Thursday, October 8, 2015

Housing, A Series: Part 67 - Better Numbers for City Rent Inflation

I have used numbers from Zillow that estimate absolute price/rent ratios for each metro area, which gives me a better estimate of home prices and expected rent inflation in each city.  I have updated the numbers from yesterday's post here.  I have used Zillow's home value data for each metro area to establish relative Price/Rent ratios in 2014 for each city.  Then I have used my BEA, Financial Accounts of the USA, and Case-Shiller data to complete the time series.

As I suspected, pegging the Price/Rent ratios to equal values in 1995 did cause home prices to be overstated in the low cost cities and understated in the high cost cities.  Even with that data, the four largest cities (identified as light blue dots in the scatterplots) lined up pretty well on the 45 degree line between actual rent inflation and expected rent inflation needed to justify market home prices.  This adjustment pulls the other cities more in line with a 1:1 relationship.

To review the last post, the 125% increase in home prices from 1995 to 2005 can roughly be divided into three causes. (1) higher intrinsic values of homes because lower long term real interest rates increase the present value of future rent payments and (2) higher prices simply due to the excess rent inflation over that 10 year period, which was significantly higher than non-shelter inflation.  This leaves the source of only about 30% of home price gains unidentified.  I have argued that this can be attributed mostly or completely to the persistence of rent inflation, which creates a growth  factor in the intrinsic value of home ownership.  In aggregate national data, this appears to bear out.  The rent inflation needed to justify home prices appears to be close to the amount of rent inflation that persists.

To confirm this idea, I have compared the actual rent inflation since 1995 with the rent inflation required to justify home prices in each individual city.  There is a lot of noise here, because home prices will be based on long term expectations, and short term local rent inflation can fluctuate significantly.  But, generally the cities with higher rent inflation have seen a similar rise in rent expectations, because our supply problems are regulatory in nature and persistent.  So, rational expectations appear to be the cause for most of that last 30% of home values at the height of the boom, leaving little or none of the boom remaining to be explained by credit expansion, monetary accommodation, or speculative overreach.

The return of high rent inflation while home prices remain well below the levels that demand this level of rent inflation means that there is an unprecedented amount of policy space available for real interest rates to rise in an expanding economy, while building and home prices both rise substantially.  There is ample room, and great need, for all of these things to happen.  Keep in mind that nationally, rent inflation is again running at more than 1% above core CPI inflation, so as we move past the crisis period without a homebuilding response, the dots in the second scatterplot will drift to the right.  Rent inflation expectations now should be higher than recent actual rent inflation.

Wouldn't it be a wonderful problem to have if a decade from now, we have disruptive levels of rent deflation in Silicon Valley, which really do lead to massive capital losses for real estate owners?  I daydream of a country that could make that happen, and that would allow 4% inflation for a few years while that did happen, in order to help prevent defaults and failures among those real estate owners without calling stability a bailout.  Millions of additional young idealists could move there and join in the technological renaissance that produces so many good things for all of us.  Let's teach those builders and speculators a lesson in boom and bust cycles.  Let's let them build!  Let's see what happens when there is a market supply response!

The city charts updated with the new required rent inflation data are below the fold.  As before, expectations were not out of line in any of the high cost cities.  And, with this new data, the anomaly that made low cost cities appear to be the only places with unrealistic rent inflation expectations, has disappeared.  With Price/Rents adjusted down, housing markets in Detroit and Cleveland now appear to be reasonably pessimistic.

Wednesday, October 7, 2015

Housing, A Series: Part 66 - Our Two Part Housing Bust, City by City

Note:  I am including a lot of detail here, which some readers may prefer to skip.  Below the fold, I present the results of the analysis.

I have been looking at aggregate home prices as if homes are a sort of inflation protected bond.  Rent (or imputed rent) is what we spend to consume housing, as a service.  Home ownership can (should) be seen as a financial security, where the cash flows are the perpetual rents on the property, less expenses.  The sharp distinction between home ownership and housing consumption is widely dismissed, usually because ownership itself is seen as having value.  This value means that most households who are able to own capture extensive surplus from ownership, so that price seems to be non-constraining.  I'm afraid that this notion that housing prices aren't efficient is a significant factor feeding public distrust of housing markets and the idea that speculators can push prices up to inappropriate levels without triggering a selling response.

But, this is not that different from most other securities.  There are some owners on the margin.  And, in fact, in the aggregate, home prices appear to follow non-arbitrage price relationships with other fixed income securities over time.  Home prices can be modeled by a simple fixed income model, such as this one:
Normally, the assumption is that house prices and rents will rise with general inflation levels, because higher rents will encourage new supply.  This should be correct.  The growth rate should be zero.  And the fact that home prices have recently risen at a much higher rate than general inflation is taken as a sign of a "bubble".  Strangely, as I have pointed out, vocal proponents of the "bubble" narrative have ignored the fact that there has been persistently high rent inflation, mostly coming from regulatory constraints in our major cities.  The bust has been taken as an inevitable result of the effect of new supply on rent.  But, the continuation of rent inflation, especially in our major cities, undercuts that explanation.  In fact, there never was a strong supply response, and there is no strong supply response coming in the problem cities.  The "bubble" was actually from a supply bust and the bust was from a demand bust that we created because we wrongly interpreted our supply problem as a demand problem.

This is why the Price/Rent ratio rose more using the Case-Shiller 10 City index (which includes the cities with the worst supply constraints) than it did in the national index.  And the Case-Shiller National Index rose higher than a measure using rent income and home values from the BEA and the Federal Reserve.  I think this is because the higher Price/Rent ratios in the major cities is a product of the persistent rent inflation (a growth rate in our equation above) which is due to regulatory supply constraints.  The only places we can build are the places with lower Price/Rent ratios.  Case-Shiller tracks the values of individual homes very well, but since marginal new homes must be homes with lower prices, Case-Shiller is a biased measure of the value of the home of the typical household.

So, there might be a growth rate informing home prices, and that growth rate would be the expected rate of rent inflation.  Here is a more detailed version of our valuation model, in nominal terms.  As a first step, here, I am using the rate on 30 year mortgages as a proxy for the discount rate.  It includes the real rate, the inflation expectation, and the real estate risk premium.  Here I am using CPI shelter inflation as a proxy for the growth rate, which we can think of as representing general inflation plus expected rent inflation in excess of that.  BEA table 7.12 gives us a measure of rent on all owner-occupied real estate, after expenses, and the Federal Reserve's Financial Accounts of the US gives us a measure of the total value of all owner-occupied real estate, which I use as a proxy for Home Price.

We can solve the equation above for the growth rate by using our measures of net rent, home prices, and discount rate.  We can call that the aggregate expected rate of forward rent inflation at any point in time.  Then we can compare that to actual shelter inflation to see how closely expectations adhere to experience.

The problem is that the mortgage rate itself is a position on future inflation.  In the 1970s, this was the dominant factor.  So, mostly what we see here is that homeowners with a fixed rate mortgage saw sharp gains from 1975 to 1980, then saw sharp losses from 1981 to 1990.  But, these gains and losses were largely a product of their short mortgage position in nominal terms.  If we look at the later period where inflation was relatively stable, we see that the expected growth rate of rent cash flows is fairly stable, and follows the actual rate of rent cash flow growth pretty closely.  There was not a sudden period in the 2000s where home buyers were depending on 5% or 10% rent growth.  This is true even if we use Case-Shiller or FHFA home price indexes as our home price proxies.

Fortunately, for this analysis, our current supply problems seem to date to the mid 1990s, and we have some market measures of real discount rates that we can use for this period, so we can cancel out the expected general inflation measures in our denominator, and use a real valuation measure which is more fitting for a real asset like a house.
This is going to get long, and I'm going to dump a lot of graphs here, so the rest is below the fold.

***ADDED NOTE: I found better data to estimate city Price/Rent ratios with in the next post.  So, some of the analysis below remains true, but the better data gives a slightly sharper result.

Monday, October 5, 2015

September 2015 Employment

Here are a few of the graphs I tend to check on with the monthly employment report.

Durations look good.  Very long term unemployment continues to slowly decline.  And, while insured unemployment has leveled out (at very low levels), there still appears to be a slight downward trend in shorter duration unemployment.  In durations, we see that last month looked like there was an aberration in very short durations that pushed the unemployment rate down.  Even with that aberration correcting back up this month, there was a decent decline in the unemployment rate this month that was hidden by rounding.

In flows, everything still generally looks good, like a well-running expansion.  The one point of concern is the sharp drop in flows from Not-in-Labor-Force to Employed.  This is why there was a drop in labor force participation.  This sort of sharp drop isn't unheard of, and could correct next month.  But, it is definitely something to keep our eyes on.  Especially with the Federal Reserve persistently erring on the hawkish side, if we proceed with a rate hike and subsequent months confirm this drop in flows into employment, this would be an important early indicator that a shift from expansion to contraction was taking place.

It would be completely unnecessary, and I hope we can avoid it.  It looks to me like we are entering a late expansion phase, similar to the late 1990s, and with inflation as low as it is, there really isn't a reason for us to be afraid of monetarily supporting as long of an expansion as we can muster.

Both the net NtoE and net UtoE flows are now on the margin of being uncomfortable.  If the weighted average NtoE (green line above) flow remains under -0.1% and the UtoE flow falls below 0.15%, these would be flow behaviors associated with a coming contraction, especially if they coincide with contractionary Fed policy and a flattening yield curve.

Friday, October 2, 2015

Today's bond reaction to the employment report is not as optimistic as it first appears

At first glance, today's movement in bond markets along with the buoyancy of equities looks like one of those instances where an indicator that the Fed keys off of is enough of a negative surprise that the positive trigger of monetary offset overwhelms the negative information.  This would not be the case if the Fed wasn't persistently positioned outside the range of optimal policy.  It is only the case because monetary policy is tight enough that loosening will benefit the real economy.

In any case, on closer inspection, I don't think the bond markets did react today with an expectation of a delayed rate hike.  In my Eurodollar futures indicator, the expected date of liftoff didn't change a single day today.  It was January 2 at the beginning of the day and it was still January 2 at the end of the day.  What changed was an increase of uncertainty about the date of the first hike and a sharp decline in the expected rate of hikes once they begin.  This is now all the way down to only 50 basis points per year.  That is very flat.  I don't think the yield curve has been this flat since the crisis.  It's a new low.

I think this is more evidence that the current natural rate is not appreciably above zero, and any rate hike is expected to reverse fairly quickly.

But, why would equities rise?  My best guess is that the lack of wage gains gives hope that the downward pressure we have seen on profits over the past couple of years will lighten up.  I'm not completely satisfied with that answer.  This is not the only indicator that is beginning to show early signs of potential cyclical peaks in equity and labor markets, so if bond markets don't expect a Fed reaction here, I would think that recession fears would dominate.

On the other hand, far forward rates only fell a few basis points today and have held fairly steady, albeit low, for most of the year.  So, maybe markets expect the Fed to stick to its current plan for the first rate hike and then to be extremely careful about doing anything else after that.  Is it possible that we can thread the needle and continue down a path of very low inflation without triggering a liquidity problem?  Or, is the buoyancy of the far forward rates due to the asymmetrical effect of uncertainty at the zero lower bound, and what we are seeing is something close to a flat yield curve with ZLB distortions?

Thursday, October 1, 2015

Housing, A Series: Part 65 - Reasoning from a Daisy Chain

Following up on Tuesday's post, I would like to think through a sort of narrative of the housing boom.  First, I want to think of a benchmark, where some reasonable amount of housing is available in places like San Francisco.  We might imagine a marginal change in our economy when a bright young computer whiz graduates from the Ivy League and moves west to participate in the tech revolution.  He finds a small 1,500 sq. ft. apartment renting for $1,500 per month in a shiny new high rise in San Francisco proper that has a 10% vacancy rate.  A few years later, we all benefit from his skill and hard work when we download his new app.  He becomes very wealthy.  And, in the meantime, a builder collects those $1,500 rent checks as a normal return on the capital she used to build the high rise.  That's pretty much the extent of the economic effect of our computer whiz's quest.

Now, let's make only one change in that story - a change that describes our world more accurately.  Let's take away that shiny new high rise with a 10% vacancy rate.  That is the only change.  Here, incidentally, is a graph showing (1) the portion of US employees living in the  New York City, San Francisco, or San Jose MSA's and (2) the rate of single unit housing starts.  This is the core of the story of the housing "bubble".  These are the cities with the highest incomes and the most dynamic economic sectors in the country, and the housing boom was facilitating a migration away from them.  This must be a rare story in the history of human migration.  We have found a way to cause people to flee prosperity.

In our more accurate story, our whiz has trouble finding an apartment, but finally finds an old 1,000 sq. ft. apartment for $4,000 per month.  The apartment had been renting for $3,500, but demand for space had been so strong that the landlord raised rents to $4,000.  This was the last straw for the couple who lived in it.  At $3,500, rent was taking half their paychecks already, and they simply couldn't make it work any more.

The couple had been looking at their options, and even though it would mean a 20% cut in wages for jobs similar to what they had in San Francisco, they decided that life in Phoenix would end up being more affordable.  In Phoenix they could move into a spacious 2,500 sq. ft. home for less rent than their little apartment had fetched.  In fact, it was so affordable, they could qualify for a mortgage to buy that spacious home.  And, so they did.

One simple change - one home built in Phoenix instead of San Francisco.  And, the result is a litany of statistical information that describes the 2000s:

1) We still get the app, and the whiz still gets his fortune, although his real income (along with everyone else, as measured) is lower because of rent inflation.  So, there is stagnation in real incomes, though that isn't as much of a concern to our whiz as it is to the custodians and school teachers who, unlike our couple, are still hanging on in San Francisco.

2) There is no new landlord earning a market return on a shiny new high rise.  Instead, there is an old landlord who keeps earning higher and higher returns on her old building as rents rise.  She is still earning a market return, but that return is based on capital gains on the old building that now earns $4,000 rent instead of earning $1,000 on four apartments in the new high rise.  Since computer whizzes keep moving in, it seems that rent increases will continue as long as anyone can tell, so since our landlord foresees more gains in the future, she has raised the selling price of her old building even faster than she has raised the rents.

3) Our couple sees their nominal income fall even though their actual standard of living has increased.  In aggregate statistical measures, though, their move reduces the average real income because their move has a negative effect on nominal income but no significant effect on inflation.  Our whiz created an effect on inflation by bidding up the price of housing in San Francisco.  But, Phoenix encourages new home building, so there is no rent inflation from the new house in Phoenix.  It affects neither the Case-Shiller index of home prices nor the CPI rent level.  And, now they are in debt.

This one simple change - a lack of housing in the places where people would like to live - leads to more debt, more homeowners, more residential investment because of the larger home in Phoenix, lower nominal incomes, lower measured real incomes, higher capital incomes, higher home prices on average, level nominal spending on housing (rent) and falling real spending on housing.

Note the irony that the only character who is clearly worse off in our new version of the story is our computer whiz, who must now spend more of the very high profits he earns from his app on rent.  Off-stage, there are also many low income residents of San Francisco who are much worse off in the second version of our story.

Statistically, this paints a story of stagnant real wages, over-investment in homes, over-indebtedness, and workers who are losing negotiating power and claiming less of the national income.  In the nuts and bolts of our story, though, all of those statistical facts are either not true or are unimportant.

The thing is, we all know these characters.  This is not a contrived tale.  And, the funny thing about this story, which, as we can see, contains all the same familiar people with all the same motivations, but is simply missing a well-placed apartment building, is that to these characters, the narrative is completely different.

The factual narrative is simple: deprivation.  We have deprived ourselves of a unit of housing.  The whiz kid sees it as a deprivation story.  He sees a frustrating sort of entrance fee on the road to his American dream - a large down payment he has to make to break into an innovative industry - a cost that would be difficult if he doesn't happen to come from a wealthy family.  Although, he probably earns some extra income as a result of the barrier to entry that the missing apartment creates into his industry.

The landlord and the couple see a bunch of tech workers coming in and throwing their weight around, bidding up rents.  The couple see these tech workers forcing their friends out of their neighborhoods and undermining their community.  They see excess and wealth ruining the fabric of their town.  They also see a greedy landlord who keeps ratcheting up their cost of living and simply pocketing unearned profits, putting them on an endless treadmill of working harder and harder just to maintain their standard of living.

Their new neighbors in Phoenix see more of that California money piling in, funding one new neighborhood of McMansions after another.  And, everyone else watching this unfold sees greedy banks piling up mortgages on their balance sheets for families that somehow can go from 1,000 sq. ft. renters to 2,500 sq. ft. owners and all those statistics about stagnation and over-investment.

And they all look at this simple picture of avoidable deprivation and they see unsustainable excess and greed.  I say they are deceived both by their own experiences and by the seemingly obvious statistical measures that confirm it.  And, so we are engaged in an ongoing process of engaging the effect of supply deprivation and solving it by imposing demand deprivation.  When we are left with an economy that seems only capable of bubbles or busts, we naturally blame the folks that seem to be holding all the cards - the bankers, the landlord, and the whiz kid.  The rich just keep getting richer.  "Stop the lending, stop the building, tax the whiz kid.  If we do let you build apartments in San Francisco, you can sure as heck bet that we're going to try to stop you from building apartments for people like him.  And, for Pete's sake, stop printing all that money.  Can't you see it's driving up the price of everything and just lining the pockets of capitalists?"

“Tell me,” the great twentieth-century philosopher Ludwig Wittgenstein once asked a friend, “why do people always say it was natural for man to assume that the sun went around the Earth rather than that the Earth was rotating?” His friend replied, “Well, obviously because it just looks as though the Sun is going around the Earth.” Wittgenstein responded, “Well, what would it have looked like if it had looked as though the Earth was rotating?”

Tuesday, September 29, 2015

Housing, A Series: Part 64 - Price/Rent measures have had an upward bias

Bill McBride shares a recent quote from San Francisco Fed President John Williams:
I am starting to see signs of imbalances emerge in the form of high asset prices, especially in real estate, and that trips the alert system...But I am conscious that today, the house price-to-rent ratio is where it was in 2003, and house prices are rapidly rising. I don’t think we’re at a tipping point yet—but I am looking at the path we’re on and looking out for potential potholes.

On Price-to-Rent Ratios and Inflation Measures

Williams refers to a rising price/rent level.  Bill McBride has this graph of Price/Rent.  This uses Case-Shiller indexes for prices and CPI Owner-Equivalent Rent inflation to adjust rent.  This is reasonable, since both of these measures attempt to measure the change in prices and rents for individual homes.  However, both of these measures are capable of drifting over long periods if there are any measurement biases.

My preferred measure for Price/Rent is to use the measure from the Federal Reserve's Financial Accounts report for the Market Value of Owner Occupied Real Estate for Price and the measure from BEA Table 7.12 for Imputed Rent of Owner Occupiers.  These should represent more of an independent estimate in each period of the aggregate Price/Rent level.  The Case-Shiller index is a value weighted index, and the aggregate Fed/BEA numbers should act like a value weighted index.  The difference between these measures should basically point to measurement drift in the measure that McBride, and presumably Williams, are using.  And, the difference is substantial.

Since 1995, the Case-Shiller/OER ratio has diverged about 23% from the Fed/BEA ratio.  That suggests that either Case-Shiller home prices have been overstated or rent inflation has been understated by more than 1% per year over the past 20 years.  This is surprising, because even as measured, rent inflation has been persistently high throughout this period.  I have used this persistent inflation - centered in the problem metropolitan areas (NY, SF, etc.) - to argue that there has been a persistent housing shortage.

I think what we are seeing here is a form of substitution effect.  There isn't a measurement error, per se, in either the OE rent or the Case-Shiller price measure.  But, what we have been seeing is rent inflation in the problem cities driving up prices with stagnant housing stock.  The prices there are rising due to both the rising rents themselves and due to rising Price/Rent levels, which we can see are especially strong in the Case-Shiller 10 cities, relative to the national level.  So, marginal new homes have to be built outside those cities, and those homes have lower Price/Rent ratios.

Even if rent inflation and price changes of each individual house are accurately tracked over time, the fact that marginal new housing stock tends to have a lower Price/Rent will mean that we have overestimated the price of the home of the typical household.  Measures of real and nominal housing expenditures (rent and imputed rent) would not be biased by this substitution.  And, the Case-Shiller measure of home prices would not be biased regarding the homes.  But, the substitution does mean that Case-Shiller does overstate the cost of homeownership for the typical household over time.

I think this bias in Case-Shiller may be somewhat inevitable, because persistently high rent inflation and the related inflation of Price/Rent will tend to only be sustainable in a supply-constrained environment.  In an unencumbered market, new building would be attracted by the high Price/Rent level.  If high Price/Rent persists, then it seems likely that marginal new building will have to occur in lower Price/Rent locations.

So, while it is accurate to say that the typical house that existed in 2003 has a similar Price/Rent today that it did then, the typical household lives in a house with a Price/Rent ratio similar to 1999.  This is because many households have traded down to homes with lower Price/Rent ratios.  In this Price/Rent graph that goes back to 1950, we can see that aggregate Price/Rent ratios are well within normal long term ranges.  Considering the present very low long term real interest rates, Price/Rent is very conservative.  This is why I claim that home prices are too low.  In the places where we allow homes to be built, homeownership is very affordable.  High income households are bidding up the price of real estate in San Francisco and New York City, but that is a negative supply issue.

In a narrative sense, for every household that remained in a condo in San Jose whose imputed rent rose from $4,000 to $4,200, and whose price rose from $1 million to $1.1 million, there was another family who moved to from San Jose to Phoenix and bought a home with imputed rent of $3,800 that sold for $800,000.  This bias in the Case-Shiller indexes created a false sense of an over-heated housing market in the 2000s in two distinct ways.  Regarding rent, from 1995 to 2006, households spent a stable level of their incomes on housing (rent), about 18%.  But their real housing expenditures over that time declined by about 13%.  Since Case-Shiller tracks homes, not households, it does not reflect this shift to less valuable housing.

Regarding Price/Rent, as mentioned above, there appears to be a bias since 1995 of about 23%.  Together, this means that the typical house, tracked by Case-Shiller, overstates the change in the price of the typical household's home since 1995 by about 39%.  The average household lives in a home with lower imputed rent and a lower Price/Rent ratio because they have been downshifting on their housing consumption.  This was especially the case during the boom.  The divergence between the Case-Shiller Price/Rent ratio and the Fed/BEA ratio mostly happened between 2002 and 2008.  As with so many factors I have considered in this series, this is basically the opposite of what everyone thinks happened during that time.

This chart, from Bill McBride is accurate, that the typical home price, in real terms, is about 40% higher than in the 1990s.  But, since households have been adding marginal new housing stock which has tended to be lower in value - mostly due to being in less valuable locations - the average household lives in a house with a price, in real terms, approximately the same as the average household's home in the 1990s, similar to what we see in the Financial Accounts/BEA measure of Price/Rent above.

Monday, September 28, 2015

Random thoughts about capital income

Apologies in advance if this is just boring nonsense.

I believe that it is fairly universally accepted that speculation is a zero sum game.  Actively managed funds underperform compared to passive funds, after fees.  In the aggregate, it is a mathematical tautology.  For every tactical long position there is a tactical short position.

In all economic activity, there is some allocation of gains between the producer, consumer, and those outside the transaction.  Generally, there is some positive externality from marginal new economic activity simply due to the creation of abundance, increased productivity, etc.  In the end, our claim on production - our ability to earn wages above subsistence - is a product of our available alternative sources of income.  So, generally, economic activity radiates some positive externalities that filter through to incomes in general.

On the one hand, the useful allocation of capital depends entirely on the application of skill and discipline.  Real work, intelligence, and wisdom is required.  It's hard work.  This work occurs within corporations, in private equity markets, among entrepreneurs, and among financial speculators.  If this work was not done, there would be no gains to capital put at risk.  But, on the other hand, the gains from this work are entirely captured by passive investors and consumers.

Ironically, the fact that all of the gains from this work are captured as externalities draws us into taking it for granted.  So, in the places where skilled allocators of capital do capture some of the ensuing gains as income, we see it as an aberration - as a confiscation of what should be ours.  This happens in areas where capital is allocated outside of the liquid marketplaces that modern financial markets have created - in the sphere of high growth start ups, private equity, hedge funds in illiquid markets, etc.

I think it is helpful to think of modern financial markets as an engine of liquidity.  That liquidity lowers the required rate of return on productive assets - it raises their nominal values.  This isn't just a pretend, "paper" increase in value.  It is a mistake to see value from finance as unreal and value from the production itself as real.  The value added by liquidity is real value.  The value is related to the amount of tactical asset allocation that can be captured by passive investors. Liquid valuations rise until the returns reflect the unavoidable risks of the broad basket of at-risk assets.

Before the advent of modern liquid financial markets, tactical allocators of capital captured all of the returns.  In that context, capitalists were all active owners.  They couldn't own a diversified portion of the broad basket of assets.  So, they earned gains above the level a passive investor would require, but they had to earn them through income, because those gains were only available due to the lack of a market through which to monetize them.

This is basically still where tactical allocators have excess gains.  I have gone on and on recently lately about how this is available in housing in the US today.  It's another mathematical tautology.  Returns on home ownership are excessive today precisely because homes are selling for less than the risk-adjusted returns should justify.  If constraints in the housing market were sufficiently removed so that it could function as part of the liquid basket of broad assets, prices would converge with other assets and excess returns wouldn't be available any more.

So, speculators and tactical capital allocators gain income in two ways.  First, in illiquid markets - small business owners, favored regulatory arbitrage, etc.- where it is simply earned as income.  Second, by bringing those illiquid assets into liquid markets - private equity, some hedge funds and corporate activist investors, large scale entrepreneurs.  In these cases, since the liquid market allows the value of that future income to be more profitably captured in the present, the gains are registered as capital gains.

With regard to the taxation of capital gains and capital income, then I think there are several categories.  First, there is capital income that is available to the passive investor.  This is mostly a product of deferred consumption and vulnerability to risk.  The general market price of risky assets reflects the cost of that risk, so if we want to avoid taxing deferred consumption, then general, average market gains to stock and bond holders probably don't warrant taxation.  Excess gains to owners of illiquid businesses or other assets (like houses, currently) and the gains to private equity investors and entrepreneurs from bringing assets into liquid markets may represent more than simply deferred consumption.  This income reflects the application of skilled labor.  So, maybe it should be taxed similarly to labor income.

On the other hand, if passive investment income shouldn't be taxed because it simply reflects deferred consumption, and if speculative income within liquid markets would not be taxed because it can't internalize any of the gains from the value it adds, why should these speculators and allocators working outside liquid markets be treated any differently?  In fact, maybe they aren't that different.  Maybe the required return on the market basket of goods tends to be about 10%, but passive investors only tend to earn about 9% because each year, tactical speculative investors and entrepreneurs capture 1% of the market by pulling illiquid assets into the basket of liquid assets.  Thinking of the entire system of productive assets, we might still say that, on net, speculation is a zero sum game, and passive investors are passively making tactical positions by not owning the illiquid portion of the market, and tactically adjusting their positions as those assets become liquid.  Speculators as a whole still don't gain any excess returns, but within that net total, what we call passive investors are really a set of speculative investors who consistently take losses on their tactical positions.

This is ok for them, because the prices of the assets they hold, and the required returns on those assets should still reflect the basic opportunity cost of deferred consumption and risk.  So, the required return on passively owned liquid assets should remain at our hypothetical 9%, but if speculators and entrepreneurs become more skilled or more active, the total return to productive assets might rise to 11%, with passive investors retaining 9% after taking their passively speculative trading loss.  The anchor point for all of these returns should be that passive required return - 9% in my hypothetical.  (Looking at equities - ignoring bonds, etc. - the difference between this hypothetical 9% and 11% gain can be seen, at least partially, in the excess returns of small cap stocks over large caps, over time, or in the difference between total returns as estimated by all US corporations in the Federal Reserve's Financial Accounts vs. total returns to the S&P 500.  It is a difficult thing to measure.  But, I think the large amount of innovation and entrepreneurial activity related to the tech revolution, which is an example of what I am talking about here, explain the broad public sense that there has recently been an unusual amount of capital income given the mediocre returns that traditional equity ownership has actually provided over the past 20 years - even if the 90s boom period is included.)

It seems counterproductive to see the activity that creates liquid productive assets as the one activity that is extractive or especially motivates us to tax it.  On the other hand, one could say this about taxing all value that is created by labor.  So, I think I could agree with some arguments for taxing some of the excess returns to certain kinds of capital income, but I have a reaction against the rhetorical treatment that usually is associated with appeals for this sort of taxation.

Wednesday, September 23, 2015

Housing, A Series: Part 63 - More Evidence that Mortgage Repression is creating a bust, and there was no bubble.

An interesting article from Real Estate Economy Watch (HT: Todd Sullivan).  The gist:
We are deep into the best market for home sales in nearly a decade and the latest hard data shows that it is just as difficult to qualify for a purchase mortgage in July as it was last March–or even in March 2012.
Since the crisis, all-cash buyers, institutional buyers, and investors have pulled up some of the slack in home buying from households who have been pushed out of the credit market.  I think some of the headwinds in housing recovery and the continued excess returns to homeownership are due to organizational limits to how quickly those buyers can expand over large portions of a market that has always been dominated by owner-occupiers.

I have been waiting to see a recovery in mortgage credit markets as a signal that owner-occupiers might begin to return to the market.  There have been faint rays of hope, but generally this proposition has not yet come to pass.  There were signs late last year that regulatory constraints on conventional mortgage standards might loosen.  But, as the article suggests, this just may not be in the cards.  So, I think we will need to see some sort of substitution within the mortgage credit market.

This is why I would have hoped to see more expansion in closed-end real estate loans retained by the banks.  But, this has been disappointing.  There appears to be a burgeoning rent-to-own market, and new single family homes built for renting.  But, I think we also need to see growth in non-bank mortgage lending.  Private securitization markets will probably face many of the same headwinds as conventional securitization markets, so it looks like what needs to develop is non-bank, retained asset mortgage industry.  As with rented single family residence housing, this currently represents a small segment of the market, so, as with all of these residential real estate trends, it looks like there are organizational limits to the amount of growth that is possible in the short term, if it isn't going to come from traditional sources.  In this first graph, we can see that Ginnie Mae loan levels, after many years of stagnation, are the only source of mortgages that has grown since the crisis began, capturing back some of the low down payment market that had been moving into private pools.  All other mortgage holder groups have declined.  So, at least as of 1Q 2015, there had not been a resurgence of mortgage growth outside of federal agencies and banks.

We can see the effect on building by comparing residential and non-residential construction.  I think we can see several patterns here.  First, while non-residential construction has been generally declining as a portion of GDP for a long time, it has recovered to near pre-crisis levels.  (Note, incidentally, the very strong growth in manufacturing construction over the past year. In fact, it looks like manufacturing spending had previously begun to recover from a lull in the 2000s, but was interrupted by the recession.)  Residential construction spending rose to an unusually high level during the 2000s, briefly peaking at the start of 2006 about 50% above the normal level, then falling to about half the normal level from 2009 until today, with a slight upward trend.

I think residential construction spending was inflated in the 2000s, in part, because of the supply constrictions in the major cities, so that we were substituting billions of dollars of lumber and gypsum board in the exurbs for billions of dollars of valuable locations in the air above residential neighborhoods of our high density development-phobic cities.  This caused home sizes and construction spending to increase and productivity to decrease, relative to the alternative.  But, in any case, as with most indicators of residential investment, this appears to show a boom in residential construction in the 2000s followed by a larger bust in the 2010s.

But, was it a bubble, fueled by subprime mortgages and federal home ownership policies, that pushed home prices into unsustainable territory?

CoStar publishes indexes for Commercial Real Estate similar to the Case-Shiller Indexes for Residential Real Estate.  Here, I have graphed two CoStar indexes: Multi-Family Residential Housing and non-residential construction.  And I have compared them to the Case-Shiller National Home Price Index.  All are indexed to 100 at December 2000.

In terms of prices there is very little difference between the Case-Shiller index for single family homes and the CoStar index for multi-family properties.  And non-residential (retail, industrial, and office) prices follow fairly closely, generally rising and peaking about a year after residential prices, but peaking at the same level as residential prices, relative to prices in the 1990s.

After the crisis, single family home prices look like they were probably boosted by temporary homebuyer support programs in 2009 and 2010.  Multi-family and non-residential real estate bottomed in 2010 and have been rising by low double digits annually since then.  In the aggregate, both types of real estate are above pre-crisis price levels - multi-family real estate is much higher.  Meanwhile, single family home price increases are moderate.

Source : accuracy of real rate, from most to least is: green, red, purple.
Subprime loans and federal homeownership programs weren't pushing prices of commercial real estate up.  Given the parallel behavior of these real estate classes, there is no reason to believe they pushed up single family home prices either.  The main place on this graph where mortgage markets appear to have an effect is since 2011, where a lack of mortgage access is preventing single family home prices from recovering to normal levels.  (Here is a graph that shows the divergence after 2007 between real long term yields and implied yields on homes.)

Non-residential real estate has continued to rise, reflecting low real interest rates and general inflation over time.  Multi-family residential real estate prices are probably rising even faster than non-residential prices because the decade-long supply depression has created significant rent inflation and expected future rent inflation, and the foreclosure crisis pushed many families into rental housing, pushing up rents.  Also, multi-family housing, as a class, is especially exposed to the high rents from the dysfunctional cities.  Rents on single family homes are rising, too, but the difference is that multi-family housing owners have access to credit outside the single-family mortgage market.  So, those properties can be bid up to their reasonable market prices.

Single family homes may need to appreciate another 30% to trigger the complex set of market reactions that will lead to the robust new building that we desperately need.  Commercial real estate prices have risen that much more already because developers can usually charge market rents on commercial real estate in the big cities (Who is going to complain that rents on corporate offices are too high?), nobody frets about affordability indexes for corporations, and nobody demands that we fine or jail bankers for making "predatory" loans to commercial borrowers.  Single family homes face all of these obstacles.  In modern America, maybe the best you can hope for is that populists hate you enough that they stop coming up with imaginary problems that they have to fix for you.

Tuesday, September 22, 2015

More Signs of Life in the Treasury/Homebuilder Position?

Closed-end real estate loans at commercial banks remain flat, after showing some life early in the year.  There have been a few other signs of life, though.

Friday, the Fed published the Financial Accounts report for 2015 2Q, which is slower than the weekly and monthly bank reports, but more comprehensive.  Finally, we are seeing an increase in mortgage levels.  Maybe non-bank alternatives to housing funding are finally filling in the housing gap for owner-occupier households.  It's only 1.6% annualized growth, but at least it is strong movement in the right direction.  After a few years of mortgage growth at the top end of the 5% to 15% historical range, we have had a decade of negative mortgage growth.  And practically everyone I talk to believes that high rents and high home prices are a demand problem.  This suggests that the Great Recession created a mental virus that may infect our national psyche for years.  But, at some point, if building a reasonable number of houses doesn't cause Armageddon to arrive, maybe everyone will tip-toe back from crazy land and believe it's ok again.

The recovery of homeowners' equity has continued, after a brief rest in 2014.  I think we may have reached the tipping point where mortgage growth and equity recovery create a virtuous cycle of new activity that helps prices and building to recover more, although homeownership continued to decline sharply in 2015 2Q.  At the current pace, we will be back to pre-bust equity levels by mid-2016.

Mortgage growth probably needs to get back above 5% to really gather enough demand to push homebuilding back to normal ranges.  I recently posted a graph about housing starts.  Here is a graph of private fixed investment.  It tells a similar story.  As of the end of 2003, private investment in structures, as a portion of GDP, was moving along within historical ranges.  Then, there was a brief jump slightly above historical ranges, followed by a decade long depression where investment in structures has been below all post WW II recessionary contractions.  A decade.  As with housing starts, this suggests that building could grow quickly until it is back to 2005 levels, and would need to continue at that level until after 2020 just to make up for the lost decade.  If we will allow it, homebuilder revenues should eventually run at double today's revenues for some time.

In total, the 2004-2005 boom together with the drop below trend in private residential structural investment is responsible for a net 6% gap in GDP.  Residential recovery could add 1% to real GDP growth for 3 full years.  But, this is investment, so the investment will add persistent value.  Currently residential real estate annual gross value added is about 7% of home values.  So, if we can build that missing housing stock, real GDP will have a persistent annual boost of nearly 0.5%.

In this graph, we can also see the tremendous drop in multi-family structural investments.  In the 1960s, this ran at about 1% of GDP.  Now, at what many consider to be an expansionary point in the cycle, multi-family structural investments are not even 0.3% of GDP.  Most of those cranes that are populating American cities are building commercial space, because nobody ever protested a developer's public meeting in order to demand below market rents for corporate offices and chain stores.

The treasury side of the position is still questionable.  If the Fed continues to be hawkish, it may be a long time before bonds have a 2%+ inflation premium.  Real rates should climb as housing expands.  But, if we don't let housing expand, then the divergence between returns to housing and real treasury returns will remain.  Over the long term, the only real way to enforce this divergence as home equity builds is to induce a recession.  Allowing housing to recover might solve most of our supposed stagnation problems.  If we don't allow it, income based residential investment trusts could provide excess returns for some time, while the rest of us muddle along wondering what is wrong with the American economy.

Right now, we could really benefit from more money, more houses, more bankers, more immigrants, and a higher trade deficit (by which I mean more capital inflows).  You know, just like all the presidential candidates have been saying....

Monday, September 21, 2015

Housing Tax Policy, A Series: Part 62 - Inflation, real incomes, and home prices

This is probably ground I have treaded through already, a time or two.  Timothy Taylor had a post recently that reflected his typical level-headed and reasonable approach.  In the post, he is defending the Fed's role in the crisis, as having plausibly prevented some version of another Great Depression.  I think he is correct, as far as it goes.  I would say that, while the Fed threw us a life preserver, it may happen to have been the one who pushed us off the boat.

In any case, his post is a nice review of some of the economic dislocations that occurred after the recession bottomed.  The most striking graph may be this one:

Over four years, home values pushed about 25% above the historical range, relative to GDP.  Then, in three years, dropped by 50% to a point below the historical range, and have now recovered back to historically typical values.

He includes the next graph, though, that relates to the rent inflation topics I have been studying.  He compares home prices to CPI inflation:

Theoretically, this should be coherent.  Various arbitrage tendencies should work to keep rent and home prices growing at the general rate of inflation over time.  The problem is that limits to housing expansion - largely regulatory in nature - cause prime real estate to be bid up, as incomes grow and the real housing stock stagnates.  So, in practice, shelter inflation and comprehensive inflation have diverged.  Given this divergence, it seems clear to me that the proper comparison is home prices and shelter inflation.

In the next graph, I have added some additional measures to Taylor's graph, and I have indexed them to 1975 values instead of 2000 values.  The blue line is the Case-Shiller national home price index.  The dark green line is CPI inflation, the higher light green line is Shelter CPI inflation and the low medium green line is a very rough approximation of Core CPI excluding Shelter.  The red line is average hourly earnings and the orange line is median household income.

We can see that home prices are generally tracking with shelter inflation with a sharp rise above trend in the past 15 years.  I think we need one more adjustment, which is to use a log scale, which in Taylor's defense is sometimes difficult in Fred.  Here I have downloaded the data from Fred and charted it in log scale.  There is still a bump in the 2000s, but the linear scale exaggerated recent proportions relative to previous levels.  Also, this makes it easier to see how much the growth of price levels across the board have leveled off compared to the 1970s, and current home price levels don't look as far from the long-term rent trend as they do in the linear scale.  Relative to rents indexed to 1975, home prices are about 15% above the rent trend level and are still about 30% below the relative top price levels of the mid 2000s.

Even if we conclude that home price levels should be back to the trend measured by rent inflation (and I don't think we should, given low secular real long term interest rates and building constraints), we can see how monetary policy that led to 3-4% inflation, similar to the 1990s, would have been capable of helping to pull home prices back close to trend without creating a nominal crisis.  This is basically what did happen in the early 1990s.  We seem to have come to a consensus that stability is not a universally applicable policy goal.

Looking back at the previous graph, I think we can see the effect the housing constriction has had on real incomes.  Median real incomes and wages have grown somewhat over the past 30 years, but rising rents have eaten up the real growth.  So, if we adjust nominal incomes with CPI, median real incomes look stagnant, but if we adjust with CPI ex. Shelter, there has been some growth.

Given that there has been some additional growth among high income labor, the use of more aggressive inflation adjustments exaggerates the amount of inequality.  And, I think that is the proper way to describe this.  Given that shelter expenditures have been level for about 40 years, in nominal terms (as a proportion of total spending), but real shelter expenditures have fallen sharply, it appears that, in the aggregate, the elasticity of demand for housing is roughly unitary.  Considering the wide range of housing investment over this time, and the substantial drop in real housing consumption (as a proportion of total spending), the trend of nominal shelter expenditures running flat for the period at about 18% of total PCE is striking.  This suggests that the excess inflation related to shelter is related to supply, not monetary policy, and that we might be better off conceiving of real adjustments to income by using CPI ex. Shelter.  The additional real income that goes toward bidding up the shrinking relative housing stock is a consumption choice.

Of course, the aggregates hide a lot of individual idiosyncrasies.  The constraints on housing create a lot of movement within the economy as households realign themselves with changing reality.  We can see this in dramatic fashion in the most constrained cities where longstanding tenants complain about gentrification and rising rents.  The problem is sharp enough that it has begun to define political movements.

Normally, a family who are long-term tenants in a house gather consumer surplus from their extended tenure.  The value they receive from the property increases as their relationship with the local community deepens.  When developers purchase entire neighborhoods for new development, we can see this play out when some households refuse to sell their properties, even at values well above market rates.  Those values don't reach their substantial level of consumer surplus.  In the cities today, we are seeing the opposite.  Rents have risen so high because of supply constraints that market rates have risen above the level of consumer surplus gained by longstanding residents.  They are being forced out of neighborhoods that, to their senses, have not changed.  Rent as a proportion of income in these neighborhoods has increased over time, to a point that is no longer sustainable.

The problem is that this problem has festered for so long that if the cities with those neighborhoods did allow supply to grow, there would still be a long period of adjustment before rents declined enough for the influx of households would reflect the socio-economic norms of the long-term residents.  So, those residents fight new supply, because it appears to only worsen their situation, because they associate the new housing units with rising rents.

But, these residents are only one side of the coin.  Many families, faced with the supply constraints of the high rent areas choose to move to lower cost cities.  This movement aligns costs with incomes, but gets lost in aggregate numbers.  State-level cost of living adjustments raise the level of measured poverty in places like California, New York, and Washington, DC.  At the top of the income distribution, households are bidding up rents in order to gain access to high income labor markets.  At the bottom of the income distribution, households accept a high cost of living until they can't manage to any more, and then move to lower cost areas.  (Actually, even relatively high income households are being forced out of the worst cities.)  There is probably a bifurcation of individual outcomes here.  High income households moving into these cities claim a higher portion of compensation because of the limited access to those markets.  Relative to aggregate measures, low income households who lived in those cities but moved should tend to have seen higher real income growth than their raw incomes would suggest due to their reduced cost of living.  Low income households who have remained in those cities should tend to have seen lower real income growth due to the excess increase in their cost of living.

In the meantime, regarding the labor/capital split, higher rents (and imputed rents to homeowners) would cause capital income to rise, and for measures that include capital gains, the associated rise in real estate values would also cause capital incomes to rise, and would create very large reported incomes for households who have sold a property.

This graph, from some recent work by Josh Bivens and Lawrence Mishel at Economic Policy Institute, does a great job of helping to consider the different aspects of recent wage divergence.  The top line estimates the growth in productivity since 1973 and the bottom line estimates the growth in real median compensation.  I am not going to try to engage in detailed statistics here.  There has been a lot of conversation about this graph, and I think others have debated the details well.  But, I would like to conceptually consider the effect of a supply constraint on these numbers.

The difference between the top line and the next line is the amount of marginal production since 1973 claimed by capital as opposed to labor.  Labor has seen a growth of 63% in real compensation while productivity has risen by 72%.  This next graph estimates the portion of domestic income captured by residential real estate owners, after depreciation and expenses.  This reached a low point in the mid 1970s   Since then, it has grown from about 3% of GDI to about 5% of GDI.  I estimate that this accounts for roughly half of the difference between compensation and productivity growth.  Note that most wage-earners are homeowners, households are divided between those who are simply earning rents on the supply constraint outside measured wages and those who must pay rents to a landlord.  But, in any case, this has more to do with land-use policies than it does with the distribution of productive output or the negotiating power balance between workers and employers.

The next gap is the difference between real compensation adjusted with consumer inflation versus producer inflation.  Here is a graph comparing CPI for all items, CPI for all items except Shelter, and the GDP Deflator, all indexed to 1973.  Here, again, we can see that nearly half of the gap is explained by housing inflation.  So, we have the same issue as with the labor/capital split, regarding total incomes, cash and imputed, for homeowners vs. renters.  (Also, we can see how sensitive these long-term measures are to the deflator.  In the comparison between nominal 2014 activity adjusted for population, and nominal 1973 activity, the deflator accounts for more than 80% of the difference.)

If we use price measures as a proxy for demand-side inflation, but the shelter component is the result of a supply issue, then using an inflation proxy that includes shelter inflation is double counting, I think.  Housing is unique in this way, in that the marginal cost from inflating rent goes to land, which is fixed in quantity.  If inflation is high because bananas have been especially costly over time, this is mostly a reflection of higher costs, and would be embedded in a net of opportunity costs and tradeoffs that would be difficult to disentwine from monetary inflation.  But, the consistency of nominal housing expenditures, and the inevitable capture of excess expenditures by land owners as unusual capital income, means that this sort of inflation reflects the transfer of income to rentiers instead of costs.  (The existence of natural arbitrage tendencies that would tether long term home values to general inflation levels seems to be generally accepted, leading to the use of CPI inflation as a trend input for home prices, as Timothy Taylor did in the post that started me off here.  But, oddly, this assumption is used in spite of the clear divergence of shelter inflation from general inflation.  This seems to lead to demand-side arguments about housing bubbles, whereas it seems to me that the acknowledgement of this long term divergence should lead us to supply-side explanations.  In other words, it seems that almost everyone models home prices as if that arbitrage has happened without bothering to notice that it hasn't.  We should all be in agreement that that arbitrage should happen.  Cutting off housing supply through credit and monetary tightening is just making matters worse.)  If we agree that the increased rents reflect a transfer of economic rents from tenants to landlords, then I think we must agree that the excess shelter inflation reflects this transfer rather than a change in the relative value of the dollar.  That being the case, I think that some of the "Terms of Trade" gap is due to a flawed inflation measurement.

And, I think, even within the "Inequality of Compensation" gap, some will be explained by the rents that are captured by high productivity workers who live in the housing constrained cities and by the various movements in and out of those cities as workers align their income potential with the cost of living in various locations.  If a worker making $150,000 in Austin can move to San Francisco and make $200,000, but they have $25,000 additional rent expense, then their real income has only increased by $25,000, not $50,000.  Using nationally aggregated inflation adjustments will exaggerate the level of income inequality in this case.  As Hsieh and Moretti point out, both the $25,000 in additional rent and some of the rest of the additional $25,000 in income can be attributed to the effect of housing constraints on incomes and rents in San Francisco, so there are several subtle ways that this problem leads to more income inequality as it is generally measured.  This effect is far too complicated for me to estimate here.

At the risk of being that guy that's always obsessing about housing, I agree with those who note that this is much more of a wage distribution story than a wage vs. profit story, and I think a good portion of these wage distribution issues are related to housing.