70 basis points to 5.63% in order to meet the requirement of affordability. Another way of looking at this is to say that if a borrower earning the median income could obtain a 5.63% mortgage to purchase a home priced on the median, that to would meet the definition of affordability.

We are suggesting that the area where housing is likely to bottom can be better recognized by looking at an affordability index, which is a function of income, home price and mortgage rates (using the median values for incomes and home prices along with the national average interest rate for a 30-year, fixed rate FHA mortgage).

The affordability index is simply found by dividing 28% of the monthly median income by the cost to finance a home priced on the median. In our opinion, housing is likely to hit a “bottom area” when 28% of the median monthly income is equal to the monthly cost to finance a home priced on the median, or when the affordability index is equal to 1.

At present levels, the affordability index is 28% of the national median monthly income ($1172) divided by the cost to finance a home priced on the median with a mortgage at the average national 30-year fixed mortgage  rate of 6.33% ($1318), which equals 0.88.

We are also suggesting that a better way to gauge the housing situation is to recognize if the affordability index is moving further below 1 or up towards it. Our assumption that housing will hit a bottom area as the affordability index moves closer to 1 is based on the idea that the vast majority of people want to purchase their primary residence and will be strongly motivated to do so once it becomes affordable.

Comments

[Chris1206:]

You are defining the median household income of $50,233 as a person. It is not it a *household*. In 2007, the median earnings of men who worked full time, year-round was $45,113. For women it's $35,102. What is the percentage of home buyers that are couples that both work? Or, one member is a stay at home mom/dad?

I think double-incomes need to be added to the conversation versus just the median household income.

2008 Sep 02 02:27 PM

[Matt from Q...:]

Point taken on household vs person however, the overall idea still holds. Households will purchase when housing meets the affordability requirement, although when that might happen is still open to question.

2008 Sep 02 05:06 PM

[double beta:]

The arguement is soft in relying on the historical conservative 28% 'front end' debt-to-income used for underwriting purposes. This ratio has ratcheted upwards into the 30+% range. If it this benchmark ratio was advanced to a more appropraite 32-35%, it would indicate that housing is affordable.

However, the bigger problem I have with this article is that the author is assuming a 0% downpayment. If I were going to assume a tight underwriting DTI, I would also assume a requred 10%- 20% equity contribution. Once again, factor a 15% equity contribution with a 32% front end ratio, and it would appear that housing is affordable in relative terms.

2008 Sep 02 05:40 PM

[Sippn:]

Affordability index has little to do with $500K+ sales right now. Lending for anybody under 720 scores is non-existent. Like raising the driving age to 35, we would need far fewer cars.

The effect is, the left over homes will fall like rocks. Duh!

2008 Sep 02 11:29 PM

[Matt from Q...:]

I think doubledata has a point confused. Lenders believe no more than 28% of monthly income should be used for a mortgage payment, and that is what we are basing our argument on.

The point about the down payment is valid-we left that out of our consideration here because we are only looking at affordability.

We do however stand by the argument in the article-when 28% of median household income is equal to the monthly mortgage payment, that household will have a strong motivation to buy and housing will be in a bottom area.

2008 Sep 03 08:35 AM

[je:]

I can't believe all of you guys bit at this.

In order to sell anything it has to have value. In the case of housing you need a job and those are on the decline.

2008 Sep 03 08:44 AM

[billddrummer:]

These statistics are interesting, but flawed, in my view. Remember, the affordability index mentioned here is a national index. And incomes vary depending on where you live. For example, in the Northern NV market, the median household income is about $68,000/year, which can 'buy' a $1,300 mortgage payment at a 28% front end ratio at prevailing rates. Trouble is, the median home price here is just over $240,000. That payment will support a home price of $240,000 if you have 20% to put down and a credit score over 720. But if you don't have the down and the credit, you won't get the best rates. For every additional 1% in rate increases the payment by $135/month. Which quickly takes you out of the market if you're a median income household.

A long way of saying that houses have farther to fall. If we look at the median sale prices in 2003 as the pre-boom year, then expect homes to fall to that level before starting to rise again.

More pain to come, and worse in formerly hot markets.

2008 Sep 03 12:01 PM

[Tom Lindmark:]

Good comments and not a bad article. I agree with Chris 1206's point that focusing on the median income misses the point that many houses are purchased by two income households. That makes the analysis too conservative. However, the analysis assumed that principal and interest payments were the only expense of owning a home. Most if not all lenders look at PITI and HOA expenses if those apply in computing the front end ratio. The analysis didn't do that so it is too liberal in that context.

2008 Sep 03 12:06 PM

[carey_jim:]

Just as housing prices rose higher than rational expectations predicted, because people thought they could make money on rising home prices, prices might drop lower than rational expectations predict because people will be afraid that their houses will be worth less in the future than they paid for them and hence not buy houses.

It can work both ways. I'm not predicting, just reminding.

2008 Sep 03 01:20 PM

[ReEconomist:]

The reasoning behind this analysis is right on.

However, all of the expert analysis assume borrowers will want to borrow the maximum amount of money a lender will give them.

What would happen to prices and the market if borrowers became more conservative on their home purchasing and instead of borrowing everything they could, spent much less on housing?

During the boom, the atmosphere was housing was a can't miss way to get rich and home buyers wanted all of the purchasing power a lender would give them, cause they wanted in on the boom.

Now, in 2008 buyers realize home prices can go down and leverage can work against them. Equity and mortgage paydown is back in style.

To get an idea of top and bottom home prices for a particular zip-code check out Home Price Ceiling and Floor fundamentals at
www.ushousingmeltdown....

The Ceiling is the top end of prices based on home price to income levels and the Floor is the bottom level of prices based on their value as income producing assets. The larger the spread between Ceiling and Floor the more vulnerable prices are. The smaller the spread the more stable prices will be.

2008 Sep 03 01:53 PM

[Totally a b...:]

waste of time. like one user here hit the nail... "In order to sell anything it has to have value. In the case of housing you need a job and those are on the decline."

And I fear we have seen nothing yet, it is like the calm before the storm. Funny, I feel it that way but at the same time, I am looking for a home. I am sure I will sadly look upon this comment of mine in 1-2 years time.

2008 Sep 03 02:04 PM

[Matt from Q...:]

billddrummer, we aren't saying housing is at a bottom now, and we aren't saying that the affordability index will necessarily improve in the short term, just that when it does housing will find a bottom area. Of course real estate is local, but we're using some national numbers to talk about housing nationally. I'm sure that a look at specific regions will be useful, but the idea of affordability will still apply.

For those of you who brought employment, there's no question ti plays a factor, but the facts are that employment has declined far less than during previous slow downs. That's not to say that job losses cannot accelerate, just that to this point the decline has been less than previously seen.

All we are saying is that when 28% of the median monthly household income matches the monthly cost to pay for a home priced on the median, housing will hit a bottom area because demand will increase.

Again. we aren't predicting this will happen right now and if the economy slows as expected in the second half of the year, housing will also take a turn for the worse.

2008 Sep 03 02:26 PM

[Matt from Q...:]

jigs rather proves the point-he is looking for a home and would be likely to buy one if the affordability index matched.

In the meantime, let's come back next month and have a look at the numbers.

2008 Sep 03 02:32 PM

[johnnybigsp...:]

House prices (like stock prices) are about future expectations. For example, if you knew that an investment would provide 15% growth for in perpetuity, you would leverage yourself to the max (up until the point where your cost of capital becomes more than 15%).

House prices were bid up with this type of expectation in mind...combined with very cheap capital.

Expectations have changed. (obviously) People now expect a house that is purchased today will fall in value 10, 15, 25% depending on who you talk to. Even a house purchased 'below market value' somehow falls into this expectation.... so the tide will sink all ships.

But wait, there's hope. As buyers (and we know there are lots of them waiting for the right time... pent up demand) expectations change... even to an expectation of 'flat / no growth' for the next couple of years, it will be enough to start the process of restoring confidence that a house is not a place where you lose $50K just by signing on.

The trick would be, are you lucky enough to time the market? ie. buy when people expect declines, just before the expectation turns to 'flat / no growth'. The *deals* are during the negative growth expectation phase.

All of this depends on financing availability. If the cost of capital increases, the sum of the cash flows = less NPV . Lets hope the banks can find a way to start lending money again in the near future.

2008 Sep 03 07:31 PM

[Matt from Q...:]

Folks, let's use a bit of common sense here and put things in historical perspective. Then, let's make a trade.

Common sense: When people can afford to purchase a home, they will. A home is going to follow the same demand and supply law that everything else does-prices and/or mortgage rates will fall until demand increases.

Historical perspective-this is obviously not the first time that housing prices have fallen. People bought before even though prices were decreasing. They will again.

Trade-you cannot "lose" money buying a house if you are paying rent. If you are living rent free somewhere-then yes, you can lose. It is always better to purchase a home then it is to rent. You are 100% assured of losing money if you rent.

2008 Sep 03 08:52 PM

[Matt from Q...:]

Forget about timong the market and all that other stuff to. And BTW, when your cabdriver says home prices are going to fall, that probably means that the end of home price declines is probably pretty close.

I'm a currency trader, and I used what i call the "Grandma" indicator to get a pretty good idea of where the dollar would bottom. Grandma's birthday is in March, and while we were celebrating Grandma said to me that the dollar would probably weaken further. I love my Grandma to death, but I pretty much knew right then and there that the Euro was close to finished at that point. The euro stopped appreciating in April.

This is also known as the "Supermodel" indicator. Once Giselle said she only wanted to be paid in euro's that was pretty much it.

The next time you're in a cab, ask the driver if he thinks now is a good time to buy a house. If he starts going off like an expert about how and why prices are going down further, run out and buy.

2008 Sep 03 09:00 PM

[billddrummer:]

To Matt,

Good comments. I remember when people used to say "when your shoeshine boy has a stock tip, sell." Oddly enough, that expression reached its heyday just when the dot com bubble peaked. It seemed that everyone was a market expert.

It seems that there are real estate market experts galore now.

2008 Sep 08 12:40 PM