By Deng Yusong, DRC Task Force on Analysis of System and Policy of the Stable and Sustained Development of Housing Market of China, Institute of Market Economy of DRC

Research Report No 19, 2012

In recent years, China has unveiled a series of real property regulatory policies to hold back the excessively fast rise of housing prices in some regions and to return such prices to a reasonable level. However, views vary at present among people about how to determine the reasonable level of housing prices, thus making it necessary to discuss and study the criteria for the judgment of the reasonable level of housing prices.

I. Major Indicators for Judging the Reasonable Level of Housing Prices

International experiences reveal three main indicators for judging the reasonable level of housing prices.

1. The reasonable level of housing prices judged by housing price-to-income ratio

The housing price-to-income ratio generally refers to the times of an annual household income to a home price. The judgment of the reasonable level is to figure the price-to-income ratio and see if it is bigger than a certain numerical value. The bigger ratio indicates the higher housing prices, and the smaller or equivalent ratio shows the housing prices are not high. Easy to calculate and intuitional, the housing price-to-income ratio is currently a main indicator adopted by most countries and international organizations to appraise the ability to pay for homes. Definitions of the housing price-to-income ratio made by different institutions vary slightly. The definition made by the United Nations is: the ratio between the median of the housing market prices and that of the annual household incomes. The World Bank is: the ratio between the mean of the housing market prices and that of the annual household incomes. The UN and the World Bank calculations differ. Calculations show that generally the ratio figured out under the median definition is about 1.2 times that of the ratio obtained under the mean definition. Easy to calculate and institutional as it is, the housing price-to-income ratio has its biggest shortcoming and difficulty of application in accurately determining the reasonable valuation range. Over a long period of time, the Chinese scholars have often used "4 to 6 times" as "international standard". Yet in fact, as levels of economic development, population status and resource endowment of various countries are quite different, there isn't an absolute reasonable valuation range for the price-to-income ratio. Even the World Bank surveys show exponentially different housing price-to-income ratios between various countries (See the table below). Nevertheless, the maximum housing price-to-income ratio had been no more than 5 times before the US sub-prime lending crisis broke out, being still within the so-called valuation range of "international standard" of "4 to 6 times".

Substantially, the housing price-to-income ratio reflects the relationships between prices of land and labor force resources in specific regions. As the endowment of the two factors of land and labor force differs greatly in different countries and regions, it is inevitable for the handsome difference to exist in the housing price-to-income ratios. Just because differences exist in such aspects as resource endowment, level of economic development, system and environment in different countries and cities, there is no sense horizontally comparing such ratios of different cities in a simple way and the objective criteria conducive to horizontal comparison will not come into being. But for specific countries or cities, as their resource endowment is certain, the average of years' ratios can roughly reflect the protracted price relationships between land and labor force, whereas, once the ratio deviates from the average, then it signifies that unusual changes have taken place in housing prices within a short period of time. For example, the US housing price-to-income ratio began to evidently get higher than its historical average level after 2004, the US real estate market has been restructured substantially since 2008, then at present the US housing price-to-income ratio has become lower than the historical average level once again. It suggests that the present US real estate market has been readjusted on the whole and there is little room for the market to get worse.

Housing Price-to-Income Ratios of Various Countries in 1998

(Grouped as per household income level)

Household Income Level (US Dollar)	Number of Sample Countries	Average of Housing Price-to-Income Ratio	Standard Deviation of Housing Price-to-Income Ratio	Maximum Housing Price-to-Income Ratio	Minimum Housing Price-to-Income Ratio
0～999	11	13.2	6.2	30.0	6.3
1000～1999	25	9.7	6.8	28.0	3.4
2000～2999	12	8.9	7.6	29.3	3.4
3000～3999	12	9.0	5.4	20.0	2.1
4000～5999	12	5.4	2.4	12.5	3.4
6000～9999	9	5.9	2.3	8.8	1.7
＞10000	15	5.6	2.9	12.3	0.8
All	96	8.4	5.9	30.0	0.8

What needs to be pointed out is that the population is transient though land is immovable, and the inflow or outflow of populations will alter the ratio between land and labor force prices. The housing price-to-income ratios of various cities in the United States reveal that cities with higher price-to-income ratios are where the majority of populations aggregate. For example, the housing price-to-income ratios of Los Angeles, San Diego, Honolulu and San Francisco are evidently higher than the US national average. Even so, the average of those cities' ratios is of great significance. After 2004, the housing price-to-income ratios of those cities went up rapidly, yet they fell down fast after 2007 and remain under the historical average at present.

2. The reasonable level of housing prices judged by Housing Affordability Index

Housing Affordability Index (hereinafter referred to as HAI) is a method to appraise the housing affordability that was firstly put forward by National Association of Realtors (NAR), which has been adopted by many institutions afterwards and has now become an internationally accepted index to appraise the housing affordability. Compared to such indicators as "housing price-to-income ratio", HAI calculations are clear and final, that is, there is no need to discuss the "reasonable" valuation range; meanwhile, apart from housing prices and household income, HAI also considers such important factors as housing mortgage loan interest rate, which is more true to household home purchases and is also conducive to analyzing the roles of financial support, such as preferential loans, obtained by residents. HAI views the urban median-income families as "representative individuals (families)" and takes their ability to pay for median-priced homes at the same period as the overall housing affordability of the urban residents. Specifically, the highest housing price P can be obtained according to household median income and the upper limit of the reasonable housing consumption ratio (the ratio of household expenditure on housing consumption to household income) and then P is compared to the real urban median price P', namely, HAI=P/P'×100. HAI=100 illustrates that the median-income families can afford median-priced homes and the residents can well afford (normally) homes; HAI>100 illustrates that households can afford homes at higher prices and the residents are much capable of paying for homes; HAI<100 illustrates that households can only afford homes at lower prices and the residents have deficient housing affordability.

Although HAI can properly reflect the housing affordability of median-income families, yet HAI is in a normal valuation range and cannot assure that problems will not happen in the real estate market. For instance, according to NAR statistics, US HAI during 2006~2008 was 106.1, 118.1 and 128.6 respectively, with the overall level being normal. However, the sub-prime lending crisis took place during those years and became a blasting fuse of the global financial crisis in 2008. The root cause of the sub-prime lending crisis is that banks have granted large amounts of housing loans to those with deficient affordability. With the amount of repayment increasing significantly after loan interest rates have gone up continually, those low-income groups will inevitably incur breach of contract.

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