My former co-blogger, Winterspeak, muses on the problem with un-swelling the housing bubble:
Now that the air has gone out of the too-cheap credit that helped inflate the housing bubble, the question becomes how to undo the bubble with as little damage as possible.When the internet bubble popped, this happened fairly rapidly: failed dot-coms closed down, their investors took a beating, and their employees moved onto other jobs, some of them still internet related but at better firms. Some went back to grad school. The end result was that the economy overall was fine, people who had invested in internet firms lost money, and the internet overall continued to grow apace, but now focused on better companies.
I think one inevitable requirement of unwinding the housing bubble market is that housing prices have to come down to fall in line with historic trends. In some areas this means very dramatic decreases -- maybe 40%+ in real terms? I'm not sure what a "deflated housing bubble" would look like if it did not bring prices back to historic norms. We are not going to see price declines of this magnitude unless we have very very motivated sellers, which means banks for older properties (which have been foreclosed on), and builders for newer properties. If prices do not fall, then transactions will dry up. I can see the government stepping in and helping owners (and their lenders) but I'd be surprised if builders will be helped that much. This means that areas that have had the most new construction should see the most dramatic price corrections.
That's good news for me, since Washington, DC was one of the most bubblicious areas. My new neighborhood is crowded with just-completed and partially finished condos.
But so far, prices have remained remarkably sticky. People are putting condos onto the rental market rather than take a loss. On a typical (non-August) day, the Craigslist real estate section is filled with ads touting "Brand new construction!" alongside demands that the renter accept a one-year lease with no smoking or pets.
There's no way to know, of course, but I've long wondered whether these rentals make financial sense. Are they covering their carry, much less the opportunity cost of the capital? Prices won't collapse until investors come to terms with the fact that their prior investment is a sunk cost, and pouring more money down the rathole won't make the problem go away.
That may take a long time . . . long enough that prices may never fall as far as they "should". Faced with selling their home at a loss, most people choose to stay put and pray. Instead, what we're likely to see is a very long period of stagnant prices. Inflation may have to do the work of bringing those prices back in line with historical values. In which case, I'd be better off taking advantage of those great rental deals . . .
So what do you do if you're renting and have a little cash? Do you keep saving for a real, live 20% down payment and then jump in at the "bottom" of the market?
Is renting really throwing your money away or is that just bubble talk?
Figure that the bubble included mostly permits to build (by far the most expensive part of a house in the bubble areas) and land costs (as distinct from the permit requirements).
There was some increase in material and labor costs like plasterboard, wiring, plumbing, etc, but not to the extent that justified the increase in housing prices. If the 50,000$ cost of materials and labor doubled to 100,000$, that still doesn't cover a house price increase from 500,000$ to 700,000$.
Which means that the collapse or inflation of the bubble depends on local, state, and federal zoning and tax policies.
Rental is the "dog that did not bark" of the housing bubble. I read lots of stories about folks who are now at risk of "losing their homes". I read zero stories pointing out that these people will simply have to go back to renting, which is where they were before, and where 30% of us are now.
An owner who, with rental income, can make their monthly is not a motivated seller (even if they are losing money on the property overall). To be motivated to sell they will have to not be able to make their monthly mortgage payment, and essentially foreclose on the property (banks are motivated sellers). And remember -- the price is set by the marginal transaction, so the price of a property in a neighbourhood will be set by its most desperate owner.
Builders who have not sold their newly constructed units are probably as motivated as banks.
Is renting really throwing your money away or is that just bubble talk?
Renting is, as Winterspeak has put it, being short housing. If you think that the house prices are too high, and are going to be stagnant or fall, then renting is saving money, and buying is throwing your money away. If house prices are going to go up, then renting is generally throwing money away. (NB: all things depend on the value to you of things like the mortgage deduction on taxes, and whether the AMT will take that away from you.)
Do you keep saving for a real, live 20% down payment and then jump in at the "bottom" of the market?
If you're good at telling where the bottom is, absolutely.
As far as bubbles go, I wonder if a location with relatively long periods to get construction approved and finished-- but where it's still possible-- have the biggest falls in price. If you can't build at all, the prices won't fall. If you can build very quickly, then they won't rise so fast. Only in areas where prices can rise for long enough to trigger lots of new housing construction that comes on the market just in time to crash it will you see the most exciting bubbles. Northern Virginia seems to fall into that category.
I moved down to the Northern Virginia/DC area about a year and a half ago, looked at the home prices, compared them to the rental prices, said "Something's gotta give, either rents up or homes down, either way I'm renting until something changes."
I suppose I shouldn't brag too much about it, though. Right now a college buddy and I are renting a recently constructed townhouse from a couple that had to move for work but didn't want to reduce the price in order to get it to sell.
As an owner of a NW DC apt that is rented, I can verify that DC has great economic fundamentals for keeping prices high. I rented the apartment less than a month ago, and had 35 callers/emails on the first day of a craigslist listing with 8 written applications the first night of showings. This after a significant rent increase over the prior (obviously not significant enough).
The support for rents, at least in DC, tells me that sales prices won't go down anytime soon. Absentee owners, like me, get a big tax incentive and make money even with month over month cash shortfalls. At current rents, my place (purchased in 2003) is doing quite well.
The good but not posh MD neighborhood that I am still watching (good commute, good schools, walkable neighborhood) seems to still be stuck at 500K and above (although a few marginal properties are in the 400s). However, I don't believe any of the houses in the neighborhood are renting for over $2100, and I believe $1800 or $1900 seem more standard. Unfortunately for owners who purchased recently, that sort of rent can't begin to cover the mortgage payments or other expenses (taxes, insurance, upkeep, etc). Meanwhile, elsewhere in the neighborhood, new $900K 3-bedroom condos are being offered for $3000 a month.
wkw: "Figure that the bubble included mostly permits to build (by far the most expensive part of a house in the bubble areas)"
Huh? Typical construction costs are anywhere from $80-$150 per square foot (can be much, much more), depending on location and build quality. Do you really believe that a 2500 square foot house in, say, Northern San Diego County (or anywhere in Florida) has permit fees WELL in excess of $250,000?
Megan (quoting): "We are not going to see price declines of this magnitude unless we have very very motivated sellers, which means . . . builders for newer properties."
It's not entirely up to the builders in most cases--they ALL have construction financing, with schedules of minimum release prices for each type of unit/TH/house. True "custom home" spec builders may have more latitude, but Toll Brothers (e.g.) has to answer to their lenders if they want to reduce prices significantly. In the really bubbly areas, slow-buildout developments (i.e., one's that started construction 5+ years ago) are the best bet for significant reductions--they have lower land acquistion costs and had based their profit model on lower expected sales prices.
Renting at a cash-flow loss is a gamble on a long-term price increase/recovery. In places where the regulatory burden is a significant percentage of the price of housing, prices will continue to go up eventually, so taking that loss is a reasonable gamble.
Housing in the Bay Area was expensive compared to most of the rest of the country before the internet boom, even in those parts of the Bay Area with bad weather. The fundamentals of housing prices here have not been affected by the credit crunch: you still need to be a politically-well-connected developer to subdivide or build condos/apartments pretty much anywhere in the area.
Zaleriana - actually, the cost of getting permission to subdivide, say, a 20-acre parcel in Northern San Diego County into 0.15-acre parcels for houses does run to the quarter-million-dollar per lot range, if you include the increase in property value when nearby development makes it politically tenable to consider subdiiding it, the carrying costs on the land while you shepherd it through the development process (you may be holding that land for over 10 years before you have planning approval), the expenses of environmental studies, the cost of defending nuisance anti-development lawsuits, and the costs of all the "development fees" and amenities for the surrounding area which become mandatory to get permission to build.
Every time renting/buying comes up I always want to make the (naive?) following observation.
If you buy a house for X principle plus I interest and plan to live there for N years, and the rental prices in that area are Y per year, and Z is the price you end up selling for after N years then:
1. Y*N = Total cost to rent, no matter what happens you will never see this money again (i.e. this is –always- a loss).
2. (X+I)-Z = Total “cost” to buy, this can easily be a negative number (i.e. you made something).
All #2 has to be is 1$ more than #1 to make buying a good option. Unless you plan to live in a house for a very short period of time I just don’t see how renting is ever a good option and yet I see it talked about all the time as a rational thing to do. The only advantage I can see in renting is the easy of moving on short notice without needing to find a buyer.
Could someone recommend a resource for reading about this trade off? Or am I making some fundamental error in my thinking that is easily corrected?
Thanks in advance!
Anthony: Yes, i recognize that $250k/lot (or even a bit more) is definitely a posibility in most parts of California. And that this is in large part a result of local government scratching for funding for various things in the Prop-13-era.
$250k/lot (or even $300k) is nothing close to "by far the most expensive part of a house in the bubble areas" and does not apply to many other bubbly areas, like, say, Florida. And it takes accounting for carrying costs and "increases in property values" (??) as a permitting cost.
A more reasonable statement would be: "in much of California, the cost of permits and related regulatory and other costs is often close to half of the total cost of a new home, and in some cases is the single largest cost." Applying California issue to all bubble areas makes little sense.
In real dollars, housing prices will return to trend. For some areas, this will result in a drop of 40% or more. It really won't matter whether or not people want to sell or not- the prices will be set at the margin.
I wish now I had sold my house in 2005 (I did consider it, but didn't want to return to renting, and I like my house). It is looking like it would have been a very profitable move, and I likely could have repurchased another at a much lower price a year or two from now.
jtd: "[why rent?]
There are a number of things, but chief among them are: Maintenance (M), taxes (T), investment return on the difference b/t rent and ownership costs (R, where O=Investment return*(X+I+T+M-Y)), and leverage.
So, Z-((X+I+T+M)*N) must be greater than (-Y*N)+(R*N) (all net of income tax effects) for it to be a financial plus.
If you own, even if nothing needs replacement, you are solely responsible for upkeep--which can be a significant cost. And some people just don't want to deal with it.
You simply left taxes out of the equation.
Opportunity cost can be big if you have a large difference b/t X+I+T+M and Y, especially over a longer period N.
Last, home mortgages are the easiest place for the average person to leverage their assets. Renting, and investing the savings, doesn't allow you to leverage your down payment (or lack thereof) to nearly the same degree. Of course, then you're locked into a real estate investment, but, if the market is good, the percentage return is great. Right now, making such a bet requires much more risk tolerance than it did 5 years ago.
zaleriana, I think what was left out of jtd's equation was not just taxes, but the return on investment of buying securities with the money you're not buying a house with, versus the return on investment of buying a house.
If the stock market right now is much less overvalued than real estate, for example, I would think it might make sense to keep renting and invest your 20% house down payment in stocks and bonds for a few years while you wait for real-estate prices to shake out (either to drop or to just remain static for a long time). If you think the liquidity problems caused by real estate paralysis are likely to cause a stock market drop too, you might be better off investing in bonds or fixed-income securities. No?
There are a bunch of calculators on-line which help you see the trade-off between renting and owning. I don't seem to be able to find the one I used last, but it included a large number of factors including all the ones listed above.
The support for rents, at least in DC, tells me that sales prices won't go down anytime soon.
Ah, but rents didn't go up during the bubble at the same rate as sale prices, at least not in the DC area. The support for rents indicates to me that there's a floor in sale prices, a limit to how far they might decline, but they still very well may decline.
When I was moving to DC from Durham, NC, I used one of those "salary calculator" things. To pick round numbers, it said that $100,000 in NC was similar to $90-100k in Fairfax County if you rented, but similar to $60-70k if you owned. That's a pretty huge disparity that it claimed, and leaves a lot of room for either rents to increase or sale prices decrease in the DC area.
Umm, I clearly wrote that backwards. $100k in Fairfax County being equivalent to $90-100k or $60-70k in Durham, depending on renting or owning.
Because DC is a government town it is far more recession proof than most places. From my understanding housing downturns do not kill the DC market very much.
How many people realize that this is a classic case of a speculative increase in the price of *land*. High housing prices are largely land prices, not brick and shingle prices (although in some places, permit costs and delays play a major role). The basic analysis was given by Henry George (try Googling if you don't know about him already) more than a century ago. Boom times raise land rents; they aren't making any more land, so land selling prices rise even faster than land rents. Then people become unable to afford the land they need, so production is checked; there are complications like overextended credit breaking down, and then there's a panic (now called a recession). It can still be hard to buy land, even if its hard to sell at top dollar, because landowners remain convinced that prices will go back up sooner or later, so they're reluctant to sell at lower prices.
What's the solution? Henry George explained that, too. Tax land, not buildings, incomes, sales, etc., and among other benefits, it becomes too expensive to hold valuable land for which you have no use. No more speculative bubbles.
Another couple things to factor into the rent vs. buy question:
1. Closing costs and real estate commission. Usually you pay most of these when you sell, but they eat around 10% of the house price. That was the portion I remember when I bought my house. If you sell too soon, you can be worse off then if you rent (for the same mortgage/rent amount). You might not have any net equity and end up with less then you down payment. Outside of a boom, I recall it taking several years, about five, for owning to be a win. So if you expect to live somewhere for only a couple years, renting may be a much better choice.
2. Would you buy a place as small as what you rent? When I bought my house, I went from a 2 bedroom apartment to a much larger house, and my mortgage payment was significantly higher then my rent. It's once thing to be in a too small apartment. When your lease is up in a year, move. However, point 1 above makes moving from a too small house either expensive or something you have to wait several years for.
My mortgae payment was about 2/3 more then my rent. If I'd continued renting and invested the difference I wouldn't have accumulated as much as my house appreciated, but only because I had the dumb luck to buy a couple years before the boom. In a more normal market, it would have been a wash, or even better to have rented.
None of this factored into my choice to buy. I was sick of living in an apartment, and wanted a house. Your tastes may vary.
1. Here in Seattle, the housing bubble is primarily a land-speculation bubble. My house, purchased in 2007, cost $500,000, of which $300,000 is the current price for a 5,000 sq. ft. lot on my street.
2. Since a teacher or nurse can't afford a mortgage for a house built on a $300,000 lot, we might be tempted to conclude that Seattle is experiencing a land-speculation bubble. This reasoning is faulty, since many potential buyers are stock-option millionaires, are selling $1M homes in California, are simply swapping houses in Seattle, etc. They want to live in a vibrant city, the supply of close-in single-family houses and buildable lots is quite limited, so they simply pay the market price. For these buyers, monthly income bears no relationship to "affordability". Teachers and nurses can't afford a Seattle house on their income, but we cannot conclude that prices will fall sometime in the future.
3. Over the long term, the cost of new construction is driven by the cost of building materials. The cost of building materials has increased 30-fold over the past 60 years. In the western U.S. in 1950, a new 1,000 sq. ft. house (including land, materials & labor) sold for $10,000. This equals $10 per sq. ft. Today a new 3,000 sq. ft. house in Seattle (including land, materials & labor) sells for $1M. This equals $300 per sq. ft., a 30-fold increase over 60 years.
4. Conclusion: Over the long term, ownership of land, copper, cement, timber, etc. is an excellent hedge against inflation. This argues in favor of owning rental houses. Note: I have 5 housemates, so the Seattle house I own and happen to live in is structured as a rental house.
"Instead, what we're likely to see is a very long period of stagnant prices."
The problem with that, Megan, is that (in some areas) the market got so deranged that in order to get back to the trend line, prices would have to remain stagnant for something like 20 years. That ain't gonna happen. Two years, sure. A market moving sideways for a long time is certainly less painful than a big drop all at once followed by a slow crawl upward along the trend line, but the latter is much more likely the larger the initial bubble.
Of course, in most parts of the country, it will just be harder to sell homes, and prices should remain largely stagnant depending on how bullheaded individual sellers are. It is in areas where banks and builders have a lot of the excess inventory that we are likely to see major upheavals in the market.
Northern Virginia also is just about to adopt several taxes to pay for transportation bonds, through a regional quasi-governmental body consisting of local elected officials set up for that purpose. One of those taxes is a 1% tax on selling a home, which may have some marginal effects.
Henry George explained that, too.
Oh, I do so wish it were easy to determine and tax the unimproved value of land. Henry George's analysis is spot-on, from an economic perspective.
Note, however, that such a tax would be pretty fiercely opposed from several social justice perspectives. People would be priced out of old homes that they'd lived in for years even faster because of the land tax, if the overall land tax brought in as much money as the property tax. A higher rate on just land versus a lower rate on land plus improvements means higher taxes when one's improvements are below par for the area post-gentrification.
That's essentially the opposite of such reforms as are often proposed in real life, such as California's Proposition 13. People don't like the idea of being priced out of one's own home due to the value of the land increasing.
Note that forcing people to sell out is almost the whole point of such reforms; the avoidance of deadweight loss is obtained by forcing land to be used for its most efficient purposes. Tweaks to prevent that from happening invalidate the logic behind it.
"[I]t becomes too expensive to hold valuable land for which you have no use," sounds nice when you say "no more speculative bubbles." When it gets turned around to "so poor folks get their small, old-fashioned houses off our valuable land that can be redeveloped into condos and businesses that use the land better," it's a lot less popular.
brooksfoe: [you left out alternate investment return as a consideration]
Um, isn't that what I wrote, here:
"investment return on the difference b/t rent and ownership costs (R, where O=Investment return*(X+I+T+M-Y))"
and here:
"Opportunity cost can be big if you have a large difference b/t X+I+T+M and Y, especially over a longer period N"
??
Interesting hypothesis about taxing land, and my experience seems to support that. I have a home in economically stagnant upstate NY and relatives in AL. Land taxation in my NY town is relatively high while land taxation is virtually zero in the county from which I'm from in AL.
The visual result is that land owners in AL feel no compunction to improve old structures in AL as it's cheaper to just clear virgin land and build your new low-wage manufacturing enterprise than rehabbing an old mill-site just a few miles away.
In NY, the taxes on the land are such that vacant buildings (excluding farmland which has various incentives to keep it farmland) quickly find new uses if the market is allowed to act without undue govt influence (this would exclude NYC, for example) as the taxes would bankrupt the non-revenue receiving owner.
If nothing else, it makes for a nicer place to live.
Thank you, Nicholas Rosen, for bringing up Henry George.
As for the social justice concerns, I'm not so sure. I'd have to pull my copy of Progress and Poverty back out, but IIRC, George believed that the single tax would hold down increases in the price of the land, stabilizing (over the long run) the tax burden long-term homeowners. The quick run-ups in property taxes in California in the 70's and Florida now were in the absence of such a system.
For what its worth, when I was an intern in Cincinnati in the late 80's there was interest in going to a single tax. I helped run some numbers at the time, and changing from Ohio's structure at least, the cost to the 'average' $100,000 homeowner was a little lower with the single tax. It was the owners of vacant land, parking lots, warehouses and the like that took a hit, because they were paying relatively little in a tax valuation system that placed most of the tax burden on the improvement.
Housing takes years to fall in value. Schiller expects 15 years before we make new real highs. I plan on starting to look in 2-3 years for a home for my family.
the cost to the 'average' $100,000 homeowner was a little lower with the single tax. It was the owners of vacant land, parking lots, warehouses and the like that took a hit, because they were paying relatively little in a tax valuation system that placed most of the tax burden on the improvement.
Sure, the "average" couple in a neighborhood is about the same, perhaps a little better off. But don't you think that the old couple with a small house they've lived in for thirty years in a gentrifying neighborhood surrounded with nice new condos would face that same type of increased burden as the owners of vacant land? The value of their unimproved land will have increased, and much faster than the value of their land plus improvements.
The gentrification of their neighborhood *has* to increase the value of their unimproved land, or else you're only pretending to have the single tax in the first place. (And unless you also want to discourage all open spaces.)
In response to Mr. Thacker, you can find sympathetic people who would lose from Georgist reform, or from other tax reform, or from leaving the system the way it is.
One can say several things in favor of taxing land instead of buildings: (1) For the same revenue raised, it would save money for most homeowners. (2) It would especially benefit poor homeowners, most of whom do not live in small houses on large lots in gentrifying neighborhoods, as compared to rich homeowners. (3) It would save money for tenants, since the land tax cannot be passed on. What about the poor old couple who rent an apartment? (4) It would end some deadweight losses, like the time and gasoline wasted driving past rubbish-strewn lots held by speculators in between cities and their suburbs.