I believe that this is another case of a sort of money illusion that arises from changing real interest rates and the typical methods though which Americans buy homes. Even before getting into the details, the commonly believed story is suspect, because, (1) marginalized or economically stagnating populations tend to deleverage and (2) it would be very strange if most of the households in an economy were experiencing stagnation and the most pronounced result of that stagnation was a sharp and sustained bidding war for housing. In fact, these developments point to a strong and aspirational middle class.
So, what's my point, exactly?
My point is that, in terms of lifetime household consumption, the equilibrating variables will be the cash flows of owning versus renting. Rent levels aren't going to react strongly to interest rate levels. They will roughly move along with income levels. So, the monthly cost of buying a home is also going to roughly move along with income and rent levels.
Think of home ownership as basically a security whose coupon is the rent payment (net of estimated repairs, maintenance, taxes, etc.) on the home, with a maturity value equal to the future sale price of the home. That future sale price will itself be a function of subsequent future rent payments. So, assuming that home values and rents will increase at the general rate of inflation (which is to say, assuming no speculative motive on the part of the buyer), the maximum current value of a home is the net rental payments over the functional life of the home, discounted by the real interest rate of the given duration.
In any case, zero coupon rates beyond 10 years tend to co-move. It is not hard to see that real rates of very long duration securities like a home have fallen significantly.
If we estimate a home value based on a 50 year functional life (with no residual value, for simplicity)and a net rental value of $1,000 per month in current dollars, at a real discount rate of 5%, the home is worth $220,000. At a real discount rate of 3%, the home is worth $310,000 - a 41% increase in nominal value. As we push the functional life of the home into the future, the nominal current value of the home increases more with each incremental decline in the discount rate. One can quibble about the functional life and the proper interest rate to use at that duration, but the end result is clear - very long duration real interest rates plunged in the last 35 years, and home values should have been very sensitive to this change.
My point is that, in the analysis of aggregate households in the face of changing interest rates, this nominal home value is meaningless. What matters to households and to aggregate measures of cost of living, etc. is that net monthly rental cost of $1,000. The nominal price of the home is a transfer between two households. And as long as the housing market is liquid and the real net rental expense remains $1,000, the market value of the home and the size of the mortgage are a mirage. They could amount to 10% or 1,000% of GDP, and the meaningful amount of debt held by the public would still be a reflection of their ability to live in homes that cost $1,000 per month - and this value did not change significantly over this time period.
Further, in the face of falling real and nominal interest rates, there were ONLY two feasible outcomes - (1) continued unremarkable behavior in the implied rent expense of homes together with significant nominal increases in home values and mortgage levels, or (2) a breakdown in the housing market which would block most potential home buyers from the market and present remaining buyers with very high returns on investment.
We had #1 until the Fed engineered #2.
I say, forget about all the other theories about the unsustainably indebted middle class. To have expected Americans to keep their aggregate real estate values below 70% of GDP, you might have well asked them to stop breathing. In the aggregate, it couldn't have been done - the outcome we saw was the only functional possible outcome, and it had nothing to do with debt-fueled consumption.
Side Note
If I was a homebuilder, and I believed that the period up to 2006 was reasonable, and that it was 2007-2008 where the housing market was broken, and if I had options on developable land, I would not be in any hurry to develop those plots. If the Fed can keep itself from torpedoing the money supply again (a big if in today's hawkish environment), those lots should see a 30-40% appreciation over the next couple of years as long as the banks rediscover real estate loans coming out of QE3.
Fantastic analysis, all the way through to the conclusion!
ReplyDeleteThanks, Ryan.
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