Wednesday, March 09, 2005

Own or rent? 

One of the leaders and the front of the Finance and Economics section in this week's Economist suggests that there is a big bubble in housing prices and suggest it's wiser to rent. This is not just in the U.S. but worldwide. From the former article:
Homebuyers tend to underestimate their costs. Once maintenance costs, insurance and property taxes are added to mortgage payments, total annual outgoings now easily exceed the cost of renting an equivalent property, even after taking account of tax breaks. Ah, but capital gains will more than make up for that, it is popularly argued. Over the past seven years, average house prices in America have risen by 65%, those in Britain, Spain, Australia and Ireland have more than doubled. But it is unrealistic to expect such gains to continue. Making the (optimistic) assumption that house prices instead rise in line with inflation, and including buying and selling costs, then over a period of seven years�the average time American owners stay in one house�our calculations show that you would generally be better off renting .
Buttonwood blames the government-sponsored mortgage lenders Fannie Mae and Freddie Mac.

Though the pace is likely to slow a bit this year, people keep on buying, and borrowing to do so. There are all sorts of tempting mortgages on offer, including 110 LTVs (110% loan-to-value mortgages), which lend the full price of the house plus a bit extra for transaction costs. Turnover is frenetic: as one commentator puts it, �Day traders in shares have become day traders in real estate.�

Does all this amount to a bubble? Without a doubt. Alan Greenspan�s attempt to save capitalism from the burst dotcom bubble in 2000 (and the effects of terrorist attack in 2001), by cutting short-term interest rates from 6.5% in 2000 to 1% in 2003, produced a new bubble in the credit markets. One sign of that is the compression in bond yields, with riskier assets paying investors only slightly more than governments and blue chips. Another is the debt-fuelled explosion in property prices.

Yet people do keep buying. The National Association of Realtors reports that 36% of homes are bought as second homes for investment or vacationing in 2004. (H/T: Newmark's Door.) An article on the front page of the Wall Street Journal last week (subscribers link) indicates that many people are getting into the rental market still, mostly mom and pop landlords. " The National Association of Realtors estimates that 23% of home purchases last year involved investment properties." Discussing a private company that buys single-family dwellings to operate as rentals,
To choose its markets, Redbrick is turning to economic models. One of Mr. Lee's partners is William Wheaton, an economics professor at the Massachusetts Institute of Technology and former director of the MIT Center for Real Estate. Dr. Wheaton crunches numbers on local economies and housing markets. The firm also has studied the costs of being a landlord, including vacancies, bad debt and management time. Most "amateur" landlords, Mr. Lee says, fail to factor in all their costs and "just don't know what they're doing."

Could we have a housing bubble caused by low interest rates and an increase in homebuying by investors (rather than house consumers)? It seems so. People buying houses that are paying low rents now are speculating on higher house prices in the future. Investors may have a lower time preference for money; they may be more patient in waiting for prices to turn around than the family who buys a home, needs more room as their family expands, or alternatively leaves a larger home as the nest empties.

But more succinctly: If the Greenspan pin prick deflated financial asset prices in 2000-01 and pushed people out of those markets, where else would the money have flowed? Precious metals? Yes, somewhat. But there's simply not enough metal to absorb the size of the outflows. Investment has to flow to other assets.

Personal anecdote: the insurance firm that covers my house insists now that I have to buy more insurance since replacement costs have risen so much; the amount of rise since purchasing my home in 1996 is 72% if their number is to be believed. That's in the city of St. Cloud, not one of those Cities burb explosions.