“Affordability” is one of those familiar buzzwords in the world of real estate. But the affordability index is a fantastic metric.
The affordability index is the home purchase price divided by the gross household income. The result is the one number that gives us a look into the real estate health of a household and even an entire city. I have used this tool for years to identify great communities to invest in.
On a city level, a low index indicates that jobs are paying very well in comparison to the price of housing. There’s potential for increased value, since residents have the disposable income to invest in their home and community. People moving into the neighbourhood have high incomes and are able to spend more on a home, driving home prices up. I often see home values increase faster than the national average in cities with a low index.
On the other hand, a high index tells me that people are overextended. Housing costs account for a percentage of their income which is much too high. Households find it difficult to save and invest in their homes. Maintenance becomes neglected as there is no money to pay for it. We may see homes, and even entire neighbourhoods, begin to appear rundown. High index cities can be held afloat by low interest rates in the short term, but home values tend to be corrected down eventually.
What makes the affordability index such a great indicator is that it accounts for local income. Home prices then become relative to income levels, creating an “apples to apples” comparison.
So what is an acceptable affordability index level? Everyone has their rules; these are mine:
• I never buy an investment property in an area where the index is above the provincial or national average.
• I wouldn’t advise anyone to buy their home with an index above 4. This means that if you are looking at a $400,000 home, your gross household income should be at least $100,000.
The affordability index has proven to be a good indicator of a possible “bubble.” Using the U.S. example, it appears that a real estate bubble begins to grow around an affordability index of 6. As the affordability index increases, so do the chances of the bubble bursting. Of course, there are many other factors unique to each city, but the index provides market watchers with an early warning system.
It is clear that some Canadian cities are now in such a bubble, as affordability has rocketed way out of control: In Vancouver, the index is at 9.46; in Burnaby, B.C., 7.6. Toronto logs in at 4.93. The national average is about 5.35.
I wanted to investigate whether Canadians overextended themselves. I calculated the average affordability across five cities; a city is considered “affordable” if the affordability index is under my acceptable cutoff of 4.
I also profiled two homes from each of these cities to compare what we are buying to what we can actually afford.
We seem to be holding things together – for now. While our national average is approaching bubble territory, we seem to have learned from the sad example of the United States.
A few markets are due for a correction soon, some experts say as much as 20 per cent or more in markets like Toronto and Vancouver. These and the other inflated cities are only sustainable in the short term, because interest rates are so low. As interest rates rise over the next 24 months, we’re in for some major changes.
Average household income: $89,519
Average home price: $441,607
Affordability index: 4.93
Average household income: $80,544
Average home price: $762,100
Affordability index: 9.46
Cape Breton, N.S.
Average household income: $54,881
Average home price: $110,981
Affordability index: 2.02
Average household income: $87,154
Average home price: $274,726
Affordability index: 3.15
Average household income: $124,064
Average home price: $733,154
Affordability index: 5.91
SOURCE: THE GLOBE AND MAIL