The Wall Street Journal

9 February 2011

Home affordability returned to pre-bubble levels in a growing number of U.S. markets over the past year as price declines laid the groundwork for a housing recovery.

Data provided by Moody’s Analytics track the ratio of median home prices to annual household incomes in 74 markets. By that measure, housing affordability at the end of September had returned to or surpassed the average reached between 1989-2003 in 47 of those markets. Most economists believe the housing boom took off in 2003.

During the boom, lax lending and speculation pushed house-price inflation far beyond the modest rise in household income. Nationally, the ratio of home prices to annual household income reached a peak of 2.3 in late 2005. But by last September, it had fallen to 1.6, matching the lowest level in the 35 years the data have been collected and well below the historical average of 1.9 between 1989 and 2003.

“Based on incomes, this is as affordable as it gets,” said Mark Zandi, chief economist at Moody’s Analytics. “If you can get a loan, these are pretty good times to buy.”

But the bad news is that those price declines are leaving more borrowers underwater, or in homes worth less than the amount owed.

Nearly 27% of homeowners with a mortgage were underwater at the end of the fourth quarter, up from 23.2% in the previous quarter, according to data to be published Wednesday by Zillow.com, a real-estate website.

The increase resulted from a 2.6% decline in home values during the quarter and the fact that fewer homes went through foreclosure after banks halted foreclosures to correct document-handling errors.

Many economists and housing analysts expect an additional decline of 5% to 10% before prices reach bottom later this year or early next year. Housing demand remains weak because buyers are skittish about the economy and lending standards are tight.

Markets that now appear to be undervalued include Detroit, Las Vegas, Atlanta and Phoenix. Even in such markets, high rates of foreclosure and underwater borrowers should keep downward pressure on prices. “They’re undervalued, but they’re going to get even more undervalued,” said Mr. Zandi.

Measuring home prices relative to income is not the only way economists calculate housing affordability. They also examine the relationship between house prices and rents. Measured by the price-to-rent ratio—the price of a typical home divided by the annual cost of renting that home—prices are fairly valued, or undervalued, in around 20 markets. Nationally, the price-to-rent ratio stood at 14.85 at the end of September, above the 1989-2003 average of 12. The data suggest pockets of the country have further to fall.

Home prices still remain overvalued by both measures in several markets, including Seattle, Charlotte, New York and Portland, Ore.

Based on rents, “it’s still not a slam dunk to buy” in those markets, said Mr. Zandi. He said markets appeared most overvalued in the Pacific Northwest, which was among the last regions to enter the housing downturn. Historical measures also showed prices were still high along the Northeast corridor from Baltimore to Boston.

The cost of owning a home looked less affordable based on rents than on incomes in part because rents also fell through 2009 and the first half of 2010. As rents rise, that could tip the scale back in favor of owning in some areas.

Of the 74 housing markets, Baltimore appeared to be the most overvalued. By contrast, prices in Cleveland, the most undervalued market, have returned to 1991 levels based on the price-to-rent ratio.

Historical measures comparing rents and incomes with home prices provide a useful gauge of affordability, but can be imperfect at measuring how close different markets are to recovering from a bubble.

After a severe housing downturn, home prices rarely stop falling once they reach equilibrium.

Some areas will stay undervalued for years as they deal with a glut of foreclosures and weak demand. Historical trends show housing could remain undervalued in many markets for six to seven years, according to economists at Capital Economics.

“It’s become cheaper to buy than to rent” in Phoenix, said Jon Mirmelli, a real-estate investor in Scottsdale, Ariz., who is renting out foreclosed homes. “But the question is: Can you qualify for a loan?”

Meanwhile, some areas that appeared overvalued relative to historic norms, such as Washington, D.C., may not completely return to pre-crisis levels thanks to structural changes in the economy that support higher prices.