Each of the following charts presents a signal that the trend of house prices du

Question

Each of the following charts presents a signal that the trend of house prices during the recent financial crisis was troublesome. What are these two signals? What troubles do they suggest? Be sure to explain your answer. Hint: what do the two ratios mean? Hovw does the trend of these ratios leading up to the financial crisis compare with other periods? Graph 1.3 - Ratio of Median Sales Price of Existing Single-Family Homes to Median Household Income in United States 1969 to 2006 (Most Recent Year) 50 4.5 4.0 3.46 3.0 1.5 1.0 05 0.0 Year House Price-Rent Ratio

Explanation / Answer

The two signals are increasing House Price-Rent Ratio and increasing ratio of median sales price of single family homes to median household income in United States.

During the crisis of 2007-08, both these ratio have hit their peak leading to crash in the real estate market, post which the ratios fell. House-Price to rent ratio is a benchmark ration which helps to decide whether it is better to buy or to rent a house. It is given by average price of house in a location divided by average annual rent in same location. As a thumb rule, a ratio of 1 to 15 indicates, buying is better; 16 to 20 indicates renting is typically better; and anything >21 indicated renting is much better.

Similarly, high values of median sales price of house to median income ratio may indicate that current house prices are claiming an unsustainably-large share of household budgets. These high values also may indicate that home buyers expect house prices to continue to increase rapidly—a characteristic of housing bubbles. These two indicators clearly show the situation that led to recession in the crisis of 2008-09.

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