In 2011, house prices started recovering from the Great Recession.
For the first few years, rapid house price appreciation was welcome news. Homeowners regained lost equity, the number of underwater borrowers shrank and delinquencies and defaults fell.
More recently, though, surging house prices have led some to worry about the potential for another house price bubble. Recently, house prices finally topped their 2006 peaks, and growth has been particularly strong in recent years, averaging 5.6 percent annually.
How can we tell when we should be worried about rising house prices?
There is no foolproof technique, but there are methods that provide useful guidance.
We employ a two-stage method approach. The first stage compares the prices of recent sales to household incomes to pinpoint areas that merit further scrutiny.
The second stage checks whether additional indicators suggest that house prices in the highlighted areas are headed for a fall in the future. So far, these indicators suggest that it’s not time to worry about house prices — yet.
First stage: Pinpointing high house prices
We’re looking for a way to spot areas where house price increases appear to be feeding on themselves for no apparent economic reason — in other words, the beginning of a bubble.
To thin the herd of over 350 metropolitan statistical areas (MSAs) nationwide, we look at price-to-income (PTI) ratios. These ratios vary a lot across the country, so assessments have to be made relative to what is typical for each MSA.
For example, San Francisco is a desirable location, and residents historically have been willing to devote a larger-than-average share of their budgets to live there. In addition, buildable land in San Francisco is extremely limited, so the supply of housing can’t expand to meet the high demand. As a result, the PTI ratio in San Francisco usually is much higher than it is elsewhere.
Ten metros with unusually-high PTI ratios as of the end of 2015 appear on our watch list. The ratios in these 10 metros are high relative to the historical experience in each metro.
Interestingly, they appear in clusters — Raleigh and Charlotte in North Carolina; Jacksonville, Orlando, and Miami in Florida; Dallas, Austin, and San Antonio in Texas; and Portland and San Jose on the West Coast.
Second stage: Are house prices headed for a fall in these areas?
The PTI ratio doesn’t, by itself, identify potential house price bubbles. Other supporting information is needed. In particular, we examine the answers to three questions:
- Are there nonfinancial reasons for the high PTI ratios?
- Are credit conditions deteriorating?
- Is leverage increasing?
Are there nonfinancial reasons for the high PTI ratios?
A key characteristic of housing markets currently is the limited supply of houses for sale. Nine of the 10 metros on our watch list have less than six months of inventory today.
Three metros have between three and four months of inventory; four have between two and three months; and Portland has just over one month of inventory. Only Miami appears to have a balance between supply and demand.
The increase in recent years in income inequality provides another reason increasing PTI ratios may not be signaling increasing house price risk. PTI ratios compare the median price of recently-sold homes to the median household income, including households that intend to remain renters and homeowners with no plans to move.
The upward trend of traditional PTI ratios may indicate simply that more-affluent households are purchasing higher-end houses. Affordability may be decreasing for average- and lower-income households, but the households that are purchasing homes may not be stretching financially to do so.
Sean Becketti, Ph.D., is vice president and chief economist at Freddie Mac.