A widely reported theory suggests that the housing market need not crash in order to bring home prices back “in-line” with traditional fundamentals but, that it merely needs to tread water for a few years to let the fundamentals catch up with it. This might be best termed the “Glass Half Full” theory of the housing cycle as it seems wrought with the very same hyper-optimism that so effectively got things out of whack in the first place.
The main prediction of this theory is that housing prices will flatten out (and possibly go down a little, but not dramatically of course) and remain flat for a few years, in which time, median incomes will “catch up” to median house prices.
Of course, there’s no suggestion for what would come next; most likely, given theses optimists attitudes, more expansion would ensue.
The fundamental problem with this line of thinking, though, is that wages have been relatively flat (along with inflation) for the last decade or more and median incomes and median home prices have become significantly awry, especially in the bubbliest markets.
To demonstrate this point, I have created a simple Excel spreadsheet that estimates that annualized rate of growth of income over the next 5, 10 and 15 years, that would be required to bring a specified towns current median income and median home prices back to a reasonable ratio.
In order to establish a “reasonable” ratio, I used the standard mortgage affordability “Rule of Thumb”, whereby no more than 29% of a households gross income should be allocated to PITI (Principle, Interest, Taxes, and Insurance).
Furthermore, I generated the estimates given the specified towns median home price with an assumed 20% down payment, financed with both a low 5.5% 30 year fixed rate as well as a more reasonable 6.5% 30 year fixed rate.
Poking in the numbers for a selection of towns in the Boston metro area resulted in an average income deficit of $73,766.83 (for a 6.5% loan), requiring either a 13.63% annual rate of income growth over 5 years, or an 6.55% annual rate of income growth over 10 years, or an 4.31% annual rate of income growth over 15 years to close.
The following is just some of towns that I used for my sample:
NOTE:
- Income deficit is the amount of additional income that would be needed for the median household income to justify the median home price given the 29% “Rule of Thumb”.
- The annual income growths specified indicate the rate of growth in household income needed in order to close the income deficit in the specified period of time.
5.5% 30 year fixed
- Income deficit: $39,078.89
- Annual income growth to close deficit in 5 years: 8.96%
- Annual income growth to close deficit in 10 years: 4.39%
- Annual income growth to close deficit in 15 years: 2.90%
6.5% 30 year fixed
- Income deficit: $49,568.78
- Annual income growth to close deficit in 5 years: 10.93%
- Annual income growth to close deficit in 10 years: 5.32%
- Annual income growth to close deficit in 15 years: 3.52%
5.5% 30 year fixed
- Income deficit: $102,222.74
- Annual income growth to close deficit in 5 years: 23.88%
- Annual income growth to close deficit in 10 years: 11.30%
- Annual income growth to close deficit in 15 years: 7.40%
6.5% 30 year fixed
- Income deficit: $117,489.46
- Annual income growth to close deficit in 5 years: 26.22%
- Annual income growth to close deficit in 10 years: 12.35%
- Annual income growth to close deficit in 15 years: 8.07%
5.5% 30 year fixed
- Income deficit: $72,963.06
- Annual income growth to close deficit in 5 years: 12.82%
- Annual income growth to close deficit in 10 years: 6.22%
- Annual income growth to close deficit in 15 years: 4.10%
6.5% 30 year fixed
- Income deficit: $87,846.79
- Annual income growth to close deficit in 5 years: 14.84%
- Annual income growth to close deficit in 10 years: 7.16%
- Annual income growth to close deficit in 15 years: 4.72%
5.5% 30 year fixed
- Income deficit: $47,660.06
- Annual income growth to close deficit in 5 years: 7.55%
- Annual income growth to close deficit in 10 years: 3.71%
- Annual income growth to close deficit in 15 years: 2.46%
6.5% 30 year fixed
- Income deficit: $62,373.57
- Annual income growth to close deficit in 5 years: 9.50%
- Annual income growth to close deficit in 10 years: 4.64%
- Annual income growth to close deficit in 15 years: 3.07%
As you can see, even at ridiculously high rates of annual income growth, it would still take 5 to 10 years to make current housing values seem reasonable. In most towns I looked at, even the 15 year annual income growth rate was on the high side especially given the actual income growth rates of the last 10 years.
Here is a link to the spreadsheet. Download it and poke in your favorite town by simply:
- Copy an existing row and paste as a new row.
- Specify the town’s name.
- Specify the town’s median home price
- Specify the town’s average monthly property tax payment (or use $400 as a rough estimate).
- Specify the town’s median income value.
At the end of the row will be calculated the income deficit values as well as the rates of growth needed over the next 5, 10, and 15 years to close the deficit.
