Minneapolis Area Association of REALTORS Housing Insights

Price to Income Ratio
There’s no shortage of ways to measure housing market performance. If home prices are your favorite barometer of market vitality, we encourage you to check out absorption rates, percent of list price received and days on market as well. But there’s also no shortage of ways just to measure home prices. Here at MAAR, we produce monthly price metrics such as the median sales price, average sales price, median price per square foot, average price per square foot and we even have our very own housing value index. A slightly less well-known metric is the price to income ratio. The same way price per square foot normalizes prices by dividing out by the square footage of the home, price to income ratios normalize prices by dividing out by the median family (or household/per capita) income. For this particular study, we’re using the median sales price compared to the median family income.


While the median sales price was within 3.5 percent of its all-time high in June of this year, the price to income ratio still has 20 percent to go before reaching its previous peak (from 2.5 to 3.0). So what does that tell us? First, this might diminsh some concerns over whether another bubble is forming. Second, and despite consistent price increases, it tells us that consumers are not overstretched. Third, it tells us that the current for-sale inventory could be more affordable than some might have thought, perhaps based on other indicators. Fourth, as incomes rise (even in tandem with prices), this ratio should remain fairly stable, since both sides of the fraction are scaling up together. The ratio of 3:1 is three. The ratio of 6:2 is also three. If the numerator and denominator scale together, the relationship can remain the same. It’s also worth noting that several major cities in the United States as well as other countries have price to income ratios upwards of 10.0.

At a time when the median and average sales price measures both near their previous highs from 2005-2006, it’s important to use other measures to either confirm or challenge this trend. Even as some metrics return to levels not seen for years, it’s important to remember that we currently have extremely low supply levels, traditional market share still isn’t back to where it once was, new construction and condos make up a smaller slice of the sales pie than in the past and multidecade low interest rates have joined forces with a recovering labor market and tightening rental market to bolster purchase demand. In other words, there are a number of factors that make today’s market different than the last time prices were this high. For that reason, now more than ever, it’s critical to examine market data through a variety of lenses so that we can get a more holistic perspective on what’s really happening given the shifts that have taken place over the last 10- 15 years.

The Inflatable Price Raft
“Accept certain inalienable truths: Prices will rise. Politicians will philander. You, too, will get old. And when you do, you’ll fantasize that when you were young, prices were reasonable, politicians were noble and children respected their elders.” – Mary Schmich

We hear a lot about home prices and how they change over time. But by far the biggest pitfall of dealing in absolute dollar terms is that a dollar in 2015 does not buy what a dollar used to get you in 1960 or even in 2010. If you’ve ever purchased the same product or service even just several years apart, you implicitly know this, though you may not be familiar with some of the rationale and technical aspects of tracking and adjusting for inflation. And let’s be clear here: that is OK!

While the nominal (not inflationadjusted) home price has certainly increased in absolute terms, the typical home that cost $15,977 in 1960 dollars would actually cost exactly $127,635 in 2014 dollars. So a lot of what appears to be price gains is actually attributable to inflation, though not all of it. This is why it’s important to separate out inflationadjusted prices from nominal, reported prices. It’s the best way to answer the question: excluding the effect of inflation, how much did real home prices actually increase?

The Consumer Price Index (CPI) is the most common method to account for inflation when dealing with time series data stated in currency units. Using the Bureau of Labor Statistics (BLS) CPI, we’ve adjusted historic home prices and restated them in constant 2014 dollars. Note how far apart the trendlines start versus where they end up. Only when nominal prices approach 2014 do the trendlines converge – since, at that point, both nominal and adjusted prices are stated in 2014 dollars.


Enough with the buildup. So what’s really going on here?

Between 1960 and 2015, nominal home prices increased from $15,977 to $261,963, a gain of 1,539.6 percent. During the same period, inflation-adjusted prices increased from $127,635 to the same $261,963 for a more modest gain of 105.2 percent. That’s a big difference, and shows just how much of the run-up in prices can be attributed to inflation.

But it’s also important to note that home prices more than doubled during the 54-year study period (1960-2014) even after adjusting for inflation and despite the downturn. That means after factoring for inflation, home prices kept pace with inflation and doubled in 54 years. An increase of 105.2 percent spread out across 54 years translates into a 1.95 percent real annualized average growth rate. That finding supports the roughly 2.0 percent annual home price increase that is referenced quite often. It also supports the fact that real estate is an effective inflation hedge.

Equally or perhaps even more importantly, while nominal home prices are quickly nearing their 2006 highs, inflation-adjusted or real home prices are still well below their previous peak in 2005. In other words, while nominal prices seem to be approaching their previous peak, real home prices are still a bargain, especially compared to 2004- 2006 prices stated in 2014 dollars. That means real home prices have to increase 26.4 percent before they break even with 2005 levels. Nominal home prices have about 6.6 percent to go before reaching 2006 levels.

But life is all about choices, and choices – at least in the strict economic sense – represent a series of opportunity costs. An opportunity cost of a choice, such as buying a house, is what you give up to get it. Most of us have to choose between two major investments at any given time. Sure, gold and other precious metals might also keep pace with inflation and then some, but you can’t live in a pile of bullion. You can only visit your gold periodically. Investing in a home is one of the most effective inflation hedges out there. Plus, while you’re quietly slaying the inflation dragon and enjoying some appreciation, you’ve got a place to live!