Why housing 'affordability' is a misleading indicator
MAY 19, 2011
UPDATE: I posted this article yesterday. Today I see that RBC has released their updated housing affordability measures. The post has been updated to reflect this new data.
Housing affordability is often cited as one of the primary reasons that Canada is not experiencing a housing bubble. Despite all fundamentals pointing to a significant level of overvaluation in most parts of the country, critics of the 'bubble thesis' point to the fact that affordability, as it is defined in several common measures, is well below all-time highs. I'd like to outline seven reasons why I believe that the most commonly-used affordability measure is quite misleading and should take a back seat to measures of fundamental value widely used in empirical research. While house prices relative to rents, incomes, inflation, and economic growth are all commonly referenced in academia when discussing the possibility of a housing bubble, affordability indices are seldom referenced....and for good reason.
The most commonly referenced affordability measure in Canada is the RBC Affordability Mndex. In the US, two widely followed indices are the National Association of Realtors Affordability Index and National Association of Home Builders/Wells Fargo Housing Opportunity Index.
Let's zone in on the RBC Affordability Measure. RBC describes the purpose of the measure as follows:
Our standard RBC Housing Affordability Measure captures the proportion of median pre-tax household income required to service the cost of a
mortgage on an existing housing unit at going market prices, including principal and interest, property taxes and utilities.
Let's start off by noting the most recent measure of affordability, as of May 2011:
As you can see, the critics have a valid point. The measure has fallen from the recent highs in 2008. However, let me highlight a few reasons why this measure is not all it's cracked up to be.
1) Affordability is still stretched by historic measures.
Even if we believed that the index was a good measure of affordability, we should still not gloss over the fact that by recent historic standards, the index is still very high. The image below has the three affordability measures with a horizontal green line drawn from their current level. You'll note that the measures are still well above the average of the past 20 years.
In fact, the most recent report indicates that the measure for all three housing types are now above their long-term trends (though below the cyclical peaks in 1990 and 2008).
Notice that the average has been since 1985. Yet during this time, interest rates have done the following...
2) Interest rates will rise much faster than incomes over the next decade.
While I do think that interest rates will stay unusually low for an extended period of time, it's important to realize that this will be a function of the inflationary landscape. Regardless, it is a catch-22. If inflation rises, incomes will rise, but so will interest rates. And you can bet that interest rates will rise much quicker than incomes. From today's level of roughly 5% for a fixed rate mortgage, a rise to 6%, which could happen in a matter of months, is a 20% jump from current levels. Don't expect incomes to come anywhere near pacing that rise in interest rates.
3) The RBC Affordability Measure assumes a 25% down payment
...which is just laughable. With banks still peddling zero-down mortgages (albeit underhandedly), and with downpayment requirements a paltry 5%, we're a far cry from that level. In fact, the most recent reliable data from CMHC indicates that down payments averaged 6-7% as late as 2007.
Granted, the zero-down mortgage was 'officially' ended shortly after this, but it would be a mistake to assume that average down payments made any major jump since then. It would be interesting to see the RBC measure weight for average down payment and average house price, data which is kept by CMHC, though next to impossible to get one's hands on.
4) The measure is in pre-tax income
As tax laws change, impacting take-home income levels, the measure would be far more telling if it accounted for these changes and reported the figures in after-tax dollars.
5) The measure uses the 'standard' home
This one's a bit intriguing. As explained by RBC:
The qualifier ‘standard’ is meant to distinguish between an average dwelling and an ‘executive’ or ‘luxury’ version. In terms of square footage, a standard condo has an inside floor area of 900 square feet, a bungalow 1,200 square feet and a standard two-storey 1,500 square feet.
Why not simply weight for average house size? I could be mistaken, but I have a hard time believing that the average bungalow in Canada is 1200 square feet and the average two-storey is 1500 square feet, particularly given recent building trends.
6) The often-cited city-specific data excludes property taxes and utilities
More relevant than the Canada wide measure is the city-specific measures. These are the ones often reported in local papers. For reference, you can see these measures on page 8 of the latest report. However, as noted by RBC, "the modified measure used here includes the cost of servicing a mortgage, but excludes property taxes and utilities due to data constraint in the smaller CMAs". As property taxes have typically far outpaced income growth in most cities, this is an important element in determining true affordability.
7) The measure ignores other consumer debt
The rapid growth in non-consumer debt is not accounted for in the RBC measure. This is a mistake. What should be examined is the growth in total debt servicing costs. The growth in consumer debt is a major topic of interest on this site.
See "So much for the 'conservative Canadian consumer'" and "Canada's credit bubble" for more on this topic.
Conclusion:
Affordability measures can be one indicator of potential housing market issues. However, they should not be placed in front of other measures of fundamental value such as rent and income growth. While the RBC measure in particular is interesting, it is not without its major flaws, a fact overlooked by some who would seek to portray the housing market as less risky than it truly is.
Cheers,
Ben
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7 Comments
In the US, they called option ARMs and similar schemes to shoehorn buyers into overpriced houses 'affordability products'. We know how that ended. The affordability index tells you nothing about households ability to withstand adverse conditions and is therefore a useless / misleading indicator as you have mentioned.
"If inflation rises, incomes will rise, but so will interest rates"
Is this guaranteed?
Surely there must be a scenario where inflation could rise while incomes fall (or have very minimal growth)...
Yes you're right. Real income growth can be negative, though it's hard to see a scenario of outright falling nominal wages with significantly rising inflation. My point is that it's a catch-22 for those looking at the 'affordability measure' as there is little room for it to improve over the next few years.
What about the Toronto Real Estate Board's Affordability Indicator:
http://2.bp.blogspot.com/-oZec6RD1gSE/TZstIeRneBI/AAAAAAAAAcs/tDXzmHp0mO...
It assumes a 20% down payment, 5-year mortgage, 25 year amortization, average property taxes and utilities, and average household income.
This indicator has hovered around the 30% area for 15 years, which is very close to the maximum recommended 32% of income for housing needs. Since interest rates have been going down for those 15 years, you would think housing % of income would go down as well, but it has only leveled off.
I do agree that you should have at least a 20% down payment, and in that case you should be ok to service the rest of the mortgage.
The real question is if the average down payment is only 5-10%, then the affordability indicator is way off.
I agree with wjk. Data obtained by today is skewed and fudged as it ever was and does not reflect 'real' market conditions.
Canada is in stagflation where asset prices are appreciating while labor markets are fractured. If there is any deflationary pressure, be assured that the BoC will stimulate and print via Canada Action Plan V2.0.
As for housing, one must look no further then CMHC's upcoming 2010-2011 balance sheets which is being delayed for unknown reasons.
Ben -- your "Figure 4" (homeowner equity by month of purchase) is frightening. (And I see no reason why that curve wouldn't keep going down if the graph were extended to 2011 -- brokers have widely reported that most new buyers are only putting down 5%, and as you mention, there are many ways to "borrow" a down-payment.)
The term "affordability" is problematic on so many levels -- it implies a "keeping-up-with-the-bills" approach to home ownership, it minimizes the impact of total debt on a household, and lost in the whole discussion is the fact that worsening "affordability" affects not just new buyers, but everyone who owns a house.
Good post. And to top things off - in spite of their flawed "housing affordability" measurement, according to the RBC even that has been eroding over the first quarter of this year: http://www.cbc.ca/news/business/story/2011/05/20/housing-rbc-affordabili...
In the long run, I can only see one direction where the housing market will go...