August 2006

Affordability and First-Time Buyers
Sara Sutachan, Associate Research Analyst
Robert A. Kleinhenz, Ph.D., Deputy Chief Economist

The CALIFORNIA ASSOCIATION OF REALTORS® (C.A.R.) has measured housing affordability with its Housing Affordability Index (HAI) since the mid-1980s. The HAI refers to the percentage of households that can afford the median priced home. It might be called a "traditional index" in the sense that it assumes traditional real estate financing terms: a 20 percent down payment, prevailing interest rates, and the condition that the monthly payment not exceed 30 percent of a household's gross income.

The HAI generally tracked long-term affordability trends in California's housing market, but readings in the last two years were clearly inconsistent with the actual pace of activity, during which the market registered record-setting sales and double-digit annual percentage increases in the median price. For example, the state achieved a record year for sales in 2005, yet affordability plunged to a record low by year end. In fact, while the assumptions behind the HAI may have accurately characterized the real estate financing environment of twenty years ago, they are quite different from the situation facing California home buyers in recent years, particularly in light of the increased variety of loan products available today and changes in underwriting standards over time.

Over the past year, C.A.R. has worked to produce an affordability index that better depicts current financing conditions in California, and also tracks more closely with current market activity. Although repeat buyers have dominated the market in recent years, affordability or the lack thereof mainly afflicts would-be first-time buyers. As such, a Housing Affordability Index for First-Time Buyers (HAI-FTB) was developed, based on recent and long-term trends in home buying among first-timers.

C.A.R. research revealed that the price of an entry-level home for first-time buyers has been approximately 15 percent below the median price of all existing homes on a consistent basis over the past 25 years. Moreover, first-timers generally make a downpayment of 10 percent and use an adjustable rate mortgage (ARM). Lenders are commonly qualifying buyers at something other than the traditional 30 percent ratio, more likely a 40 percent ratio, and even a 50 percent ratio in some cases. Thus, the HAI-FTB is based upon the following assumptions:

Median price of an entry-level home equal to 85 percent of prevailing median for all homes
10 percent downpayment, corresponding to a 90 percent loan-to-value
One-year ARM index for previously occupied homes that includes points and fees, reported by the Federal Housing Finance Board
-Qualifying ratio of 40 percent, meaning that the monthly payment (including taxes and insurance) cannot exceed 40 percent of household income.

Applying these assumptions to the market in the second quarter of 2006, the entry-level median was $482,000 (85 percent of the overall median of $567,060), the effective ARM was 6.48 percent, and the resulting monthly payment on a $433,800 loan was $3,290. The minimum qualifying income for this monthly payment was $98,720. The resulting HAI-FTB was 23, meaning that 23 percent of California households had an income that matched or exceeded the minimum qualifying income. This was down 7 percent from a the second quarter of 2005, when 30 percent of households could afford to buy an entry level home priced at $446,710, with an effective ARM of 5.5 percent, a monthly payment of $2,800, and a minimum qualifying income of $83,890.

To be sure, affordability in California is low, even with the first-time buyer assumptions. By comparison, first-time buyer affordability for the nation was 59 percent in the second quarter of 2006 on an entry-level median of $193,380. This is more consistent with the current situation in which approximately 25-30 percent of the market consists of first-time buyers.

To learn more about our Trends Newsletter, please contact the Research & Economics Department at research@car.org  or (213) 739-8352.