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Affordability of Housing: Concepts, Measurement and Evidence - WP 06/03

3.3  Strengths and Weaknesses of Selected Measures

3.3.1  Outgoings-to-income Ratios

OTIs are very easy to calculate and understand. Data for these ratios are also readily available. However, since it is a ratio, it does not fully depict a household’s ability to pay housing expenses and still cover other costs. For example, some households on low incomes may not even be able to pay 20% of their income on housing, while a high income household might be able to pay 50% of their income on housing and still maintain a high standard of living. This problem can be partially overcome by looking only at low-income households; especially if we are concerned with affordability for first-home buyers.

OTIs do not incorporate any allowance for the number of dependents in a household. For example, the same ratio would have different implications for a four-child family compared with a one-child family. Nor do the allow for upfront costs, such as bond money, mortgage deposits, relocation costs and utilities.

The OTI approach does not encompass any measure of the quality of the housing. By focusing on actual payments, no allowance is made for differences in quality between households. A low OTI for a particular household may seem satisfactory, but this data tells us nothing about the standard of their housing. Furthermore, when considering time series it must be noted that what is deemed ‘adequate’ housing has been constantly changing over time.

A major limitation of OTIs is that they only consider affordability at the present moment. For example, when considering mortgage repayments as a ratio of income, the value of the house, the interest rate and the earnings are all usually taken at that point in time. Affordability is taken into account at that moment. There is no consideration of future changes to interest rates, incomes, and house values, all of which would have a significant effect on the affordability of the house, and people’s decision-making.

Furthermore, we are given no indication of how long a particular house will remain at a given OTI. If there are 20% of households with an OTI above 25%, but the majority of these will remain at this level for only 3 months, then the nature of this issue is significantly different than if 20% were in long-term housing stress.

There has been much debate about precisely how to calculate the ratio (see Section 3.4 for various methods). This matters since it alters how the ratio behaves under changing circumstances.

Another limitation of all the financial measures of affordability is that they fail to fully capture differences in quality. The concept of adequacy has at least three dimensions: Physical standards (eg, dampness, light); amenities (eg ablutions, privacy); and household size (eg, shared bedrooms, the use of sleep–outs or caravans). A measure of affordability does not directly capture such factors as crowding. Affordability measures are not designed to measure well-being.

3.3.2  Residual Income Measures

Residual income measures are designed to address one of the major concerns about OTIs; namely that OTIs do not accurately describe a household’s ability to cover housing and then other costs. They are simple to calculate, given that they use largely the same data as the corresponding OTI. While addressing the first problem of OTIs, residual income (RI) measures also suffer from all the other flaws of OTIs.

The problem of different household compositions can be addressed by equivalising RI. This involves some form of standardisation so that a given measurement value represents the same thing for any household composition. Equivalising RI has proven far simpler than equivalising OTIs. One such method is the revised Jensen scale used by Statistics NZ[6].

3.3.3  House price to income ratio

The ratio of average house price to average income is often used and cited, due to its simplicity and ease of understanding. However this simplicity is precisely what limits its usefulness since it fails to incorporate many factors that affect the affordability of housing.

The main factor not directly considered by this ratio is the prevailing interest rate. Since the majority of house purchases involve a loan, the interest rate is an important influence on people’s ability to pay. Of course, house prices themselves will in part reflect prevailing interest rates. Other factors not considered include banks’ lending practices, and the amounts of rates and repairs.

It is also only directly useful for existing and would-be home owners, not renters. Renters are affected indirectly by the ratio of house prices to income, but this effect cannot be discerned immediately from the ratio.

3.3.4  Other problems

The fact that a household may be able to “afford” a house in a given region, might simply be due to its lower quality or relative inaccessibility. . That is, differing affordability values may simply reflect accessibility premiums and different neighbourhoods.

Relative differences in OTIs or residual income may not reflect differing levels of affordability, but rather differing preferences. Housing is a consumer good, and it is reasonable to expect people to have varying preferences for trading-off housing and other expenditure items.

Similarly, people may have a relatively unaffordable housing position by choice due to their life cycle position. A good example is current or recent students, who are not earning very much at present, but have large amounts of human capital and reasonably expect to have high future income streams. The point-in-time measure shows them being in a state of relative unaffordability, but they have chosen this position since they believe they can afford it over the medium to long term.

3.3.5  The best way forward

All of the measures outlined are useful to some degree. They all provide information about the affordability of housing. However no single measure gives a complete picture of the situation.

When considering affordability for specific individuals we need to consider more than one measure. For example, a particular individual could have a high OTI that may look unsatisfactory, but if they have a high residual income then they are probably not in an unaffordable situation that requires government assistance. Similarly if an individual has a low residual income and a low OTI then their problem is a lack of income, which may require different government assistance.

We also need to consider more than one measure when investigating affordability at an aggregate level. A basket of measures can give a reasonable overall picture of affordability. Furthermore, analysing the differences between each measure’s trends can reveal the underlying elements of the situation.

This paper focuses on housing affordability at the aggregate level. We do not examine affordability for specific individuals or small subsets of the population. A more detailed analysis of any individual’s circumstances would be required for assessing their need for any government assistance.

In Section 4, we use several of the measures we have outlined earlier. We analyse each individually, and then all of them collectively. We believe this type of analysis is the best way to approach an investigation into trends of housing affordability.


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