U.S. Home Prices 19% Below Fair Value

There are two things people must consider when buying a home: whether they can afford it and whether the market they’re buying in is trading at fair value.

The first consideration is a debt-to-income ratio. This is principal, interest, taxes, insurance, plus all other non-housing debt obligations as a percentage of income. Lenders will give you a mortgage even if your debts to you go to up to 45% of your income, though your lifestyle impact will be more similar to renting if you’re 37% or less. This is broadly speaking of course, and each person’s objectives and budget priorities are different.

The second consideration is fair value of the home you’re buying. This is normally defined as a price-to-rent ratio, which helps you understand total costs of owning vs. renting a home. Below is an excerpt from this week’s Economist showing that your chances of obtaining fair value in the U.S. is pretty high right now. Obviously all markets are local and pricing varies wildly, but even in a high priced market like San Francisco (where I am), rents are rising so quickly that home affordability math works for a lot more home buyers than it used to.

Earthbound prices are returning many markets to “fair value”, defined as the long-run average ratio of house prices to disposable income and to rents. Housing is now around or below its fair value in eight countries. But reaching this mark does not mean prices will stop falling. After dropping by a third from their 2006 peak, prices in America now stand at 19% below fair value. The bottom of the market is close, however. The month-on-month Case-Shiller index of 20 cities increased for the fourth consecutive time in May, by 0.9%. Housing sales are picking up, although they remain below their long-run average, and the number of mortgages in foreclosure has fallen to its lowest level for three years. Financing is cheap, too: real 30-year fixed mortgage rates are at 30-year lows.

Global Housing Prices: an era of frothiness is over (Economist)