This paper outlines an approach to constructing a Dynamic Housing Affordability Index (DHAI) that reflects the true cost of owner-occupied housing and performs well in tracking changes in the demand for home ownership and other aspects of the housing market. It takes into account the benefits from the U.S. income tax deductions for mortgage interest and property taxes and it considers the role of expected house price inflation in reducing the cost of housing. It shows that the DHAI predicts national and regional consumer sentiment with respect to the demand for owner-occupied housing, regional and MSA homeownership rates, and housing market characteristics including housing starts, and sales of new and existing housing. There is evidence that the DHAI performs better than other popular measures of affordability. This paper develops a new measure of the affordability of owner-occupied housing; specifically, one that incorporates the forward-looking aspect of households’ decision of whether to own or rent. The new measure differs from existing affordability indexes and our empirical work shows that it is predictive of a measure of the demand for homeownership and other aspects of the housing market. Affordability measures have an ad hoc nature; however, linking a measure to economic theory is desirable. Our review of the literature suggests that a well-founded measure is the “owner cost” of housing. Owner cost combines information about the price of housing and the “user cost” per dollar of investment in housing. We use this concept to guide our development of a new affordability index that builds on existing affordability indexes such as the National Association of Realtors (NAR) Housing Affordability Index (HAI). The primary focus of our analysis is the time from the first quarter of 2007 to the third quarter of 2014; however, we also extend our index back to 2003 to capture the boom in the housing market.

Our measure, designated the Dynamic Housing Affordability Index (DHAI), theoretically improves on existing indexes in multiple ways. First, it accounts for the tax benefits of homeownership due to the federal income tax deductions for mortgage interest payments. Existing affordability measures generally ignore the tax benefits for households that itemize deductions and thus tend to understate affordability. Second, our index includes the cost of property taxes and the associated federal tax deduction benefit. Third, our index includes the effect of expected house price changes on the affordability of housing.