Sunday, May 15, 2016

Housing: Part 148 - The implications of the Price/Rent relationship

I am surprised at how regular the relationship between price and price/rent is, even nationally.  Here is a scatterplot of Price/Rent ratios, arranged by price (on a natural log scale).  Even at the national level, the r-squared of the regression is 0.77.

For each doubling in price, Price/Rent rises by 3.4x.  That means that at very low price levels, most of the increase in price is a positive feedback effect.  A $60,000 home sells at a Price/Rent, typically, of 5.8x.  A $120,000 home sells at a Price/Rent of 9.1x.

That means that the $60,000 house rents for $10,345 (annually) and the $120,000 house rents for $13,187.  That means that a 24% increase in rent leads to a doubling of home prices at the low end of the scale.  This is a log-linear relationship, so the effect declines as prices rise, until it appears that Price/Rent ratios do eventually level off within each MSA at prices above about $500,000.

This is why the Closed Access cities were the one group of cities where low priced homes increased at a faster rate than high priced homes - because rising rents and rising expected rents were the key reason why home prices rose in those cities.  Rising rents move homes up the line in this relationship, so they have a strong effect on low priced homes.

Long term real interest rates, on the other hand, serving as a foundation for Rent/Price levels (the inverse of Price/Rent), tend to cause the entire curve to rise.  In effect, what we might call the "home equity spread" - the difference between the implied yield on home ownership and the yield on risk free inflation adjusted bonds - is much higher on low priced homes than it is on high priced homes, so they are less sensitive to changes in the risk free rate.

This is why changes in homeownership were fairly uniform across cities during the boom.  The factor that causes households to own instead of renting is the value of control that comes with ownership.  We can think of a control premium as a discount to the required rate of return one needs on a capital investment.  The difference between these Price/Rent rates is a combination of expected rent inflation, the ability to claim tax benefits, and the effect of credit constraints on demand.  When interest rates decline, households with a higher control premium are more likely to become owners.

If the implied return on homes in a neighborhood is 8%, then the difference between a household with a 0% control premium and one with a 2% control premium is 1/4 of the return. But, if risk free rates decline so that the implied return is 6%, then the difference between those households amounts to 1/3 of the return.  As required returns decline, the relative incentive into ownership for households who are in a position to value control increases.

I would have expected credit constraints to be significant, too, but the fact that (1) homeownership rose in the late 1970s when real risk free rates were low but mortgage payments were difficult because of inflation and (2) marginal new homeownership was focused on the higher income levels during the 2000s when lower credit constraints should have expanded low income ownership, suggest that the control premium is the dominant factor here, not credit constraints.

Now, we can look at a house like this, in Phoenix, currently estimated to be worth $135,000, with an estimated rent of $1,150/month and an estimated mortgage payment of about $600/month.  This is a house with a Price/Rent ratio of nearly 10x.  This isn't even a particularly low-priced house, either.  At current rates, if the household living in this home is renting, they would nearly cut their monthly cash payments in half by buying the house.

If they made no down payment and doubled the interest rate from the conventional 3.4% to a rate of 6.8%, their monthly payment would be about $1,200.  In other words, if control held any value for them, they could get control while greatly lowering their monthly cash outflows - more than a free lunch.  Or, worst case scenario, if they had no savings and a poor credit record, they could get a subprime loan and get the control premium for free.  Sure, they would need to be prepared for maintenance expenses, etc.  On the other hand, they have now frozen their monthly expense at $1,200 while they will pocket the growing value of the home, whereas their rental expenses would have crept up with inflation each year.

Or, here's an $82,000 house in Atlanta, also with an estimated rent of $1,150/month and an estimated mortgage payment of about $425.

You know what would be really helpful for households in these homes that would find value in ownership?  A mortgage!  Even an expensive one!  Even one that you, in your 15x Price/Rent $350,000 two-story would consider outlandish!*

Policy by attribution error is what we have been engaging in.  We conflated two Americas.  The America where Closed Access policies create rising rents that force out low income households and drive up costs, where home prices were far out of the ranges of the rest of the country; and the America where low-priced homes were selling for the single-digit Price/Rent level.

Here is a comparison of foreclosure rates in two parts of the San Francisco consolidated metropolitan area: San Francisco County, where the median home price topped out at $787,000 in 2005 and San Joaquin County, where prices topped out at $415,000 in 2005.  San Francisco County prices are rising because the poor are being forced out and high income households are moving in, because they are a Closed Access city.  San Joaquin County is sort of the first stop for households that are trying to find a compromise between cost and location because of San Francisco's policies.

I have included Orange County and Riverside County also.  Los Angeles has the same pattern.  We got our panties in a wad because of prices in Orange County and San Francisco from aspirational households buying access to high incomes in a Closed Access, fixed pie regime.  So, we "fixed" it by bankrupting the families that were trying to escape it in Stockton and Riverside.

By the way, the median price of a house in San Joaquin today?  $260,000, about 38% below the 2005 peak.  And San Francisco?  $1.1 million, about 40% above the peak.  Please, oh please, political activists in San Francisco, tell me of your deep felt concerns for the working class and the poor.  Please, oh please, tell us how the bankers did this to us.  Please, oh please, preach to us about the evils of deregulation in housing.

The reason that the country is flocking to populists is because the one possible solution to this mess is a solution that is not available to a society mired in prejudice about the financial sector.

The family that would value owning that $82,000 home in Atlanta can't get a mortgage for it, because we are protecting them from hobgoblins.  Every day dozens of cynical op-eds come out somewhere in this country, reporting that some new low-down payment mortgage plan is being marketed, snarking something like, "Oh, yeah.  Nothing could go wrong with that plan." or "Here we go again."  Think about those no-doc loans that did this to us.  For the family that would like to own that $82,000 house in Atlanta, but can't because they can't get a mortgage, you know what factor would be completely unimportant to a reasonable mortgage broker?  Their ability to pay.  Because they would be lowering their monthly expenses.

Think of how we had to impose this bust on ourselves because somebody polled home buyers in San Francisco, and some of them thought home prices would keep rising by 5% or 10% or more each year.  That's unrealistic!  They needed to learn a lesson!  And the bankers were enabling this!

Well, you know what?  Those San Francisco folks were basically right.  And, you know who else thought home prices (and rents!) in San Francisco, or Orange County, were going to keep going up and up and up?  Those families that moved to Stockton and Riverside.  They were right, too.  So, with nothing else to do, and with great sadness and financial distress, they picked up, said goodbye to their friends and neighbors, and moved off to try to salvage a reasonable lifestyle.  Some of them thought they might be able to make a go of it in Riverside or Stockton.  Some thought Phoenix or Las Vegas.  Others, if they could, moved off to farther reaches.  Drive until you qualify is what the cynics that write those op-eds call it.  Except by 2005, you might have had to drive a thousand miles or two.

The thing they were wrong about.  The thing they didn't count on, along with all those households who were buying little $130,000 bungalows in Dallas and Topeka, was that our moral certitude would settle for nothing less than their financial ruin.

One of the oddities of human nature is that we can become so errant as a group that admitting our error would mean that we and those we respect would lose face.  As my research continues to lead me to these conclusions, I am beginning to worry if that is the tipping point that is the main danger facing us.  We have basically fallen back into North, Wallis, and Weingast's Limited Access order.  After creating the understanding of what that means, even they professed a loss of ideas about how a society moves from a Limited to Open Access order of civility and abundance.  Because limited access policies beget limited access reactions.

* I think this attribution error even infects those who work in finance.  People who were working with private MBSs report incredulously that their underwriters were asking for no-doc loans.  It was madness, they report.  And we imagine unscrupulous mortgage originators duping people into irresponsible transactions.  And, it's easy enough to find many anecdotes to support this idea.  Anecdotes by the thousands.  Anecdotes that are frequently true!**  But, I wonder, if we were able to remove the cynicism from our vision.  Is it that hard to imagine that mortgage broker looking at a middle class family looking to buy a starter home selling for something around 10x Price/Rent, which was not unheard of in many cities even in 2005?  And, failing to qualify for a conventional mortgage, the broker suggests a no-doc mortgage.  "You'll have to settle for a higher interest rate until you can refinance, but since you're not really increasing your monthly expenses, I don't see your income as a problem here.  And, if you can refinance in a couple of years, your expenses will really go down, plus you'll be building equity."

That's how mortgage brokers I have talked to think.  Could it be possible that our country is full of people like us?  People trying to do a decent job?  People who have a knack for one skill or another, who like to use that skill to help other people, and make a bit of income along the way?

The hobgoblins have pushed those people out of our imaginations even while they populate our neighborhoods.  As long as they are there we will be dividing ourselves and harming ourselves.

** Home prices topped out by around the end of 2005.  By that time, the Fed had already nearly finished pushing interest rates up.  By the end of 2006, the mortgage origination industry was already in crisis.  Check the dates on all the exposes of fraud and exotic CDO securities that supposedly were the cause of the bubble.  They all happened in 2005, 2006, 2007.  By then, our "solutions" were already at work.  Those things happened after the bust had begun.  This is like the fraudulent S&Ps of the 1980s.  This was really desperation that was the result of things which had already come to pass.  Our mistaken interpretation of the decade leading up to that as a type of fraud leads us to comingle all of these activities in our heads.  But, it was our error that led to both the bust and the desperation.

If you need further evidence that it was our error, scour the nation's op-eds today to see how many people are demanding that we loosen our grips on mortgage originations so that the family who might buy that home in Atlanta can become owners while cutting their monthly expenses in half, and compare that to how many people are calling the next housing bubble.  We are not being reasonable.  If you're not too far gone, reach up, grab the pinnacle of that tipping point, pull yourself over here with me.  We can fix this.


  1. I have a post on chopper drops over at Historinhas. I think there is an interesting idea that the Fed chooses to cool off the economy by throttling real estate.

    It may not be so much that the Fed "chooses" to do this, but that commercial banks primarily lend on real estate and the Fedis trying to constrain bank lending when cooling off the economy.

    Ergo, real estate get steamrollered when the Fed tightens to cool off the whole economy.

    Increasing or decreasing chopper drops would work much better.

    1. I think you're right about that. Housing is famously a forward indicator. Maybe it is a forward indicator of contractionary monetary policy. I believe at the same time that housing starts decline, rent inflation tends to rise going into recessions, which would corroborate your hunch.

  2. Purely, out of curiousity, what's up with that line of outlier zipcodes sitting around 2 Price/Rent all along the bottom at every price level?

    1. Great question. I believe those tend to be on Long Island. I think property taxes might have something to do with it, but I'm not completely sure. In general, I'm sort of making the old error here of looking for my keys under the streetlamp. I don't talk about New York much, partly because the data seems a lot messier there, which I think may be due to the fact that they have been developing these closed access policies for so long that the entire area is a hodgepodge of discontinuous targeted policies. But it would take more local knowledge to figure it out.

  3. The no doc loans that caused trouble were the teaser rate, no doc loans. They were very popular.

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