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I have been arguing for years with my colleagues that having house prices go up 10% pr year and salaries only 3-4% means that we have less money, not more. They in turn say that its not a problem since the equity in their house will make up for it. Now I have been trying to argue against this by saying that eventually prices will be so high that interest rates on the mortgage alone can't be keept down, but somehow I always fail at convincing them.

So I am looking for a simple, convincing argument for why house prices just can't keep rising indefinitely out of tune with peoples real income.

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What if you own several houses? In this case you have more money.. You can say that you can buy "less houses" with your salary, but you can't say that people have less money :S –  Andreas Bonini Aug 13 '11 at 18:02
    
@Andreas, if you have multiple houses, you have more assets, but not necessarily more money. That's a big difference... –  Timo Geusch Aug 14 '11 at 4:25
    
@Timo: the op said (quote) "house prices go up [...] means that we have less money"; following your reasoning (which I agree with) we don't have less money; we simply can buy less houses with that money. I was merely pointing out that with any reasoning (ours or his) prices going up it doesn't mean you have less money –  Andreas Bonini Aug 14 '11 at 11:16

9 Answers 9

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Your friends are overlooking a couple of problems with house prices and salaries being out of whack:

  • Home 'equity' is a paper gain unless you realize it by selling the house. If you don't, but use the 'home ATM', all you're doing is piling up more debt that's secured on an asset that has downside risk. Ask anybody who's refinanced their house to buy a new boat or SUV in 2006/2007. In other words you're remortgaging the chickens before the eggs hatched. Of course they're also forgetting that all this debt will have to be paid back at some point, and that usually takes income, not equity.

  • In a certain sense the housing market is a pyramid scheme that requires an influx of new buyers to maintain prices. Very simply, if you can't sell your house to buy a bigger one because the first time buyer you're trying to sell it to can't afford the down payment or the payment on the mortgage, then you can't sell your house to buy a bigger/better/nicer one and the next person in the chain can't sell his/hers. Cue the domino effect. House prices are only sustainable if people actually can afford to buy houses and if there's a massive disconnect between house prices and salaries, then house prices will fall eventually. It might just take a little longer depending on the amount of creative financing options that will eventually dry up.

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At least the housing-market pyramid scheme generates jobs in the process :-) realtors, bankers, etc... –  corsiKa Aug 16 '11 at 16:28

"Indefinitely" is easy to answer. Assume that the average house currently costs four times the average salary, and that house prices rise 1% faster than salaries indefinitely. Then in only 1,000 years' time, the average house will cost around 84,000 times the average salary. In 10,000 years, it will be 6.5*10E43 times the average salary. That doesn't seem plausible to me.

If you want arguments about "for the foreseeable future", instead of "indefinitely", then that's harder.

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Good point and this was also why my friends did not buy my argument about interest rates on the mortgage being to hight to pay off since they are only looking at a 10-20 year time frame. –  Lars Tackmann Aug 13 '11 at 16:40
    
Compound growth makes everything crazy –  David Oneill Aug 15 '11 at 18:00

Those folks should be introduced to some real estate folks I know, they'd get along famously, being as how they still think it's 2007.

The amount of housing out there requires that a large market of consumers is available to purchase them. If housing prices rose infinitely ahead of salaries, the market for potential buyers would continue to shrink until supply would outstrip demand. And then we have the wonderful housing bubble like the one that we just went through (or in some places like China, have the potential to go through).

Short version: It violates the relationship between supply and demand.

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Here's another way to think about. Let's assume it is 2011 and we have a married couple who are 25 and make a combined salary of $50,000/yr net. A suitable first house in their area is $300,000, six times their annual net salary. Assuming they could scrimp so that 1/2 of take-home went toward saving for their home, they could save enough to buy the house using cash in 12 years, at the age of 37. Onerous, but they could do it.

But now let's allow salaries to increase by 3% a year and homes at 10%/yr, as in your question, and let's run things out for 20 years.

Now a 25 year old couple at the same sort of jobs would be making $87,675/yr. But the houses in that town would be worth not $300k but $1,834,772. Instead of six times their salary, a house is now nearly 21 times their salary. This means that if they saved 1/2 of take-home to save up for a house, they could afford to buy the house using cash when they were 67 years old.

It gets worse quickly. If you run it out for just ten more years, to 30 years, a couple would be able to buy the house -- at $4.8 million or 40x a year's salary -- in cash when they were 105 years old. (Let's hope they ate brown rice).

Mortgages can't save them, since even if they could put down ten years' worth of savings on the 2041 house (that'd be 14% down), they'd still carry a $4.1 million mortgage with a $118k annual net salary.

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LOL @ the brown rice –  George Marian Aug 14 '11 at 7:35

They can't keep rising with respect to people's income because eventually you run out of buyers. If there's roughly one house for every five people, then you'd better make sure that the price you set to sell your house is affordable to people in the upper fifth of income scales, or else you are mathematically guaranteed not to have any customers.

Now, it's true that the price of particular houses can get much higher, but they tended to be higher in the first place. Housing isn't exactly an efficient market, but for the most part you have to pay for the house that you get, or else someone else will outbid you.

An individual area might, temporarily, buck these trends because it suddenly becomes popular and there are a lot of extra buyers putting money on the table. In the long run, someone is going to build for those buyers, even if it means moving up the chain from enormous rural lots to suburban single-family homes to low-density garden apartments to residential towers.

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The three basic needs are food, clothing, and shelter. Housing falls into the third category.

Because it is "basic," housing takes up a large part of one's disposable income. The rule of thumb is that you shouldn't spend more than 25% of your income on rent or mortgages. And that is income BEFORE taxes. Anything much more than that takes up too much of one's budget.

You simply CAN'T double housing's share of the budget from 25% to 50%. Whereas, it's easy to go from 1% to 2% for say, a cellphone upgrade. In the long run, housing prices are constrained by the size of people's housing budgets, which in turn are tied to incomes.

Nowadays, that includes FOREIGN buyers. So there may be a case where west coast housing prices are driven up by Asian buyers, or Florida housing by buyers from Latin America, driving Americans out of local markets.

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There's a few things going on here. If we fixed rates (and terms) over time we'd expect a pretty tight chart of home prices to income, almost lockstep. Add a layer of growth above that in boom times due to the wealth effect (when stocks are way up, we have extra money to blow on bigger houses) and the opposite when markets are down. Next, the effect of rates. With long term rates dropping from 14% in 1985 to 5% in 2003, the amount that can be bought for the same monthly payment rises dramatically as rates fall. Easy to lose site of that and the fact that the average size house has increased about 1.5% per year over the last 40 years, surely that can't continue. When you normalize all these factors, houses cost fewer hours-worked almost at the peak of the market than 25 years ago. Mike's logical example of extrapolating out is very clever, I like it. In the short term, we'll see periods that are booms and busts, but actual prices will straddle the line representing the borrowing power of a week's pay.

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The big problem with your argument is the 10% per year figure, because in the long term (especially if adjusted for inflation) the prices have not been going up nearly that fast.

Here is a site with some nice graphs for prices over the last 40 years, and it's pretty clear to see that pretty much just what you were talking about happened, prices outpaced the ability of people to pay, which progressively locked out more and more first time buyers, and eventually that breaks the cycle, pops the bubble, and the prices adjust.

There is always of course the choice to NOT buy a house, and just rent, or if you had the feeling that you are near the top of a bubble, SELL and go back to renting. It's interesting to note that in general, rental rates did not increase at nearly the same pace as the prices in the recent bubble. (which of course made it harder for anyone who bought 'investment' properties in the recent 8 years or so to cover their payments via rental revenue.)

40 years of house prices and trend lines House prices vs Rent equivalents

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+1 beautiful charts, Chuck. I love the lower one, it shows graphically what I tried to state, as rent tends toward a week's pay. With renting as the alternative to buying, we are now approaching affordability, where buying a home may be cheaper than renting. –  JoeTaxpayer Aug 16 '11 at 3:31
    
Great explanation and very nice charts. the 10% number is for Denmark, but I quite sure that the US graph you show will also hold here in europe. –  Lars Tackmann Aug 16 '11 at 7:47
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I can only take credit for finding those charts, not making them. but they do make the bubble rather obvious.. it does really make you shake you head, even without the post 2006 numbers, how could lots of otherwise sensible people have been thinking at that time that housing prices would just continue to go up as they had for the past 5 years.. make all sorts of crazy loans.. greed can really blind people to reality I think –  Chuck van der Linden Aug 16 '11 at 9:45

I'd suggest changing the subject when your friends talk about real estate to save your sanity and friendship.

There's a difference between "belief" and "knowledge". Arguing with a believer isn't a very productive course of action, and will ultimately poison the friendship. Reality is a harsh mistress.

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good point, I also mostly asked here to check if it was me who has a lacking understanding of how these things works. –  Lars Tackmann Aug 14 '11 at 11:34
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Lars - an absurd analogy - your friend moves to Boston in February, finds 20F temperature, but 3 months later it's 60F, not bad. Problem is that 3 more months, it's 100F and he realizes that in 6 more months it will be 180F and wonders if anyone else knows they need to escape. Years ago, electronic components showed a long term trend of 14% annual growth. I remarked that this was unsustainable as one subset of the economy can't outpace the economy itself forever. I showed how by this decade the growth was likely to slow for this reason. It was a tough audience. –  JoeTaxpayer Aug 14 '11 at 18:44

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