Buying a House—A Wise Financial Decision? (1)

Buying a house can be the most important financial decision you’ll ever make, especially if you live in coastal areas, where real estate prices tend to be higher.

In a series of posts, I will consider how wise it would be from an economic perspective to buy a house today. I will not discuss psychological factors involved, for example, most people want to live under a roof of their own, or some other practical factors—you are very limited in being able to renovate or make changes in a rented house, and your rights as a renter could be hurt by your landlord—and who really wants to have a landlord?

As an economist, I believe that everything can be quantified up to some level. I can generate parameters for some of the factors listed above, but I want to focus only on the financial aspect of the decision. To get to the bottom of this, there are two questions we should ask: Is buying a house today a wise financial decision? If not, was it ever a wise financial decision?

The real estate market today

A good way to start the analysis would be to check the status of today’s real estate market. In 2011, prices hit a new low following the subprime crisis. Since then the market has been growing almost nationwide (and almost worldwide). According to the Case-Schiller index, which tracks price changes in major U.S. metropolitan areas, the average increase in prices in the country from 2012 to 2016 was above 40%, and in some metropolitan areas in the West, such as Los Angeles, San Francisco, Las Vegas, Phoenix, Seattle, and Portland, the increase in prices was above 55%. San Francisco dominated again with a whopping 78% increase during that period.

So, investing in San Francisco five years ago was not such a bad idea, but are these gains sustainable?

The median price of a house in the U.S. is $296,200, but as a smart man once said, “Statistics are like bikinis. What they reveal is suggestive, but what they conceal is vital.” And these statistics conceal that prices in many areas may actually be much higher than the overall median price of a house in this country. For instance, the median price of a house in San Francisco is more than $1.3 million, and the median price in Los Angeles has reached $0.6 million, and the closer you are to the city center, the prices are higher.

Having said that, we need to remember that prices themselves don’t tell us much, since prices are just numbers, and numbers only matter if they are part of a ratio. Some ratios reflect the status of the market, and the most notable ones focus on affordability.

Affordability

Affordability is a key parameter when assessing the status of the housing market, since a market in which houses become unaffordable for most people is a market that pushes aside those same people. And when fewer buyers are in the market, the demand side of the market will soften, and we could anticipate a decrease in prices.

The price-to-income ratio is a good measure of affordability since it reflects the real changes in prices. Price to income measures the ratio of a median house price to a median household’s disposable income. If house prices rise by 10% and salaries rise by the same amount, most people are not affected (on average, as always). If the price of houses rises more than the increase in salaries, though, the average person’s ability to buy a house is affected.

It should be noted that not everyone who buys a house depends on a salary, but many of them do, and history has shown that during real estate bubbles the price-to-income ratio hikes, and when the bubble explodes, the ratio crashes.

Price to income

The U.S. is a large and diverse country, and the differences between regions and cities are astronomical in terms of prices and income. In Middle America, prices have increased during the past few years but are still in line with household income in these areas, as the price-to-income ratio has stayed within a reasonable margin. For instance, median prices in Chicago, Atlanta, Dallas, and other major cities in Middle America have remained affordable, although they have still risen in the past few years.

On the contrary, If we refer again to San Francisco and some other expensive cities, salaries in these coastal areas tend to be higher, as the average employee in San Francisco may work in a top technology firm, but the price-to-income ratio is a ratio that measures this exactly, and this ratio has spiked at a staggering pace.

To analyze affordability, I have evaluated a data set of price-to-income rates in major metropolitan areas since 1985. Prices were extremely volatile before and after real estate and financial crises, so I considered two data sets with less fluctuation: 1985–1999 and 2000–2015. I then compared their averages with the ratio at the end of 2016.

The results were astonishing:

  • The ratio in the whole country hasn’t changed much. The average for 1985–1999 was 2.76 (which means that 2.76 years of disposable income would allow you to buy a house), and that number today is 3.36.
  • Ratios in large metropolitan areas on the East Coast have changed but not as much as one might have imagined. New York, which is probably the most sophisticated real estate market, had a ratio of 4 for 1985–1999, and the ratio today is 6. More interesting, the ratio for 2000–2015 was even a bit higher. The story in Boston is pretty much the same.
  • The major metropolitan areas in the West are a completely different story. Price-to-income ratios in San Francisco, San Jose, and Los Angeles are now above 9 after being around 5 for 1985–1999 and less than 8 for 2000–2015.
  • Ratios today in the booming metropolitan areas of Seattle, Portland, and Denver have almost doubled from the average for 1985–1999. They are still at a reasonable ratio of 5, which might indicate there is still room for growth.

Recent price to income changes are not solely an American phenomenon. The hike in all prices of assets following the subprime crisis, the low-interest rates, and demographic changes have resulted in great changes in real estate prices in many countries. Canada has seen a 17% increase in the price-to-income ratio between 2010 and 2016, which you can consider again as a statistics lie, since prices in Toronto and Vancouver experienced much sharper gains, whereas the rest of the country saw moderate growth. In New Zealand, the price-to-income ratio is 33% higher, and European states have also suffered: ratios in Austria, Germany, Sweden, and Switzerland gained 26%, 21%, 20%, and 19% respectively. Only Spain and Italy have seen ratios decline, which tells us more about their economy than anything else.

Debt

Other parameters also need to be examined to determine the full picture of the market. When affordability becomes an issue and people still want to buy houses, they will need to leverage their money more than ever before. We can assume that the price-to-income ratio hike is correlated with an increase in household debt, which primarily comprises mortgages. The problem is that household debt is limited by nature, and banks are limited by the number and amount of mortgages they can offer.

We can measure household debt in various ways, but the most common is to look at disposable household income. Household debt in the United States increased to 80.1 percent of GDP in the fourth quarter of 2016. The percentage of household debt to GDP in the United States averaged 56.29 percent from 1952 to 2016, though just before the last bubble burst in 2007 the ratio had reached an all-time high of 95.50 percent of GDP, so the situation probably can be worse.

Yet again, some countries have bubbled more than the U.S., such as Canada (167%) and Australia (a whopping 189%). Numbers in some European countries are even above 200%.

Bottom line

Housing affordability is becoming an issue in many cities today, as it recently was in San Francisco. Salaries are increasing in the country, but at a small pace—perhaps too small—and home prices are increasing at a much faster pace than before in most metropolitan areas. Affordability for the general public is low and in some areas even historically low. Financial intuition tells us that buying a house today is not the best idea unless you believe that prices can be separated from salaries. In terms of affordability, buying a house today does not seem like a wise decision in growing regions of the country, but we also need to consider some other factors.

In terms of debt, the situation in the U.S. is not great, but it does not seem that disaster is waiting to happen as is the case in some other countries, where a bubble burst can deeply hurt the economy. The anticipated hike in interest rates by the Fed and other central banks in the world makes these debts impossible to live with, thus decreasing the demand for houses (and other products).

As I near the end of this post, it’s important again to emphasize this disclaimer: buying a house in order to live in the house is a different story. I’m only referring to real estate investment as a method for yielding a high return. Observing the real estate market in the United States today, it seems that buying a house is not the best choice for investment if you have some free cash.

Has it ever been a smart decision?

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