The Math Skills of Crowds

Submitted by Rich Toscano on April 21, 2005 - 10:15pm
An article in today's Economist concerning the global housing bubble contains this stunning claim:
"A recent survey of buyers in Los Angeles indicated that they expected their homes to increase in value by a whopping 22% a year over the next decade."
Let me get this straight. Real estate is, by every conceivable measure, far more expensive than it's ever been. Homes are already so incredibly expensive that most people can't buy one unless they take out a teaser-rate mortgage or they have a pile of cash from the sale of their prior home. Affordability is at an all-time low, despite the fact that interest rates are about as low as they've been since the 1950s. And from these lofty heights, homebuyers are expecting prices to rise a staggering 22% a year for the next decade?

Let's run those numbers real quickly. The median household income in Los Angeles, according to Wikipedia, is $42,189, while DataQuick lists the median home price as $420,000. The NAR Affordability Index puts Los Angeles affordability at 17%, meaning that only the top 17% of wage earners can afford the median priced home. (As I've mentioned before, the problem with the Affordability Index is that it accounts neither for "creative financing" nor for income from home equity gains. However, since those two factors are very likely ephemeral, the Index actually provides a good idea of who should be buying, if not who IS buying).

Now let's project 10 years into the future. As of last month, per the BLS, incomes were increasing at a rate of 2.6% per annum. Assuming that trend continues, the median household income in Los Angeles would be $54,535.

Not bad, except that at the anticipated home price growth of 22% per year, the median LA home price would be over $3 million. The Affordability Index would put Los Angeles at an impossibly low 3%--and even lower if rates were to rise from their current rock-bottom levels. For a visual representation of why this will not happen, let's look at a chart of LA's median monthly household income compared to the monthly payment on a median-priced LA home growing at 22% (assuming the purchaser puts 10% down on a 30-year fixed mortgage—we'll say rates remain at today's 5.2%):

Like I said: it's not going to happen.

Intuitively and mathematically, the idea that home prices will rise 22% per year for the next 10 years is absolutely preposterous. Yet there the LA homebuyers are, gleefully fantasizing about their future riches without bothering to pick up a calculator or even think anything through. And there is no question--no question at all--that those anticipated gains are priced in to current home valuations. What will happen should those gains fail to materialize?

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