Wednesday, January 28, 2015

Housing Tax Policy, A Series: Part 3 - Total Returns to Capital is Conceptually Important.

There is so much to consider here, I'm kind of getting strangled in the weeds at the BEA.  I hope to have some follow-up posts soon.  In the meantime, I want to float an idea that I haven't seen addressed elsewhere.

In macro-economic discussions, profits seem to be frequently treated as the return on capital.  But, interest is just as important when looking at returns to capital.  I touched on that here.  Even in finance, we tend to start with the risk free rate and then add an equity premium to that, which, also leads to a viewpoint where debt is a step to take to get to profit.

I have gotten into the habit of looking at total unleveraged return as the baseline value.  Then within that total return, there is a swap where equity holders exchange fixed income to debt holders for a premium.  So, we start with a total return, and the equity premium becomes a fixed income discount.  I like this framing better for several reasons.  One reason is that total return appears to be more stable than equity return, and this framing helps to see how the changing risk free rate is mostly a product of debt holders adjusting the discount they are willing to pay to avoid manageable volatility.

Homes are no different than corporate assets, and the same behavior seems to be in place with them.

The red line in this first graph is the Rental Income to Persons after Capital Consumption Adjustment.  (All of these graphs are for owner-occupiers only.)  This red line is similar to the income I have discussed in earlier posts.  This is real income accruing to households that isn't showing up as compensation, because it represents the profit they gain from being home owners.  The red line is the important line for that analysis.  (edit: Although, even there, the total return is important in the long run.)  But, for analyzing the value of the homes themselves, we should look at Rental Income to Persons plus Mortgage Interest.  This is the total return on the asset.  And, it is much more stable over time.

Here it is shown as a portion of GDP.  Here we can see that the dip in Rental Income in the 1980s was the result of high interest mortgages.  But, this still doesn't quite give us the right comparison, because spending on imputed rent and home ownership rates change over time.  So, we need to look at these returns to real estate capital as a portion of real estate market values.

And, as with corporate returns, here also we find that the total return level is much more stable than the "profit" level.  Here we can see that returns to real estate have remained within a range of 2.5% to 4% of market value for nearly a century.  I think this will be an important reference point for my analysis in this series of posts.

A Difference Between Real Estate and Corporate Assets

There is an important difference between real estate and corporate assets regarding this debt-equity trade.  The main factor in this trade on corporate assets is a risk premium.  When the risk premium is high, more of the return is retained by equity as profit.  When the risk premium is low (interest rates are high, equity premiums are low), more of the return goes to debt as interest.

But, with real estate, both the house and the mortgage are relatively low risk assets.  They both tend to have relatively stable income returns (either through interest or through rent).  Both of those income streams are much more stable than the net income stream to corporate equity.  So the trade here isn't a risk swap.  It's an inflation swap.

But, this gets really complicated, and I haven't completely figured out how this affects reported incomes and production.  The BEA doesn't account for capital gains on existing assets because they are not the result of production.  But, when homeowners engage in this trade, especially in a high inflation context like the 1970s & early 1980s, they are exchanging a cash expense for a capital gain.  That is how net returns on housing (Rental Income) could actually dip into negative territory.  Homeowners were earning returns on their homes that were about as high as they have always been.  But, when inflation was 8%, part of their interest expense was an exchange of an 8% cash interest expense which they paid to the bank, in exchange for ownership of the home, which would provide them with an 8% unrealized capital gain.

With the increasing level of spending on housing and the high inflation of the 1970s, this has been a significant effect on the way incomes are reported.  Maybe it just amounts to a fairly arbitrary exchange between income reported as financial corporate profits vs. capital income to persons.  But, I wonder if stated national incomes are somehow being distorted.  I wonder if there could be some distortion related to this that is coming through the capital consumption adjustment.  I haven't fully wrapped my head around this problem, because it's a conceptually complex exchange through time, mixing changing asset values and income.


  1. It's a fascinating study - I've been grappling with this for years, grasping at air.
    What's intriguing is that normally corporate profits are treated as a return for risk and for providing goods that people value, etc. But with housing the return to capital is sort of circular in that your customer is yourself - capital and customer are the same party/agent, with the addition of a debt stakeholder too. I suppose effectively you put the imputed rent into savings that grow at some rate, tax free, and at the inflation rate at least. Also, I wonder if these savings are ever eventually consumed in the style of normal savings. It can't be the living-in-the-house since that would be the same if you were renting. I suppose though that the gradual build up in the savings becomes equity in some new, better home, and that's the eventual consumption, that and being able to pass this accumulated savings to one's kids.
    Anyway, keep up the good work, and thanks for the spreadsheet and formulas, etc. I do have some questions about the assumptions but I think I'll leave you in peace to let these ideas percolate around your head for a bit longer!

    1. This is an interesting topic, Sean. I'm digging into it some more in part 5. I think there are interesting implications for national income and savings measures.

  2. Hi Kevin,

    Where do you find Net Rent (I am guessing it is Net Operating Surplus) just for owner-occupied housing?

    Also when is the ETA on the book?