Background

Over the past several years, the homeownership rate in the U.S. has broken all-time records, with over 66% of households owning their own homes as of 2004. Furthermore, many homeowners have gone through the purchasing and selling process on more than one occasion. Even among those who haven't been able to afford a house or whose circumstances have not permitted them to purchase, it is likely most potentail buyers will consider such options at some point in time. As such, the mathematics of involved in financing a house provides an effective means of introducing basic real estate finance principles that affect real estate markets in general, and the impact of growth management programs in particular.

Residential Finance: A Frontdoor Approach

One of the challenges that potential homeowners face is the determination of how much of a house they can affort to purchase. In the absence of a mortgage, this calculation would be relatively straightforward, depending on the savings the household had amassed that can be allocated to a housing purchase. Due to the common practice of obtaining mortgages, the potential price a household can afford is dependent on the availability of mortgage capital. One approach to analyzing the housing market is to begin with the costs of land and improvements, and then solving for the mortgage payments and income necessary to be able to "afford" the purchase. This process can be referred to as Frontdoor Analysis in a manner somewhat analogous to "A Field of Dreams: Build It and They Will Come." This approach is graphically presented in the following exhibit,

Residential Finance: Frontdoor

As noted in the exhibit, there are a couple of key inputs that establish the required income including:

• Purchase Price or Property Value,
• Loan-to-Value (LV) Ratio,
• Mortgage Rate, Mortgage Term and Periodicity, and
• Mortgage Capture Ratio (i.e., percent of income allocated to mortgages)

Residential Finance: A Backdoor Approach

As an alternative to the Frontdoor Approach which solves for the income necessary to purchase a house, the Backdoor Approach begins with an income for a targeted market segment , and then backsolve or reverse engineers the process to determine what price members of that segment can afford to pay. Given the use of standard mortgage qualification rates (i.e., 28% of income can be spent on principal and interest payments), and 33% on total housing costs including insurance and taxes ( PITI) and standardization of mortgage rates across geographic regions, it is fairly easy to back into a construction and land budget or to determine the " effective demand" for housing.

Residential Finance: Backdoor

As in the Frontdoor Approach, the key financial variables include the Mortgage Capture Ratio, the Mortgage Term, and the LV ratio. However, rather than starting with the price, the process solves for it by reversing the math, beginning with the income of the targeted buyer or market segment to whom the property is designed to appeal and backing into the Maximum Justified Price they can afford to bid based on the borrowing capacity of their income. In addition, the maximum price that can be supported may be constrained by their ability to make a downpayment if that is more limiting than the income.