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Boston MSA Price/Income Approximation: 1975 - 2007 (- 2013)
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PostPosted: Thu Mar 12, 2009 11:21 pm GMT    Post subject: Boston MSA Price/Income Approximation: 1975 - 2007 (- 2013) Reply with quote

Possibly one of the most important fundamentals in determining what a property is worth is the income of those living in the area. Employment and business opportunities vary geographically and people would logically be willing to pay more to live in areas with better income opportunities. Income is also the source of the money used to purchase housing and as such limits the extent to which housing prices may rise over the long term. While such a limitation may be overpowered for periods of time by factors such as aggressive financing and temporarily low interest rates, in the long term prices must be sufficiently supported by income.

A simple method of approximating how well housing prices are supported by incomes is to calculate the ratio of sale prices to incomes and compare the ratio from different time periods. While this does not provide an intricate model detailing exactly how incomes affect prices, it does illuminate how much income has been necessary in the past to support housing prices as well as when prices rose beyond what was sustainable for the long term. A plausible hypothesis is that there is a correct ratio at which one would be able to purchase a home with a certain number of years worth of labor and if the market were always appropriately priced that ratio would be nearly constant over time.

Below is a chart of an approximation of the price to income ratio for the Boston MSA from 1975 - 2007, with a market based estimation of the ratio's range through 2013. Many datasets were combined out of necessity in order to produce a long running series. The datasets which were treated as authoritative when available were The S&P/Case-Shiller Index for Boston (1987 - present) and the U.S. Census Bureau's table of median household income for Massachusetts (1984 - 2007). The ratios are expressed as a percentage of the most recent authoritative ratio.



The key feature of the chart above is the thick blue line. It is the approximation of the price to income ratio for the Boston MSA. The yellow line is a running average of that ratio. The red and green lines are one running standard deviation above and below the running average respectively. They represent the range that could have been viewed as historically "normal" at that point in time. The muted red lines represent additional standard deviations above the average - what could have been considered extreme departures from normal.

The muted turquoise, muted blue, and muted violet lines on the right of the chart provide a potential range for where the price to income ratio might be in the future. The price is the market expectation based on the S&P/Case-Shiller futures for Boston. The income is the inflation adjusted average of the U.S. Census Bureau's table of median household income for Massachusetts, plus or minus one standard deviation (hence the three lines). Future inflation is estimated (poorly) by the yield on 5 year US Treasuries.

Based on the data above, the moving average for the price to income ratio was 27.3% below the latest authoritative ratio (December 2007). This is the correction that would be needed if the price to income ratio were to instantaneously return to the historical average. It is not a prediction of an expected correction in prices, even if the ratio does return to the historical average, because that may occur through a combination of declining prices and rising incomes. However, the near term might actually see both falling prices and falling real incomes, given the current recession and rising unemployment in Massachusetts.

The historical average is not an independent gauge on the magnitude of the bubble, though, because the bubble itself has changed the average. It has raised the historical average so far that what the average is now would have been considered abnormally high when the bubble began as it would have been over a standard deviation away from the average then. (The start of the bubble is considered here to be when the price to income ratio first rose above one standard deviation over the running average at the time.) Using the pre-bubble metrics makes the situation appear more dire - the pre-bubble moving average was 38.2% below the latest ratio. It is impossible to say whether a 27.3% correction, a 38.2% correction, or some other correction will occur. Eventually, though, the ratio and the moving average almost certainly will converge because either the ratio will fall enough or the average will rise enough.

A common complaint against analyzing the price to income ratio is that the monthly payment to income ratio would be preferable. While that might be more relevant if you had no down payment, used a fixed rate loan, inflation was constant, and you stayed at the same property forever, none of these are likely apart from the fixed rate loan. While it would make for an interesting additional comparison, using the purchase price instead avoids the following problems:

  • Down Payment - A comparison of expense ratio is necessarily going to depend upon the down payment used to purchase the property. This will vary from individual to individual. Some people are willing to pay entirely in cash now for the right property. Their monthly mortgage expense would be $0.
  • Loan Type - Interest rates are still low, historically speaking, and there would be plenty of precedent for them to go higher. That would increase the monthly expense of those with adjustable rate loans. You could control this by using a fixed rate loan, but a lot of people don't.
  • Inflation - Low interest rates generally accompany low inflation. For a given price, housing is actually more affordable when inflation is higher because the burden of fixed payments is reduced as income rises with inflation. For more information, see the Center for Economic Policy Research article entitled The Housing Affordability Index: A Case of Economic Malpractice.
  • Holding Time - On average, US property owners own a given property seven years before selling. When you sell a property, the price is all that matters - what you paid each month for the last seven years is irrelevant. Seven years also only accounts for 23% of the time covered by a 30 year mortgage, so the sale price will be a much more dominant factor. If the majority of people are stretching to make a certain monthly payment now when interest rates are still low, as interest rates return to normal new buyers stretching to make the same payments will be able to finance less and prices will necessarily fall. In this way, you will be limited by what interest rates are seven years in the future even if you have a fixed rate loan. Even if you plan on staying in a home for a substantially longer period of time, bear in mind that unforeseen family and work developments can necessitate moving.

Double checking of the data presented here by others would be greatly appreciated in order to identify and correct any errors. The following sources were used:

The latest version of this report can be found at http://www.bostonbubble.com/latest.php?id=ma_price_to_income Previous versions of this report are available for:

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john p



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PostPosted: Fri Mar 13, 2009 1:30 pm GMT    Post subject: Reply with quote

What are the list of things that happened in 1997 / 1998?

Here's one perspective:

http://www.eriposte.com/economy/indicators/bush_deficit_graphic.gif

Here's another perspective:

http://www.youtube.com/watch?v=1RZVw3no2A4


It's funny how people want their cake and eat it politically. People like to thump their chests when they talk about the Clinton years economy (wasn't a bubble economy but rested on terra firma), but in the context of housing it's entirely Bush's fault. That's believable...

My belief is a combination of the socialistic band aid gone awry called the Community Reinvestment Act put on the hemmorage of wealth being redistributed TO CHINA.

http://www.american.com/archive/2007/january-february-magazine-contents/0116-question-answer-trade-deficit/

In each chart look in around 1997...

i.e.

http://www.american.com/graphics/2007/january/q-a-trade-deficit/Components%20of%20the%20Current-Account%20(large).JPG
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JCK



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PostPosted: Fri Mar 13, 2009 1:37 pm GMT    Post subject: Reply with quote

To follow on john p's point, here are two other things that deformed fundamentals in the late 1990s.

First, the $250k/$500k capital gains exemption on home sales replaces a one-time capital gains deduction. This change greatly encourages people with valuable homes to re-enter the market, thus creating more demand from people with large amounts of equity.

I'd be curious how much this affected home prices in the so-called "immune towns" where the capital gains for people who bought in the 1970s and 1980s were (a) significant, and thus worth taking advantage of and (b) likely approaching these limits, thus encourage people who would otherwise stay put to sell (and likely trade up).

The second is the end of rent control locally. I know that rents went way up in the 1996-2000 time frame in Cambridge. What I don't know is how much of this was due to the concurrent dot-com bubble, and how much was due to removal of rent restrictions.
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PostPosted: Fri Mar 13, 2009 2:15 pm GMT    Post subject: Reply with quote

JCK wrote:

First, the $250k/$500k capital gains exemption on home sales replaces a one-time capital gains deduction. This change greatly encourages people with valuable homes to re-enter the market, thus creating more demand from people with large amounts of equity.

I'd be curious how much this affected home prices in the so-called "immune towns" where the capital gains for people who bought in the 1970s and 1980s were (a) significant, and thus worth taking advantage of and (b) likely approaching these limits, thus encourage people who would otherwise stay put to sell (and likely trade up).


I've wondered about the impact of the change in the capital gains deduction too. I don't think that those with equity who were trading up created the dominant dynamic during the housing boom, though. When comparing the three tiers of the S&P/Case-Shiller Index for Boston, the high tier actually experienced the smallest growth, proportionately:



JCK wrote:

The second is the end of rent control locally. I know that rents went way up in the 1996-2000 time frame in Cambridge. What I don't know is how much of this was due to the concurrent dot-com bubble, and how much was due to removal of rent restrictions.


Where was rent control in effect? Judging from a New York Times article I found, as of 1995 it was ended (and presumably only in effect) in Boston, Brookline, and Cambridge. If those were the only cities, that may not be a wide enough area to have had a large effect on the S&P/Case-Shiller Index, especially considering that the regular S&P/Case-Shiller Index only tracks single family homes and that is a smaller proportion of the stock of housing in those cities relative to the suburbs.

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JCK



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PostPosted: Fri Mar 13, 2009 3:22 pm GMT    Post subject: Reply with quote

admin wrote:

the high tier actually experienced the smallest growth, proportionately:


I don't know that you can rule it out as a factor, though, based solely on proportional comparison. An increase from $500k to $750k ($250k) may "only" be a 50% increase, whereas an increase from $150k to $300 would be proportionately bigger, but smaller in terms of dollars.

Also, the effect on the middle class buyer might be greater in the former case (who wouldn't consider a home in, say, Lynn or Lawrence at either $150k or $300k, but no longer can afford that home in Newton when it goes from $500k to $750k) than in the latter.

Quote:
I found, as of 1995 it was ended (and presumably only in effect) in Boston, Brookline, and Cambridge. If those were the only cities, that may not be a wide enough area to have had a large effect on the S&P/Case-Shiller Index, especially considering that the regular S&P/Case-Shiller Index only tracks single family homes and that is a smaller proportion of the stock of housing in those cities relative to the suburbs.
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Hard to say. I think a good portion of the rental stock was in these cities, and it's easy to imagine that rent control in Cambridge, affected rental prices in, say, Arlington and Somerville.

If the condos in Cambridge become more valuable (because of higher equivalent rent), I would suspect you'd see a "trickle up" situation where values get pushed up across the board. So, although I'm clearly speculating here, I think you might see across-the-board increases in prices, even in areas that didn't have rent control.
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PostPosted: Fri Mar 13, 2009 4:34 pm GMT    Post subject: Reply with quote

Going along JCK's trickle up theory-

Think about this: ready.... Many properties close to Boston were built a long time ago right? Well that means that they're owned by someone who most likely PAID for the place a generation or two ago.

This is like my best real estate thought in a while...

Think about how many properties were passed down to their family members. Think about how the relationship of price to income changes when you get a growing amount of people getting free houses from older family members. I know that a relative had been given a triple decker, one level to each kid. One of the kids bought the other two floors from their siblings and then rented them out and with the money, they went out to a Route 2 suburb.

I think one thing to think about in this analysis is that if a person has seven kids, only one gets to inherit the nest and five others need to find their own, assuming that one other will pair up in another inherited nest with their husband/wife. Now you used to see extended families in homes so it doesn't compare exactly, but it is very important to understand that after WWII we needed more nests, so the mass construction outside the 128 belt were modest homes built on cheap land. As people migrated out of Massachusetts, they left behind these old WWII starter homes and with the fewer buyers and lots of WWII starter homes, the people in their mid-late forties were able to grap a place for a song. If you factor the increase for the premium for land, the shrinking family size and more homes to will to relatives, and how relatives could now rent these places out, the whole owning a second property wasn't just for rich people, it was for everyday people.
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PostPosted: Fri Mar 13, 2009 4:38 pm GMT    Post subject: Reply with quote

Following up, when you had people getting free houses willed to them, their mortgage was free, so they could save a very large portion of what they made. They were these people that had modest income, but because they had no mortgage, lived very large.

Take your salary and back out your mortgage and see what is left, then think of what type of job you'd need to get that cash flow. My guess is that a doctor with medical school bills, someone who works 60 hours might not get ahead of someone as a WalMart Greeter who had a house given to them.
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PostPosted: Fri Mar 13, 2009 8:06 pm GMT    Post subject: Excellent work! Reply with quote

Nice job... great charts and analysis...

I'm really feeling like we haven't even begun to see falling incomes... Its altogether very likely that this bout of unemployment is going to push incomes down much more than at any other time on the post-war period.

So incomes have been stagnating... falling in real terms and now they will fall in nominal terms as well.

I think this argues for a far more harsh housing price correction possibly sending the ratio significantly below the long run average for a time.
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PostPosted: Fri Mar 13, 2009 8:14 pm GMT    Post subject: Reply with quote

You have to discount for the mortgage rate and look at the monthly payment trend as well, as Admin qualified. A mortgage consists of principal (house price) and cost of capital (mortgage rate). The lower the cost of capital during the first part of this century increased the affordability reach.

This graph speaks to just one of the two major components in a mortgage payment, principle not cost of capital. I'll try to save Admin another post and say that if mortgage rates do go back to historical norms of around 8.5% or so, it will REALLY put downward pressures on house prices because affording today's mortgages is tough, add two to three points of interest on it and see what you've got.

I wish they just took all the people that got upside down and did this: either let them foreclose or offer some government backed mortgage for a 40 year mortgage. I think lengthening the term gives them the right punishment while still letting them stay in their homes...
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PostPosted: Fri Mar 13, 2009 8:30 pm GMT    Post subject: Re: Boston MSA Price/Income Approximation: 1975 - 2007 (- 20 Reply with quote

Regarding the estimates of future P/I:

admin wrote:
The muted turquoise, muted blue, and muted violet lines on the right of the chart provide a potential range for where the price to income ratio might be in the future. The price is the market expectation based on the S&P/Case-Shiller futures for Boston. The income is the inflation adjusted average of the U.S. Census Bureau's table of median household income for Massachusetts, plus or minus one standard deviation (hence the three lines). Future inflation is estimated (poorly) by the yield on 5 year US Treasuries.


It sounds like you are adjusting for inflation in the divisor (income) but not in the dividend (price)?

Wouldn't it be simpler to adjust neither one for inflation, since the effects are equal in both price and income, and therefore cancel out?

Great chart regardless. Thanks.
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PostPosted: Fri Mar 13, 2009 8:45 pm GMT    Post subject: Re: Boston MSA Price/Income Approximation: 1975 - 2007 (- 20 Reply with quote

Teavo wrote:
Regarding the estimates of future P/I:

admin wrote:
The muted turquoise, muted blue, and muted violet lines on the right of the chart provide a potential range for where the price to income ratio might be in the future. The price is the market expectation based on the S&P/Case-Shiller futures for Boston. The income is the inflation adjusted average of the U.S. Census Bureau's table of median household income for Massachusetts, plus or minus one standard deviation (hence the three lines). Future inflation is estimated (poorly) by the yield on 5 year US Treasuries.


It sounds like you are adjusting for inflation in the divisor (income) but not in the dividend (price)?

Wouldn't it be simpler to adjust neither one for inflation, since the effects are equal in both price and income, and therefore cancel out?

Great chart regardless. Thanks.


Sorry, I should have phrased that better. The divisor (income) is the estimated, nominal future income, and this estimate is generated using the inflation adjusted average of past income along with an estimate of future inflation. Real income in the past has fluctuated up and down within a given range. That range was simply converted back into nominal terms for the future using an estimate of inflation. The end result is that both numbers in the ratio are nominal, so the inflation cancels out as you said.

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Eric
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PostPosted: Wed Mar 18, 2009 7:51 pm GMT    Post subject: comparison to Boston Globe graph Reply with quote

Can someone help me reconcile the price/income graph in the original post to the price:income graph in this article?

http://www.boston.com/business/personalfinance/articles/2009/03/07/consumers_who_could_lift_market_not_ready_to_buy/#commentAnchor

The latter makes it appear that the ratio is the lowest it's been in 20 years (implying that homes are relatively affordable).

Eric
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john p



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PostPosted: Wed Mar 18, 2009 7:56 pm GMT    Post subject: Reply with quote

Although the market is primed based on the affordability metric, the concern is solvency (people are afraid that they will lose their jobs and it is risky to buy something and think it is safer to stay on the sidelines and perhaps see prices decline further).

Another thing that might skew these numbers is that the babyboomers are in their peak earning years so that increases the median income, and second, younger people often have heavy debt burdens from college loans.
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PostPosted: Wed Mar 18, 2009 8:02 pm GMT    Post subject: comparison to Boston Globe graph Reply with quote

john p wrote:
Although the market is primed based on the affordability metric, the concern is solvency (people are afraid that they will lose their jobs and it is risky to buy something and think it is safer to stay on the sidelines and perhaps see prices decline further).

Another thing that might skew these numbers is that the babyboomers are in their peak earning years so that increases the median income, and second, younger people often have heavy debt burdens from college loans.


I wasn't really asking about the content of the article. It was the graph of P/I that caught my eye. It looks very different from the P/I graph in the original post. I was wondering if anyone had a simple explanation.
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PostPosted: Wed Mar 18, 2009 8:04 pm GMT    Post subject: Re: comparison to Boston Globe graph Reply with quote

Eric wrote:
Can someone help me reconcile the price/income graph in the original post to the price:income graph in this article?

http://www.boston.com/business/personalfinance/articles/2009/03/07/consumers_who_could_lift_market_not_ready_to_buy/#commentAnchor

The latter makes it appear that the ratio is the lowest it's been in 20 years (implying that homes are relatively affordable).

Eric


When I looked at the Globe article earlier, I wondered the same thing. I was unable to find their source data, so I couldn't verify their graph. I didn't look for very long, though, so maybe somebody else can dig it up.

One big difference is that they are using the median housing price and the graph at the beginning of this thread uses the S&P/Case-Shiller Index for Boston for the time period in question. They didn't specify which median they used, which confuses things even further - prices are down a lot for the state, but not so much in the higher priced Boston suburbs (yet). They may have been using the median for the whole state rather than just Greater Boston. Additionally, the median is also susceptible to other distortions which the S&P/Case-Shiller Index avoids.

In any case, I wouldn't buy the conclusion implied by the Globe's graph (that affordability is good again) if you can't reproduce the graph yourself.

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