20 December 2018, 07:26AM UTCChief Investment Office GWMInvestment Research

US housing: The affordabilityconundrumReal estate markets Authors: Jonathan Woloshin, UBS Financial Services Inc. (UBS FS)

• Although affordability is not as robust as someconventional metrics purport, for many markets in thecountry it is likely not as stretched as many headlinesin the popular press would have one believe. Forhomes priced closer to the US median figures, webelieve the rate of price increases will continue to slowbut the risk of outright price declines is low (barringa recession or major liquidity crisis).

• The coastal California, New York City, and Honolulumarkets are the most affordability-challenged in theUS and could be at risk of outright price declines,particularly at higher price points.

• Despite the recent increase in mortgage rates andthe multi-year run-up in US home prices, monthlypayment as a percentage of median income is wellbelow prior peaks as a result of mortgage rates beingsubstantially lower than during the housing bubble.

• It is likely that the decreased level of affordability inmany markets could lead to a continuation of tighterlending standards.

The jump in mortgage rates in 2018 following severalyears of significant home price increases has sparked avociferous debate in the investment community regardingthe affordability of US housing. We believe it is importantfor investors to remember that the housing market is notmonolithic. Housing is one of the most local businessesin the world and has very different regional and localdynamics. In addition, we believe housing should not belooked at in a vacuum – investors should consider therelative affordability of all shelter options in a given marketin assessing affordability.

Our high-level conclusions are as follows:

• Although affordability is not as robust as someconventional metrics purport, for many markets in thecountry it is likely not as stretched as many headlines inthe popular press would have one believe. For homespriced closer to the US median figures, we believe therate of price increases will continue to slow but the riskof outright price declines is low (barring a recession ormajor liquidity crisis).

• The coastal California, New York City, and Honolulumarkets are the most affordability-challenged in the USand could be at risk of outright price declines, particularlyat higher price points.

This report has been prepared by UBS Financial Services Inc. (UBS FS). Please see important disclaimers anddisclosures at the end of the document.

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• Despite the recent increase in mortgage rates and themulti-year run-up in US home prices, monthly paymentas a percentage of median income is well below priorpeaks as a result of mortgage rates being substantiallylower than during the housing bubble.

• Following the global financial crisis, apartment rentshave increased significantly faster than monthlyownership costs. This has lowered the monthlyownership payment premium significantly, particularlyfor existing homes.

• Despite the high cost of shelter in the coastal California,New York City, and Honolulu markets, renting is stilla more affordable option than purchase, particularly inlight of the inability for many potential buyers to savethe requisite down-payment amounts.

• Reduced affordability has historically led to decreasedlevels of single-family starts and home priceappreciation. Declining rates of appreciation are alreadyevident across many markets, and the combination ofrapidly increasing construction costs and the dearth ofskilled labor is currently limiting new housing starts.Future reductions in affordability could further weigh onstarts and appreciation.

• It is likely that the decreased level of affordability in manymarkets could lead to a continuation of tighter lendingstandards.

Conventional affordability metrics may not paint acomplete pictureOne of the most widely published measures of affordabilityis the National Association of Realtors Affordability Index(NARAI). According to the NARAI, a value of 100 meansthat a family with the median income makes exactly enoughincome to qualify for a mortgage on the median-pricedhome in the United States. A reading above 100 means thata family earning the median income has more than enoughincome to purchase the median-priced home. As can beseen in Fig. 1, the NARAI is approximately 147. This impliesthat the median-priced home in the US is very affordable,despite the fact that the index has declined from 164 inJanuary 2018. The 2018 readings have been widely quotedby many in the housing industry to justify the view of across-the-board affordability.

Although we understand the methodology behind theNARAI, we believe several of the underlying methodologicalassumptions lack the robustness necessary to provideinvestors with strong predictive results, including:

Fig. 1: National Association of Realtors AffordabilityIndex time series

Source: National Association of Realtors, as of December 2018

• The NARAI assumes a 20% mortgage down-payment.The existence of 3% down-payment programs fromFannie Mae and Freddie Mac, as well as the 3.5% down-payment requirement for the majority of FHA loans, hasled to average down-payments being significantly below20% following the bursting of the housing bubble.Given that the FHA/VA and Fannie Mae/Freddie Maccontinue to account for a bulk of the new mortgageissuance, we believe reduced down-payment levels arelikely to continue. In our work, we have utilized a 10%down-payment assumption, as we believe it is morerepresentative of the post-recession environment.

• The NARAI only factors in housing debt into itscalculation, whereas as back-end debt-to-income (DTI)ratios factor in all of the debt of a mortgagee.

• The NARAI utilizes generic median figures of incomeand home price as opposed to DTI calculations whichare specific to the mortgagee and the home they arepurchasing.

• The NARAI assumes a constant representative mortgagerate and structure over time, whereas the DTI ratioreflects the mortgage structure and terms specific to themortgagee.

• The NARAI only includes the monthly mortgage paymentin its calculation. It does not account for real estate taxes,homeowners insurance, and maintenance costs.

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So what does affordability look like broadly?A review of Figs. 2 and 3 would lead even the casualobserver to conclude that housing is largely unaffordablegiven the strong divergence between home prices andincome growth. As can be seen in Fig. 2, both existingand new home prices are near their historical peaks on amultiple-of-income basis. However, the decline in mortgagerates that began during the global financial crisis has helpedmitigate some of the headwinds of rapidly rising homeprices (see Fig. 3). This is evident in Figs. 4 (existing homes)and 5 (new homes), which highlight the reduced levelsof monthly mortgage payment as a percentage of incomedespite rising home prices.

Fig. 2: Median new and existing home price as multipleof median income trends

Source: National Association of Realtors, US Census, UBS, as of December2018

Fig. 3: Median existing home price, household incomeand 30-year fixed rate mortgage trends

Source: National Association of Realtors, Freddie Mac, UBS, as ofDecember 2018

Another way one can assess affordability broadly can befound in Fig. 6. In the analysis, we assume a 10% down-payment and utilize the FHFA conforming 43% back-end DTI limit to calculate the required income necessaryto purchase the median-priced existing and new home.

Even after "fully loading" the monthly payment for realestate taxes, homeowners insurance, and maintenance, themedian household income of approximately USD 63,000 issufficient to purchase the median-priced home in the US.

Fig. 4: Median existing home price as multiple ofincome and monthly mortgage payment as % ofmedian income

Source: National Association of Realtors, FFEIC, UBS, as of December 2018

Fig. 5: Median new home price as multiple of incomeand monthly mortgage payment as % of medianincome

Source: US Census, FFEIC, UBS, as of December 2018

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Fig. 6: Required and available income required topurchase median existing and new home

Source: National Association of Realtors, US Census, FFEIC, FHFA, UBS, asof December 2018

The aforementioned notwithstanding, many people neitherearn the median household income nor live in an area withhomes priced at median levels. To that end, we examinedthe housing costs for the top 60 metropolitan statisticalareas (MSAs) in the US (see Fig. 7). We calculate the currentmedian existing home price as a multiple of median income,and the payment as a percentage of monthly incomeon both a nominal and fully loaded basis. Nominal onlyincorporates the monthly mortgage payment, while fullyloaded includes our estimate for monthly real estate taxes,homeowners insurance, and maintenance. What shouldcome as no surprise is that the coastal California, New YorkCity, and Honolulu markets are among the most expensiveand unaffordable in the country. Miami, Seattle, and Denverare bumping up against unaffordability as well, but thingsare more benign for many other markets.

Fig. 7: MSA level median home price as multiple ofincome and monthly payment as % of median income

Source: National Association of Realtors, FFEIC, UBS, as of December 2018

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One question we are often asked is how can some of thesehighly unaffordable markets not be at risk for significantprice retrenchment. We would make several observations:1) a number of these markets have begun to see outrightprice declines, particularly for higher-priced homes; 2) anumber of people in many of these expensive marketsearn significant noncash compensation; this could helpsupport pricing beyond headline fundamentals; and 3) newdevelopment is extremely difficult, particularly in costalCalifornia and Honolulu. This, combined with elevatedconstruction costs, is likely to keep supply more restrainedin these markets – something that could support prices overa longer period of time.

How does the rental market impact the affordabilitycalculus?As we mentioned previously, it is important to evaluatethe concept of affordability as it pertains to overall shelter,including rental options. The significant increase in homeprices during both the housing bubble and the post-great-recession periods has masked an interesting phenomenon –that apartment rents have actually increased at a faster ratethan mortgage payments. This can be seen in Fig. 8 wherewe compare average apartment rents to the fully loadedmonthly ownership costs for existing a new homes on anindexed basis.

Fig. 8: Indexed national apartment rents and monthlyfully loaded monthly ownership costs for existing andnew homes

Source: National Association of Realtors, US Census, UBS, as of December2018

In addition, the decline in mortgage rates has substantiallyreduced the ownership cost premium over renting. In Fig.9, we detail a time series of the ownership premium forboth existing and new homes (on a fully loaded basis)compared to apartment rents. Despite rising home pricespost-2009, the ownership premium has shrunk due todeclining mortgage rates.

Fig. 9: Ownership premium for existing new homesover renting on fully loaded ownership basis

Source: National Association of Realtors, US Census, Freddie Mac, UBS, asof December 2018

Taking a deeper dive to the MSA level in Fig, 10, themore expensive coastal California markets as well as NewYork City and Honolulu have elevated rental costs as well(as measured by rent as a percentage of income) but arerelatively more affordable on a rental basis (based on rentfor a three-bedroom apartment) as compared to ownership.

Fig. 10: Price-to-income, rent as % of income and rentas % of fully loaded ownership costs for top 60 MSAs

Source: National Association of Realtors, FFEIC, CBRE, UBS, as ofDecember 2018

Fig. 11 provides another way investors can assess the relativeattractiveness of renting versus owning at the MSA level.In Fig. 11, we plot the median existing home price as amultiple of median income (Y axis) against the rent for athree-bedroom apartment as a percentage of fully loadedownership costs for the largest MSAs in the US (X axis). Allelse being equal, for all the MSAs in the upper left-handquadrant, it is less expensive to rent versus own. For theMSAs in the lower right-hand quadrant, it is less expensiveto own versus rent.

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Fig. 11: Rent vs. own affordability plot by MSA

Source: National Association of Realtors, FFEIC, CBRE, UBS, as ofDecember 2018

How might reduced affordability impact housingstarts and future home price appreciation?Although no cycles ever behave exactly as theirpredecessors, historical relationships can provide someinteresting potential predictive value. Fig. 12 highlights thehistorical relationship between affordability (as measuredby monthly payment as a % of income) and the year-on-year change in single-family housing starts. If the historicalrelationship holds going forward, single-family housingstarts are likely to be more restrained in the current cycle.Rising construction costs and a lack of skilled labor couldfurther exacerbate this risk.

Fig. 12: Monthly ownership payment as % of income(inverted) and y/y change in single-family housingstarts

Source: FFEIC, US Census, UBS, as of December 2018

Fig. 13 highlights the historical relationship betweenaffordability (as measured by monthly payment as a % ofincome) and the year-on-year change in existing home priceappreciation. If the historical relationship holds, home priceappreciation rates could continue to decline going forward.

Fig. 13: Monthly ownership payment as % of income(inverted) and y/y change in existing home priceappreciation

Source: National Association of Realtors, FFEIC, UBS, as of December 2018

What about the impact of affordability on mortgagecredit availability?For all the talk of loosening mortgage standards and a repeatof the systemic risk to the financial system that occurredduring the housing bubble, underwriting standards remaingenerally conservative. This is not to say there are noexcesses in the system or that there is not some poormortgage underwriting that has occurred. That said, ascan be seen in Fig. 14, FICO scores for conventional andFHA purchase mortgages remain well above those observedduring the housing bubble. In Fig. 15, back-end DTI ratiosremain very conservative for conforming mortgages andwell below the 43% limit, while they appear to have leveledoff for FHA mortgages. It is likely that the decreased level ofaffordability in many markets could lead to a continuationof tighter lending standards. For example, earlier in 2018Fannie Mae rolled back its July 2017 expansion of the back-end DTI ratio from 50% to 45%.

Fig. 14: Conforming and FHA FICO score trends forpurchase mortgages

Source: Ellie Mae, UBS, as of December 2018

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Fig. 15: Conforming and FHA back-end DTI ratio trendsfor purchase mortgages

Source: Ellie Mae, UBS, as of December 2018

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Appendix

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