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Affordability Measures in Residential Real Estate Markets

Posted: 26-12-2008 | Views: 184

Affordability is a measure of people's ability to raise money to obtain real estate. It is often represented as an index that compares the cost to finance a median house price to the percentage of the general population with the income to support this house price. Theoretically, the affordability index should hover around 50%.

For instance, in Orange County, California, in 2006, only 2.4% of the population earned enough money to afford a median priced home. When affordability drops below 50%, there is a problem in housing; when it drops to 2.4% there is either a severe shortage of housing, or a housing price bubble. Most often, it is the latter.

One way to envision affordability is through supply and demand diagrams like those found in introductory economics textbooks. Affordability is the demand curve. There are a small number of buyers who can afford very high prices, and many buyers who can afford very low prices. There is a limit to how high buyers can push prices. This limit is usually determined by lenders who provide the bulk of the money for real estate transactions.

During the Great Housing Bubble, these limits were nearly eliminated. In terms of the demand curve, the loose credit standards and low interest rates shifted the demand curve dramatically to the right. Thus many more people were enabled to buy and they were able to do so at much higher prices. In bubble markets, once prices started to rise, they were bid up to levels were affordability was at record lows by historical measures. In a number of other markets, 2005 and 2006 were not the least affordable years in recent history. Markets not historically prone to bubble behavior might have a population which is decreasing (like Detroit,) steady (like Chicago,) or increasing rapidly (like Dallas). In fact, changes in population has very little to do with housing affordability in a particular city.

When affordability drops, people often respond by buying whatever is available due to the fear of being priced out. This self-fueling fear causes the buying and commensurate increase in price that prices people out of the market. The Great Housing Bubble saw record lows in affordability across many markets.

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