I wanted to take a different approach. After looking at a few things, in my opinion, house prices need to come down about 33%, if not more. This number may vary from market to market.
For my analysis I turned to data provided by the US Census Bureau. I wanted to see how house prices related to household income.The reason for this is quite simple. The amount of house you can afford is closely tied to the amount you make. It is one of the most important factors lenders consider when qualifing borrowers for a loan. If you make X dollars a year, lenders have different formulas to determine they will lend you up to Y dollars for a home. This is a slight simplification as there are other factors involved such as your credit rating which impacts your interest rate which will affect how much you can borrow. But the underlying factor in your ability to repay is your income.
Before I go into the details let me show you the chart of the data I collected. Income and house prices are on the left y axis, and the price per barell of oil is on the right y axis.
The recommended house prices were determined by applying a very simple formula. Before the year 2000, the average house price to income ratio was around 3.0. This is inline with many recommendations that the amount of house you can afford is about 3 times your yearly income. Other factors are involved but this is a good rule of thumb to use as a starting point. So to come up with what the recommended home price should be for a given year, I multiplied the median incomes by 3.0.
Lets first look at the income data. It's been flat. Going up and down a little bit here and there but there have been no major swings. From 2000 to 2007 the median home price jumped to 150% but incomes didn't jump up by that same amount. They didn't jump at all. In 2000, the median house price was in line with the recommended median house price I came up with. In 2006, the median home price is 150% of that recommended price.
How can people afford these home prices? Their income hasn't improved. Not everyone is winning the lottery or finding out some long lost rich uncle they never knew about has passed and they're they only beneficiary. Has demand increased considerably? Well, owning a home is the "American Dream" and there hasn't been a 50% increase in population.
So what happened? Demand for homes did increase because more people were able to purchase homes and supply is pretty fixed. There are only so many homes in a given area and only so much land to build on. How is it that so many more people were able to buy homes?
The conservative practices of lenders from 1981 through 2000 kept the house price to income ratio around 3.0 with very little deviation. Notice I didn't say that home buyers kept the ratio at this level. Someone may want to buy a $1,000,000 home to live in, but if they only make $20,0000 a year, they're not going to find any responsible entity to lend them the money, which means they're not going to buy the house.
In the year 2000, lending practices were changing. In 1999, the Home Price to Income Ratio was 3.0. In 2006, it was 4.6, 153% of the 1999 value, which correlates to the rise in home prices. Below is a chart showing historical values of this ratio. The median yearly prime rate is also included for comparison. What we see is that the prime rate historically has not affected the home price to income ratio. House price to income ratio data is from The State of The Nation's Housing 2007 put out by the Joint Center for Housing Studies of Harvard University.
Well is it bad that more people are able to buy homes that previously weren't able to. No, everyone that wants to buy a home should be able to buy one. Is it bad that people are allowed to buy homes that are 153% the price of homes that they would have been able to buy in 2000. Definately!
It is bad for them, it is bad for the housing market and it is bad for the economy. The extra money that is being used to pay for housing is not going to other areas of the economy.
Lenders and appraisers should have done a better job keeping house prices in check and they had the power to do so. All the money they were making probably clouded their judgment.
The median house price needs to be around $200,000 not $303,517, that means they need to come down about 33%. That's not even factoring the spike in the cost of crude oil and how that impacts so many other aspects of our economy, not just the price of gas. If it costs more to drive a truck full of vegetables from the farm to the market, the price of vegetables is going to go up. You can take a bike or public transportation all the time but you can't completely avoid the price of gas.
How long is it going to take for that correction? Let me turn to the tech bubble again and bring up a quote from Scott McNealy of Sun Microsystems which I used in the past. Sun is one of the iconic companies that was affected by the tech bubble and is still around.
But two years ago we were selling at 10 times revenues when we were at $64. At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes that with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?
It took around 2 years for Sun's stock price (NasdaqGS:JAVA) to finally hit bottom. Can we afford two years until the housing market hits bottom? I don't think so. People need to come to terms with what has happened and start making changes. A lot of people are going to get hurt. But I think we're better off making things happen sooner, rather than later. We don't need people trying to keep housing prices afloat so that they can get out at a reasonable price. All they are doing is handing off that debt to someone else that may not be able to afford it. Although it does seem that with the collapse of the sub prime market lenders are starting to be more conservative. And as I've posted earlier, the local lenders that stuck with their conservative lending practices throughout the hype have been doing better than the large commercial lenders.
We had a good balance going for a long time that worked and we need to get back to it quickly. While there were ups and downs in the housing market it was usually due to external factors.
So how did things get so out of hand? The post Speculation or Investment, on the Irvine Bubble Blog, is a good explanation of some of the things that happened. The practices of lenders also contributed, as well as appraisers that were willing to fudge some numbers. At any point, lenders could have said, like the community based lenders did, "We're not going to authorize a loan for that amount, we don't think the house is worth it." Should taxpayers be expected to bail out these companies that could have prevented the problems but instead chose to profit by authorizing loans for properties with inflated market values to people that shouldn't have been able to qualify for that loan in the first place?
Update: Bergen County Information
There was a question in the comments by Donald about how Bergen County looks. I did some digging and found income data for Bergen County NJ and used the charts posted by Rich on NJREReport.com to come up with a Bergen County specific chart.
For the recommended price I used 3.46 times the median income. The reason I used this value is because from 1990-1999 this was the average home price to income ratio. In 2000 is when the ratio started to rise dramatically. At it's peak in 2007 it was over 5.5. The 2008 value is about 90% of the 2007 value. Notice though, that the drop in home prices isn't as sharp as the ratio drop. That indicates to me that prices haven't adjusted inline with the ratio, but as you can see from 2000 up, prices did increase inline with the ratio. As lenders tighten up and the ratio comes back down to the 3-4 range, we should see an appropriate drop in house prices.
Some numbers to put things in perspective
So lets look at some numbers. In 2006, the median home price was $303,517 and using a home price to income ratio of 3.0 the median home price would have been $199,710. HUD's Median household income for 2006 is $66,570.
Assuming putting down 20% and an interest rate of 6.39% (the 2006 median 30 year fixed mortgage), the average household would be spending $1,517.22 a month, not counting property taxes and insurance, for their mortgage. If they bought at the 3.0 ratio price their monthly mortgage payment would be $998.31. That's a difference of $518.91 a month. That's an extra 10% of their gross monthly income. Assume a third goes to taxes and that's 12.5%.
$518.91/month is $6,226.92 a year that could be going into the economy in areas other than housing, per household. The maximum economic stimulus rebate for a married couple is $1,200.
|Average Family Budget From www.money-zine.com
|Apparel and Services||$143.00|
|Personal care products and services||$45.43|
|Tobacco products and smoking supplies||$22.72|
|Personal Insurance and Pensions||$378.00|
|Median Home Mortgage at 6.4%||$1,517.22|
|Total Expenses (not including prop tax or home insurance)||$3,827.44|
|Average HUD Estimated Household Income less 1/3 taxes||$3,698.33|
|Total leftover for savings, property taxes and home insurance||$-129.11|
And that's if you got an average mortgage APR for a 30 year fixed mortgage, put 20% down like you used to be expected to. If you didn't put that much down you'd be in worse shape. So obviously the average household will have to spend less to be able to afford their home. Which means less money going back into the economy.