Any sports fan knows that, buried among the cavalcade of statistics, there is usually one number that is the best immediate insight into a player’s performance. On-base percentage. Yards per completion. Unblocked shots on goal. Service hold. These aren’t perfect, but if you had to pick one number to tell you something about a player, you’d probably focus in on these. Real estate investing has a similar number that lets you know both the short and long-term trends of investing. That number is the “price-to-income ratio.”
The price-to-income ratio is essentially as simple as it sounds. It is the median price of housing compared to the median average income. When the ratio tilts too far in favor of price, housing becomes unaffordable; when it is in favor of income, the market tends to be swallowed up. This has its drawbacks, too, as we’ll explore. Understanding the impact of this ratio on the market is important for investors to know when is the best time to get a hard money loan to prepare for the future.
There is no number set in stone for home-buyers, but the best advice is that they shouldn’t be purchasing housing that costs more than 2.5 times their annual salary. So, if a dual-income couple is making $100,000 a year, they shouldn’t be in the market for a house that costs more than $250,000. They don’t want to have monthly payments exceed 28% of their monthly salary, either.
Now, granted, this isn’t set in stone. If someone has a heavy debt-to-income ratio, going 2.5 times is way too much. Both the “front-end” and “back-end” ratios have to make sense for a home-buyer. Otherwise they can lose the house as quickly as they got it, and as we saw in 2007 and 2008, that can end up badly for everyone.
How Does the Price-to-Income Ratio Work on the Macro Level?
For decades, the national price-to-income ratio was around 2.2%, which is below the suggested norm. This, of course, was great for home buyers and, despite some dips, it held steady for many years. In the 2000s, it started to drift upward, past the 2.5% mark, which didn’t slow down home-buying but which did play a role in precipitating the economic collapse.
Now, how does this all impact you, the real estate investor? When looking at macro trends, it is important to look at the market in your area. Every area has different income levels and median home prices. Here are a couple of different scenarios:
When the PTI is Below 2.5%
Expect supply to fall behind demand. If the average price is lower than most people are willing to spend, this means that there will soon be a need for more housing. This is a great time to get into a market. It is counterintuitive, because it seems like you are entering a weakened real estate zone, but a rising income and lower prices tend to balance out, leaving a supply void, which quickly becomes a seller’s market.
When the PTI is Above 2.5%
As this Forbes article argues, a higher price-to-income ratio eventually leads to too many houses that people can’t afford. This isn’t always good for the custom home builder, but it is good for the rental or condo market. This is especially true if the PTI shifts because house prices are outstripping wages, and not just because wages are falling. In markets like San Francisco, where wages are high but home prices are even higher, you aren’t dealing with a depressed economy, just a historically out-of-whack PTI. High-end rentals or luxury condos can fill this void for people who have money to spend, but not to buy.
Every region is different; every city idiosyncratic. Understanding how the price-to-income ratio impacts your area can teach you what to invest in, what to build, what to flip, and when. It is one of many factors, of course, but it is a consistent trend that you ignore at your peril.
Your real estate assets are your best investments for the future. At Socotra Capital, we’re proud to be the premier direct hard money lender for California real estate. Contact us today to learn more about how we can help.