Thursday, July 2, 2015

The naive rentier economy

Bill McBride notes that multi-unit housing starts are peaking.

Here is one of his charts.  Notice they are peaking at about the same ceiling level they have peaked at since the 1990s.  As I have pointed out in my housing series, rent inflation started rising in the 1990s, and most of that inflation is due to just a few cities.  You can see in this chart how much more housing expansion was allowed back in the 1970s and 1980s.  This is a huge supply constraint.  And, this is why residential investment in single family homes was so high in the 2000s.  There is nowhere else to go.

We are hitting this ceiling while vacancy rates are at all time lows - down to 7.1% nationwide in 1Q 2015.  And guess what the vacancy rates are in LA (3.8%), NY (3.1%), San Diego (4.6%), San Francisco (3.6%), and Washington (4.6%)?

Here is an article that talks about insider buying at Real Estate REITs.  One thing that I find interesting is that real estate financial insiders seem to view real estate entirely through an income lense.  And, since we don't have a long history of easily tracked real bond yields, there is not a tradition of marking returns in real estate to market yields.  I think this is why there was such a large cottage industry of small-scale real estate speculators in the 2000s.  Between the low real long term rates on low risk alternatives and the high rent inflation that was coming out of supply constraints, there were speculative gains to be captured.  But, insiders who might have positioned institutional money to take advantage of this shift just don't look at real estate with that paradigm.  The financial institutions built around real estate, including the complex set of capital arrangements and organizational management, aren't set up to be speculative.

Even today, I think large real estate financial institutions have their capitalization rates set too high.  They present their investment values in terms of getting a high yield.  I have even seen presentations where analysts have explained that they might review market conditions and reduce the target capitalization rate.  But, they don't seem to account for the fact that reducing the cap rate on a real asset with a 50 year (or more) life is a bold speculative statement to make.  They seem to just see the changing cap rate as a way to calibrate fund discount rates to properly capture income from the available pool of investment opportunities.

This is reasonable.  Transaction costs in real estate are high.  Real estate investment institutions should be built around long term holdings.  Core competencies will be built around very localized information.  Over the long run, aggregate property values should roughly rise with inflation.  This leads to a peculiar outcome where insiders are not in a position to capture speculative gains that are the greater factor on the aggregate value of real estate in our current low interest rate, constrained supply environment.

Part of the problem is probably that there is no way to know how permanent the constraints on retail mortgage funding will be.  If the banks start lending freely again, nobody wants to be sitting on millions of dollars of apartments in Phoenix.  So, builders and landlords capture excess rents because that uncertainty keeps potential housing out of the market, even in cities that don't have artificial political constraints on housing.


  1. Fascinating post. Also, as a long-term play I imagine immigration policy is very important to real estate.

    If the US kiss Pete population, I would guess demand for housing is somewhat limited in the future although we could continue to see smaller households.

    1. That's a great point, although I am coming to the opinion that housing has been under supplied for a couple of decades. It is interesting that household size has been declining even while real housing consumption has been declining relative to total consumption and housing inflation has been rising.

  2. If the US population has peaked...

  3. I suppose it is possible even with a stable US population, we will see chronic housing shortages where people want to live, You can buy the mansion new to the old Ford mansion in Detroit for $25,000 today. It was empty as of a year or two back.

    You can barely wedge a unit into parts of L.A. of SF, or the City of San Clemente. BTW, is is easier to build a condo tower in "liberal" downtown L.A., than almost anywhere in "conservative" Orange County, and especially in the GOP beach cities. They simply will not allow condo towers there.

    1. Good point. With housing and monetary policy there seem to be bipartisan support for regulatory self flagellation.