One of my all time favorite rock albums is The Who’s “Who’s Next†and one of my favorite tracks on that album is “Won’t Get Fooled Again.†Right now there is much talk of a housing bubble, making for the possibility that a lot of people are getting fooled.
There are two ways to assess whether there is a housing bubble. The first can be termed the “historical approach,†and it involves looking at the historical relationship between house prices, levels of income, interest rates, and demographic factors. According to that approach house prices look significantly out of whack.
The second can be termed the “comparable cost approach,†and it involves comparing the relative cost of renting versus buying. A recent study by Professors Gary and Margaret Smith of Pomona College in Southern California uses this approach and concludes that house prices are generally not over-valued. Their findings have quickly been advertised by the mainstream media (New York Times, Saturday April 1, 2006), but the comparable cost approach has serious limitations. In the spirit of openness, here are some cautions about their conclusion.
People buy houses to enjoy the accommodation services that houses provide. An alternative way to get those services is to rent an equivalent house. If over the lifetime of occupancy, a house can be rented for less than it can be purchased this would suggest house prices are over-valued. Such a comparison involves a complicated calculation involving assumptions about future rents, future home ownership costs, and future house price appreciation that determines what an owner gets when they sell. Using this method, and assuming future annual rent increases and house price appreciation of three percent, the Smiths found that house prices were fair to under-valued, except in a few areas.
The main problem with the Smith’s study is that it assumes away the bubble. Their baseline calculation assumes a three percent annual increase in house prices, which automatically means no bubble. If prices keep rising, there cannot by definition have been a bubble.
That leads to the core problem with the comparable cost approach, which is that it provides no insights into future prices of houses or rents. Instead, it compares existing house prices with existing rents and factors in an assumed future path for prices and rents. That makes it a good tool for framing the “rent or buy†decision, but not for predicting future prices. It is possible that rents today are too high and could fall and drag down house prices. Alternatively, house prices could fall and drag down rents. There is some evidence that both may happen, but this vital evidence is ignored.
House builders are reporting record profits, which means that cost of building homes is significantly below the price of homes. Consequently, builders have an incentive to keep building homes and adding to the supply of homes until prices return closer to building costs. Given today’s prices and costs, new house construction promises to keep the lid on home prices and possibly lower them.
The same holds for the rental market. Real Estate Investment Trusts have also reported record profits. This suggests that rental properties are profitable, providing an incentive to build more rental units, which will keep the lid on rents. This incentive is strengthened by the fact that rental supply has been reduced by conversion of rental units into condominiums.
Either of these effects – flat home prices or flat rents – dramatically changes the conclusion that houses are fairly valued under the comparable cost approach. Note, that neither prices nor rents need to fall to generate the conclusion that people in many locales are over-paying. All that is needed is for prices or rents to flat-line, in which event buying a house is a poor investment at today’s prices.
A second core problem with the comparable cost approach is that it completely ignores risk. For renters, the main risk is faster than expected future rental price increases. For buyers, the main risk is capital loss, and this risk is closely linked to how long one holds the house. If you hold a house for thirty years, it is unlikely you will incur a capital loss because the long-run trend of house price appreciation will dominate temporary price fluctuations. However, if you hold it for less than ten years, the likelihood of loss is much larger – particularly after a period of rapid home price increases.
Given the leveraged nature of home buying, small decreases in home prices can inflict large losses on owners. Consider a $500,000 home with an initial ten percent down payment. If the house price falls ten percent, the owner loses one hundred percent of their equity. If the price falls twenty percent, they end up with negative equity of $50,000 that would probably bankrupt most households. This can have lifelong consequences by denying future access to credit, which can also prevent future home purchases.
These considerations are especially important to young buyers who often buy condominiums. The holding period for young buyers is shorter, exposing them to greatly enhanced risk of loss. Moreover, home prices do not even have to fall to impose large losses. Remember, the cost of selling a home is six percent. For the above $500,000 example, the exit cost is $30,000 and that wipes out more than half of the initial equity investment. The important point is that houses are illiquid and risky investment. Such investments usually trade at a discount to flexible liquid investments (i.e. renting), and homes (especially condominiums) should therefore sell at a slight discount to renting.
If there is a bubble, it is likely heavily concentrated in the condominium market. However, the effects will ramify throughout the residential real estate market. Many condo owners could find their equity wiped out, and condos are often the first step on the housing market ladder. Consequently, condo market weakness will ripple into broader housing market weakness. Over the long run prices will recover, but as the great British economist John Maynard Keynes remarked, “In the long run we’re all dead.â€
If I were a landlord, I would raise the rent until it was just under the monthly payment that a new family might be expected to come up with when they buy a house. For that reason, I would think that rental prices would automatically be about the same as monthly mortgage+prop tax payments on currently for sale single family homes.
Looking at the federal funds rate, it seems that it is significantly lower (less than 5%) than it was when other big collapses in real estate prices occurred. This is making me think that there’s a long way to go before housing price bubble would actually burst. What does Tom Palley think of that logic?
Am enjoying your blog in general. Read all that comes out.
Thanks, Marie… Landlords confront demand curves too so they cannot just raise the rent as high as they want… 5% can be a very high interest rate if prices have moved up a lot. Remember the interest burden = interest rate x amount borrowed.
I am – by profession – a commercial real estate appraiser, but at various stages of my career, I was a residential real estate appraiser by necessity. (or at least very close to one).
The basic logic of real estate appraising reduces to a series of principles applied to valuing real estate assets. These include the principle of anticipation and substitution. I note that the same principles are precisely those distilled by very distant Austrian – in their own ways equally heterodox – economic colleagues – Peter Lewin and Steve Phelan in “Rent and Resources”. Thier opinons notwithstanding – these principles are classically stated in the Appraisal Institute’s “Appraisal of Real Estate”.
These principles form the basis for interpretating the data you cite below: the relevance of the sales (substitute existing properties for the one you have), cost data (substitute a replacement property of equal utility to the one you have), and the relevance of rents (the anticipation of the future benefits of ownership of the asset).
Note that terminology is confusing here: no appraiser would ever refer to the situation described by the Smiths as “comparable cost” but would consider their work as measuring value through “income” (or through the imputation of income as a measure of anticipated future benefits of owning or renting). And of course, modest as appraisers are, they would consider such an imputation highly “speculative” in that it strays from the immediate evidence offered by the actions of market participants (as opposed to discovering underlying ‘forces” that drive their behavior). Your points about the liguidity and financing risk of the ownership vs rental decision are very much to the point.
Their seems to be solid evidence that the “bubbles” vary from market to market with the greatest disparities in the coastal markets. There is a very distinct geography to this phenomena.
Another factor relevant to the data is the problem of land values – as well as builder profits. Land costs historically have contributed 20-25% of the cost of a new home. In areas such as Silicon Valley, residential (including multi-family) land has sold at or above the salvage value of many commercial properties (older R&D buildings with functional problems). Thus, the supply of land for residential use has expanded beyond what was available over a relatively long period of time when commercial rents were much higher in some areas. Price deflation or stability in the multifamily sector occurred in some cases following the end of the dotcom boom.
In other areas, such as Southern California, commercial property prices are at or near record highs and force the price of residential land higher encouraging projects with higher density (such as condominiums). These regional patterns are cyclical and suggest that their reversal may alter land values.
I recently talked about the housing bubble with an appraiser in southern California who pointed out the large amount of interest-only residential mortgages tied to short-term indices as indicative of the “risks” you cite at the end of your essay.
My wife and I have been renting a large apartment here in a medium-sized Blue-ish Town with good schools here in Red-State America for some time now. Rents in my city have been relatively low while the housing market is ridiculous for a place with only marginal economic potential in the grand scheme of things. My complex has a 20% vacancy rate and is doing many improvements just to hold steady. Right now so many people are so hell-bent to get into an overpriced home market that landlords cannot affort to have their rents get into the ballpark of a monthly mortgage payment for fear of losing tenants. Now, if the bubble bursts, I better watch out. But, then I’ll be looking to buy from someone facing foreclosure. We’ll see.
Also, if you avoid living in a “popular” area of town or a “luxury” complex, and find a complex that steers you toward one-year leases (which weeds out transients and college kids), you can beat the mortgage payment and related costs by a mile. Also, home prices are based on the assumption of two-working adults, which allows them to ask for more while you have to outsource your child-rearing (which I believe should be added to the cost of home-ownership for most households as this is what drives it). Good child care is $12-15,000/year minimum. By renting, my wife can work part-time from home (doing what she really likes to do instead of what she has to do in order for us to cover child care and an inflated mortgage), raise our son, and we can still have fun, take vacations, drive newer cars, and save quite a lot (compared to most Americans) in liquid investments. (We have no debts beyond our cars.) We only know a handful of couples in our income bracket who can say the same.
Finally, keep this in mind. When my parents bought a home, my father (who had only a high school education) still managed to earn more annually than the price of our house (~$35,000) in his middle age. Today, a house comparable to our apartment would run $120-170,000. I’m optimistic about my annualized earning potential. But, even with a college degree, I find that amount is still a ways off. I don’t need no dern statistics to tell me that housing prices are outrageous by any estimation. I’ll buy when I can get the deal I want. Right now I enjoy not owning (or being owned by) a home.
Thanks for presenting a great article. It is refreshing to know that there are still economists out there who evaluate issues from both perspectives. The article is enlightening and easy to understand for a novice like myself.
An excellent discussion of the circularity of the comparables approach. I must visit your website more often.
But in fairness to the Smiths’ study, I think they were responding to many other studies claiming that rent comparability proves that a bubble exists. These also are circular. The main evidence cited for the existence of a bubble is that house prices now are higher than in the past. But if one assumes that house prices in the past are a guide to prices in the future, the Smiths could equally assume that patterns of historical price appreciation in the past are a guide to future appreciation. They were simply demonstrating that if one assumes past appreciation trends continue, rents are not out of line with historical norms. Actually, their main contribution was a more realistic method of comparing rents and house prices.
The best argument for the existence of a bubble arise from the fact that prices are higher in the past, and nobody seems to have a compelling explanation for it. The default explanation is an asset bubble, which is more of a label than an explanation. There is other evidence but it’s murky. As to builders’ profits, for example, big publicly traded builders have been reporting high profits recently, but they claim this is because their efficiencies are driving small builders out of the market. If so, presumably the profits of smaller companies are lower. I think part of the uneven pattern of price appreciation around the country arises from increased income inequality: prices in areas where the affluent are likely to want to live (coastal urban areas, resorts and retirement locations) rise to reflect their greater expected wealth, while prices in most of the country stagnate. But that’s just a guess with no evidence whatever to back it up. We will see.
Thanks again for your insight.
I have a question relating to the housing bubble, rents, and the growing income disparity. With such a concentration of wealth in the hands of so few people, the wealthy seem to be running out of places to invest their money to garner the returns that they have become accustomed to. (This to me is a fundamental flaw of “trickle down economics,” but that is another story.) Is it likely or even possible that there is enough equity and wealth built up by the ownership society that they could in essence “price fix” rent? I know that the market will adjust things to an extent, but hasn’t history shown us that people starve not because there is lack of food, but that food is too expensive? I realize that houses are more expensive than potatoes, but the process is the same. There is a lot of fake money in the wallets of the wealthy thanks to our national debt. Is there enough in there to prop up rents?
I read your response to Marie above regarding the demand curves. I guess I am wondering if it is possible to experience a situation to where the demand curve becomes almost insignificant.
Tom,
Am I understanding a vicious circle/catch-22 here correctly? Tax cuts go primarily to the wealthy. It is argued that this will “trickle down.” (I know they renamed it “Supply Side Economics”.) It instead goes into whichever investment yeilds the most return with the least amount of effort. Oil market looks like a winner. This drives up the prices of oil. Now the economy is actually being damaged by the high price of fuel. GDP still looks good of course, but any form of measurement that considers health and sustainability of the middle class is conveniently ignored. Results- tax cuts undermine the economy. Cheap money was given to those who didn’t need it. They borrowed heavily at 1% and will loan that money back to the US at a profit in the form of bonds. They profit fom our our pain at the pump, or tax our manufacturing through copper and steel, etc. Higher prices and higher personal debt force people to work for less for fear of major losses. National debt cripples the ability of our federal government to serve its people. Commonwealth becomes common debt.
FDR put the money in the hands of the working class. Capitalist “competition” was for the good life, not for survival. (Should there be a law that requires journalists to study economics before they are handed a microphone?)
We are being punished for forgetting history. The Great Depression put to rest the myth of lassiez fare. It’s BAAAACK!! This time it needs to be buried forever. We should have buried it under a solar panel. They would have never found it there!
BTW- I learned of you by regularly reading tompaine.com. Glad to have met you. I appreciate your feedback because there’s nothing worse than a fool who believes in himself to a fault!!
i thought that bubble is true.. i mean when you look at homes for rent you think that is true.