Saturday, January 10, 2015

Evidence of the Real Estate Credit Problem

Normally, around the perimeter of Phoenix, you see signs like this:

For the first time ever, today, I saw this sign:

This is a single family home neighborhood where new homes are being built specifically for the rental market.  Builders want to build.  But, if they build, they can't find very many households that can buy them.  So, a builder has realized that they can use their access to credit to find a way to build homes.  They build them to rent.  This is what you get in a housing market where households that can afford your home can't get a mortgage.

This isn't about affordability.  The rents on these homes are in the ballpark of what mortgage payments would be for buyers of the same homes.  But, since they don't have access to credit, the households moving into these homes won't gain equity as nominal real estate values increase, and they won't have rental payments that are perpetually protected from inflation.  The difference is huge, and we are seeing the echoes of those benefits to home ownership in the high rent inflation in the CPI and in the high returns to real estate in the national income accounts.

On the topic I touched on the other day, I think that if we didn't have the mortgage interest tax deduction, we might see more of this sort of thing.  And, it would be ok.  But, that would be in a context where households were choosing to be renters because of their individual circumstances.  In today's context, households are choosing to live in these homes because they are locked out of the credit markets.  And, many of the households that are well-off enough to get over the hump to get a mortgage and buy a house - households that are usually financially more secure - get a government subsidy.

I believe that home prices are currently below the values they would have in a context where mortgage credit was being generously distributed, even if we didn't have the mortgage tax deduction.  And, on top of that advantage, we have the government basically writing those households a check.

The mortgage tax deduction amounts to an annual payment nearing $100 billion made from renting households to owning households.   That's about 1/2 % of the economy, paid from the bottom half to the top half of economic households.  Those owning households enjoy another tax break, relative to renters, that is probably even larger than the mortgage tax break, when they sell their homes with capital gains exemptions.  (edit: The total between the two might be 1 1/2% of GDP annually. Please let me know in the comments if you have a source for the scale of the capital gains tax exemption.)

Lots of self righteous ink is spilled these days about inequality and a "rigged" system.  But, a lot of this kind of stuff enjoys wide bi-partisan support.  When you think about it, of course it would.  Easy self-righteous indignation aimed at the bogeyman of the day is a heck of a lot more fun than trying to understand something as complex and counterintuitive as an economy.  I am not holding my breath, waiting for my politically active friends to invite me to an angry march to the capital building against the mortgage interest deduction.  And certainly there isn't going to be a march to eliminate corporate and capital gains taxes (which, among other things, is a tax on renters.)


  1. You're in the Phoenix metro area! What a coincidence...

    I will repeat what I've offered previously. Even if it is the case that the borrowing constraint binds, lower prices are a solution (in that they relax the borrowing requirements). Lower prices have the added benefit of relaxing the income and budget constraints. My preferred solution, then, has the advantage of fallibility - if i am wrong (about prices being too high), i still win.

    On the other hand, your preferred approach (relax borrowing constraints), will increase the supply of cash pursuing a fixed inventory of real estate. Prices will rise. If the interested bound for many households is price- rather than credit-related, such an approach will make things worse. See, for example, the higher education markets. The education-choice constraint is unambiguously not credit-related, given that the federal government provides largely unlimited and unconditional access. However, run away price inflation has also unambiguously eroded the returns-to-schooling relative to historical norms. Whether we are closer or further to a first-best equilibrium on net, I don't know, but I suspect we are further (relative to, say, 1990 labor markets).

    Is it possible that young household formers have secondary concerns beyond mortgage access that would drive them to conclude they should not purchase homes, at current prices? Personally, I think returns to homes relative to asset risk are too low for young households. Prices need to fall, and rents need to rise, all else equal. Given the uncertainty facing young people generally - and Phoenecians specifically - it is perfectly rational for many of them to rent rather than buy when equivalent monthly payments are just at parity. Home buying is a commitment and a risk, and it does require some kind of returns to justify, particularly in current economic environments (there is far more labor market competition today than, say, 30 years ago - consider a blue-collar versus white-collar worker living in New York and Texas, respectively - coincident with reduced economic mobility post-recession).

    I'd delay buying a home, too.

    Public policy effectively forcing young people to buy homes they do not want or need creates outside economic distortions that culminate in events like the most recent recession. Look at the trend in rents to prices in the period before the "great housing price expansion", and in the period immediately before the current "home price slowdown". If we had data going back further, what do you think the two trends would more closely mirror?

    1. Glenn, I agree that where home prices are near intrinsic values, buying a home probably isn't optimal portfolio management for young households.

      You are right about price being the solution. The problem with the price solution is that returns move inversely to price, so that if the issue is lack of access to credit, then there is basically a transfer of economic rents from non-owning households to owning households. Liquid, universal markets are a public good. We should support housing policies that lead to them. Maybe the best policies would lead to lower prices, compared to now. That's fine. But, I don't see the point in limiting access to ownership and then subsidizing the households that are already earning rents.

      I think instead of comparing mortgage to rent, we should compare alternative investments to rent. It so happens that the cash initial cash flows of a highly mortgaged home are a decent estimate of the risk-adjusted required returns on the home, so I use mortgage payments in these comparisons sometimes, but I think it is always more clear to think of homeownership as if it is not mortgaged.

      The required gross return on a home is basically:
      taxes & maintenance + real long term interest rates + inflation premium

      Right now, a good ballpark for that is 2%+2%+2%

      For a $400,000 house, that's $2,000 a month.

      But, rent isn't inflation protected, so there is no inflation premium. So, the breakeven rent on that hypothetical $400,000 house would be based on 4% returns, or $1,333 a month.

      Thinking of it another way, the homeowner needs to make $1,333 a month in rent, and they are also gaining $666 a month in capital gains.

      As the real rate declines or inflation increases, the ratio of breakeven rent/mortgage declines.

      In a housing market without distortions and frictions, we would have a lot of building going on right now, at higher prices, of homes that are owned by baby boomers looking for relatively safe income producing assets, and rented to those young families that we agree might not be served well by home ownership. IMHO

      Here we're chatting on the blog, and we'll probably find out we're neighbors.

    2. I'm in agreement about extending credit to more people .. renting out single family homes is odd. Of course developmental restrictions play their role too--maybe some of these renters should be renting, just within a development style better suited to it.
      But that's all throat clearing. What I wanted to point out is that if there is a housing downturn, these renters obviously can't end up underwater. If theres a job market downturn, evictions for non payment of rent are easier than foreclosures and wouldn't tend to do the same collateral damage to neighboring home values. So it weakens the feedback loop. And a little bit more dynamism in terms of who was free to move to look for more work and a bit more speed in getting new occupants into houses people had to be thrown out of might have helped a lot in recent years.
      Still, making people with borderline credit pay for all the structural rigidities in our housing market seems an undue burden.

    3. Great point, Nick. There are some pros to having more rent-based housing. I would be all for it if the issues you raise were the binding issues in the rent v. own decision instead of limited access to economic rents.

    4. I think you are underselling the costs here. You need a liquidity premium for owning vs renting, you need a discussion of upfront costs (closing costs, inspection, realtor costs) and insurance to start to get a more accurate picture of owning vs renting.

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  6. For me, it's better to pay for a house that will eventually be yours in the future, rather than rent for it for how many years and still get nothing. Well, I hope this neighborhood will also soon open an option where you can get a mortgage. Thanks for sharing, Kevin!

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