Housing Affordability Index: A Very Useful Indicator for Property Investors

housing affordability index

The housing affordability index is a quite useful metric for real estate investors. This indicator can be used for assessing the sustainability of further price increases in an urban housing market because the less affordable house prices are becoming to households the more difficult will be for further price increases to take place.

The housing affordability index describes in essence the relationship between the household income of an “average” household and house price levels in an urban housing market. The National Association of Realtors (NAR) in the United States publishes a monthly housing affordability index. The methodology to calculate that index is described in detail in this link: https://www.nar.realtor/research-and-statistics/housing-statistics/housing-affordability-index/methodology.

In short, the NAR methodology calculates the housing affordability index as the ratio of the qualifying income for obtaining a mortgage loan for purchasing an existing (not new) single-family house with the median price over the median family income[1]. The minimum qualifying income is defined by NAR as the amount that is four times greater than the annual mortgage payment required to service a conventional mortgage loan for purchasing a house. This is referred to as minimum because any income level about that what certainly qualify for the particular mortgage loan. The specific formula used by NAR for calculating the minimum qualifying income is the following:

Qualifying income = (Monthly mortgage payment * 12) *4

Note that the median home price for a particular area and period is entered in the above formula in the calculation of the monthly mortgage payment. In order to calculate the latter we need to have the loan amount, the effective interest rate (which besides the loan contract rate takes into account and initial fees and charges) and the term of the loan. NAR calculates the loan amount as 80% of the median house price and assumes a 30-year loan term, which represents the term of the majority of conventional residential mortgage loans in the US. The interest rate used for the calculation of the mortgage payment is the average effective rate on loans closed on existing homes from the Federal Housing Finance Board at the particular area. Once the qualifying income for an area and period is calculated then NAR calculates the housing affordability index using the following formula:

NAR Affordability index = Median Family Income *100/Qualifying Income

Based on the above formula, if the median family income is equal to the minimum qualifying income, then the affordability index will take the value of 100. An affordability index of 200 would signal that the median household income of the area is twice as high as the qualifying income required to purchase the median priced house in that area. This, in turn, would imply that housing affordability in the area under consideration is quite high. You can see the NAR Housing Affordability Index (at the national level) for the last 12 months and for a few years back at this link: https://www.nar.realtor/sites/default/files/documents/hai-09-2018-housing-affordability-index-2018-11-01.pdf

California Housing Affordability Index

The California Association of Realtors (C.A.R.) publishes a somewhat different Housing Affordability Index indicator which measures the percentage of an area’s households that have higher income than the minimum qualifying income. The latter is calculated in a slightly different way by the NAR (as described above) as the monthly payment includes property taxes and property insurance in addition to the mortgage payment. Furthermore, in order to calculate the minimum qualifying income, it is assumed that this payment cannot represent more than 40% of a household’s income. The C.A.R. estimates of the affordability index for the third quarter of 2018 (2018Q3) for the state of California and Los Angeles MSA suggest that in both areas single-family house prices were high compared to the income of the households in those areas. In particular according to the index, in the third quarter of 2018 only 27% of the households residing in the state of California had sufficient income to qualify for a conventional mortgage for buying the median-priced home, while in the Los Angeles Metropolitan Statistical Area (MSA) only 30% of the area’s households had sufficient income to qualify for such a loan. C.A.R.’s estimates of the affordability index for the state of California and all counties within the state for the third quarter of 2018 are provided in this webpage.

Using annual data on median house prices from C.A.R. and effective interest rate data from FHFA for California we estimated a simpler affordability index. This index was calculated as the ratio of the annual mortgage payment for a 30-year fixed-rate loan and a loan amount equal to 80% of the median house price, over the median household income. So in essence, our affordability index measures what percentage of the median household income is represented by the annual payment for a conventional mortgage loan. So the higher this percentage is the less affordable houses prices are compared to the area’s median household income.

Figure 1 portrays the median house price and our affordability index estimates for the state of California from 1990 until 2017. As we can see from this figure, the affordability index peaked at 62% in 2006, the same year that the median house price peaked. Obviously, with the mortgage payment representing 62% of the average household’s income, single-family houses were the least affordable during that year in California. This, in most likelihood, must have been one of the key factors that triggered the downfall in house prices in 2007 and thereafter. To better grasp how unaffordable houses were in that year, consider that in the NAR calculations of the qualifying income for getting a conventional mortgage loan the annual mortgage payment represents 25% of household income at maximum.

Figure 1 California Median House Price and SPI Affordability Index Estimates

housing affordability index

Although it appears that the median house price in California in 2017 had almost returned to its 2006 peak (in excess of $500,000), the affordability index climbed at a considerably slower rate at 36%, a considerably lower level compared to 2006. The main reason for this was the considerably lower effective interest rate in 2017 (4.08%) compared to the one that prevailed in 2006 (6.53%). Considering that NAR’s affordability benchmark for the ratio of mortgage payment over household income is 25%, the value of our affordability index estimated of 36% for 2017 does not signal a very healthy relationship between house prices and income in California.

[1] The median price is determined by ranking the sales prices of all existing single-family homes that were sold during the period under consideration and within the market under consideration from lowest to highest and identifying the “middle value” of this distribution. So it is the sales price that is higher than 5O% of the sales prices in this ranking and lower than the other 50%. In the same way, the Census Bureau determines the median family income by ranking the family incomes of the households included in the sample for a particular period and area. The median family income is a more reliable indicator of the income earned by an average family than the average family income because the latter is biased upwards due to the very high incomes earned by a very small percentage of the households residing in an urban area or country.

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Author: Petros Sivitanides, Ph.D.

Dr. Sivitanides is a seasoned expert in real estate investment strategy and analysis, property portfolio modeling and strategic analysis, and real estate market research and econometric forecasting with over 16 years of experience with leading global real estate investment managers and real estate consultants (CBRE Global Investors, AXA Real Estate, Torto Wheaton Research, DTZ, etc.). He is the editor of the textbook titled “Market Analysis for Real Estate”, which has been used as the main textbook for a graduate course at Harvard University. He is also the author of the book "Real Estate Investing for Double-Digit Returns" and many widely quoted articles that have been published in popular real estate journals. Currently, he is the Head of the Real Estate Department at Neapolis University in Cyprus, and an international real estate consultant.

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