The NY Times recently published a very powerful interactive graphic comparing median income vs. median home prices from a wide selection of American cities dating back to 1979.

At first glance, it really does appear all that sensational.  However, as a personal finance blogger, the conclusions I’ve drawn from this graphic is a prime example of behavioral economics run amok.

Why is behavioral economics my prime target?  Simple.  It’s the wealth effect in action and ingeniously displays which cities fell victim to the dangers of a Boom & Bust cycle and which ones did not.

When people make more money, or have access to cheap and easy credit (whether they can repay it is a separate debate), they want to spend it.  Often on big ticket items.

That causes asking prices to go up, and up, and up… until an apex in price is reached.  Market conditions will eventually come back to reality and the old gravitational law of “what goes up, must come down” will run its course.

So if you’re looking to jump into the real estate market in the future (as a home buyer or real estate investor), keep these basics points in mind when it comes to signing on the dotted line.

1. When home prices are 10x higher than your annual salary, keep renting.  At the height of the dot com boom, everyone in San Francisco was making money from stock options as tech stocks were going from $10 to $200 in less than a year (e.g. JDS Uniphase, CMGI, Applied Micro Circuits).  Irrational exuberance never lasts, and you’ll be left stuck with the mortgage.
2. Following the herd is extremely difficult to resist.  When you are competing for the same basic resources that everyone else wants, be prepared to pay extra for it.  In this case, if you want to live in the city where stars decorate the boardwalk or reside in financial capital of the world because you think it will expand your horizons, just know that many others feel the same as you do. Our brains come pre-programmed to follow along with the herd because there is safety in numbers, but if you can recognize that you’re feeling anxiety by being singled out or fear that you might be left behind while everyone else gets rich, exercising some patience and investor discipline may save you big money in the long run.
3. The working class, Blue Collar or Redneck cities didn’t fluctuate that much.  Cities like Atlanta or Charlotte representing the “Dirty South”, colder climates like Minneapolis, and working class cities like Cleveland were basically flat during the entire real estate boom.  They might not have participated in the profit making boom cycle, but they’re not facing as many foreclosures in the bust cycle either.  Sometimes chasing the slow and boring dollars is the safest bet after all.
4. Cities that hyped tourism were hit severely hard.  Cities like Las Vegas or Miami dependent upon out of state tourists attracted to their perfect weather, sunny beaches or nonstop action are hurting badly.  Worse yet, the NAR (National Association of Realtors) heavily promoted buying a second home or vacation home in these cities.  Once the recession hit full swing, investors dumped these “sure thing” investments or went into foreclosure supersaturating the real estate market with homes that few investors want to buy.
5. Non-diversified cities were hit hard when specific industries collapse.  No big surprise here, but when a city is dependent upon one or a few select industries (e.g. Detroit & Big Three Automakers, San Francisco & Silicon Valley) instead of diversifying their local economy, their housing market is hit hard and fast.

The simple truth is that median income should not exceed 3 to 5 times your bring home income (and that’s being generous).  Granted, this may not be possible for everyone considering your geographic location, but it’s a solid rule of thumb when it comes to the 15 to 30 year commitment you’re making with your mortgage lender.

And if you’re a potential home buyer, or perhaps a savvy vulture investor with the liquidity to snap up some of these bargains, the deals are becoming more and more difficult to ignore.

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