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Improved housing affordability

| September 27, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

After rising for several years, home sales weakened in 2018 and early 2019.  But in recent months, the demand for homes has begun to perk up again.  These movements can be largely explained by a relatively simple gauge of housing affordability compiled by the National Association of Realtors.

Housing affordability defined

The National Association of Realtors (NAR) publishes an index of housing affordability.  The index measures how much house the typical household can afford to buy, so that an index value of 100 indicates that the household with median income can just afford the median-priced single-family existing home.

There are three main variables that govern the NAR’s affordability index: home prices, mortgage rates, and median income.  The NAR uses its own price measure from the monthly existing home sales release.  The mortgage rate is the Freddie Mac 30-year mortgage rate.  These two variables are used to calculate the level of the monthly principal and interest payment on a mortgage for the median-priced home.  A qualifying income is then derived using a 25% ratio for monthly housing expense to gross monthly income assuming a 20% down payment.  That qualifying income is then compared to the actual median family income.  This measure is benchmarked to the last annual US Census on household incomes, and then estimated forward using the average of wage growth and income growth in the last year of the survey.  The affordability index is the ratio of estimated median income to the qualifying income level.

Affordability Deteriorates

After holding steady in 2015 and 2016, the NAR gauge began to deteriorate in 2017 and 2018.  This reflected two forces.  First, home prices were rising rapidly for much of the decade.  The NAR measure of existing home prices increased by 4.5% or more in each year from 2012 through 2017 before finally beginning to slow down in late-2018.  Second, mortgage rates increased sharply, beginning after President Trump’s election in late-2016.  For most of 2015 and 2016, 30-year mortgage rates had hovered between 3.5% and 4.0%.  The rise in 2017 was modest, with the rate mainly running in a 3.80%-to-4.20% range, but borrowing rates jumped in 2018, reflecting economic optimism driven by the tax cut and faster growth, as well as a steady diet of Federal Reserve rate hikes.

By late 2018, the 30-year mortgage rate was nearing 5%.  The combination of higher prices and higher borrowing costs pushed the monthly payment figure up substantially.  Thus, despite solid income growth, the NAR affordability gauge slipped noticeably (Exhibit 1).

Exhibit 1: NAR housing affordability index

Source: National Association of Realtors, Amherst Pierpont Securities

Not surprisingly, the cumulative impact of rising prices and borrowing costs eventually took a toll on the demand for homes.  After steadily rising in 2015, 2016, and well into 2017, combined new and existing home sales flattened out in 2017 and began to deteriorate in 2018 (Exhibit 2).  The chart shows that home sales have tracked the NAR affordability index well over the past several years, with a lag of several months.  The steep deterioration in affordability in the first half of 2018 corresponded with a substantial slowing in home sales over the course of last year.

Exhibit 2: NAR housing affordability index and home sales

Source: National Association of Realtors, Census Bureau, Amherst Pierpont Securities

Housing turnaround

The movements in the affordability gauge also help to explain an improvement in the demand for homes in recent months.  The steep drop in mortgage rates since late 2018 has cut the level of the median monthly mortgage payment, even though the NAR gauge of home prices, unlike other more prominent home price measures like FHFA and S&P/Case-Shiller, jumped in late 2018 and early 2019.  In addition, the pickup in wage gains has helped to drive a faster pace of growth for the median income proxy.

The NAR affordability index bottomed out around mid-2018 and total home sales have been trending gently higher so far this year.  The July-August average for home sales is up by more than 7% from the Q4 2018 average and is roughly back to the yearly average for 2017, so far the peak of the current expansion.

The NAR gauge posted an advance in July, the latest reading available, and seems likely to inch higher again in August given the further slide in mortgage rates last month.  This bodes well for housing demand for the balance of 2019.

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