There was a recent report done by CBS News in Sacramento asking the question if we are in a real estate bubble or not. After all, home prices feel like they are back to the highs of the market in 2005 so it is a reasonable question to ask.
What is a real estate bubble? According to Investopedia, “A housing bubble is a run-up in housing prices fueled by demand, speculation and exuberance. … Speculators enter the market, further driving demand. At some point, demand decreases or stagnates at the same time supply increases, resulting in a sharp drop in prices — and the bubble bursts.”
What were the circumstances that allowed the real estate bubble to occur in 2005/2006? Lending institutions encouraged 100% financing, no-income verification loans, negative amortization loans, and other sub-prime loan products. They gave buyers access to unlimited sums of money which allowed buyers to drive up home prices. Home values were not supported by income because income became an irrelevant part of the equation. Homeowners used to use their homes as piggy banks and refinance every 6 months and pull out tens of thousands of dollars at a time to support their spending habits. They even leveraged their homes to buy more homes and repeat the process. Access to these loans turned the entire population into potential homeowners which created an artificially high demand and caused the runaway home prices – a.k.a. real estate bubble.
The lending environment is vastly different today. Buyers are required to have skin in the game. While most buyers still do not put 20% down to buy a home, they are required to have some sort of down payment (FHA loans only requires 3.5% down). In addition to a down payment, income verification is a must today. Since income verification is a must, and if there is a debt-to-income ratio limit, then home values will ultimately be limited by the region’s income levels. This is the key to understanding if we are in a real estate bubble or not.
Instead of looking at home prices to determine if we are in a bubble, we need to look at home affordability. There is something called the Home Affordability Index. This index tells you what percentage of the population can afford the median home price. (If you are curious about the methodology of how this index is calculated visit http://www.car.org/marketdata/data/haimethodology/.) Every region across the country has their own historical average of what is affordable. For example, San Francisco has always been less affordable than Sacramento. You want to be sure that you compare an index to its own historical average.
Below is a chart from 1st quarter 1991 to 3rd quarter of 2016. The blue line is the median home price. The red line is the “unaffordability” rate. The percentage of “unaffordability” is the percentage of households who cannot afford the median home price. I chose to show the “unaffordability” as opposed to affordability because it is easier to observe the correlation.
Back in the 1st quarter of 2005, only 19% of households could afford the median home price!! Talk about a bubble! In the 4th quarter of 2011, 74% of households could afford the median home price!! What an opportunity! Where are we today? We are at 45% affordable (according to the chart, we are 55% unaffordable). Historically Sacramento County has ranged from 45% to 55% (the average of all the data points is 50% in case you were wondering). We are in the lower end of that range. If you look closely at the end of the chart, you’ll noticed that while home prices are increasing, home affordability is trending steady. How is that possible? The dropping interest rates have been able to keep homes affordable even though the values are going up.
Now that interest rates are starting to climb again, we will see homes become less affordable. Does that mean we are in for some kind of bubble burst? Hardly. There aren’t any ingredients to cause a pullback in prices. Homes are still affordable relative to the income in the area. There are no signs of income dropping. Unless we see a serious spike in interest rates or a drop in income due to a recession, I believe these prices are here to stay. If the home affordability index drops down to 40%, then we should expect a market correction but NOT a bubble “bursting”. The last time the home prices were at this level, only 35% of households could afford the price. Today we see a much healthier 45%. Don’t let the local news station fool you with their sensational headlines. Remember to consult your local Realtor!