Definition
The not-so-obvious concept of price-to-income or commonly known as P/E ratio is used to measure the affordability of homes in a specific market. As of 2022, lenders and other financial institutions extent home loans heavily rely on price-to-income ratio to assess how affordable the subject property is to the borrower. Keep in mind, this is different from Debt-to-Income ratio.
The P/E ratio also serves a great parameter and a comparison tool to judge the current affordability of homes of a region relative to how affordable it was historically. If the ratio goes up, it means that homes are becoming less affordable. If it declines, the homes become more affordable.
historically speaking!
As I was doing my research and projects at the institutional & portfolio level, I came across the Case-Shiller Home Price Index, which was designed by Robert J. Shiller and Karl E. Case to measure the purchase price level of existing single family homes in the United States. As a matter of fact, their index is considered the leading measure of U.S. residential real estate prices.
If you take a closer look, interest rates have a huge influence on this index ratio. Reflecting back in my academic year, theoretically, whenever interest rates dip, the affordability of a house goes up so people tend to spend more money on a house and shoot the home demand up tremendously (as you can see for the past 2 years in 2020 and 2021).
To make you feel any better, even with the current rate around the time of this article, interest rate is still considered low now as it was as high as 15.32% in 1981. And when growing rate of demand exceeds supply’s, the price increases! Basic Supply & Demand economic theory.
The graph below shows a great trend comparison between Home Price and Median Income. The Red Line is the Case-Shiller Home Price Index and the black line is the Median Household Income in the U.S
So why am I telling you all of this?
Simply just for you to gain another perspective. In the past, an average house in the U.S. used to cost around an estimate of 5 times the total annual household income. Wasn’t it great? Yes, it was. Fast forward to the housing bubble of 2006, the P/I ratio surpassed 7. What does that mean? It meant an average single family home cost 7 whooping times more than the annual household income. As of May 2022, we surpassed 8. Some may say we already are in a recession and there’s a greater chance we are facing another housing market crash. Do I agree with this statement? No, I do not.
How did we get to this point? There are just so many factors leading us to this outcome and as much as I want to dive deep into these discussions, it’ll defeat the purpose of this article, which is strictly for your own education only. However, if you still want to chat, just need to shoot me an email at chad@chadvorealestate.com and we will have an open discussion.
Who knows? I may cover those discussions in the future so make sure to check back to our website and subscribe to our monthly newsletter here!
You may also read the September 2022 market updates here as well.
Data Sources
- Recent data
- Federal Reserve Bank of St. Louis: S&P/Case-Shiller U.S. National Home Price Index
- Federal Reserve Bank of St. Louis: Median Income since 1983
- Historical data
- census.gov Median Income from 1947 until 1965
- DaveManuel.com: Median Income from 1967 until 1983
- Online Data Robert Shiller: Historical US Home prices until 1983