I have noted how there has been a longstanding housing shortage, which only partly abated in the housing boom, and may have had a significant part in rising home prices, including rising price/rent ratios.
Here is a graph comparing different measures of Price/Rent. Price/Rent increased the most where rent inflation was highest - in the 10 cities that are in the Case-Shiller 10 city index. In that post, I walked through a valuation summary where homes are like an inflation protected bond, but where the inflation adjustment comes from rent inflation instead of, say, general CPI inflation.
(edit: As pure speculation, I wonder if the lower Price/Rent level from the Flow of Funds data is a product of new homes. The Case-Shiller data and rent inflation data should both basically track the price and rent of an individual home. But, the Flow of Funds data is an aggregate number for the values and rents of all homes, which would include new homes. Since most new building happens in the suburbs, where there are fewer limits to building, most new building happens where rents are lower, and where rent inflation is also lower. This should have the effect of lowering the relative price/rent over time of the data series that includes marginal new additions to the housing stock. Think of the potential utility we are losing as a society because we have pushed new building to the places where it is least demanded. Trillions of dollars worth of potential value, unrealized.)
I think it is important to think about home values in terms of an all cash purchase, because thinking in terms of mortgage funding just complicates matters, homes have an intrinsic value regardless of funding sources, and there are many ways in which intrinsic values correlate with mortgage interest expenses in a way that confuses causation. So, in my valuation exercise, I simply considered home values on their own terms. And, I demonstrated how home values could have risen in the way that they did because of a combination of three factors: (1) lower long term real interest rates, (2) rising rents increasing home prices before any change in Price/Rent, and (3) an increase in Price/Rent from this concept of homes as real bonds with a rent inflation adjustment factor.
Today I want to think about this same issue, but from the point of view of a renter who is a potential leveraged buyer. If we are in a steady state, without a housing shortage, in 2003, we might imagine a context where expected inflation is 2%, expected rent inflation is 2%, and 30 year mortgage rates are 6%. This basically describes 2003, except that rent inflation was higher because of the shortage of housing, especially in major cities.
In this steady state context, the real interest rate on the mortgage is 4%. As I have pointed out, home prices tend to move over time so that imputed net rental income follows the same pattern as real mortgage interest rates. So, the renter would be facing a decision to purchase a real asset with a return of approximately 4%. To the extent that they could not fund the entire purchase, they could borrow the unfunded portion at that same approximate rate, 4% in real terms. So, the main decision for the marginal buyer is whether they want their portfolio to include a large asset with a fairly safe 4% real return. (For this exercise, we can ignore idiosyncratic factors about the value of the house, such as the benefit of ownership or the length of time the household intends to remain in the property. Most households are not the hypothetical marginal household.)
Now, let's tweak this scenario so that it is more like the actual 2003. National rent inflation was persistently around 3%. In large cities, rent inflation was more like 3.5%. The nominal rate on mortgages was still 6%. For mortgage lenders, the required rate of return was not dependent on rent inflation. Mortgages just needed to provide a return relative to general inflation expectations. (Also, even though rising Price/Rents would have been adding potential valuation risk to mortgages, expected rent inflation would have reduced risk similarly by raising expectations of future home prices.) So, mortgages would have demanded a 6% rate - 4% real plus a 2% inflation premium. But, in this context, if Price/Rent remained the same, the home would be expected to provide a 4% real return from net rental income plus a 3.5% return from expected rent inflation, for a total return of 7.5%.
So, without the housing shortage, our marginal homebuyer had been looking at a 6% total return. Now, unless home prices change, they would expect a 7.5% return on their home.
So far, this is basically the same exercise I did before. We would expect home Price/Rent ratios to be bid up to a level where their total returns would only be 6%, which would be the price level that eliminated arbitrage profits on residential real estate. Marginal households that would buy homes with expected real returns of more than 4% (plus 2% inflation) would bid up home prices until that was the expected return. That would be true for a household that was purchasing the house in an all-cash transaction.
But, what if home prices are sticky, and for some period of time, mortgage rates are 6% while returns to home ownership are 7%? In that context, a household that would require more than a 4% real return would be incentivized into home ownership because of the arbitrage opportunity. But, these tactical households wouldn't necessarily want to tie up their net worth in a 7% investment. What they would want to do is utilize a mortgage that cost only 6% to leverage a position on the real estate that is returning 7%. Leverage doesn't boost the returns of a household buying a home in a normal market with equilibrium prices. But, leverage does boost the returns of an arbitrage position.
A surge of households buying homes with very low down payments would be a sign of a supply shortage and sticky prices. And, except for the devastating dislocation created by a monetary shock, where households were being foreclosed on and were downsizing, rent inflation has continued to rise. It is now above 3% again, even as core inflation has slowed. So, housing speculators would have had good reason to continue to expect continued price appreciation, since nothing has been done to cure the housing shortage, and the public policies that created so many capital losses in the housing market have only made the shortage much worse.
It's easy to write off these sorts of models based on rational expectations, because they seem to rely on that old strawman, homo economicus. Of course, though, this is frequently how markets behave. It is very difficult to earn excess profits in the stock market - in other words, they are bid to non-arbitrage prices. But, you wouldn't know that by reading Yahoo Finance message boards, or even tracking buy-side analysts. But, even if home buyers didn't look at it with the model I outline above, they were certainly looking at the same pieces of the puzzle. They were looking at rents that were rising more than 3% per year, with no lack of available renters, with mortgage rates at 6%, and alternative investments like 20 year TIPS bonds selling at 2% yields.
The counterfactual could have been an economy where limits to building were minimized - no rent control and fewer demands on private multi-unit residential developers in large cities, fewer zoning restrictions, etc. In that context, I think all three influences on home prices would have been decreased. Lower rents from the extra supply would have reduced both the basis for home valuations and the effect of expected rent inflation on price/rent. And, in the end, after many trillions of dollars of new homes would have been built, the added vehicles for investment would have helped soak up the large amount of global savings, so that, maybe, even real interest rates themselves would have bumped higher, pulling price/rents down even more.
The irony is that since none of this happened, once we get past all of these self-imposed demand shocks, it will be the housing speculators who will have been proven right. For those who have been able to hold their properties through the crisis, they will earn solid total returns on those properties. And, in the meantime, the public policies which enjoy nearly universal support and which created this crisis have pushed the balance sheets of millions of households into disarray, likely causing more inequality and middle class stagnation than any of the policies at the center of the arguments fueled by those topics.