Cullen Roche is worried that the trajectory of housing prices might deviate from what practical assumptions would predict
Real estate returns are not rocket science. Because they’re such a huge portion of the consumer balance sheet they tend to be tied very closely to wage growth. Wage growth, by definition, is very closely tied to the rate of inflation. That explains why the long-term historical return of real estate is roughly in-line with the rate of inflation. But this survey from Zillow shows that real estate “investors” are probably still too optimistic.
I can see why these assumptions are attractive, but they are not quite what drops out of macroeconomic analysis.
Fundamental Upward Pressure of Prices
Wage growth, per se, shouldn’t drive housing prices. What we might expect is that wage growth drives rents and rents drive housing prices.
The wage-rent relationship, however, is not an iron law.
Matt Yglesias and Ryan Avent are famous for pointing out that rents – and hence housing prices – could be much lower in coastal cities if residents would abandon restrictive zoning laws. For example, Dallas and Philadelphiahave roughly the same median household income, but home prices in Philly are much higher than in Dallas.
In general, if a fundamental driver – regulation, technology, preference – causes rents to eat up a higher portion of folks pay checks then rents and home prices will be higher.
To some extent the national rise in home prices is due to both technology and preferences driving more people to want to live in high rent areas like the Northeast Corridor.
Those same forces are leading some people to want to live in Houston, Austinand Raleigh-Durham, but because of looser regulation that simply translates into booming housing supply and a booming population rather than higher prices.
In addition, the relationship between rent and housing prices depends on interest rates – both the real portion and expected inflation. A house is like a utility company. Instead of providing power services, it provides shelter services and keeps you from having to pay rent.
Many finance folks are familiar with the rule-of-thumb that utilities tend to trade like bonds. Higher interest rates lead to lower bond and utility stock prices. Lower interest rates lead to higher bond and utility stock prices.
This is because – like a house – you are receiving a fixed stream of services over a long period of time.
Though this framing is kinda technical, most of these factors can be summed up in a really straightforward comparison: monthly rent vs. monthly mortgage payment for similar homes.
When the market is balanced the monthly mortgage payment should be slightly higher than the rental payment because 1) Mortgages get a tax break and 2) Traditional rate mortgages offer you the stability of a fixed payment.
Adjustable rate mortgages (ARM) need to produce a payment close to or even below rent to be a good buy. That’s because you lose the security of a fixed payment and depending on the terms of the ARM you may actually be facing more payment volatility than with renting.
Trulia crunches the numbers and it looks like under their baseline assumptions its cheaper to buy than to rent in every one of the top 100 metropolitan areas in the United States.
In traditional hotspots like the San Francisco Bay area, New York City and Orange County, CA, the discount is low. Still this is a recipe for fundamentals house price appreciation.
If housing prices merely stabilized into a sustainable equilibrium with rents then the future probably wouldn’t be too dramatic. We would see a rapid shoot-up in home prices now, followed by a long period of little to no price growth as the Fed raised interest rates.
Rents would still be going up and monthly mortgage payments would rise with them to maintain equilbrium. However, mortgages payments would be rising because interest rates were rising, not because home prices were rising.
Eventually, the Fed would stop raising rates and home prices would start to drift higher and eventually home price growth would converge to rent growth.
However, there is an ever increasing chance that this is not the future we are facing. Some time in the near future it is very likely that credit standards for homebuyers will fall. This will allow homebuyers to make larger offers and it will allow young people to buy a home even when they lack a down payment.
This rapid increase in the number of buyers and their purchasing power will likely drive home prices into a bubble. Likely not as large as 2005, but it’s not out of the question that the bubble could be even larger.
We might think – “didn’t lenders learn their lesson?” Or perhaps, “see this is what we get when we create moral hazard.”
Neither of these are correct. A perfectly competitive market in mortgage lending could not help but go into bubble. To the extent our lenders avoid it, it is because regulations and/or tacit collusion among major players, prevents the competitive equilibrium from being reached.
On the most abstract level this is because liquidity earns real rents, those rents are distilled by a perfectly competitive market and ultimately accrue to the owners of the irreproducible factors of production. In this case the owners of land located in the inner residential rings of cities. That is, for the most part, homeowners.
On a more tangible level, the lenders will be encouraged to loosen standards because if any lender loosens standards then he or she will gain market shareand increase asset volatility that makes all loans riskier.
If a lender tries to play it safe then she will still get screwed by the fact that any loan she makes will be to a buyer who is paying market price, which is bubble inflated. Yet, she will be doubly screwed by the fact that she is losing market share and thus not even making a lot of money on the upside of the bubble.
So she is pushed to lower standards as well.
This is amplified by the fact that the actual consequences she faces as a decision maker will be harsher the more atypical her choices are. If she goes with the flow she probably will not be punished when everything goes bad. If she refuses to go along with the flow then she will be punished for making low returns while everyone else is profiting from the bubble.
Given all of that it will be very hard for her to resist the pressure to lower standards. Hence, we should predict that a competitive market will see standards go down.
As standards go down, buyers rush in with more buying power and we enter a new bubble phase. To my knowledge neither the government, the lending industry nor we as a society have done anything that promises to prevent this.
by Karl Smith