Houses and Land

Kevin Erdmann writes,

The real long term natural rate right now is about 2.5%. If you have tons of cash or you can run the gauntlet and get a mortgage, or if you are an institituional investor going through the difficult organizational process of buying up billions of dollars of rental homes, you get the preferred rate of 4% real returns.

Pointer from Tyler Cowen. Erdmann thinks that we have not built enough houses, so rents will be rising, so owning rental property is a great investment. My comments:

1. I would have thought so, too. I put a lot of money in REITs. It has not done well. I also invested a lot of money in firms that own/manage a lot of apartments. It did not do well. Maybe all that says is that I played in a segment of the market that is efficient, when the point is to try to exploit the inefficient segment.

2. If I understand his thinking, there are not enough buyers to bid house prices to their fair market value. So you can own an apartment building at a high rent/price ratio. But it seems to me that, at least in some markets, the price/rent ratio has gone up rather than down in the past few years.

3. I am not sure that I trust my intuition about housing markets. My friends and relatives tend to be located in Blue cities where regulation restricts supply. I do not have a good feel for less-regulated markets.

12 thoughts on “Houses and Land

  1. “And this relationship broke down at the end of 2007 when we shut down real estate credit markets. The lack of access to home ownership made real estate returns go up while bond yields were going down.”

    I’m not sure I get how this relationship works. If the supply of credit is constrained, that means fewer buyers and more renters, which seems to me would only help real estate investors. Returns on owner-occupied homes ought to be pretty lousy, then, no? The esteemed Mr. Erdmann seems to be saying that every real estate owner is enjoying outsized returns, but I would think not.

  2. Arnold, thanks for giving this some attention.

    On point 1, I think you are right. I have not found a satisfactory way to profit from this except for buying rental properties outright. Because there is such a disconnect between mortgage rates are housing yields, leverage would seem to be useful there, but since there have been sharp price fluctuations unrelated to rental cash flows and these may happen again due to continued monetary and credit policy problems, the leverage needs to be based on debt that is resilient to short term market value fluctuations.

    On the other points, I think it is useful to think of homes in a simply DCF model. Price = Cash Flow / (Discount Rate – Growth Rate). One of the ironies in this issue is that bubble proponents like Robert Shiller argue that long term growth rates in housing can be assumed away because supply will drive rents back down to core inflation rates. The irony is that Shiller is seen as a behavioral finance guy pushing back against the EMH. But, his model is based on an efficiency assumption that anybody who has tried to build residential housing in NYC or Silicon Valley in the past 50 years knows is invalid. Shiller is the one assuming a can opener. So, in terms of implied yields (or their inverse, Price/Rent), in cities with persistent demand and sharp constraints to supply, we need to put the growth factor back into the equation. Since the discount rate on home ownership is relatively low, it doesn’t take a very high rent inflation expectation to push Price/Rent levels up.
    Here is a post where I address this in a little more detail, with graphs from individual cities:
    http://idiosyncraticwhisk.blogspot.com/2015/10/housing-series-part-66-our-two-part.html

  3. 1) Today prices are still historically high (compared to post-WW2 period.) but it was just the Bubble were extremely high.

    2) It is taking young adults until 30 to get married and have settled careers. So housing does not move. (Throw in the student loans and a lack of buidling small houses.)

    3) Mortgage debt is not increased at all the last 5 years (I believe around $13.5T) Realize with such low rates, mortgage borrowers are paying the debt quicker.

  4. In congested urban areas, booms and busts are in price on an overall rate of appreciation, while elsewhere they are in supply with little to no appreciation. The former are real investments, the latter stores of wealth.

    • That’s a good point, Lord. Another irony about this mess is that it is sort of a Baptist and Bootlegger thing, but without the Bootleggers. The developers want to build, which would create the supply response that would bring down rents. The affordable housing (sic) advocates in these cities consider the developers to be the enemy, even though they consistently enforce new policies that create economic rents for the landlords. Then their only reaction is to tax and punish the landlords for capturing the rents, which of course will only lead to more rents, until they make the cost of their cities finally outpace the geographically captured value of the networks of high skilled labor that are working there, and the whole thing comes crashing down.

      Here is a post where I show how the problem is entirely contained in just a few MSAs and the rest of the country is the picture of classical economics with free flow of labor and capital.

      http://idiosyncraticwhisk.blogspot.com/2015/10/housing-series-part-76-there-are-two.html

    • Good point, baconbacon. But, with all of these factors, it is important to look at city data. Vacancy rates in the problem cities are very low. That is where the problem radiates from.

  5. As someone who actually trades stocks on a daily basis, and know quite a bit about the real estate market, my first response is it is rare when macro trends make for good investments, normally it on should make investments based on valuation, and it has been a long time since apartment REITs were cheap on a valuation basis.
    Point #2, is there is an efficiency to owning verses renting. As no one ever washes a rental car, most renter do not care for their rental abode, while they do care for a house or condo they own. That difference is not insignificant, and increase as the price of the housing unit increases (which is why, on a location adjusted basis, rentals are on average much lower cost units than for purchase housing).

    • That’s a good point, Michael. I think that’s why people have a hard time imagining housing through a financial cash flows lens. Most of us are never the marginal household. Usually we hit some milestone in our life that pushes us well over the margin from being a renter to being an owner, where we aren’t that responsive to the relative price/rent context we are buying in. That’s also probably why there was a backlash to the high home prices. They were eating up a lot of consumer surplus that we usually take for granted.
      But, I think there are some caveats. First, simple models of home valuations based on rent and long term interest rates seem to get close enough to actual home prices, at least before 2007, that it appears there is enough activity at the margin (probably dominated by local small scale landlords) to make prices fairly efficient. The usual stability of home prices also makes it a little easier for efficiency to be achieved even though most owners are never on the margin.

      Also, from a financial POV, there is a strong non-diversifiability problem with owner-occupied housing. So, if the value of control lowers the discount rate, non-diversifiability increases the discount rate. This may pull more households to the margin of a buy or rent decision than it seems. Large scale landlords can diversify in several ways, so while rented homes don’t have that control premium, large landlords should be able to push the price up because of diversification.

      Of course, the tax benefit of imputed rents is pretty substantial, too. But, I think these things mostly shift the demand curve of owners to the right, and the general bifurcation of rental into multi-unit and owned into single unit, means that these demand shifts don’t affect Price/Rent ratios so much as they decrease the quantity demanded by renters vs. owners.

      This is why there has been widespread expansion of rented single unit homes since the crisis. Home prices have been below the equilibrium that they would hit in a liquid credit market, so landlords can compete. If we don’t get rid of the tax benefits to ownership, those rented units would probably move back to owned if prices ever fully recover.

      I wonder if we could get the benefits of both factors (the control premium plus diversification) if, instead of a mortgage based ownership system, homes were generally owned by REITS, and households would by something akin to a long term call option on the property. Interests would be aligned, but all the drama of highly leveraged debt would be reduced.

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