By Nathan Moeder, The London Group

November 2005, the peak of the market here in San Diego, seems like a different world ago. Since then everything has been in flat-out turmoil (subprime) or just plain limbo (sidelined buyers and investors). Predicting the precise bottom of the market is nearly impossible ? just like trying to buy a stock at the cheapest price.  And we don?t realize we?ve hit bottom until there is hindsight. But here is some interesting data that may suggest stabilization is around the corner (or maybe we?re rounding it now.).

The price-to-income ratio is one metric to determine if the housing market is affordable and sustainable. It?s simple ? take the price of the median home and divide it by the median income. For the 1980 to 2000 period this ratio reached a low 4.1 (1985 and 1996). In 1989 it reached a high of 5.7. But the 2000?s yielded much higher ratios, reaching 9.0 in 2006. The reason for this was lower interest rates, new mortgage vehicles, and lax underwriting??..or basically just the ability to finance and how much.

This statistic is now the center of debate of those trying to predict the market. The most common argument is that that the price-to-income ratio must fall back to historical norms (in the 4.0 range) for the market to be in equilibrium.  However, past is not prologue, and just like reading any ancient script, you must consider the context. The context here is leverage. To say that price-to-income ratios will return to the 4.0 level is to suggest that we will be in a high interest rate environment. I agree that is where we are heading, but the interest rates at those price- to-income levels would mean that 30-year mortgages return to the double digits. In the 1980?s the average 30-year mortgage cost you 12.7%. In the 1990?s it was 8.1%, which was a market that was affected more by job loss than the high cost of housing.

The adjacent table depicts the change in leverage between the past 20 years and where we are today. The average interest rate was 10.3% and price-to-income ratio was 4.6 for the 20 year period from 1980 to 2000. However, if we assume that 30-year mortgages will be at 6.5% to 8.5% over the next couple years, consumers can afford to finance 18% to 43% more compared to the prior 20-year period. This translates to a price-to-income ratio of 5.3 to 6.3.

So where are we today. The price-to-income ratio has dropped back to 5.8. In addition, the Case-Shiller index demonstrates that prices have receeded to 2003 or 2002 levels. This information is shown the following chart along with the percentage of income that is spent on housing. Currently, 36% of income is spent on housing, which it hasn?t been since 2000 - 2001. This is also less than the late 1980s and early 1990s period.  But if the price-to-income ratio fell to the 4.0 range, the correlating percentage of income spent on housing would be 25% to 29% - which would be lower than even the lowest point in the past 20 years. 

(click on chart for larger version)

It?s hard to picture that the fundamentals of housing affordability in San Diego could fall to its lowest levels in 20 years. And if it did, we would have more severe economic conditions than just a housing slump, which means that qualified buyers and affordability wouldn't necessarily be the problem. But when the micro-markets of San Diego stabilize it will be at different times, largely due to the concentration of foreclosures. Currently there are already some initial signs of stabilization in some of the coastal neighborhoods in San Diego. I don?t know if we?re there yet, but it might be closer than we think. The next question is: how long will we be there.

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