Life and history are made up of short runs. If we are at peace in the short run that is something. The best we can do is put off disaster, of only in the hope, which is not necessarily a remote one, that something will turn up. ~ John Maynard Keynes
I just returned from a business trip to Los Angeles and, regardless of who I talked to, it didn’t take long for the topic of the local housing market to come up. Simply put, the price of housing in LA has escalated to a point where many families can no longer afford to buy a home, sentiment supported by a recent report by mortgage and loan site HSH.com which lists the salary needed to buy a median priced home in LA at $92,091*.
Upon hearing the sacrifices people are making to get into the housing market in LA, I wondered, “Why not rent?”
According to everyone I spoke to on the matter, as well as this October 2016 report by Apartment List, it turns out the rental market in LA is also quite dismal. Not only are rents escalating at rates higher than the national average (3.1 % vs. 2.1 %), with median rental rates of $2,630 for two-bedroom apartments, rents are also very high. For example, the median rate on a two-bedroom apartment in Venice Beach is a staggering $5,100/month.
Signs of another housing bubble?
Although housing markets are usually dominated by local economic conditions I thought it would be interesting to dig into some data from the US census and the Federal Reserve Bank of St. Louis (from here and here) to see if we can see any warning signs. (Special thanks to my office mate James Spezeski for helping with the reporting.)
- The top frame of the plot below shows changes to (new) home sale prices and (nominal) household incomes
- The bottom frame takes the ratio of these two numbers and plots these data alongside home ownership rates
- The vertical shaded gray regions define the boundaries of recessionary periods that in turn correspond to the years noted on the x-axis.
Looking at homeownership rates (the orange line) you can see that after the big run up to the last recession ownership rates have now dropped below their 50-year historical average of 65 percent.
More interesting though, is how the ratio of home prices to household income has changed over time (the green line). From 1987, the ratio was remarkably steady until 2001 when, as a result of large increases in home prices, the ratio increased 25 percent over a six-year period until the economy augured in and there was a massive correction to the housing market. Since the end of the recession however the ratio between home prices and household incomes has once again been on a very steep climb and today sits even higher than it did before the recession.
If one considers that housing starts (see plot below, data from here) and interest rates are still below their long term averages, bolstered by some of the stories I heard while I was in LA, here is what I believe is going on**:
- Regulatory conditions *** are making it difficult for the market to respond to local housing demands.
- High home prices coupled with regulations have made it more difficult to secure home and construction loans thus putting pressure on the rental market.
- For those who qualify, low interest rates (and higher valuations) are enabling purchases at higher prices.
I’ll leave the question as to whether or not there is a housing bubble to the experts (despite the fact they failed to predict the last bubble). Still, I think it’s reasonable to say if we reach a ratio of home prices to income greater than four, we have reached a “threshold for concern.” Well, that’s according to a branch of economics I follow which happens to bear our family name: fru(eh)galnomics. By the way, we are currently at 5.29 percent.
Although a simplistic rule-of-thumb, you can do your own gut-check by taking your family income, multiplying it by 4 and asking yourself if you’d be comfortable buying a house that costs that much money. Don’t know about you but I start feeling queasy long before getting to 4x my income which, by the way, is why I live in a $200K home.
To be clear, there is a big difference between a “bubble” and feeling queasy. For there to be a true bubble, there has to be an expectation that prices are going to continue increasing. Granted, I’m not drawing from a statistically valid sample, but based on my conversations, I did not get the sense people have any expectations about the direction of the housing market; rather, everyone I spoke to is simply trying to figure out how to live in an area with many opportunities, great weather, and a great vibe.
Now at this point, despite the opportunities, weather, and vibe, some of you may be questioning the rationality of living in Los Angeles. After all, why not just move next door to Arizona or Nevada? If however, you share in the sentiment of the former governor of the Bank of England Mervyn King that:
In the face of “radical uncertainty” about the future, people don’t attempt to “optimize” so much as merely to struggle to cope with potential disaster. ****
If we want to limit the scale of future disasters it seems like a better question to ask is “What is hindering the market from supplying new/affordable housing in LA?” For, as noted by the California legislature’s nonpartisan fiscal and policy advisor (LOA):
Building less housing than people demand drives high housing costs.
I’ll save the answer to that question for 2017 but, before checking out for the week, with LA on my mind, this seems like a great opportunity to introduce you to Sonny Knight and the Lakers via the title cut off of their new release “Sooner or Later”. Fronted by a 68-year old retired trucker (Sonny Knight) and backed by an outstanding seven-piece band, I hope you’ll agree that Sonny Knight and the Lakers have created a unique soul groove that puts you on notice and get’s you moving.
* Quite a bit more than the $44,715 you’d need to buy a home in Phoenix but when compared to the $161,947 you’d need to make to buy a home in San Francisco, much to the chagrin of local residents I talked to, it’s no wonder that Silicon Valley companies such as Google are setting up shop in LA.
** It hopefully goes without saying, but I’ll say it: None of this should be construed as “financial advice.”
*** See for example Josie Huang’s recent piece on Southern California Public Radio titled How California Home Prices Got So High.
**** This quote as well as the quote that heads this article is from Judy Shelton’s review of Mervyn King’s book The End of Alchemy: Money, Banking, and the Future of the Global Economy in the November 7th edition of The Weekly Standard.
Video not displaying properly? Click here.
Having said that, I am interested to hear from you. Good, bad, or otherwise, please feel free to drop me a line at email@example.com. I’m the only person who will read your email and, as time allows, I’ll do my best, at a minimum, to personally acknowledge receipt.