December 21, 2016

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Beneath the surface of current conditions within the housing market is a growing concern about affordability. Not limited to the challenges faced by low- to moderate-income households, housing affordability is concerned with the ability of the median income household to find housing, either to purchase or rent, within a reasonable share of their income. With the recovery of the housing market, several structural and cyclical changes have emerged that may impact the capacity of the market to fully supply the housing needs of a large segment of households, particularly those with more moderate incomes.

A decline in housing affordability may be considered a leading indicator of potential stress in the market that could lead to a market correction. Simply put, as housing affordability diminishes, households begin to experience greater stress in covering their housing costs. In such a scenario, the demand for housing declines, inventory levels increase, and home prices trend downward. In the case of the period prior to the 2007–09 downturn, as affordability declined, demand was in part propped up by a surge in alternative mortgage instruments and subprime borrowers into the market. Despite the sharp increase in new home construction, supply levels could not keep up with demand and prices sustained an upward trend. However, once housing affordability reached its trough in January 2006 and delinquencies began to rise, both the demand for housing and the availability of credit dried up, leading to a large buildup of inventory and a sharp correction in home prices. By now, we are all familiar with this story. However, understanding the role housing affordability played in the most recent correction may provide an important clue for identifying potential risks in the future.

Factors that go into determining housing affordability include median home prices as well as median household incomes and current interest rates in a given area. The National Realtors Association's (NAR) Housing Affordability Index measures if the median-income household can afford to purchase and make the payments on the median-priced house in a region, given the current interest rate. The index assumes that a household makes a 20 percent down payment and that the monthly principal and interest payment does not exceed 25 percent of annual household income.

During the current recovery cycle, NAR's national Affordability Index (not seasonally adjusted) has remained relatively high, indicating that, at least on the surface, housing is affordable. An affordability index at 100 means that housing is affordable for the median-income household. An index above 100 means housing is more affordable while anything below 100 means housing is less affordable. At the end of September of this year, the index stood at 167.5, indicating more affordability.

More to the story

However, this may not tell the full story. Since 2012, home prices have increased steadily and, in many markets throughout the country, have recovered to pre-recession levels. The reason for this is an overall lack of inventory in both the new and existing home sectors. At the same time, incomes and wage growth have remained relatively flat. Typically, this would translate into a decline in housing affordability, as home prices have increased faster than wages. However, affordability has been helped by very low mortgage interest rates. Through mid-November, the Federal Housing Finance Agency's (FHFA) effective rate on loans closed on existing homes was around 4.27 percent, still near historic lows despite increasing slightly. The low-rate environment since the recession has partially shielded the market from the fact the wages and incomes have not kept pace with the cost of housing. Should rates rise in the future, the lack of affordability in the market may become more apparent, as seen in 2013 when rates increased slightly. As rates rose, affordability dropped, home sales declined, and price appreciation moderated. Although rates are expected to rise gradually over time and should correspond with improving economic conditions and wage growth, higher interest rates in the future will certainly change the current dynamics driving housing affordability.

In addition to the mortgage interest rate effect, the overall national index also does not account for differences by region and submarket. In coastal markets, such as California and South Florida, inventory is particularly scarce and affordability is much lower. In addition, high-demand submarkets within the core of many regions tend to be less affordable when compared to more fringe submarkets. In the Sixth District, Miami is the most unaffordable region overall as a surge of foreign capital into the real estate market has helped to push median home prices out of reach of the median income household. Although markets like Atlanta and Nashville remain affordable overall based on the regional affordability index, affordability within high-demand submarkets close to the urban core is diminishing.

Decline in affordability tied to inventory

Most of the decline in affordability seems to be tied to the lack of moderately priced inventory. In a typical housing cycle, a shortage of inventory is normally met by a surge in new construction. Although construction levels overall in both the for-sale and rental markets are improving, they have not kept pace with demand. Today, overall single family building permits remain at levels last experienced during the early 1990s. Since the recession, new home construction activity has been more selective, with many homebuilders shifting away from entry-level price points in favor of move-up price points while concentrating activity primarily within top-tier submarkets. As a result, today only 28 percent of all newly built homes are priced below $250,000 according to data provided by Metrostudy, a national new home data provider. This level is down from 43 percent before the crisis.

Additionally, shrinking developed lot supply levels in many markets have limited capacity in the new home construction sector. Since 2008, vacant developed lot supply levels have declined by 34 percent and many markets have less than a 24-month supply of lots remaining. Part of the decline is due to a drop in new lot development. Acquisition and development lending has become more limited and, because of rising costs, profit margins for developers have been suppressed. The lot development that has occurred has either been in high-priced submarkets or for builders' own use. Higher land and construction costs as well as increased local government regulations have also added restrictions on construction activity, especially in affordable price points. Many builders who are able to build affordable new home product under $250,000 are only able to do so because they acquired lots at a discount during the downturn. Once these lots run out, the replacement cost to develop new lots will likely increase significantly, making it harder to deliver more affordable product in the future.

Building in the city

At the same time, much of the new apartment construction that has occurred over the past few years has been in high-rent Class A product, mostly within the urban core. This production is in response to a surge in demand for Class A apartments from millennials and empty nesters looking to downsize. However, it is also due to the inability of developers to build more affordable rental product and make a profit as construction costs rise. As a result, many of the developers and homebuilders we speak with affirm that it has become increasingly difficult to build new home product in affordable price points, whether single family or multifamily.

When discussing this issue, analysts note that the typical solutions are to either build greater density or build farther away from the urban core where the land is cheaper. Greater density would enable a builder/developer to build more units and sell or rent for lower prices. However, many local governments, concerned about the lack of infrastructure to support density, have employed zoning policies and other restrictions that make it difficult to develop more densely. At the same time, it is not clear that demand for affordable units far away from the urban core is strong enough to encourage builders to invest there. Although some builders are slowly beginning to venture farther into the exurbs, many are too skeptical of the demand potential to take the risk.

Stronger economic conditions could improve affordability

So where does this leave us and what are the implications? It appears that structurally, costs have increased to a level that makes it difficult to produce affordable product. Existing home inventory remains tight as well, as many homeowners have refinanced their mortgages, locking them in at a low rate, and are unwilling to sell. The lack of inventory has increased upward pressure on home prices. Meanwhile, rising rents could put additional strain on households that continue renting. If the typical cycle in the housing market does not resolve this issue, more and more households may be priced out of homeownership in many markets and submarkets and will be forced to look for less expensive alternatives.

With the specter of rising rates in the future, the hidden effects of the strain on housing affordability may become more apparent. However, stronger improvement in economic conditions, particularly in wage growth, could be a major step in improving the underlying conditions affecting affordability. As the unemployment rate drops below 5 percent and the labor market nears full employment, most expect greater upward pressure on wages. In fact, any increase in mortgage rates would likely be predicated on a corresponding increase in wages and other factors that measure the health of the economy. Higher wages would help elevate the strain on affordability in the short term. Long term, however, the structure of the housing market may have to evolve to find ways to meet demand for affordability. For an interesting look at one response to the affordability issue, take a look at our article on the tiny homes trend.

Domonic Purviance

A senior financial specialist in the Supervision and Regulation Division of the Federal Reserve Bank of Atlanta