There are a few rules of thumb that exist about how expensive housing should be. Three rules – about incomes, yields and affordability – are familiar to many people but what is perhaps less well understood is which are the sturdiest.
One rule of thumb is that the price of a house should be on average between three and three and a half times the income of those living in the house. A second is that the price of the house should be something like 20 times the annual rent for the same home.
And the third is that when renting, or indeed when thinking about a monthly mortgage payment, the amount spent on housing should be no more than a third of all disposable income. It turns out that we can rank these three rules by how useful they are – one is only marginally helpful, one is helpful once caveats are born in mind while one should be at the core of housing policy.
Rules of thumb are – as their names suggests – rough guides, not hard and fast rules. Nonetheless, it is interesting to note that the first of these has, in recent years in Ireland, gone from a rule of thumb to a cornerstone of macroprudential policy.
The mortgage rules introduced by the Central Bank in early 2015 include loan-to-income restrictions, in particular that the size of the mortgage can be no more than 3.5 times the household’s income. On the face of it, this seems sensible. For those of a certain vintage, it reminds them of the building society rules that lasted until the 1990s.
However, scratch at the surface of this rule and the justification is pretty slim. Whether a household on a €50,000 a year can afford a mortgage of €125,000 depends not only on those two numbers but on many other factors too. Two obvious ones include interest rates and tax rates.
Interest rates in Ireland switched from around 10% in the 1980s and early 1990s to around 5% (or indeed mostly below) since entering the Eurozone. Similarly, the tax rates that applied in the 1970s and 1980s would horrify workers today.
Even taking the housing market at a particular point in time, house prices – and thus mortgages – will vary by location far more than incomes do. So, while attractive in its simplicity, there is little foundation to the first rule of thumb.
The second rule of thumb, that what you should pay for a house should be something like 20 times the annual rent, is far more solid. If you think of that ratio the other way around – what percentage of the price is the annual rent – it is a percentage that you can compare to the return on other assets, like a savings account.
If house prices are 20 times the annual rent, the rent gives a yield of 5% of the price (five goes into 100% twenty times). Economists think of the yield of any asset – in this case housing – as being the sum of two bits. The first component is known as the “risk free rate”, the yield on the most secure asset in an economy.
Typically, this is the interest rate on government debt (unless of course there is a risk of the government defaulting). The second component is the specific risk attached to that asset. For example, if there is a risk of a falling rents because of slow economic growth, this should be priced in to the yield.
If the yield goes down to 3% or below – as it did during the Celtic Tiger bubble – this is a sign that the market has taken leave of its senses. The same applies for individual properties. Ultimately, if you paying more than 20 times the annual rent, you need to have a good reason why.
Another way of thinking about this is that if you are the highest bidder on a property, you value that property more than anyone else on the planet. Are you clear why?!
But it is not the case that there is one just one multiple that will hold in all cases. For investors, the yield that they will require will be different to an owner occupier, because they face an income tax bill that an owner occupier doesn’t.
And what a healthy yield is now, for any given buyer of a specific property, will be different to what it was a generation ago. A generation ago, the yield on property was closer to 8% – and a generation before that, it was at least 10%.
So while the link between rents and prices is a very useful barometer of the housing market, it is not set in stone. It varies with the ‘regime’ governing the housing market.
The final rule of thumb is about affordability: a household should not spend more than roughly one third its disposable income on housing. Unlike the rule about prices to incomes, it takes account of taxes and interest rates. If interest rates go up, this will reduce the amount of debt someone can borrow, even if their income stays the same.
But thinking in terms of monthly income and spending gets around this. It also gets around the prices vs. rents argument. It doesn’t really matter what the system is that governs the yield – whatever that system, if you are spending more than a third of your disposable income on housing, you are financial exposed.
This is by far the most robust of the three rules of thumb. It’s not a cliff-edge: going from a third to 35% – or even to 40% – is unlikely to bring financial ruin to a household. But it does increase their vulnerability.
Nonetheless, this rule of thumb should be at the heart of housing policy. Mortgage rules and construction costs should be designed with affordability for the average household in mind. And perhaps most importantly, housing subsidies should be too.
If a household earns enough that one third of their income is adequate to cover the cost of housing on the market, great. But if not, society should step in to top up their income so that they can.
An edited version of this post was originally published in my column in the Sunday Independent.