A while back, a commenter made the following claim:
What history tells us will happen is that prices will level off, and appreciation rates will reflect your average inflation rates (on average) until wages catch up with home prices and the fundamentals start to match back up.
As most of you know, this scenario is commonly known as the “soft landing.” Actually it’s a slightly harsher version of the traditional soft landing, in which appreciation rates dip down to 5-6% as opposed to falling all the way down to the level of inflation (traditionally 2-3%). So if this version of the soft landing is true, just how long will it take for wages to “catch up with home prices”? For the answer, let’s get our Excel on.
To begin, we need some good starting data. Let’s assume for the sake of this argument that in the first quarter of the year 2000, homes were “affordable.” The Washington Center for Real Estate Research (WCRER) “affordability index” for Q1 2000 was 96.6, so this is likely a fairly accurate assumption. So, let’s take a look at the housing market vital statistics for the year 2000:
Q1 2000
Median Home: $245,000
Median Household Income: $54,590
Interest Rate: 8.21%
Affordability Index: 96.6
Tim’s Affordability Index: 93.0
Since I don’t know how WCRER calculates their affordability index, I created my own. The calculation I used is simply 30% of the median monthly income divided by the monthly payment on the house (assuming 20% down and a 30 year mortgage). So, what does the situation look like now? Here are the most recent numbers:
Q1 2006
Median Home: $399,500
Median Income: $60,700
Interest Rate: 6.15%
Affordability Index: 77.1
Tim’s Affordability Index: 77.9
Ouch. Not so affordable anymore. Home prices have increased an average of 8.5% per year, while wages only increased an average of 1.8% per year! No big deal though, right? Prices will just “level off” and wages will catch up.
Let’s make some (relatively optimistic) assumptions and see what the “wages will catch up” scenario would look like. Let’s assume home prices “level off” to 2.5% annual increases. Furthermore let’s assume that interest rates increase just 0.125 points each year until they top out at 8.00%. Lastly, let’s assume that wages increase at 5% per year. Under that scenario, my affordability index reaches the 2000 level of 93.0 in the year 2021. That’s fifteen years of stagnant home prices, under a relatively rosy set of numbers.
What if interest rates go up 0.25 points each year and top out at 10%? Look to afford a home in 2029. What if instead wages only increase at 4% per year? Homes become affordable again in 2031. What if I tweak the numbers ever so slightly and assume 3% home price gains, 4% annual wage increases, and a maximum interest rate of 9%? Don’t expect to afford a home until 2053.
Keep in mind that these figures totally ignore the already high and still increasing expense of the 20% down payment. Inherent in the calculations is the optimistic assumption that people will somehow manage to come up with the money. In the first scenario I outlined, the affordable home in the year 2021 would cost $578,595, requiring a $115,719 down payment. The median household income would be $126,191.
Maybe I got the formula wrong. Or maybe the “soft landing” scenario is a steaming pile of… well, you know. Honestly I have no clue what’s going to happen. Maybe it really will be 10-20 years before homes become affordable again. For your enjoyment, I have added these calculations to a new sheet in the big Seattle Bubble spreadsheet. Feel free to download it and play with the numbers yourself. If I’m way off base and making inappropriate assumptions or using stupid equations, please let me know.
Sources:
(Home Prices & Affordability: WCRER)
(King County Incomes: King County Government)
(Interest Rates: Federal Reserve)
(Inflation: InflationData.com)