A question that economists at NAHB are often called upon to answer is, “What happens to housing affordability?” when either interest rates or house prices go up.

The most straightforward way of answering begins with a representative house price and interest rate, changes one of those parameters, and then observes the impact on affordability.  The most convenient concept of affordability to use is based on mortgage underwriting standards.  Under those standards, the question becomes, “How many households can qualify for a mortgage before the change, but not afterwards?” Those are the households that are effectively ‘priced out’ of the market for a home.

Applying this method to the U.S. as whole shows that in 2005—under typical assumptions about the nature of the mortgage, property taxes, and insurance—25 basis points tacked on to the mortgage rate will price about 1.2 million households out of the market for the median-priced new home. A $5,000 increase in the price of the home has a similar impact, also pricing out about 1.2 million households.

The same method can be applied to individual metro areas. The size of the impacts varies across metros, for the obvious reason that U.S. metropolitan areas themselves vary in size and therefore contain drastically different numbers of households to price out.   In the 318 metro areas studied here, the impacts of a 25-basis point interest rate hike and $5,000 increase in the median new home price range from fewer than 200 households priced out of the market in some of the smaller metros to more than 20,000 in metro areas like Chicago, Houston, and Washington, DC.

The Priced Out Calculation

Most home buyers take out a mortgage (according to the Census Bureau’s 2003 American Housing Survey, well over three-fourths of the owners who reported moving within the past year also reported having at least one mortgage), so it’s reasonable to use ability to qualify for a mortgage as an affordability standard.    A qualifying criterion used by the Fannie Mae and Freddie Mac guidelines limits the “front end ratio” (also known as “PITI” for Principal and Interest on the mortgage, plus property Taxes and homeowner’s Insurance) to 28 per cent of household income.

Mortgage originators sell about half of their conventional loans within a year, so   acceptability of these loans to the secondary market is an important consideration, and originators for that reason are inclined to follow the Fannie/Freddie guidelines.  Many of them in fact use a standard application form developed jointly by Fannie and Freddie.

Other underwriting standards are based on “back end” ratios, which incorporate consumer debt.    From the standpoint of a priced-out calculation, the primary disadvantage of back end ratios is that sufficiently detailed information about household debt is not always available.  The front end ratio, on the other hand, requires only an income distribution for the area of study.  The impact of interest rate and house price changes on PITI is the same whether a front end or back end ratio is used.

The affordability standard is thus a ratio of housing expenses to income, and the number of households that qualify for a mortgage to buy a home of a given price will depend on the income of households in an area.  Reasonably detailed income distributions for all parts of the country are available from the Census Bureau, but not always for the current year, so they most often need to be adjusted for the most recent changes in population and incomes. 

 
Table 1: 2005

Income Range:                      Households       Cumulative

$0                    to         $11,588           10,284,365      10,284,365

$11,589           to         $17,383           6,800,951        17,085,316

$17,384           to         $23,178           6,743,530        23,828,846

$23,179           to         $28,972           7,085,686        30,914,531

$28,973           to         $34,767           6,947,837        37,862,369

$34,768           to         $40,562           6,863,272        44,725,641

$40,563           to         $46,356           6,370,825        51,096,466

$46,357           to         $52,151           6,094,666        57,191,133

$52,152           to         $57,946           5,357,429        62,548,561

$57,947           to         $69,535           9,743,074        72,291,635

$69,536           to         $86,919           11,240,983      83,532,618

$86,920           to         $115,892         11,032,390      94,565,008

$115,893         to         $144,866         5,610,083        100,175,091

$144,867         to         $173,839         2,713,647        102,888,738

$173,840         to         $231,786         2,372,169        105,260,907

$231,787         or         More                2,556,705        107,817,612

To adjust for income growth, NAHB typically uses the estimates of median family income published each year by the Department of Housing and Urban Development (HUD) for every state and county in the country.   HUD published median income estimates for 2005 early in February.   Population or households estimates rates are available from a number of government sources.  Table 1 shows a U.S. household income distribution based on the number of households in the Census Bureau’s Housing Vacancy Survey.  The total number of U.S. households in 2005 is projected by applying the growth rate from the first half of 2004 to the number of households in 4th quarter of 2004.

Other assumptions used in the priced out calculations are a downpayment equal to 10 percent of the purchase price and a 30-year fixed rate mortgage.  For a loan like that, the calculations also assume lenders require private mortgage insurance with an annual premium of 45 basis points.[2]  Effective property tax and hazard insurance rates can be constructed from decennial Census data.[3] For the U.S. as a whole, the rates work out to $11.27 per $1,000 of property value for property taxes and $3.06 per $1,000 of property value for insurance.

Under these conditions, 39.7 million of the 107.8 million U.S. households could afford to buy the median priced new home in 2005—assuming that they pay a 5.75% interest rate on the mortgage.  This is different from the number of households that currently own a home, but of course current owners bought their homes at different times in the past, when house prices and the other variables that go into the analysis were sometimes quite different.


Interest Rates

If the mortgage rate rises, the monthly mortgage payments will be higher and some of the 39.7 million households will no longer qualify to purchase the home.  The size of the priced-out effect depends in part on the starting house price.  A median price of $224,400 for new homes in 2005 was generated by starting with the Census Bureau’s median price for new homes sold in 2004 and assuming one year of inflation at 2.5 percent, based on NAHB’s forecast for changes in the Consumer Price Index.

 
Figure 1 shows the number of households priced out of the market for a $224,400 home by each 25 basis-point increase in the mortgage rate between 5.75% and 7.00%.


The figure shows that an increase in the mortgage rate from 5.75% to 6.00% will price about 1.2 million households out of the market, and the increases from 6.00% to 6.25% and 6.50% will have comparable impacts.  Above that, the impacts begin to taper off slightly, so that boosting the interest rate from 6.75% to 7.00% prices about 950,000 households out of the market.  The tapering off occurs, because we are moving into a slightly thinner part of the U.S. income distribution, where there somewhat fewer households to be priced out.

 

House Prices

House prices may go up for many reasons.  Some are the result of changes in demand, such as those driven by rising household incomes.  The priced-out calculation, however, is designed to estimate the impacts of something that takes   place on the supply side of the market—conditions somehow changing so that it becomes more costly to deliver a home to its final consumer.

An example often encountered by developers is an impact fee.  If an impact or other construction-related fee goes up, all else equal, the price of the home will go up and fewer households will be able to afford it.  In fact, the final price of the home to the buyer will usually go up by more than the increase in the fee.

The reason is that, when costs of construction and development rise, other costs such as commissions and financing charges also rise.  Rates of return to home building also need to remain competitive with other investments, or businesses will leave the industry until the rates even out.

As a result, most cost increases are passed on to the buyer with a mark-up.  The size of the mark-up depends both on the type of cost increase and when it’s imposed in the development/construction process.   NAHB has estimated that a $1 increase in impact fees imposed at the time of development will typically raise the price of a house to its final customer by $1.25.  So an increase of $5,000 in the price of the home is consistent with an increase of $4,000 in impact fees, the way many of the fees are imposed.

If the price of the median-priced home goes up by $5,000 (from $224,400 to $229,400), the effect is similar to a 25 basis-point interest rate hike, pricing out about 1.2 million U.S. households (Figure 2).

The size of the priced out effect is largely a function of the income distribution in Table 1.  The $5,000 price increase stays within the same part of the distribution, simplifying the process of approximating the impacts for smaller price changes.  The impact of each $1,000 price increase in that range, for instance, is roughly one-fifth of the $5,000 impact, or about 240,000 households priced out of the market.(Figure 2)

As the house price gets higher and higher, the problem again shifts into a thinner part of the income distribution with fewer households to be priced out.  The last $5,000 price increase at the right of Figure 2 prices an additional 930,000 households out of the market.    Over most of the price points a developer is likely to be interested in, the number of households priced out tends to become smaller as the house price goes up.

Individual Metros

An advantage of the priced-out method outlined above is that it can easily be adapted to local markets.  NAHB has often applied the method to smaller geographic areas, as many of the crucial supply-side effects that drive up house prices—e.g., impact fees and constraints on land use—are imposed at the local level.

The most recent data source providing household income distributions for a large number of local areas is the 2000 Census.  Using the Census data, the number of households priced out of the market by a 25-basis point interest rate hike and a $5,000 price increase were calculated for 318 metro areas.[5]  It makes little sense to use the same price for all metro areas, as a representative new home price for, say, Pine Bluff Arkansas would seem  inappropriate in a high-priced metro area like San Francisco, so the analysis is based on an estimated median new home price that varies from metro to metro.

The number of households priced out of the market for a median-priced new home by a 25-basis point interest rate increase (from 5.75% to 6.00%) ranges from 78 in Syracuse, NY to 26,652 in Chicago, IL.  The number priced out by a $5,000 increase in the house price varies from 139 in Syracuse to 22,292 in Houston, TX.

As a general rule, the house-price effect tends to be high relative to the interest-rate effect in metro areas that start out with lower median new home prices.  House price effects would be more similar across metros, and therefore perhaps easier to compare,   if they were based on a percentage change in the price, rather than a straight $5,000 increase.  Experience has shown, however, that the largest share of NAHB’s audience is most interested in house price increases, expressed in dollar terms, within a particular market area.

Summary and Conclusion

This article describes the priced out analysis that NAHB uses frequently to estimate the impacts of changes in housing markets.  The analysis shows the number of households that will no longer be able to afford a particular home if either its price or interest rates go up.   The article also gives numerical examples for the U.S. as a whole, as well as for several hundred metro areas.

The results of a priced out analysis don’t answer all possible questions, such as, “How many  households will not buy a house when they otherwise would have?” or “What will the resulting reduction in home building be?”

Although these are important questions, doing a good job of answering them requires a complex economic model that addresses issues such as the willingness of households to accept homes that are somewhat smaller or have fewer amenities to achieve affordability, how different segments of a local housing market are related to one another, and how builders will adjust the product they build when affordability problems are on the rise.   An analysis that substitutes crude assumptions for this type of complex modeling will be difficult to justify, especially to a skeptical audience.

 In contrast, the priced out effect is relatively easy to understand and justify, straightforward to calculate, and available for any local housing market in the U.S.


NAHB

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President George W. Bush’s "ownership society" is a seductive idea: who wouldn’t want to become the owner of their home, health care, retirement, and destiny? From the "home on the range" to the adulation heaped on high-tech entrepreneurs, the concept is rooted in the American experience. No other nation places more value on the importance of individual autonomy. Ultimately, however, Bush’s promise of an ownership society is an empty one. In exchange for ownership, we receive increased risk while the wealthy and corporate interests benefit, as in his Social Security privatization plan. In Bush’s world, everyone gets a little piece of the pie, but at the cost of giving the wealthy extremely large helpings. Bush has, in fact, exacerbated a long-running trend: not only is income inequality greater in the United States than in any other advanced society, but the ownership of wealth is literally feudal in nature–and getting more so. The top 1 percent garners more income than the bottom 100 million Americans taken together. A mere 1 percent of wealth-holders, however, own just under half of all financial assets. A slightly larger group, the top 5 percent, own roughly 70 percent of all business assets. In 2003, the top 1 percent alone received 57.5 percent of all capital gains, rent, interest, and dividend income.

With recent rollbacks of the estate tax, incentives for retirement savings from which the well-off disproportionately benefit, and tax cuts that reward wealth, these inequities will only deepen. Morally, this is offensive to progressives and anyone with even a semi-serious conception of justice. Practically, this is troubling–and should be–to people across the political spectrum, because societies in which wealth disparities are so great are unstable societies. Divisions are magnified. The bonds of citizenship and brotherhood are weakened. The social fabric is frayed. A nation that begins down this path ends up with a country that begins to look more like a developing nation in Latin America and Africa: high walls keeping a restless and poor population out of sight and out of mind.

Decrying such inequities is nothing new. Yet, unfortunately, the progressive response of the twentieth century–redistributive tax structures and public assistance–no longer has the capacity to alter the dominant trends. Not only has income inequality continued to expand despite large-scale entitlement programs like Medicaid and Social Security, but there is little prospect that significant new programs will come into being any time soon. In a world of deepening deficits, an aging population, global competitive pressure, and persistent public skepticism of government, the appetite for the tax hikes and entitlement programs needed to rebalance these inequities is weaker than ever.

Although the redistributive door is largely closed, the ownership door is, in fact, open. Not ownership in Bush’s skewed sense, but rather ownership in a democratic sense through the possibility of community-based investment in, and control over, wealth creation. Employees, companies, non-profits, cities, and states are using diverse and innovative strategies to create community wealth. It is wealth that improves the ability of communities and individuals to increase asset ownership, anchor jobs locally, expand the provision of public services, and ensure local economic stability, rather than just boost corporate profits and shareholder fortunes. A common thread runs through the employee-owned firms, community development corporations, and even the traditional co-ops: the idea that real wealth equality can only be built by communal involvement in the means by which that wealth is produced. Such approaches provide ownership for millions of Americans–in many cases, through a tangible asset that can appreciate and be passed on to subsequent generations. Others create community wealth by enabling businesses and jobs to stay in the United States.

But more than that, these ownership strategies give people a real stake in their community, strengthening the bonds of citizenship and the connections between people, institutions, and places. These are not incidental by-products of a progressive ownership society; they lie at its core. A country where more people have a tangible stake and believe they can create better lives for themselves and their children is a strong society–and a strong democracy. "Necessitous men are not free men," Franklin Roosevelt urged. Or as an earlier President, John Adams, reminded a young nation: "The balance of power in a society accompanies the balance of property."

Interestingly, the idea of using investment strategies to benefit non-elites has been difficult for some progressives to grasp–it sounds too much like the other side’s programs. However, properly structured, such strategies can be a practical and effective way to combat wealth inequalities. Indeed, at the grassroots level, a progressive ownership society is already quietly taking shape–one that enables the poor, blue- and white-collar workers, and the middle class in general (broadly, the vast majority of perhaps the bottom 95 percent of American society) to create and gain the benefits of wealth ownership. These various strategies, and they are indeed very diverse, are beginning to change who gains from wealth ownership and investment. Some do it directly, helping low-income individuals increase savings and asset-holding. Others do it indirectly, but nonetheless importantly, by increasing the numbers of non-profit corporations that have established businesses to help finance neighborhood development or various social missions. Still others use municipal and state strategies to build community wealth. And all of these efforts are found throughout the country, in states "red" and "blue."

Community Wealth Strategies

Several proposals have emerged in recent years that move government policy beyond conventional redistribution and toward wealth creation. For example, prompted by the Clinton Administration, a bipartisan coalition came together in the late ’90s to provide federal backing for Individual Development Accounts (IDAs). In the typical IDA, the government directly matches the savings of poor families or individuals up to a certain level, thereby doubling their efforts and allowing them to benefit from the ownership of capital. Although IDAs are still very much in the experimental stage, roughly 400 community-based organizations currently administer some 20,000 individual accounts; in the San Francisco Bay Area, participants have consistently saved 5 percent or more of gross income despite averaging less than $20,000 per year in household income.

Bush has committed only modest federal funding to the initiative, but it has nevertheless spawned a number of proposed variations in recent years, many with bipartisan backing. In 2005, for instance, the America Saving for Personal Investment, Retirement, and Education, or ASPIRE Act, was jointly introduced by two Republicans and two Democrats: Senators Rick Santorum, Jim DeMint, Jon Corzine, and Charles Schumer. ASPIRE would provide every child with a starter deposit of $500, with children from households below the national median income eligible for an additional $500. In Great Britain, a similar "baby-bond" measure is now law, with the first "Child Trust Funds" opened last year.

The most far-reaching effort so far proposed, however, is that of Yale Professors Bruce Ackerman and Anne Alstott. This would provide every young person a "capital stake" of $80,000 on reaching adulthood, to be used for any purpose they chose. An interesting wrinkle here challenges existing wealth inequality directly: the program would be financed through a 2 percent wealth tax. Bill Gates, Sr. and Chuck Collins of United for a Fair Economy have suggested an additional angle of attack that, like the Ackerman-Alstott approach, also simultaneously challenges existing wealth inequality through the tax code. They propose a revised estate tax to begin at $2.5 million in assets, with the proceeds used to support a "wealth-building" fund to finance a variety of individual and community-benefiting strategies.

These programs and proposals, while noteworthy, are in some ways old wine in new bottles: they focus on wealth creation, but still mainly rely on the redistribution of funds through government policy as their means of doing so. But beyond Washington, in the "laboratories of democracy" that are the states, leaders in the private, public, and non-profit sectors are exploring even more creative ways to build community assets for broader groups and for communities.

Employee-Owned Firms

The most intriguing and instructive approach in the new mix is the employee-owned firm. "Worker ownership of the means of production" used to be a hoary radical demand; today it is increasingly an accepted reality. Few realize that roughly 11,500 U.S. businesses are now wholly or substantially owned by their employees–up from fewer than 300 a generation ago. The 10 million individuals involved in employee-owned firms include more people than the entire membership of private-sector labor unions.

Take, for example, the 7,500 employee-owners of W. L. Gore and Associates, manufacturer of Gore-Tex fabric, who control facilities in 45 locations around the world. Management is both sophisticated and participatory: workers may lead one task one week and follow other leaders the next week; teams disband after projects are completed, with team members moving on to other teams. The firm, which regularly ranks on Fortune’s "Best Companies to Work For" list, enjoyed revenues of $1.84 billion last fiscal year.

Other enterprises range in size and impact. Appleton Co. in Appleton, Wisconsin, is a world leader in specialty-paper production and is owned by roughly 3,300 employees. Reflexite is an optics company with approximately 420 employee-owners in Avon, Connecticut. In Harrisonburg, Virginia, ComSonics–owned by its 200 employees–makes cable television (CATV) test and analysis devices and boasts the largest CATV repair facility in the United States. These companies were not birthed from some sort of commune or communal movement. Rather, the typical employee-owned company is established when a retiring owner of a medium-sized business decides to sell to his workers, taking advantage of special tax incentives for firms organized through employee stock option plans (ESOPs).

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