Tuesday, December 29, 2015

Housing, A Series: Part 95 - Closed Access is Waste

The forward-looking tendency of markets means that the costs of our policies tend to be captured as the policies are implemented.  I have argued that the rise in Price/Rent levels in the Closed Access cities after 1995 was partly a result of the persistence of rent inflation.  The expectations of future rent increases gradually fed into higher home prices, much like a growth stock would carry a higher Price/Earnings ratio than the stock of a slowly growing firm.

So, once those expectations are internalized in prices, the existing real estate owners have captured all of the gains of the policy.  A transfer, based on future rent expectations, has been made from current real estate owners to those who owned real estate before these policies created rent inflation.  If we can ever reverse these policies, pulling rents back down to unconstrained levels, current owners will bear the cost of that policy improvement.  Market efficiency means that the costs of these policy errors are sunk costs.

One subtle takeaway from this realization is that the high cost of living in the Closed Access cities applies to both renters and owners.  For new residents in these cities, it doesn't matter whether they own or rent.  Their after-rent income is low either way, even when they are paying rent to themselves, because owner-occupiers have to forego the opportunity costs of the excess capital they transferred to the previous owners when they bought the unit.

Let's compare four households, based on incomes before and after rent.  An owner and a renter from a Closed Access city with high and rising rents, and an owner and a renter from an Open Access city with low and stable rents.  For simplicity of comparison, each household will have enough capital to own their units without a mortgage and values are in real terms and excess capital is invested in assets with returns equal to the net return to housing.

The point of this simple exercise is to help think through how, once rent expectations have been internalized in the price of a home, the high cost of rent is imposed on both renters and owner-occupiers.  I have contrived the numbers to make the point, but generally these numbers reflect actual incomes and expenses of the median household in the Closed Access cities versus the Open Access cities.

With these contrived, but realistic, numbers, all four households enjoy the same incomes after the costs and capital gains of housing are accounted for.  (This example is of a zero inflation economy, so the capital gains accruing to the High Cost owner reflect the realized gains that come from the effect of rising rents on the current value of the home.)

Here is a graph, as a reminder of the extreme and recent nature of this issue.  Any time before 1995, there was no systematic relationship between incomes and housing expenses among US cities.  (1979 is shown in the graph, but the scatterplot for 1995 is similar.)  Then, a handful of cities with vibrant labor markets and sclerotic housing markets suddenly took a dramatic turn, where the Closed Access atmosphere created by those housing restrictions created high local wages which tended to flow to real estate owners.  So those cities simultaneously saw a wholly unprecedented level of unusual local incomes and a rising portion of those incomes going to rent.

The table above reflects this problem.  And, it does not matter whether the households in these cities are renters or owners.  All else equal, incomes equilibrate, regardless of ownership status.  My intention here is to use the total returns on savings, including both the house and other investments, as an easy way to understand the opportunity costs of capital, and to walk through how the sunk costs of the high priced home which were claimed by the previous owners lower the income of the high cost residents.  Home ownership claimed after high rents were already established is not a way to avoid the costs of high rent.  It is a way to hedge future changes in rents and to stabilize future housing costs, but it is not a way to avoid them.  In effect, home buyers in those cities are exchanging the risk of rising rents for the risk of changing property values.  As I have pointed out in previous posts, the problem created by the housing policies of these cities forces the residents of those cities to be exposed to those risks.  Home ownership is just one way to try to hedge those risks.  To label home buyers as "speculators" is an error.

In addition to being an numerical exercise in how incomes and expenses accrue to households in these cities, this table also shows how the position taken by the home owner in the high cost city must include capital gains.  The expected accrual of those capital gains is a result of the persistently rising rents of the city.  So, a household trying to stabilize their future housing costs by taking an ownership position has to lower their relative cash income in order to take that position.  The "Housing ATM" is an inevitable outgrowth of the problem of these cities.

The typical characterization of those households as speculators, as reckless optimists using their homes as ATMs, as actors in an unsustainable bid for real estate trading profits, is a massive case of attribution error.  This is a sign of efficiency.  Efficient real estate markets will naturally settle where these home buyers are taking on some form of risk that is of a scale similar to the risks taken on by renters.  The risks here are the risks imposed by Closed Access cities on their residents.  The risks come from local policies.  If we are upset by the risks home buyers and lenders were taking in the midst of the boom, then we should be just as upset by the risks taken by renters.  To focus on either is to blame the grass for a drought.  The source of the risk is the cities themselves.  Blame the voters.  Let's talk about predatory voters.  Because, everything that follows when these policies are in place is as inevitable as the grass turning brown.


  1. Build more housing!

    In Los Angeles, a $1 tax on gasoline, and free mass transit, might help alleviate concerns about density. Residents of Los Angeles complain the traffic is unbearable.

    Keep in mind the federal government sucks money out of urban areas and redeposits it in rural areas. Many of these urban areas have not the resources to build the infrastructure they need, thanks to a parasitic federal government and rural America.

    1. Why is metro L.A. filled with suburban housing instead of skyscrapers? I always found the fact L.A. was the densest metro area in the country while being filled with one-story buildings stupid. There should be high-rises in Redondo Beach.

    2. Are there height restrictions for building in a lot of LA suburbs? Or strict zoning requirements that would either prohibit or make more expensive building skyscrapers? I imagine this is the case in a lot of metro areas.

      Slightly off-topic question (for Kevin): what did delinquency rates for mortgages look like in closed-access cities during the housing boom and bust relative to open-access cities? And what would we expect relative delinquency rate changes in open vs. closed access cities to look like during the crisis, if it is true that housing supply constraints are the root cause of the crisis?


    3. I believe they were generally higher in the closed access areas. I think the first wave of delinquencies came in inland California and other 1st and 2nd tier outlets for middle class families moving out of closed access cities to cities with houses and lower costs. Delinquencies were generally a product of the combination of falling prices and young mortgages. Prices fell more in closed access cities (because intrinsic home values there are more vulnerable to changing expectations) but there more more young mortgages in cities with more housing starts. There was a spike in prices in places like Florida, Arizona, Nevada, and Inland California in late 2005, which was the result of the combined effects of migrations out of the closed access cities as costs shot up there. And this period in those cities does seem to be the one area where there is a "demand-side" element to price increases. And there were a lot of young mortgages there. In the core Closed Access cities and other cities, it depends on the amount of price collapse there was, etc.

      I think supply constraints are the root cause. You can see my train of thought in the archive of this series. I was some 30 odd posts in before I realized the importance of this issue. I started out thinking I might uncover some of the effects of tax policy, etc. on the crisis. Now, I am convinced supply is the core issue.

      I'll let commenters with more local knowledge reply to the LA question. There are many factors involved. I haven't dug into the details so much, because the general recognition of the problem of obstacles to building in those cities seems to be uncontroversial.

    4. Here's a map of delinquencies.

    5. Thanks, precisely what I was looking for.

      I have indeed been looking at some of your posts on the role (or overestimation of the role by conventional wisdom) of subprime mortgage growth in causing the crisis. You contend that the rise of subprime mortgages during the boom is in fact an effect of housing constraints, right?

      One thing I'm wondering is, by your account, what precisely triggered the bust? Is it as simple as 'the Fed raising rates'? Because they were trying to curb demand but failed to realize that inflated demand wasn't the problem.

      I was just thinking though that the 'conventional' narrative could actually be accurate in one respect: both consumers and banks, based on recent trends, believed that housing prices would continue to rise indefinitely, leading to speculation, excessive demand, etc. because they failed to realize that supply constraints were the real cause of rising prices. And existing constraints on supply can only push prices so high; eventually housing prices peak and the bubble pops, just as in the standard explanation for the housing crisis (as I understand it).

      In this scenario, the root cause is the same as what you have been arguing: housing prices originally go up due to supply constraints. Only the second act is the same as what is usually argued: that there was a conventional bubble spurred by the expectation of indefinitely increasing housing prices (instead of by greedy bankers or misguided GSEs or what have you).

      Just a possibility I've been wondering about, and I've been thinking about how one would test it. I honestly have no idea how one would determine how much of a price increase is due to a decline in supply relative to demand vs. the expectation by speculators that prices will continue to rise in the future (and in housing, all owners are in some sense speculators; expectation of future price increases likely influences anyone's willingness to buy a house vs. continuing to rent).

      Sorry for going off topic. The supply constraint theory piques my interest quite a bit.

    6. PS: I am the same poster who was 'anonymous' above your post. Just realized I have a google account or something I had forgotten about.

    7. Whoa. That's a lot of ground to cover. I'll try to give the telegram version of the answer. I believe that buried in the 95 posts, you will find expanded answers to most of this.

      I do think that one mistake observers have made is to complain of subprime leading to over-consumption, when supply constraints mean that the median renter is spending 35%+ of income on housing in the bad cities. I think the data shows that buyers were actually reducing their housing expenditures. On net, this was probably mostly done by moving away from the high cost cities to the places where they were building and houses were cheap. Also, in total, subprime-type loans did not expand. There was mostly just a shift from FHA/Ginnie Mae loans to private loans, and after 2003 when the GSE's sharply cut down on originations, there was a shift from them to private loans. But, yes, it seems like it would be very hard to buy a housing unit in San Francisco on conventional terms.

      I have had a habit of sort of blaming the Fed because they are the last mover. Economic stability is their job. And, I think there are some telling trend shifts that happened as they pushed rates above 5% and held them there with an inverted yield curve, which is a clear sign of coming economic distress. But, I'm coming around to more of an idea of emergence. There was bound to be some stochastic movement in economic measures, and since the country was passionately wrong about what was happening, the consensus developed to manage for instability instead of for stability. One way or another housing was going to collapse because we all decided it had to. The Fed happens to be where the final marginal decisions about how to suffocate the victim natural lie. Even today, Bernanke talks about how home prices falling were something inevitable and this is taken as uncontroversial. If there was the same Fed attitude backed by national consensus that there would be 20% deflation at some point in the near future or that stocks would drop by 50%, it would be a self-fulfilling prophecy, because things change naturally, and if we explicitly manage things to let them happen, the random walk of the economy, helped in no small way by expectations, will inevitably go there. We willed this on ourselves.

      My contention is that home prices never deviated from reasonable valuations - even with 10 years of additional data on rents since the peak of prices. Prices only deviated in late 2007 by going too low. Cash flows on homes have remained strong.

      There were two housing booms. The housing starts boom and the home price boom. They were mutually exclusive. The starts boom doesn't require unrealistic expectations because prices weren't particularly high in those areas. The price boom is justified by continued rent inflation in those cities. Prices are driven even higher because the housing shortage creates a labor shortage in the dynamic sectors in those cities. That's one of my central findings - that there is a very sharp and unusual connection between rising rents, prices, and incomes. Those high incomes should not be sustainable, and they would not be if there wasn't a housing constraint. Basically, SV housing is expensive because the housing constraint lowers competition in the tech sector, causing rising profits and wages. Most of the wages eventually go to the landlord.

      The bust is totally a demand bust issue because prices were not unsustainable. When San Francisco and Manhattan announce that they are greenlighting 2 million new units, we can talk about a classic housing bust. The bust we had included falling home prices in Texas, even as early as 2006. There was no market reason for prices in Texas to fall, especially when long term interest rates were falling as the crisis deepened.

      I think that covers it.

    8. Thanks for the response. I've been occasionally reading your posts for a little while and would have asked about this on a more pertinent post but probably would've been a rather old post, so I chose recency of relevance.

      I can imagine that if a good's value doesn't depreciate much (and houses don't depreciate much), then no matter what causes its price to go up, the expectation of a future price increase would likely cause 'overconsumption' just from increased use of that good as a store of value or from speculation. If, say, tomorrow the government announced that it were going to start rationing some highly durable good (with a low depreciation rate) and that every year, the permitted supply of that good would be reduced by 10% (with presumably no corresponding decline in demand), you would likely see a great deal of hording of that good, of 'overconsumption.' Then, one year, the government stops reducing the permitted supply (or even just decides to only reduce supply by 2% from then on instead of 10%). You might see a 'bust' and prices for that good would plummet. And some people then interpret all this as the result of it being too easy for people to get loans to buy this good (or an inexplicable surge in greedy speculators) and excess demand.

      Anyway, great blog, very informative and interesting (compared to most econ-related blogs I've come across), if a little over my head sometimes.

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