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Boston MSA Price/Income Approximation: 1975 - 2009 (- 2014)
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PostPosted: Fri Oct 15, 2010 4:47 pm GMT    Post subject: Boston MSA Price/Income Approximation: 1975 - 2009 (- 2014) 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 - 2009, with a market based estimation of the ratio's range through 2014. 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 - 2009). 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 estimated by temporarily removing inflation from the U.S. Census Bureau's table of historical median household income for Massachusetts, calculating the average plus or minus one standard deviation (hence the three lines), and then adding inflation back to those three estimates using the inflation expectations published by The Federal Reserve Bank of Cleveland.

Based on the data above, the historical moving average was 19.74% below the latest price to income ratio at the time of the last authoritative data point (December 2009). 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 state of the economy. The Massachusetts median income actually fell from 2008 - 2009, not just in real terms, but in nominal terms as well.

The historical average is not an independent gage 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 32.86% below the latest ratio. It is impossible to say whether a 19.74% correction, a 32.86% 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 may 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 anomalously 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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Renting in Mass



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Location: In a house I bought in December 2011

PostPosted: Fri Oct 15, 2010 5:42 pm GMT    Post subject: Reply with quote

So... you're saying it's a great time to buy, right? Wink

Great analysis. Thanks for doing it.
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PostPosted: Fri Oct 15, 2010 5:48 pm GMT    Post subject: Reply with quote

Renting in Mass wrote:
So... you're saying it's a great time to buy, right? Wink

Great analysis. Thanks for doing it.


You're welcome. Thanks for reading it.

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mpr



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PostPosted: Sat Oct 16, 2010 4:35 am GMT    Post subject: Reply with quote

admin, I think that ignoring interest rates makes this an almost
meaningless measure of house prices. You can see this with some
simple thought experiments:

Someone paying a fixed amount $X for a house would rather pay
5% than 10%. Therefore the house must actually be worth more
in the former case than the latter.

How much more ? Well, we can at least begin to get a feel for
some numbers. Lets say we have a model homeowner who stays in
their house for seven years. As you point out, we should take into
account the possible sale price seven years from now which will be effected
by interested rates seven years from now. These can (in principle) be
estimated using bond prices or some other fancier derivative. In any
case lets imagine we've estimated using some method what the sale
price should be seven years from now. Then every 1% drop in the
homeowners *current* rate will save her 7% in interest over the seven years.
So logically they should be prepared to pay (about) 7% more for the house
for every 1% change down in rates.

Now lets take into account the potential sale price. This is effected in
the same way (as a first estimate) by rates. So we should add
7% to the estimated sale price for every 1% drop in estimated rates.

One could refine this in various ways, I'm sure,
(and I'd be very interested if someone implemented it)
but this already tells you that when long bonds are substantially below
the historical average house prices should be substantially above the
historical average (compared to income) and that this is perfectly
rational.
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PostPosted: Sat Oct 16, 2010 4:56 pm GMT    Post subject: Reply with quote

mpr wrote:
admin, I think that ignoring interest rates makes this an almost
meaningless measure of house prices. You can see this with some
simple thought experiments:

Someone paying a fixed amount $X for a house would rather pay
5% than 10%. Therefore the house must actually be worth more
in the former case than the latter.


I agree that your thought experiment is worthwhile, but I am not at all convinced that the effect would be large enough and reliable enough to render the price to income metric "meaningless." You also have to consider the effect working in the opposite direction which is detailed in Dean Baker's paper mentioned above, which is that higher rates usually go hand in hand with higher inflation, which makes servicing debt easier in real terms. That would be achieved through rising incomes, which would likely rise faster in nominal terms when rates are higher. I'm not sure if Mr. Baker's analysis is identical to your thought experiment (I read it ages ago and only re-skimmed it now), but I think the conclusion was the opposite - that is, the 10% rate would be preferable.

I think in the bigger scheme of things, it doesn't matter much, though. If the super low rates are temporary, then there isn't much value in factoring them out of the price to income ratio. If they are permanent, then the moving average will adjust to reflect that before too long. The entire time frame of the data set is short enough that the current moving average is already a standard deviation above the pre-bubble moving average (or pre "new normal" rates, if you prefer).

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balor123



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PostPosted: Sat Oct 16, 2010 5:38 pm GMT    Post subject: Reply with quote

Bond prices can't be used to predict interest rates because there's not an efficient market with them. It is largely driven by government intervention, which is highly unpredictable. The argument that a high ratio isn't a problem because it can always be resold to someone else is a bad one because, like Ponzi schemes, they are susceptible to failure. As we've recently discovered, it only takes one incident to cause a massive crash. As a nation, I think it is good for economists and politicians to focus on moving away from low interest rates as a method of subsidizing home ownership as it adds risk to the housing market and economy as a whole while providing increasingly diminishing support for affordability. As I've mentioned in the past, limiting loans to a limited amount for land and building, perhaps based on national averages, would make more sense.
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PostPosted: Sat Oct 16, 2010 5:42 pm GMT    Post subject: Reply with quote

Thanks for providing this chart again btw. To me it shows that housing is still very risky. I think the graph is somewhat friendlier than it should be because it is an average of all the price tiers. Higher priced homes have a delayed reaction from the mid and lower priced homes so it would be nice to see that data broken up historically as well. I bet you'll find that its ratio has held up quite well.
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mpr



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PostPosted: Sat Oct 16, 2010 7:09 pm GMT    Post subject: Reply with quote

admin wrote:

but I am not at all convinced that the effect would be large enough and reliable enough to render the price to income metric "meaningless."


Well I suppose that depends on what kind of error you are willing
to accept. If its +/- 50% maybe its ok.

Here is a graph of historical mortgage rates. They have covering
almost the same period as your time series.

http://morningmortgagenotes.com/historical-mortgage-rates/

Now just eyeballing I would say the average rate for that period is at least
9% - and I'm ignoring to some extent the big spike in rates round 1980.

The current rate is about 4.5% and let me estimate the rate in 7 years
time at about 6.5% (just based on 30 treasury plus 2% - its crude,
but if anything an overestimate).

Based on this the current price should be about the average by 7 x 4.5%
(9% - 4.5%) plus 7 x 2.5%, or about 50% above the average.
So interest rates make a huge difference.

Perhaps its more accurate to take a shorter series beginning
in say 1990, since interest rates were in a range we're more familiar
with. Then the current price level seems about average or just above
and the average rate is about 7.5%, which indicates the current
price should be about 28% above the average.

Of course this methodology doesn't take into account rising incomes
or expectations of rising/flat incomes. You could build that in too
perhaps taking inflation/ inflation expectations as a proxy for this.
(Although in past posts you were quick to point out that inflation
did not imply rising wages.) But I'm sure that interest rates are
a much more dominant term in rational prices than changes in
income. Thats why I said your graph was "meaningless" - you're
making an estimate while ignoring the most important variable
in what you're trying to estimate !

balor123 wrote:

Bond prices can't be used to predict interest rates because there's not an efficient market with them. It is largely driven by government intervention, which is highly unpredictable.


Yes, lets base it on the prognostication of people on blogs instead Smile.
Actually, thats the beauty of a deep market like the one in bonds.
Even if you believe its chiefuly driven by govt intervention.
(which I dont believe - look up the size of the US and global
credit market compared to the size of Fed interventions) the market
can give you the consensus estimate of the effect of those interventions.
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PostPosted: Sat Oct 16, 2010 7:49 pm GMT    Post subject: Reply with quote

mpr wrote:

Of course this methodology doesn't take into account rising incomes
or expectations of rising/flat incomes. You could build that in too
perhaps taking inflation/ inflation expectations as a proxy for this.
(Although in past posts you were quick to point out that inflation
did not imply rising wages.) But I'm sure that interest rates are
a much more dominant term in rational prices than changes in
income. Thats why I said your graph was "meaningless" - you're
making an estimate while ignoring the most important variable
in what you're trying to estimate !


How do you know that interest rates are more important than changes to income when you've left income changes entirely out of your model? You really should read Dean Baker's paper - my paraphrase probably did not do it justice.

And I think you must be thinking of someone else with regard to the incomes not tracking inflation. In general, I assume that they do, at least over the long run. In fact, the projected price to income ratios on the chart above are based on exactly that assumption.

Finally, I don't think it's accurate to say that I'm ignoring interest rates given that the moving average would necessarily reflect their impact if they are indeed dominant. Please note that the latest price to income ratio was actually less than one standard deviation from the moving average now, and a lot of that is due to a rise in the average.

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mpr



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PostPosted: Sat Oct 16, 2010 9:41 pm GMT    Post subject: Reply with quote

admin wrote:
[
Finally, I don't think it's accurate to say that I'm ignoring interest rates given that the moving average would necessarily reflect their impact if they are indeed dominant.
- admin


Yes this is right in the sense that the decline in interest rates shows up in
your graph as an increase in prices, and its also right that if this is
sustained that average will eventually move up. But this means
we'll have to wait a while before your metric correctly indicates the
rational price for housing (via the avg.).
Its really the flip side of your claim that
the bubble is skewing the average. I think your data during a period
of substantially higher interest rates (up to 12-13% during the eighties)
is what is really skewing the average.

Why dont you rerun the data with a shorter series, say starting in 1990,
when rates were at least < 10%.

As for incomes, well they've increased over time, so my ignoring them
can only lead to an underestimate in the rational price of housing.

I take your point that during periods of high *wage inflation*
nominal prices can be expected to rise more and the real burden of
debt falls. It would be interesting to repeat the calculations
using a kind of
"real interest rate wrt wages" = rate on mortgage - wage inflation.
But I dont have the data to do that.
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PostPosted: Sat Oct 16, 2010 10:00 pm GMT    Post subject: Reply with quote

mpr wrote:

Yes this is right in the sense that the decline in interest rates shows up in
your graph as an increase in prices, and its also right that if this is
sustained that average will eventually move up. But this means
we'll have to wait a while before your metric correctly indicates the
rational price for housing (via the avg.).
Its really the flip side of your claim that
the bubble is skewing the average. I think your data during a period
of substantially higher interest rates (up to 12-13% during the eighties)
is what is really skewing the average.


Yes, I would accept that the early eighties and the seventies is probably skewing the average (not that the bubble didn't skew it too). I also agree that there is a lag before the moving average is "correct." Maybe I will make a separate chart with a more limited time frame when I get some free time.

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PostPosted: Sat Oct 16, 2010 10:15 pm GMT    Post subject: Reply with quote

balor123 wrote:
Thanks for providing this chart again btw. To me it shows that housing is still very risky. I think the graph is somewhat friendlier than it should be because it is an average of all the price tiers. Higher priced homes have a delayed reaction from the mid and lower priced homes so it would be nice to see that data broken up historically as well. I bet you'll find that its ratio has held up quite well.


This is just (real) price and not inflation, but here are some updated graphs of the tiered indexes for Boston.

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PostPosted: Sat Oct 16, 2010 10:36 pm GMT    Post subject: Reply with quote

admin wrote:

This is just (real) price and not inflation


Oops - I meant income, not inflation.

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PostPosted: Mon Oct 18, 2010 3:49 pm GMT    Post subject: Reply with quote

Just my 2 cents - if the blue line (price/income ratio) spent so little time near/below the yellow line (historical average), then I don't see why the 2 lines will suddenly converge in the near future.

Which means if you use it to gauge the market risk, then be prepared for a very long wait.
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PostPosted: Mon Oct 18, 2010 4:38 pm GMT    Post subject: Reply with quote

I think everything you guys are saying makes sense.

When I look at information, I like to see analysis and synthesis. Sometimes when you blend too much information together you miss key points of influence and if you strip out key pieces of information you have blind spots.

Even when you stretch it, pull it, walk all around it, disect it, chart it, etc. you still have to remember that we're talking about people and what perceptions are driving them.... For instance, when a snow storm is coming, people go to the supermarket and buy a ton of shstuff. It doesn't make sense, many rational people don't but who knows why the ones that do do?

After years of observing the housing market, my approach is to think of it as a changing form of material that behaves in certain ways in certain conditions. If the housing market is in a state of vapor, a windlike force can move it, if it is in a liquid state, you see ripples on the surface, and when it is solid nothing moves. Certain periods of the market you saw people describing it as being "sticky" or having downward forces applied to it but not seeing a reaction right away. Momentum obviously affects a market and even after a pendulum hits the low point, it keeps going upward because of the force behind it.

I think what we are all trying to do here is understand when inflection points occur, understand the properties of the market and of human perception so that we understand when we are observing an overshooting of the market so we can get an advanced reading of things. Although I was starting to get delusions of competence at this, the FED and others were distorting the market with their own interventions, which is all now part of the given in the word problem. That unforseen force has created uncertainty and that uncertainty has taken a life of its own.

What's happened now is that they are trying to lead with a blowing wind and hoping that their followers are vapor and will drift right along. Things aren't working because people are resisting the game plan and are in a solid state of conservation. People are saving more, the personal savings rate is building because people are hoarding what they have like the people at the supermarket before the snow storm. Now, when people were making all kinds of money and getting offers from competitors to come and work for them, they said, hey, I can afford to buy a home that is 4 to 5 times my salary because I'm going to double my salary in a few years at this rate.... That mental throttle of adrenaline versus fear changes the properties of the material and just like the boiling point of pure water is different than salt water, you have to think about the actual ingredients in the solution of the water. Now there is potential and latent energy in a market and just like whenyou're brewing beer, certain enzymes break down at certain temperatures, you have to really understand the sweet spots of the market to understand when activity will occur.

I use the Honda Accord or the pick up truck analogy. These two types of cars represent the optimal sales and profit for the median of the auto market. These are price points that balance with volume. I think about what the household salary is for that typical buyer of a Honda Accord, how many kids they have and what their expenses are and what they worry about and what they value. For instance, I know that a higher percentage value a shorter commute to spend more time with kids than say a larger home with more breathing room from their neighbors, etc.

Beyond this, it is about understanding any long term changes to the market solution. For example, as Boston changed from a Blue Collar town to a White Collar town, it totally changed the boiling point and behavior properties of the market. Now sometimes the bigger they are the harder they fall can happen when you dont' have a well stratified and allocated market structure. If the financial market tanks, will the Wellesley and Hingham market drop because their isn't a strong tech market to catch it, meaning as someone gets laid off from State Street Bank, will an IT Architect slide in and buy that home on the market or is his salary so far below that his affordability reach can't support that price level?

Other game changers happened during bad economic periods like after the late 70's and after the recession of the early 90's where you saw surges of women entering the workforce. I remember seeing the movie 9 to 5 with Dustin Hoffman who pretended to be a woman. Remember those songs "She works hard for the money so you better treat her right.... alright..." Back then, the surcharge of income helped familes live a little better, go on nicer vacations, live in nicer homes, etc. After we got a surcharge of women in the mid 90's and you got even distribution of men and women in the colleges, women and men were closer to equal population in the workforce and unfortunately the market adjusted so that you needed two earners to just earn a living. "Household Income" used to mean 1 or 1.25 workers versus today it might be like 1.75 workers. That's a big deal in my mind.

Future game changers we've all talked about, but in a white collar market, people can work longer. The portability of data you're seeing competition from areas that you didn't see before.

Memory is also like an impression made in metal and all those dents and dings from past experiences mold our expectations in the future. My grandparents grew up and got married during the Great Depression. Their conservative nature got passed down to my parents and then to me. My parents got married in the mid 60's when church membership was at an all time peak in our Nation's history so that got passed down to me and that type of community is important for me. My point also is that just as people's expectations of say having one job at one company for an entire career and getting a pension for retirement has totally ended, will we have a society that has members who become a lot more flexible mentally for change and adaptation and can we become more elastic and snap back from the stresses and strains of a more turbulent, faster moving reality? If this is the case, however, is the Boston market really the place to be or are we all overpaying here? Have people been traumatized in this past economic downturn where they are less likely to throw inhibition to the wind and pay 4-5 times their salary for a home? If so, do the historical Price to Earnings ratios really matter?

People need to talk about the profile of buyers as natives versus non natives. If Boston is a place where you can become rich, you'll get a lot of non natives who'll drive up the price to earnings ratio. When other areas offer a better opportunity you lose that surcharge of non natives in the market. Sometimes, even when things look grim around Boston, they might look even grimmer in say areas like Albany or Providence, so the best and brightest there sometimes move here. I was just in tropical Albany and to my surprise saw some absolutely amazing Queen Ann homes that were selling dirt cheap, so they might get a rebirth, who knows? I'm wondering why I'm not out near the Rockies in the Pacific North West. Moving from the North Shore to the South Shore was a big deal; I'm wondering if the younger generation is more adventurous?


Now try to align the packaging for this new type of individual (much more flexible with say a lower risk tolerance) with the current housing stock. The upwardly mobile professional who doesn't own their own set of tools fits nicer in a new condo versus a fixer-upper farm house. The retired guy who likes to work on old cars might like the old farm house, however. How many of these guys are out there? The less and less people care about family and church and tradition, the more flexible and individualistic they become so at that point why would anyone pick a colder climate where you have to shovel show and rake leaves? I remember when the Southern / warmer States started getting all the talented kids for football scholarships. I mean why on earth would you want to play for Penn State when you could go to Southern California and check out babes in bikinis all over campus?

Sometimes, the macro outlook doesn't work when you zoom into one or two homes because at that point you're evaluating a small handful of individual's outlooks. This is why being flexible to find that right opportunity where you have the most leverage or the least competition for the greatest reward is critical.

Lastly, I think having a perfect understanding of something as compex as the housing market is difficult. What one can strive for is building enough knowledge and experience where you will get a higher probability of having a better result. You can do this piece by piece. I think as we all go back and forth in our deliberations we've all picked up the understanding that you get your highest selling price at the peak season of the market and your best buying opportunity at the weaker selling seasons; the quality and value is a case by case evaluation. That knowledge alone helps. In the end it is about the FUTURE not the past. We have to turn the corner and face the future and building the skills to adapt and capture opportunties is really what it is about.
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