Are we in a housing bubble? Whenever house prices increase faster than general inflation for a year or two, we hear that question more often. Can the market sustain the new higher price, or has something artificially or temporarily inflated these prices?

We think of a housing bubble as house price growth that isn’t sustainable because it isn’t consistent with underlying fundamentals, like income and job growth. To determine whether a bubble exists, we must look at both factors: the change in house price levels and the underlying fundamentals.

Nationally, we are not in a bubble

Nationally, over the past five years, the increase in house prices has outpaced inflation by 34 percent cumulatively since 2012 (figure 1). Though noteworthy, the increase is less than half the pace seen between 1997 and 2006, which saw house price growth outpace inflation by 87 percent.

The critical question, however, is whether the recent appreciation is driven by fundamentals, such as growth in household income, or by pure speculation. To assess this, we use the Housing Finance Policy Center’s housing affordability index (see page 19 of our October chartbook), which tracks whether the median household can afford a standard mortgage on a median-priced house. 

Today, the median household can afford a house that is $70,000 more expensive than the price of the median house sold. In 2006, there was a $22,000 shortfall between what the median household could afford and the median sales price. Despite recent increases, house prices remain affordable by historical standards, suggesting that home prices are tracking a broader economic expansion.

At a national level, then, we are not in a bubble and nowhere near the situation we saw preceding the 2008 housing crisis.

Locally, there are areas of concern

Of course, real estate is local, so we should also ask if there are any regional housing bubbles. We examined the same two key factors to measure the likelihood that a metropolitan statistical area (MSA) is in a bubble, and we offer a method that ranks the largest MSAs against each other based on these factors. 

We began with the 37 largest MSAs and looked at the real increase in house prices since their lowest point following the crisis (the trough) and our affordability measure. We then sum the rankings and re-rank the MSAs most likely to be in a bubble, our “bubble watch” rank. 

The top 10 MSAs are ranked high on both home price growth and lack of affordability measures. But further down the list, the rank could be driven by one measure or the other.

For example, in Detroit and Las Vegas, prices have gone up a lot but remain relatively affordable. The opposite is true in Philadelphia, where prices have not gone up as much but are already unaffordable. To model these, one would need to account for the following factors:

1. Lack of building has constrained supply. Most of the 25 metros that rank highest on our measure have experienced shortages of housing supply in recent years. The only exceptions are Detroit, Michigan, and Forth Worth–Arlington, Texas.
2. Some MSAs are rebounding from “overshooting” in the downturn. As the poster child for declining cities, Detroit didn’t experience much of a boom during the last bubble but saw a major bust as the bubble burst. Detroit house prices increased only 12 percent at the height of the housing bubble but dropped 62 percent in the downturn. Despite the rapid home price increase from the trough (ranked 3rd), Detroit remains one of the most affordable areas (ranked 23rd). Detroit has the biggest gap between the two measures. Its number 14 bubble-watch rank is mostly driven by home price growth, different from similarly ranked Phoenix, which has seen relatively rapid house price increases and limited affordability.
3. International investors are buying houses in certain MSAs. International activity in the US residential market has been strong in recent years, and California, Florida, and Texas are the top destinations for foreign buyers. Metropolitan statistical areas in these states rank high in our bubble-watch list.
4. New nontraditional investors are buying houses to rent. This may increase purchase prices and rental prices in ways that are unsustainable.

Our bubble-watch measure is a signal to pay attention to whether house prices in these MSAs have become unsustainable.

This is an important consideration for public policy and affects several issues, including whether the Federal Reserve should continue to increase interest rates and whether states and localities should rethink building and land-use restrictions. At the same time, we’ll continue to refine our measure to better distinguish areas experiencing healthy and sustainable house price growth and those in bubble territory.