The Affordability Limit In Residential Real Estate Markets

By Author: Lawrence Roberts
Total Articles: 4762
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Affordability is the ultimate limit of any asset bubble. If prices are so high that no buyer can afford them, there are no transactions and thereby no market. The fear of many buyers in a financial mania is that prices will remain elevated to the absolute limit of affordability permanently. People who have this fear will put every available resource into getting a house before this happens. This becomes a self-fulfilling prophecy as prices get bid higher and higher by fearful buyers.

If prices were to remain at the upper limit of affordability for a long period of time, the rate of price increase would slow dramatically until it only matched the rate of wage growth and inflation because prices could only rise if people had income gains they could use to bid prices up further. If the rate of house appreciation slows down to where it only matches inflation, it fails to have significant investment value. Money would generate much greater returns if invested in other asset classes.

During the Great Housing Bubble, certain of the most inflated markets saw prices more than double their rental equivalent value. This ...
... significant additional monthly cost provides an economic return while prices are increasing rapidly, but once the rate of price increase slows, the additional "investment" is not providing sufficient returns to justify the use of capital. If price increases do not provide an investment return, many who bought in anticipation of that investment return will decide to sell the asset in order to put their money toward more productive uses. This selling slows the rate of appreciation even further. Also, if prices are not rising in excess of inflation, there is little financial incentive to buy because when affordability is very low, it is much less expensive to rent.

If there is no financial incentive to pay more than the cost of rent, people stop buying. The additional selling pressure from those no longer obtaining a return on their investment combined with the diminished buying enthusiasm for the same reason plus the presence of a low-cost substitute (rental,) stops prices from rising and eventually causes a price decline. Once prices start declining, the incentives are even more negative, and prices fall back to levels where they are affordable again.

As prices begin to fall, lenders become more conservative. They do not loan large percentages of the value on a depreciating asset because they do not want to have the loan balance exceed the resale value of the house since the only assurance banks have for getting their money back is the collateral value.

Prior to the Great Housing Bubble, lenders demanded 20% down payments to give them a cushion if values declined and they limited debt-to-income ratios to 28% to make sure the borrowers could afford to pay them back. When house values start declining, lenders require more cushion to protect their investments. The demand from lenders for larger downpayments to protect themselves reduces the number of buyers in the market because less people meet the more stringent requirement. Fewer buyers causes even lower prices and a downward spiral of tightening credit. This continues unabated until 20% down payments are the norm, and debt-to-income ratios fall back to their historically "safe" levels for banks (28%).

The deflation of the housing bubble was all part of the credit cycle. Credit availability is the greatest and standards are the loosest at the end of the rally when prices reach the affordability limit. Once people begin to default on their loans, credit began to tighten, and the real estate bubble began to deflate. Prices will continue to fall until they are affordable.
About Author:
Lawrence Roberts is the author of The Great Housing Bubble: Why Did House Prices Fall?
Learn more and get FREE eBooks at: http://www.thegreathousingbubble.com/
Read the author's daily dispatches at The Irvine Housing Blog: http://www.irvinehousingblog.com/ Visit The Affordability Limit in Residential Real Estate Markets.