Why Prices Will Continue to Fall

Lots of experts (and bloggers) are saying that home prices probably haven’t bottomed out yet.  Some of the more mathematical ones trot out charts and graphs and analyses to prove their point. I don’t know about you, but that stuff makes my eyes cross.

Fortunately, you don’t need to be an economist to figure out that prices are still too high in greater Los Angeles. (It’s pretty obvious, isn’t it?)  But if you need proof, there are at least two meaningful indicators that even a novice (like me) can understand.

Every quarter, Housing Tracker publishes an affordability report for major markets, including the L.A. area.  Included are two formulas that are important for anyone thinking of buying a home to keep track of:

1) Price to Income Ratio

A formula that lenders used to use for qualifying people for mortgages was this:  The price of the house should be no more than three times the buyers’ annual income.  So if you’re a couple making $100,000 a year, your home should cost no more than $300,000.

I can hear all you Angelenos laughing heartily.  It’s no wonder many of us have never heard of this formula, the same way we’ve never heard of $300,000 homes in greater L.A. 

Even if we agree that homes are in general worth more here, and therefore the ratio should be higher — say, four or five times income — well, we’re still a long way from that.  According to Housing Tracker’s third-quarter 2007 affordability report, the median-priced home in Los Angeles is more than 10 times the median family income. 

2) Price to Rent Ratio

Another meaningful measure is to compare a home’s selling price to its monthly rent.  The conventional wisdom is that the price of the home should be no more than 200 times (150 times is better) the cost of the monthly rental payment on the house. So if you’re renting a house for $2,000 a month, it shouldn’t cost more than $400,000 to buy.  Ideally it would cost around $300,000.

Housing Tracker compares the median single-family home price in L.A. to the median monthly rent for a three-bedroom apartment.  Our price to rent ratio in the third quarter of 2007:  314.8.  That says that a house that costs $2,000 to rent would cost more than $600,000 to buy. 

Loose credit standards and exotic mortgages allowed people to “afford” overpriced homes during the boom.  Home values stopped appreciating, but mortgage payments didn’t. The folks that own these overpriced properties (and/or unaffordable mortgages) have to work their way out of the market (i.e., sell at a loss or walk away) before things get back to normal.

Once the above ratios fall to more reasonable levels, buying will start to make sense again.

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