Wednesday, May 6, 2015

Housing Tax Policy, A Series: Part 31 - The Market Response to a Housing Shortage

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.


  1. Kevin,
    Regarding the ongoing housing shortage, I missed this Megan McArdle post from last month - which, like so she writes, gets to the point in a hurry. She lists a number of factors which have bearing as to why I advocate innovation at a basic infrastructural level. Less expensive ongoing maintenance would mean communities could build less expensive housing, which wouldn't "do them in" financially, in the long run.

  2. Sorry, forgot to include the link:

    1. Thanks for the link, Becky. It also seems like a sign of the lack of progress in housing that we still build houses on site. I assume that much of the reason for this is that local building codes and inspectors make it difficult to design a single home for many markets. Because, at this point, the advantages of modularity and centralized production seem like they would be huge.

      There are a complicated set of challenges here, aren't there?

      It's kind of amazing that we still see the sort of economic progress we do when 3/4 of the economy is in housing, health care, education, and other public sectors, which all seem to be characterized by rising costs.

    2. Lots of people have tried, or are trying, to do modular housing. There are tons of complications even ignoring zoning/code issues (which are significant). Just window layout is complex to do well. I own a twin- our side has the southern exposure and 30 ft between it and the next building and so is well lit, the rental side has the same number and placement of windows, but has the northern exposure and a house 10 ft away- so it is terribly lit. Even if each layout was good for a 15 degree rotation of a house you still need a dozen layouts for the side and a dozen for the front/back. Tons of things (how much insulation you need for example) are somewhat site specific, which really prevents putting out a good quality modular house. The best you can really do is put out average or slightly below average houses with complicated and costly development costs (that have to be reconfigured if large kitchens or 10 ft ceilings become popular).

      If zoning/codes issues were resolved or just the costs lowered I think there would be a ton of demand for them to use in multi-unit rental structures, but people seem to value an attachment to homes they buy, and it is very hard to give those houses any character, or build them optimally for the site.

  3. The first two points in that article are dubious. Commodities are generally down the past few years- including lumber, copper and oil which are major housing components. If builders lost their labor force to the downturn that should make potential labor cheaper. There should be tons of people with experience (drywalling/plumbing/electrical hasn't changed much since 2006, this isn't the tech sector where 2 years out and your skills are worth zero). Even with the need to retrain to some degree the fact that there are millions more on UE than in 2006 and stagnant/lower wages since then for many who moved out of construction should mean there is the opportunity for investment to build.

    Perhaps the last two points overwhelm the first two, but from the jump that article smells of knee jerk reaction.

    1. Good points, baconbacon. There might be something to her employment point, because it looks like a lot of the labor pool that was dumped out of construction in the crisis may have moved to other industries, so there may have been a loss of available skilled workers available for expansion without experiencing some market frictions on the way to getting them back to construction.

    2. There are always frictions in expanding a sector, the fact that there are even semi skilled workers potentially out there should imply lower than average retraining costs.

      There seem to be, in my view, two pretty strong headwinds for housing. Low immigration now, and low fertility rates in the 80s.

    3. I would have agreed with you about headwinds. But I have been surprised at how much the data points to a longterm supply problem.

  4. Am I about to put my foot in it? I think so, and if I am wrong on any of this I will look stupid.

    Your post #27 starts off with the national home price index vs new home sales and say

    "Here's a graph of new home sales and home prices over time. Note in this graph how home prices tend to lag home sales."

    Correct me if I am wrong here (and I very well might be) but isn't the national home price index an aggregate index? From their methodology section

    "The S&P/Case-Shiller U.S. National Home Price Index (‘the U.S. national index’) tracks the value of single-family housing within the United States. The index is a composite of single-family home price indices and FHFA data for the nine U.S. Census divisions:"

    "The composite home price indices are constructed to track the total value of single-family housing within its constituent metro areas:"

    The interpretation that "prices tend to lag new home sales" is erroneous, no? It is simply an artifact of new homes selling for more and pulling up the aggregate when new home sales are high.

    1. It's very possible - probably likely - that I have some error in interpreting the data. But, I'm not sure I'm following what you are saying.

      If I understand you correctly, changing composition of housing supply would be an issue in the new home average sales price, and other series like that.

      But, my understanding is that Case-Shiller is treated kind of like a stock index. When a new property is added to the index, it only affects the relative changes going forward, it wouldn't change the basis. I could be wrong, but I think that's the whole point of the Case-Shiller indexes, to minimize compositional changes.

      Is that what you are saying?

    2. Yes its a compositional thing. Again I might be stepping in it, but I think the national series you used is different from the same home sale price index (though generated from the same data). This is my memory/combined with understanding, so grain of salt here, but the goal of the goal of the national home price index is to track the value (price) of housing, and not price changes of same housing. The compositional changes aren't as, what is the word, aggressive?, because they also want to represent the value of new construction.

      Again, don't take this as gospel, but I think there is a better series than that one.

    3. You might be right. Different indexes, in order from most to least price increases during the boom seems to be: C-S10, C-S20, C-S National, Flow of Funds data, Average New Home price. So, the indexes that are composed of or include new homes tend to show more moderation, with C-S National in between. I don't see any difference in timing between the indexes, except that the new home price series has a more gradual increase - stronger in the 90s and not as much of a spike in the 2000s - but I don't really see a lag between them.