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| Incomes and Affordability Don’t Paint the Entire Picture |
| Written by Jonathan Smoke | |
| 12.27.2007 | |
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Discuss this article on the forums. (0 posts) Our loyal readers have noticed that my volume of posts has dropped dramatically this month. A few have been egging me on to write more, but I don’t enjoy writing for the sake of filling space—I want my posts to inform and entertain, and to do that I need something interesting to happen, or I need something new to inspire me. Normally it doesn’t take much to inspire me. But given a rush of year-end projects combined with the usual holiday craziness, the same-old, same-old on housing has not been inspirational. Do you really need more talk of price declines, inventory increases, sales declines, and housing-induced recession?  If anything, I feel like creating a funny blog to poke fun at all of the so called experts who have nothing but doom and gloom to say about housing. After all, dozens of people did the opposite in the first half of this decade. Now the pendulum has swung too far in the opposite direction. I personally would like a little balance. After all, it can’t all be bad. And it’s not.So today I found inspiration from none other than the page one article on The Wall Street Journal titled “Pace of Decline in Home Prices Sets a Record.” I always enjoy reading how the media take the tender and kerosene from S&P/Case-Shiller and make the most out of it. The core inspiration came from one simple sentence in the article: “That means house prices will have to fall to a level potential buyers can afford.”
The premise is that home prices should follow some “normal” pattern in relation to incomes so that if we have a period where prices have risen far more rapidly than incomes, we should see a corresponding period of price decline to get the prices into a historic ratio. If this sounds familiar to you, it should. In November I did a series of posts regarding a Fortune article that loudly forecasted double-digit home price declines for most markets in the country over the next five years based on the same premise. Let’s think about this logically. What impacts home prices? Start with econ 101. Supply and demand. What impacts supply? Inputs such as land, materials and labor. The nature of competition. Cost of capital. What impacts demand? Household growth. Incomes. Employment. Demographics. Ownership preferences. Availability of financing. Cost of financing. Affordability. Lifestyle preferences. Available substitutes (e.g., renting). Incomes do matter and clearly the demand curve should have shifted to the left to reflect a generally lower level of demand now as a result of affordability declining and financing drying up and some forms of financing becoming far more expensive. As a result, we should -- and do -- see a decline in prices and in quantities sold. )) Yet in most areas households continue to grow along with incomes and employment. The population is aging, and home ownership increases with age. So demand hasn’t -- and won’t -- disappear despite what the media tries to do with the housing doom story. Meanwhile supply hasn’t been static and ignorant about the decline in demand. Granted, supply is slow to respond and likely hasn’t pulled back enough yet to be fully in line with the change in demand, but it too has likely shifted left. While these curves imply that we can precisely measure the housing market, the reality is that the housing market is really impacted by a complex set of variables that is impossible to model and forecast with any sort of precision. This is further complicated by the fact that many metrics needed for such a model are either impossible to measure or too limited to really reflect what’s going on. Clearly as a market researcher and the founder of a web site dedicated to housing intelligence, I think it’s critical to monitor and analyze as many of these variables as possible. Incomes are one of those variables and studying home prices relative to incomes is important, especially if the demand you are seeking is impacted severely by affordability or availability of financing. But a model to predict future homes prices built solely on an assumption regarding a permanent relationship of home prices to incomes ignores all of the other variables to its peril. Put the economics aside. If home prices are ultimately governed by levels of income, why is there greater variation in median home prices across markets than median incomes would predict? Could it be that some locations are more desirable? How about scarcity—is there an unlimited supply of highly desirable locations? Today was for the inspirational rant. Tomorrow I’ll share more intelligence about what we and others think is happening with home prices, while taking far more into account than just incomes and affordability. 
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