Three Theses on Housing

The Northeastern housing market is weird in a lot of ways. By, “Northeastern” I mean, “anywhere that land value is most of the cost of housing”. So: New York, Boston, DC, California, Chicagoland, Cascadia, Connecticut, New Jersey, and increasingly Pittsburgh, Austin, and Miami. These are not normal markets. They are usually described as, “high cost of living”  Here are three weird facts about them:

1. These markets are all about speculation.
2. In such a market, prices will only somewhat be a function of supply and demand, but expansions in supply can cause extreme reductions in prices.
3. The, “cost of housing” is irrelevant to most people. The only effects, really, are on renters who have to be there for work and poorer people who like their communities.

These Markets are All About Speculation.

It’s no secret that many decisions made about housing treat housing as an investment good rather than a consumption good. Consider the empty-nest power-walker in her Lululemons complaining to her fellow empty-nest power-walker (in a northface) about the reduction in property values that will result from a third neighbor (who wears Free People) painting her entire house purple. The Lululemoner is not worried that she will be displeased by the purple house. She thinks that others will fear it, and thus be less willing to buy houses in the neighborhood. This will be a problem for the Lululemoner when she sells her house to move to Palm Beach.

So, needless to say, people who own houses really think of them as financial assets. The decisions these people make are investment driven. 

One thing this means is that, to a buyer, cost of housing in a neighborhood is immaterial. They were already going to sell the house at some point. Who cares whether they have to invest $800,000 now or only $250,000? When they retire, they’ll get it all back (plus interest!).

Now, there are two kinds of investment-driven decisions affecting the housing market:

1. Individual households deciding what houses to build and buy.
2. Communal decisions on what housing to allow in neighborhoods. 

Both of these exhibit investment-driven, or speculative, behavior. More importantly, both of them exhibit bubbly behavior. 

How can we tell what’s bubbly? It’s tricky, and the trouble is this: houses aren’t normal assets. People aren’t just trying to maximize the value of their house: they have to live there. So their interests are torn between two concerns. First, they want to enjoy living in their home. Second, they want to be able to sell their house at a high value when they turn about 67. So, some investment driven behavior is normal, and even desirable. If I owned a house and were totally uninterested in selling it, once I decided to move out, I would burn it down just for shits. Probably bad.

But I’m writing a blog post about investment driven behavior in home sales. So, presumably, I think something is wrong.

So, our question is not whether homeowners make investment driven decisions. They do. Our question is whether homeowners make investment driven decisions that we wish they would not.

You see, there are investment driven decisions and there are investment driven decisions. If the whole housing market were sane, then, even if people are making investment driven decisions, those decisions are directed toward future consumption. What does this mean?

Well, you might hate having a roof over the bathroom (it’s dark in there!), but you know other people like privacy so you demur from calling the handyman to bring over his jackhammer. Even though the roof isn’t improving your time with the house, you can reasonably expect that it will improve the time of the future owner, and they’ll pay more for that enjoyment. So the roof stays attached. Even though the roof isn’t enhancing present consumption, you keep it there because it will enhance future consumption.

But a weirder thing might happen. You might make a decision about your house not because you like it, and not because you think that other people like it, but because you think that other people think that other people like it. That’s a little abstract, so let’s give a concrete example. Imagine you want to make a good impression at a dinner party. So, you start talking about the weather. Now, you don’t like talking about the weather. Of course you don’t. No one likes that; it’s boring. But people think that other people like talking about the weather (otherwise, why would people talk about it all the time?). So, even though people at the party are not having a good time, they all think other people like talking about the weather. So they think you made a very tactful choice and you rise in their esteem (this is, like so many things, Keynes’ beauty contest).

So our question is this: is there anything in the housing market that no one likes, but people do it anyway because it’s “good for the property values”?

Maybe. We all hate McMansions, and it’s possible that they’re partially inspired by speculative motives. As America’s favorite architecture critic writes, “The inside of McMansions are designed in order to cram the most ‘features’ inside for the lowest costs”. McMansions look suspiciously well designed to appear sellable despite being generally less hospitable to human life than the empty lot on which they were built.

But, it’s hard to tell. Maybe people just love poorly installed granite countertops and large, empty bathrooms. What we would really need to tell what’s purely speculative is to see the behavior of people totally unconcerned with what they think will sell well in the future.

Luckily, there are just such people. There are people out there who do consume housing (everybody’s gotta live) and aren’t affected by investment incentives: renters. A renter (like me!) is just living where he wants to live. It doesn’t matter to a renter how the house will sell: he doesn’t have to sell it! So, renters can, more or less, show us how people would consume housing if they didn’t have to worry about investing. Is there any way that renters differ from homeowners in their behavior?

Well, the main thing is that they won’t pay to live in a fucking $5 million house. 

Let’s break that down. Rent is typically around 5% of of the value of real estate over a year. But, at the really high end of the market, rent is much, much lower. In a $5 million dollar house, 5% rent would be $250,000 a year. No one is going to to pay that.

Rent for a two bedroom on the upper east side is typically about $4,000 a month. That’s about $48,000 a year. But these apartments usually sell for about $1.5-2,000,000. That’s a return of around 3%. Given New York taxes, the risk of vacancy, and the trouble of keeping repairs and utilities, that is an unbelievably bad investment. 

But… if these condos are worth so much, why will no one pay much to live in them? Perhaps a rephrasing is in order. If no one will pay much to live in them, why are these condos worth so much?

First, there are some boring reasons. You get a tax incentive on the mortgage for the house you live in. So, it’s cheaper to own your own home than to rent the same home. But that incentive just isn’t enough to explain the huge difference in a house’s value to renters and its value to homeowners.

Also, owning a home is a slightly different experience from renting it, because you can remodel. That’s nice, it surely helps raise the value above what a renter would pay for it, but it’s unlikely to matter that much in a big, thick market like New York where you can more or less find what you want.

So that gets us to the third reason. People are willing to buy these apartments because other people will buy these apartments. The people who live in very expensive homes had the option to rent a similar apartment instead of buying the one they bought, then take the money they didn’t have to use to buy the house and put it in index funds. And, they didn’t do that. Instead they bought a house.

The index funds would typically pay a higher interest rate than the rent they avoided by buying the house they bought. So, it looks like they made a bad deal. But this means that their decision only makes sense if they expect the value of their house to rise. If the house is going to rise in value, homeowners don’t have to worry about the low return they’re getting on it right now. Later, they’ll sell it and make a killing.

The fancy northeastern housing market is a big bull run of real estate speculation. 

But what’s interesting about that?

First, it partially explains why everyone who owns real estate will fight you to the death if you try to build any housing. I speak of a creature that goes by many names, yet has but one spirit.

Some see it in the act of declaring a fucking gas station a historic landmark.

Some hear it in Minimum lot requirement that every household be 3,500 fucking square feet.

Still others sniff it out in laws that you can build a building large enough for four perfectly legal, medium-sized apartments, but only one family can live there.

The fact is, home owners will do literally anything possible to stop you from building new buildings or having any place to live. Obvious, the financial incentive to restrict plays a role.

Now, I should add a quick caveat. Owners in metropoli have another perfectly good reason to being nearly violent at the prospect of new construction: parking. Before I moved to the New York Metro, I didn’t understand why so many 40- and 50-somethings seemed to have no political priorities or emotional lives beyond finding a place to put their car.

Now I know.

But, beyond the horrors of trying to find a single spot within six blocks of the God-Damn Trader Joe’s, owners prevent construction because they want prices to be high. If I owned Apple stock, and I were on a community board that got to decide whether we let people print out Apple stock as long as they had the paper and ink, I would have a very easy decision to make.

This is basically what neighborhood review is.

But this leaves us with a curious result. For a moment, dream with me. Suppose we brushed this all away. Imagine that The Powers That Be strike down the zoning restrictions, and the neighborhood planning commissions, and suddenly, across all of America’s priciest neighborhoods, cranes spring up like flowers after a desert rain.

Prices would fall. But, contrary to what many YIMBY’s would tell you, it’s not supply and demand that would drive down the price.

What holds up the prices of elite housing isn’t demand; no one would pay $180,000 a year just to live in Palo Alto/Berkeley/Manhattan. It’s speculation, and construction’s effect is on making that speculation incoherent. You can’t raise an asset’s price if people can just make more of it, so the costs of housing tether to about the cost of construction, which is much lower than current housing costs in some places. We could be more like construction heavy Tokyo, where $1,000 a month is comfortably enough to pay for a two bedroom apartment in the right part of town.

But of course, that’s only a dream.