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 (50% above and 50% below) to the percentage of the general population with the income to support this house price. 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.
The simplest way to envision affordability is through simple supply and demand diagrams like those found in introductory economics textbooks. Affordability is the 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 a real estate transaction. 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. Once prices started to rise, they were bid up to levels were affordability was at record lows by historical measures.
The supply curve is the opposite of the demand curve: sellers will make very few units available at low prices, and sellers will make a great many available at higher prices. Wherever these two curves meet is where supply and demand are in balance and market transactions are taking place. In the initial stages of a market rally both transaction volumes and prices are increasing rapidly. In the Great Housing Bubble, this was caused by a dramatic expansion of lending and credit. As a price rally matures sellers become reluctant to sell because the asset they own is going up in value quickly, and they don’t want to miss the opportunity to profit. This limits the supply on the market. In terms of the supply and demand diagram, this shifts the supply curve to the left which pushes the balance between supply and demand to a higher price point. The combination of the demand curve shifting to the right from the increased liquidity of the lending environment coupled with the supply curve shifting to the left because of seller reluctance, the intersection of these two lines moves prices dramatically higher. However, once these two forces come into balance, their intersection is at a point of low transaction volume. There are fewer buyers who can afford the higher prices, so transaction volumes begin to fall.
The first sign of a troubled real estate market is a dramatic reduction in volume known as buyer exhaustion. There are simply not enough buyers able or willing to push prices any higher even at the lower transaction volumes. In a residential real estate market, this phenomenon is particularly pronounced at the entry level. The imbalance between supply and demand first becomes apparent at the bottom of the affordability scale with entry-level buyers because these buyers are not bringing the profits from a previous sale with them to the next property. Affordability is less of a problem for existing homeowners in the move-up market due to this equity transfer.
The real estate market can be visualized as a massive pyramid. There are very few multi-million dollar properties at the top of the pyramid, and a large number of relatively inexpensive entry-level properties forming the base. Like any structure, if the foundation is weakened, the structure may collapse. In the same way, housing markets collapse from the bottom up due to problems with affordability.
The foundation of a residential real estate market is the entry-level buyer. Entry-level buyers are generally young people starting to form new households. When a homeowner wants to sell their house and move up to a nicer one, someone needs to buy their house. If you follow this chain of move-ups backward, eventually you come to an entry level buyer. If there are no entry level buyers pushing the sequence of move ups, the entire real estate market ceases to function. The entry level market was initially boosted the moment 100% financing became available because many more people were enabled to purchase; however, it was imperiled at the same time because of the change in savings incentives. This market was subsequently destroyed the moment 100% financing was eliminated because few entry-level buyers had a downpayment and very few people were in the process of saving to get one. In the past, people would rent and save money until they had the requisite downpayment to acquire a house. The barrier to home ownership was not the ability to make payments; it was having the necessary downpayment money. When downpayment requirements go up, the number of people capable of buying a house declines dramatically, particularly for entry-level buyers who must save this money rather than transfer it from a previous sale. Since few potential entry-level buyers were saving money during the rally, sales volumes suffered dramatically in the wake of the bursting real estate bubble.
The way real estate markets collapse from the bottom up due to affordability has some unique issues for reporting on the declines. The most widely reported measure for real estate prices is the median sales price. This is the price level where 50% of the transactions occurred above and 50% occurred below. This measure has weaknesses, but over time it does a reasonable job of documenting overall prices and trends in the marketplace. One of the problems with a median as a measure of house prices is a lag between when a top or a bottom actually occurs and when this top or bottom is reflected in the index. During the beginning of a market decline, the lower end of the market has a more dramatic drop in volume than the top of the market. This causes the median to stay at artificially high levels not reflective of pricing of individual properties in the market. In other words, for a time things look better than they are. At the beginning of a market rally, transaction volume picks up at the bottom of the market at first restarting the chain of move ups. During this time, the prices of individual properties can be moving higher, but since the heavy transaction volume is at the low end, the median will actually move lower.
Affordability is the ultimate limit of any asset bubble. If prices are so high that no buyer can afford them, there are no transactions and thereby no market. The fear of many buyers in a financial mania is that prices will remain elevated to the absolute limit of affordability permanently. People who have this fear will put every available resource into getting a house before this happens. This becomes a self-fulfilling prophecy as prices get bid higher and higher by fearful buyers. If prices were to remain at the upper limit of affordability for a long period of time, the rate of price increase would slow dramatically until it only matched the rate of wage growth and inflation. If prices are not rising in excess of inflation, there is little financial incentive to buy because when affordability is very low, it is much less expensive to rent, and the extra money going toward a housing payment is not generating a financial return. If there is no financial incentive to pay more than the cost of rent, people stop buying, and prices fall back to levels where they are affordable again.