What is the Fair Value Variable?
Introduction
Purpose of the Fair Value Variable
The Fair Value Variable (FVV) was designed to serve as an adjustment factor for assessing discounts or premiums in the residential real estate market. It relies on national data to estimate a value that reflects whether residential real estate in the United States is undervalued or overvalued. While the FVV can offer valuable insights, it has a nationalistic scope and may not adequately consider regional variations in the real estate market. For instance, when comparing the percent change between January 2020 and August 2023, residential real estate in Miami experienced higher appreciation than that in Milwaukee.
Calculation
Variables
The variables used to calculate the FVV are as follows:
Median household income
Median sales price of houses sold
Mortgage interest rate
Assumptions
Moreover, the assumption underlying the Fair Value Variable (FVV) is that a significant portion of Americans engaging in residential real estate transactions opt for a 30-year fixed-rate mortgage. While this mortgage structure may not be universally applicable, it serves as a foundational reference point for gauging the median cost of a mortgage.
To calculate the FVV, start by determining the median household income spent on annual mortgage payments. This involves using the prevailing mortgage interest rate and the median sales price of houses sold to compute the median mortgage payment. Annualize this amount and divide it by the median household income to obtain the percentage of income spent on annual mortgage payments for a given period.
To enhance data stability, introduce rolling averages, including 5-year, 10-year, and 15-year averages. Further smoothing is achieved by calculating the average of these averages. Compare this averaged value against the current period to identify the disparity. The FVV is derived by assessing the premium or discount needed to apply to the current median sales price of houses sold, aligning it with the current period's median household income spent on annual mortgage payments.
In simpler terms, the FVV represents the premium or discount that should be applied to current residential real estate prices to align them with what Americans have become accustomed to over the past decade.
The emphasis on recent data stems from the significance of volatility and its impact on homebuyers. To illustrate, Argentinians have become familiar with double-digit inflation rates. Individuals in regions with persistent economic volatility factor these conditions into their purchasing decisions. The key consideration lies in how drastic the change in conditions is, rather than the absolute level of change. For instance, a country with a consistent 10% year-over-year inflation rate over the past 30 years may not be perceived as volatile, as citizens have adapted to this level of inflation. Conversely, a country accustomed to a 2% year-over-year inflation rate would find a sudden increase to 10% unsettling. This understanding is crucial in the context of the FVV.
Evaluating the average of averages for the percentage of median household income spent on annual mortgage payments provides a valuable metric for assessing the housing costs Americans have become accustomed to. To derive the FVV, one can adjust the median sales price of houses sold to align with the value that equals the average of averages and the current period figure.
For instance, if the average of averages is 25%, it indicates that, over the past decade, Americans have typically spent 25% of their gross household income on annualized mortgage payments. If the current period's value is 35%, this represents a significant shift in housing costs, signifying a 40% increase. Given that housing costs are typically the largest expense for Americans, this change is notable.
Historical
Importantly, the FVV is a real measure rather than nominal, as it accounts for inflation when considering the variables mentioned earlier in its calculation.
Notable historical figures
The highest recorded percentage of median household income spent on annual mortgage payments was in November 1981, reaching 53.5%. This period coincided with a housing recession. From December 1984, this percentage consistently remained below 40%, only surpassing that threshold in November 2022. Between 2010 and 2019, the average value was 23%. However, as of November 2023, this figure has risen to 39.9%, marking a substantial 73.5% increase in housing costs.
In October 1981, the FVV was at a notable low of -46.1%. This figure was closely rivaled in May 1980 when it reached -47%. During the Great Recession, the FVV hit its lowest point in June 2006, registering at -13.5%. As of November 2023, the FVV stands at -36.7%.
Conclusion
In conclusion, the Fair Value Variable (FVV) serves as a crucial tool for evaluating the relative affordability of residential real estate in the United States. By incorporating key variables such as median household income, median sales prices, and mortgage interest rates, the FVV offers insights into whether the housing market is experiencing overvaluation or undervaluation. The emphasis on a 30-year fixed-rate mortgage as a reference point adds a practical dimension to the calculation, despite potential regional variations.
