Tepid wage growth and rising house costs prices out low-income households

Higher prices and weak wage growth, particularly among lower income Americans, prices out many marginal buyers.

no-house-for-youEach prospective buyer investigates current financing terms as part of their process. Lenders apply current underwriting standards and determine the loan balance they will approve and down payment required before they will fund. Since loan plus down payment equals maximum bid amount, prospective buyers house-shop with the budget established for them by their lender. As is human nature, most people spend their full budget.

Every buyer goes through this basic process, and since financed purchases dominate the resale market, price levels of individual properties become tethered to the incomes of individuals who desire that property. If high wage earners suddenly became enamored with living in condos, prices would rise substantially. The substitution effect to similar resale and rental properties keeps income, price and quality in balance.

When supplies are limited, as they are now due to the presence of so many underwater borrowers stuck in the purgatory of cloud inventory, the substitution effect forces buyers at every price level to buy a lower quality house than they otherwise would. At the very bottom of the housing ladder, those buyers who can only afford the least expensive properties get priced out by higher wage earners substituting downward. If the inventory restriction is bad enough, large swaths of wage earners are priced out of the market, and sales volumes necessarily suffer — just as we are seeing today.

Affordability Pyramid Shows Housing Market is Bottom Heavy

By Natalia Siniavskaia on August 5, 2014

With the release of the 2014 Priced Out estimates, NAHB Economics revised its affordability pyramid that translates U.S. household income data into a distribution of homes that households can afford by price range.


At the base of the market for housing is a large number of households with relatively modest incomes. The homes that these households can afford are also relatively modest. As the price of a home goes up, there are fewer and fewer households in each tier who are able to afford it.

The pyramid shape is typical of income distributions, and since home prices tether to income, home values also display this same shape. The very top gets a bit heavier due to very wealthy all-cash buyers and accumulated equity from long-term homeowners making move-up trades. The width of the bottom relative to the top fluctuates with economic policies that influence wage distribution.

What’s important for our current circumstances is the size of the bottom tier today. Since house prices have gone up without a commensurate increase in incomes due to lender policies to reflate the housing bubble, the bottom tier of the housing market is being priced out. Pricing out these marginal buyers is one of the reasons housing demand is off this year.

The Housing Market Pyramid

Lenders are reflating the housing bubble by restricting inventory. This causes every level of the housing pyramid to substitute downward in quality to artificially boost house prices. It also prices out the bottom tier. Over time as prices rise and cloud inventory gets liquidated, the pyramid will revert back to its normal distribution, but until then, prices will be artificially boosted, and sales volumes will be lower than most economists expect.

Based on conventional assumptions and underwriting standards, it takes an income of about $26,695 to purchase a $100,000 home. In 2014, about 31 million households in the U.S. are estimated to have incomes lower than that threshold and, therefore, can only afford to buy homes priced under $100,000. These 31 million households form the bottom step of the pyramid. Of the remaining 87 million who can afford a home priced at $100,000, 22.8 million can only afford to pay a top price of somewhere between $100,000 and $175,000 (the second step on the pyramid).

Conventional mortgage assumptions also consider today’s 4.1% mortgage rates. When those rates eventually rise, even fewer households will be able to afford houses.bubble-money

This trend continues up the pyramid of house prices. Each step represents a maximum affordable price range for fewer and fewer households. The peak of the pyramid shows a very small share of households that are able to afford homes priced above $1.25 million. It’s possible to have more million dollar homes than this in the U.S., because many households would have initially purchased homes at lower prices which subsequently appreciated.

Since so many buyers from 2004-2008 are underwater, the appreciation on those properties flows back to the banks, so the move-up market will be impaired for several years, perhaps even another decade.

The pyramid is based on an income threshold and a 10 percent downpayment assumption. …

Since 20% down payments are the norm, this study exaggerates the number of people capable of buying houses at the high end. Further, since those at the low end generally use FHA financing, which has onerous fees, far fewer households have the income necessary to afford houses than this study would suggest.

Demand, supply and football

Demand is measured by a borrower’s ability to put money toward real estate, and contrary to popular belief, desire is not demand. Excess supply lowers base market prices established by demand. To better illustrate this concept, consider the following football analogy:super_bowl

Sellers (supply) are blitzing linebackers and buyers are offensive linemen. If more linebackers blitz than offensive linemen block, then the offense gets thrown for a loss. If more sellers want to sell than buyers want buy, then prices decline; buyers have to be enticed from the sidelines. However, if enough offensive linemen pick up the blitzing linebackers and push the scrum forward, the offense advances the ball. If buyer demand exceeds seller offerings, prices go up as sellers have to be enticed from the sidelines.

In football, the offense generally advances the ball just as buyers generally advance prices with their rising incomes. However, in football, each team is limited in the number of players. In housing markets, no limit exists which can create enormous supply and demand imbalances. When subprime lending took off, we sent hundreds of offensive linemen on the field, and they pushed prices across the goal line. Now, we have a much smaller and leaner offensive unit facing a defense composed of the zombie debt holders who previously were celebrating in the end zone.

Lenders are ordering linebackers not to blitz to prevent further losses, but the number of linebackers building on the defensive side of the ball ensures the offense will not be advancing the appreciation ball very far. Such is the nature of overhead supply — banks may hold on to properties to prevent a loss, but they will sell swiftly if they can get out at breakeven.

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