Tuesday, January 2, 2018

Housing: Part 273 - Rental income in a repressed regime

Reader Ben Cole pointed me to this article on rising housing costs.  In general, I thought it was a decent article.  It avoided some of the worst problems I see in housing reporting.  But, I think it might make for a useful template from which to look at some basic reminders about housing income and costs.

The article includes this graph:

The measure the author uses does appear to include both owner-occupied rent and tenant rent to individual owners.  This does represent almost all rental income, because housing is a very unconcentrated sector, and most properties are held by individuals.

But we have to be careful about these measures, because housing is a real asset, but the BEA measures income in nominal terms.

Ownership is divided between residual owners (equity holders) and fixed income owners (creditors).  I can use BEA data to estimate the incomes of owners and creditors for both owned and rented properties.  Here is the data for "Net Operating Surplus", which is net income before interest payments:

Rent has generally been rising as a portion of domestic income.  Before the 1990s, this was largely due to increasing consumption of real housing.  Since the 1990s, rising, and even level, rental income is due to rent inflation in cities with constraints on housing expansion.

Next, I further disaggregate this between creditors and equity-holders.  The equity lines (the dark lines) should roughly add up to the graph that I copied from the article.  These measures of rental income to owners are much less stationary than the net operating surplus measure I used to show total net rental income above, but we can see that most of that movement is due to shifting shares of income between owners and creditors.  It has little to do with net operating surplus.

A major cause of this shift is the problem that interest payments include an inflation premium while rental income is in real terms. (Owners gain their inflation premium through the nominal rising value of the property over time.)  So, these measures are really pretty useless.

Next, I have estimated the real interest payment, and added the inflation portion of the interest payment back to the owner, since that portion of the payment really is a purchase of equity, if we think about it in real terms.  (A level nominal value of the outstanding mortgage is actually a declining real value because of inflation.)  I have simply subtracted annual CPI inflation from the effective interest rate, so this measure is a bit messy, but it's close enough.

Here, we can see that the author is on to something, even though she has arrived there accidentally.  Owners really are pocketing a rising income.  This rising income comes from two sources: (1) rising net operating surplus from rising rents, and (2) declining real mortgage rates, and the larger factor is declining mortgage rates.

This points to one of the misconceptions about housing that comes from paradigms that pin Wall Street as the boogeyman of the crisis.  Incomes to financial intermediaries and creditors have been cut very low.  The reason is that lending markets are generally competitive.  Returns get bid down to the competitive level, and since the crisis has led many investors to seek safe income, there are many competitors for lending.  Homeowners, on the other hand, are protected by (1) political limits to new housing in Closed Access cities, and (2) political limits to lending that limit access to new ownership in other cities since the crisis.  Both of these limitations to competition increase their profits, but they have different effects on price.  The first limit increases rental income with a stable yield on investment, so property values increase.  The second limit increases rental income by increasing the yield on investment, so it operates by increasing rent and decreasing price.  This means that it is good for homeowners in general, but very bad for existing owners who need to sell and very good for existing potential buyers who can still buy in spite of the government's attempts at thwarting mortgage lending.

Since investors tend to be much less leveraged than owner-occupiers, they have not benefitted as much from low interest rates.

Using Federal Reserve measures of mortgages outstanding and real estate market values, we can estimate yields for homeowners and lenders, based on current home prices.

These yields tend to run together over the long term.  The deviations in the 1970s are due to inflation shocks, which caused mortgages outstanding to be repaid with inflated dollars, decreasing the real yields to lenders.  Then, when inflation was pushed back down in the 1980s, that led to higher yields for lenders, since the dollars they were paid back with were worth more than they had been expected to be.  But, the ability of homeowners to refinance limited the upside to lenders.  The recent deviation isn't from an inflation shock.  It is from the two sources of obstruction - obstructed building and obstructed lending - which push owner yields up and lender yields down.

Here is a section from the article:
In the aftermath of the downturn, home values nose-dived, distressed properties were plentiful, and interest rates were at all-time lows. In conditions like those, owners hold all the cards - even when they’re also the tenants.
That’s well and good for Americans who are already homeowners, but the flip side is that many renters have been stuck. Many have been unable to transition into homeownership, whether because of stricter underwriting and regulations — or because of what Khater calls “economic” reasons like unemployment or stagnant wages. And as home prices started to rebound, ownership became out of reach.
“The decline in homeownership and rapidly rising home prices are a driver of inequality,” Khater said in an interview. “As a lower proportion of Americans own a home and that’s the biggest portion of wealth, that drives a wedge between the haves and have-nots. Homeownership is a great way for the middle class to achieve wealth and those opportunities are declining.”
Khater has advocated developing housing policy to address supply — more options that are more affordable for ordinary Americans — rather than demand, with more attractive financing deals. For owners and renters alike, he said, shelter is the biggest expense. If policymakers addressed out-of-control housing costs, that would be “a great way to enhance living standards,” Khater said.
The "That's well and good for Americans who are already homeowners" line is sort of an echo to my analysis above, but the author seems to ignore the huge capital losses that were taken by homeowners.  This is a strange conclusion to come to when describing the aftermath of a foreclosure crisis.  But, confusion about these matters is not unusual.  It partly comes from confusion about housing as an investment vs. as consumption.  The author is describing a situation where an owner-occupier who owned a $200,000 house that had annual net rental income of $10,000 now owns a home worth, say, $175,000, with net rental income of $12,000, in real terms.  I don't think homeowners are out celebrating their windfall rental income profits as a result of this.

On the other hand, if they are wealthy enough to be considered worthy by the CFPB, and they managed to refinance their mortgage from 6% to 4% in the meantime, then they probably are quite happy about that.  But, that added cash flow didn't come from their market power over their renter (themselves), but from their market power over "Wall Street", who are competing over who can lend to the limited number of borrowers the government has deemed acceptable.

This is yet another way that the "they bailed out Wall Street instead of bailing out families" rhetoric is not useful.  It's not even wrong.  It's like watching a TV channel that has a scrambled signal.  It comes from seeing information in a way that renders it incapable of conveying a coherent story.  In the section from the article above, the quoted economist joins the conventional view that loosened lending standards can't be a part of the solution.  At least the quoted economist recognizes the supply problem.


  1. So basically, now's the Time to buy in NYC?

    1. It depends on what type of risk you want exposure to. Buying in NYC exposes you to local housing policy risks. Buying in cheaper cities exposes you to mortgage market risk, which is highly biased in an owner's favor, so I think in general buying in other places is better, but if you feel comfortable that local housing constraints will remain in place, then NYC would be fitting for your portfolio if you can accept the potential downside.

    2. At this point, rent is the same price as a mortgage + maintenance, which coming from SF really shocked me. Yes, there's a down payment, but given that the Donald keeps tweeting about the company in which I own lots of stock...

      Since I'm stuck here for 5 years and see no reason for NYC rents to go down in that timeframe (A city of 20 Million added 26,000 units in the metro area and this is historic, WTF guys), I'm considering it deeply.

  2. Great post. I would guess a healthy fraction of apartments in America are owned by corporations, LLCs, sole proprietorship, or other business formats.

    The BEA says such income is not included in rental income totals.

    I am not sure what this means.

    1. There is Table 7.4.5 and 7.12. Table 7.12 is imputed income, and it details owner-occupied rental income and costs. Table 7.4.5 includes all housing, and subtotals proprietor, personal, and corporate income. Both tables have a "rental income of persons with capital consumption adjustments" category. I think the author used the measure from Table 7.4.5, which does include rentals.

      The BEA does have a table of domestic income, which, as you found, seems to include only imputed rent of owners. But, the rental income category in Table 7.12 is lower than the category in Table 7.4.5, and the 7.4.5 number seems to be the number that corresponds with the BEA shares of domestic income. So, it seems that the author is correct that some of the rental income to persons measure is for privately owned rental units. According to Table 7.4.5, in terms of profit, proprietors and corporations only account for about 15% of housing. I suspect that the sorts of properties owned by corporations and other forms of firms have lower profit margins than individually owned properties, or at least that the individual owners are working on their properties, so that some income that is really compensation is recorded as profit. So, on a gross basis, firms might own more than 15% of the housing stock.

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