Recent House Price Trends and Homeownership Affordability U.S. Department of Housing and Urban Development Office of Policy Development and Research Recent House Price Trends and Homeownership Affordability Prepared for U.S. Department of Housing and Urban Development Office of Policy Development & Research Prepared by David T. Rodda Abt Associates Inc. Cambridge, MA Jack Goodman Hartrey Advisors Contract C-OPC-21895 Task Order CHI-TO007 May 2005 Acknowledgments The authors are grateful to the HUD staff who have provided useful guidance and valuable feedback throughout the project. In particular, we are indebted to the efforts of William Reeder for his careful review of multiple drafts at the design and final report stages. In addition, we appreciate the comments from Mike Hollar, Theresa DiVenti, and Mark Shroder at HUD and Jill Khadduri at Abt Associates. We would also like to acknowledge the careful programming and analysis work of Bulbul Kaul at Abt Associates. The authors take responsibility for any remaining errors. The contents of this report are the views of the contractor and do not necessarily reflect the views or policies of the U.S. Department of Housing and Urban Development or the U.S. Government. Table of Contents Executive Summary ...........................................................................................................................vii I. Introduction................................................................................................................................1 II. House Price Trends....................................................................................................................3 Homeownership Trends...............................................................................................................4 Affordability Trends ....................................................................................................................5 III. House Price Indexes...................................................................................................................9 Indexes Based on Median Sales Price..........................................................................................9 Indexes Based on Hedonic Regression........................................................................................9 Indexes Based on Repeat-Sales Methodology...........................................................................11 Indexes Based on Hybrid Approaches.......................................................................................12 Analysis of American Housing Survey, 1985-2003 ..................................................................13 IV. Affordability Indexes ...............................................................................................................23 House Price Burdens Using AHS Data, 1985-2003...................................................................28 V. Determinants of House Prices.................................................................................................35 VI. Demand Factors .......................................................................................................................41 Demographics ............................................................................................................................41 Income........................................................................................................................................42 Wealth........................................................................................................................................42 Ownership as a Hedge Against Rent Risk .................................................................................43 Tax Effects on Housing Demand ...............................................................................................44 Easier Mortgage Financing........................................................................................................45 VII. Supply Factors..........................................................................................................................47 Market Segmentation and Filtering............................................................................................48 Renovation .................................................................................................................................50 Elasticity of Supply....................................................................................................................51 VIII. Regulatory Constraints ...........................................................................................................55 Conceptual Papers......................................................................................................................55 Empirical Studies on Regulatory Constraints............................................................................60 IX. House Price Dynamics .............................................................................................................65 Financial Accelerator Model......................................................................................................68 X. Bubbles......................................................................................................................................73 XI. Behavioral Finance and the Formation of Price Expectations ...........................................77 iii XII. Summary...................................................................................................................................81 House Price Indexes...................................................................................................................81 Affordability Indexes.................................................................................................................83 Determinants of House Prices....................................................................................................84 Demand Factors.........................................................................................................................84 Supply Factors ...........................................................................................................................85 Regulatory Constraints...............................................................................................................86 House Price Dynamics...............................................................................................................87 Bubbles ......................................................................................................................................88 Behavioral Finance and the Formation of Price Expectations...................................................89 Implications for the Current Housing Market............................................................................90 Recommendations for Future Research.....................................................................................92 References ...........................................................................................................................................95 Appendix ...........................................................................................................................................107 iv List of Exhibits Exhibit 1. Historical Relation Between Mortgage Rates and NAR Home Affordability Index ...6 Exhibit 2. Comparison Between Owners After-Tax Mortgage Payment and Renters Contract Rent as a Percent of Income, 1975-2001 .........................................................................6 Exhibit 3. Average Bundle for All Owners in 1985-2003...............................................................14 Exhibit 4. Average Bundle for New Owners in 1985-2003 ............................................................15 Exhibit 5. House Price for Average Bundle for All Owners and New Owners............................16 Exhibit 6. OFHEO and AHS House Price Indexes.........................................................................16 Exhibit 7a. Constant Quality House Prices for All Owners and New Owners, by Income Group...........................................................................................................18 Exhibit 7b. Constant Quality House Price Index for All Owners and New Owners, by Income Group, Normalized (1985=100)....................................................................................18 Exhibit 8a. Constant Quality House Prices for All Owners, by Region .......................................20 Exhibit 8b. Constant Quality House Price Index for All Owners, by Region, Normalized (1985=100)......................................................................................................................20 Exhibit 9a. Constant Quality House Prices for All Owners, by CMSA........................................21 Exhibit 9b. Constant Quality House Price Index for All Owners, by CMSA, Normalized (1985=100)......................................................................................................................21 Exhibit 10a. Constant Quality House Prices for All Owners, for More CMSAs.........................22 Exhibit 10b. Constant Quality House Price Index for All Owners, for More CMSAs, Normalized (1985=100)...............................................................................................22 Exhibit 11. Housing Cycle BarometerTM Readings for the Most Overpriced and Underpriced MSAs ..............................................................................................................................27 Exhibit 12. House Price to Income Ratios for All Owners and New Owners .............................. 28 Exhibit 13. House Price to Income Ratios, By Income Group.......................................................29 Exhibit 14. Financing Costs to Income for All Owners and New Owners ...................................30 Exhibit 15. Financing Costs to Income Ratios, by Income Group................................................30 Exhibit 16. Effect of Expected Capital Gains on Owner Costs by CMSA, Los Angeles.............33 Exhibit 17. User Cost to Income Ratios, by CMSA........................................................................34 Exhibit 18. Instrumental Variable Regulation Model....................................................................39 Exhibit 19. House Price Model.........................................................................................................39 Exhibit 20. Determinants of House Price Percentage Changes for 130 MSAs from 1984-1998..............................................................................................................66 v Appendix A1. Hedonic Regressions on All Owners by AHS Survey Year: 1985, 1987.............107 Appendix A1. Hedonic Regressions on All Owners by AHS Survey Year: 1989, 1991.............107 Appendix A1. Hedonic Regressions on All Owners by AHS Survey Year: 1989, 1991.............108 Appendix A1. Hedonic Regressions on All Owners by AHS Survey Year: 1993, 1995.............108 Appendix A1. Hedonic Regressions on All Owners by AHS Survey Year: 1993, 1995.............109 Appendix A1. Hedonic Regressions on All Owners by AHS Survey Year: 1997, 1999.............110 Appendix A1. Hedonic Regressions on All Owners by AHS Survey Year: 2001, 2003.............111 Appendix A2. Effect of Expected Capital Gains on Owner Costs by CMSA, Boston...............112 Appendix A2. Effect of Expected Capital Gains on Owner Costs by CMSA, Buffalo..............113 Appendix A2. Effect of Expected Capital Gains on Owner Costs by CMSA, Dallas................114 Appendix A2. Effect of Expected Capital Gains on Owner Costs by CMSA, Denver..............114 Appendix A2. Effect of Expected Capital Gains on Owner Costs by CMSA, Denver..............115 Appendix A2. Effect of Expected Capital Gains on Owner Costs by CMSA, Hartford...........116 Appendix A2. Effect of Expected Capital Gains on Owner Costs by CMSA, Los Angeles......117 Appendix A2. Effect of Expected Capital Gains on Owner Costs by CMSA, Miami...............118 Appendix A2. Effect of Expected Capital Gains on Owner Costs by CMSA, New York City.119 Appendix A2. Effect of Expected Capital Gains on Owner Costs by CMSA, Pittsburgh ........120 Appendix A2. Effect of Expected Capital Gains on Owner Costs by CMSA, Portland ...........121 Appendix A2. Effect of Expected Capital Gains on Owner Costs by CMSA, Providence .......122 Appendix A2. Effect of Expected Capital Gains on Owner Costs by CMSA, St. Louis ...........123 Appendix A2. Effect of Expected Capital Gains on Owner Costs by CMSA, Seattle...............124 vi Recent House Price Trends and Homeownership Affordability Executive Summary House prices in the U.S. overall have increased by at least 6 percent annually for each of the past four years, according to most measures, more than twice the rate of inflation overall. Variation across markets has been substantial, and annual gains in many metropolitan areas have been well above 10 percent. The price hikes have been far in excess of income increases, and the house price to income ratio for the nation is the highest in at least twenty years. Despite these price increases, home sales have remained strong. The number of existing homes sold in 2004 was up 10 percent from a year earlier, easily setting a new record. New home sales also have risen to record levels, and the demand that has pushed these sales has lifted new single-family construction to record levels as well. The homeownership rate–the proportion of households that own their home–is at its highest level ever, at 69 percent. The sharp increases in house prices have spurred debate as to their causes, their implications, and the prospects for the future. Whether the increases can be fully explained by income growth and interest rates, given prevailing supply conditions, or whether prices have been boosted by speculation to “bubble” levels, has been hotly contested by analysts. The consequences of the increases in prices for household wealth and consumer spending and borrowing have been scrutinized by macroeconomists on Wall Street, the Federal Reserve, and in academia. Finally, the outlook for house prices has been pondered not only by all these professionals but also by consumers wondering if now is the time to buy or to sell. Those anticipating that prices will drop or at least stop increasing note that house price increases have far exceeded both income growth and rent hikes for the past few years. They also point to the rising share of home sales that have been to investors, a fickle segment of the total demand base, rather than to owner-occupants. Those with a more sanguine outlook state that the record low mortgage interest rates of late are the factor reconciling the disparate facts and bring order to the assessment and stability to the outlook. They note that, as a share of household income, the cash flow costs of owning a house have not changed much. The purpose of this report is to shed light on these questions by reviewing past research on house prices, by providing new evidence on recent trends in prices and ownership affordability, and by offering suggestions for next steps in house price research. vii House Prices: Different Measures, Distinct Trends Several measures of house prices are available, each with strengths and weaknesses. Median sales prices of both new and existing houses are available for a large number of places and are updated regularly, but they do not control for improvement in quality or fluctuations in sales volume. Hedonic indexes developed from statistical regression analysis carefully control for quality differences but require fairly detailed housing data that are available only for a limited number of places and time periods. Repeat-sales indexes cover a large cross-section of metropolitan areas and states but may not fully control for changes in housing quality. Hybrid approaches can improve on repeat-sales, largely by incorporating additional data and hedonic techniques, but obtaining those additional data on a regular basis is difficult. Hedonic indexes estimated from the American Housing Survey (AHS) indicate that, controlling for changes in housing quality, real house prices increased 32 percent between 1985 and 2003. First-time home buyers faced price increases almost as large. By market segment, prices rose the most for the type of house typically occupied by higher income households. The price increases estimated from the AHS are somewhat less than those of the prominent Office of Federal Housing Enterprise Oversight (OFHEO) repeat sales index, perhaps because houses that are sold do not represent all houses. Incomes, Interest Rates, and Affordability: Sharp Contrasts from House Price Trends The recent house price increases are best assessed in comparison to consumers’ ability to pay for them. There are many different ways to measure this ability to pay for housing, often labeled “affordability.” The ratio of house price to income is the simplest, and indeed this ratio has risen over the past few years for both all homeowners and for first-time buyers, suggesting reduced affordability. But the affordability story is quite different when measures of the ongoing cash flow costs of homeownership and the changes in house asset values are considered. Largely because of substantial declines in the cash costs of mortgage payments on constant quality houses, the ratio of cash costs to household income, did not increase appreciably between 2001 and 2003, despite the sharp rise in the ratio of house prices to incomes over this period. This pattern held among all owners and also among new home owners. Housing demand has been fueled not only by the mortgage interest rate reductions but also by consumers’ expectations of future capital gains from continued house price appreciation, according to findings of previous research. Illustrative calculations of our AHS data, under the assumption that future house price expectations are based on the experience of the past eight years, show that a simplified measure of “user costs” (mortgage payments less expected capital gains) of constant quality houses fell sharply between 1997 and 2003 in a diverse set of large metro housing markets nationwide. viii The Long Run Determinants of House Prices Of the theoretical approaches and models used by economists to study house prices, the most prominent is the traditional stock-flow model. The model assumes that the stock, or supply, of housing equals demand in equilibrium. The change in supply, or the flow, of housing during any period is new construction less depreciation of the existing stock. Housing demand in stock-flow models is typically taken to be a function of demographics, income, the price of housing, financing costs, and (for stock-flow models of owner-occupied housing) the price of the competing good, that is, rent. The volume of new construction in a period is taken to be a function of housing prices (what the new house can be sold for) and the costs of building that new house. Research based on the stock-flow model has provided three basic conclusions. First, the housing market has a somewhat predictable cycle, with positive serial correlation in prices. Second, the housing market experiences significant episodes of sustained disequilibrium, because of delays in participants’ realization of the disequilibrium and because of the time required for construction. Third, costs for the various factors of production do not seem closely related to the amount of construction, although poorly measured input prices may be part of the explanation. The basic determinants of housing demand have been widely researched, and some more subtle demand factors also have received attention of late. The growth and composition of the population in a local housing market is perhaps the main demand driver in the long run, although income is obviously central to determining how much and what kind of housing is demanded. Regardless of current income, household wealth influences what consumers are willing and able to spend for housing as well as for other goods. The availability and price of mortgage financing, and the various tax provisions affecting homeowners have been shown to be strong determinants of housing demand. Among the less obvious demand factors, ownership’s value to consumers has been found to depend on the risk of future rent increases they would otherwise face if they were not to buy. The supply side of the housing market and supply effects on house prices have received less attention than has the demand side, in part because of the lack of data available to adequately understand and calibrate supply influences. In particular, little empirical evidence is available regarding the behavior of the decision makers on the supply side–developers, builders, and financiers–in contrast to the demand side of the market where decision-making consumers have been the subject of numerous surveys. Important adjustments to the housing stock and prices within segments of the market occur not only through new construction, but also through filtering of units up or down in the quality spectrum over time and also through renovations. The responsiveness of these sources of supply change, as well as new construction, to house price changes determines the overall supply elasticity of housing and the long-run effects of demand shifts on housing prices. A number of recent empirical studies have examined these components of supply change, or the overall supply elasticity, but our understanding of housing supply remains limited. Government’s Role in House Prices Regulatory constraint on what can be built, and where, is another example of a widely acknowledged influence on house prices for which empirical evidence is inadequate due to data limitations. The paths by which zoning, building codes, environmental regulations, and property taxation and other ix