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Rent/Buy Ratio II

I think a lot of people responding to my first post on the falling rent/buy ratio were missing the point.

I take it to be true that the price of home purchasing is affected by things like the tax preference given to homeownership and fuzzy factors like "pride of ownership," etc., but none of this has changed dramatically over the past several years. The issue here is why the rent/buy ratio would be dropping. Now Brad Delong, a bona fide economist, says the rent/buy ratio is too crude a measurement because it doesn't take into account the impact of interest rates. I'm not a bona fide economist, but that seems wrong to me. My landlady derives income from renting this house. She could, however, derive income from selling it instead. If the sale value of the property rises, that should lead her to either sell the property, or else to increase the rent to keep her rental income proportional to the sale income she's forgoing by holding onto the property.

We recently resigned our lease, and our rent was not raised. Nevertheless, the sale value of the home has increaed over the past year, at least according to the real estate agent who just sold the (basically identical) house next door last week. In other words, the rent/buy ratio is declining. The only reason my landlady would want to not take advantage of the decline in the rent/buy ratio (i.e., the fact that demand for home purchasing in the neighborhood is increasing faster than the demand for home rentals) is that she anticipates the ratio will fall further in the future, thus making a 2004 sale a bad deal in light of the fact that she can continue to obtain rental income in the interim. This thinking on her part may be correct, but it's a fundamentally speculative rationale. In light of the fact that the rent/buy ratio is already falling, you don't really want to buy in this neighborhood unless you think that it will fall even further. But my landlady doesn't want to sell until she thinks the ratio has stopped falling. She's looking, in other words, to hold on to the house despite its failure to generate additional rental income (indeed, I suppose that in real terms her rental income is slightly declining) and then sell it to a sucker at some point in the future.

This may work out for her -- many people do, in fact, wind up making money by selling assets to suckers. At the same time, many people wind up losing money because it turns out that they're the sucker. And as Henry Blodgett points out, people systematically underestimate the likelihood that they, in fact, are the sucker -- instead believing themselves to be canny investors when, in fact, they just got lucky in the past. The dynamic, in other words, is one of a bubble market. Of property ownership driven by speculation rather than by changes in the fundamentals. Interest rates, though certainly relevant to general rise in housing costs, shouldn't effect the rent/buy ratio since when sale prices increase, property owners should either increase rents proportionately or else sell.

Now none of this should be in any way construed as financial advice to my landlady to the effect that she should raise my rent or kick me out of the house in order to sell the property. A University of California economist and former high-ranking Treasury Department official says that what you're doing may well make sense. And the New York Fed agrees! Don't listen to me and some shady folks from the San Francisco branch....

December 16, 2004 | Permalink

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» Sometimes what looks irrational at first is actually very rational to the principal from City Comforts Blog
A question is raised about why small real estate holders don't always do what apears to be in their self-interest. It's true; people who own real estate do not always appear to act like rational economic actors. [Read More]

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» Interest Rates and the Rent/Buy ratio from Deep Thoughts by Dan Ryan
Matt Yglesias and Brad DeLong have been engaged today in an interesting colloquy about housing prices, interest rates, and the falling rent/buy ratio (here, here and here). As Professor DeLong notes, as interest rates fall, the same mortgage payment su... [Read More]

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» How Many Greater Fools? from Silent E
My conclusion is that Matt's landlady is an idiot. As I noted before, GFT has an underlying faulty assumption - that there only needs to be one person out there more foolish than you. Wrong. Prices drop when sellers outnumber buyers . . . GFT thus ... [Read More]

Tracked on Dec 17, 2004 12:24:51 PM

Comments

off topic, but..

Am I missing something obvious?

I was wondering why Bill O'Reilly hasn't been run out of town? Usually when someone sets themselves up as a paragon of moral virtue while lashing out at an impulsive, morally bankrupt society, gets caught doing something totally immoral (which seems to happen quite often actually) don't they usually have to.....go away? at least for a while? Why hasn't he faced any backlash? He hasn't even caught any of that phony outrage backlash, it's like nothing even happened?

That one dude couldn't show his face on tv for like a year, just for playing the slots, why no punishment for O'Reilly?

Posted by: teemeup | Dec 16, 2004 12:48:25 AM

" people systematically underestimate the likelihood that they, in fact, are the sucker -- instead believing themselves to be canny investors when, in fact, they just got lucky in the past. The dynamic, in other words, is one of a bubble market."

This particular malady - disbelieving that there is in fact a masssive speculative bubble poised to burst in probably a matter of months - strikes me as especially widespread in America. I suppose I shouldn't be surprised, given that market capitalism rather Christianity is our real national religion, but nevertheless it is vaguely painful to watch so many otherwise smart people do such stupid things (like buying into this market for instance.) The combative defensiveness displayed by people in real estate, not to mention everyone else who has a stake in believing that its-really-different-this-time-and-the-boom-will-last-forever, is tiresome too, but whatever. The hour is getting late. They'll get theirs soon enough.

Posted by: Robert | Dec 16, 2004 12:53:51 AM

All I know is, if you can't spot the sucker during your first half hour at the table, then you're the sucker.

Posted by: JP | Dec 16, 2004 12:58:02 AM

One possibility may be that renting and buying aren't necessarily as tightly coupled from a landlord's perspective. One advantage of being a landlord is that you have a regular income for your rentals.

I also suspect, that the situation may also be a function of your location. D.C. has a very large population of transient professionals who are only going to be there until the next election. It might be interesting to take a look at similar "student-oriented" neighborhoods and see if they're similar.

Although, then again, there is a student slum phenomenon that might disprove all of my airy persiflage.

Posted by: Mike Collins | Dec 16, 2004 12:58:30 AM

I think what you're missing, Matt, is that the decision whether to sell or hold depends not only on the anticipated direction of the market, but also on alternative investment opportunities and transaction costs. If your landlady expects property values to level off or even fall somewhat, she still might choose to hold the house if she thinks she's getting a better return on her investment now than she would if she sold it and put the money somewhere else, or if she thinks the advantage of her other options are too small to be worth the trouble of selling the house.

Posted by: AF | Dec 16, 2004 1:06:01 AM

Matt, I think you're missing Professor DeLong's point about interest rates. Yes, the sale value of her property has gone up so she gets a bigger pile of cash when she sells. But... interest rates have gone down, so she gets less income from that bigger pile of cash than she used to (e.g. if she put in a CD or bonds she'd get a lower interest rate). So the income stream from her rental income and the income stream she'd get from selling may still be comparable (since the pile of cash and the property are, by assumption interchangeable).

Posted by: Ravi | Dec 16, 2004 1:26:43 AM

There's always the possibility that your landlord is incompetent or not paying attention. Economics always assumes a perfectly rational actor, but in real life the actor may be asleep at the wheel, or simply lazy in accepting a certain predictable income while not thinking about rising interest rates or whatever. So an anectodal example means very little, despite how interesting it is for those of us who read your blog.

I point that out since I'm a rational actor in my business field (where I'm paid to be) but in my personal life I'm lazy because it requires so much of my personal time and don't enjoy it, despite my best interests. (I also don't go the gym as much as I know I should, for example.)

Posted by: ScrewyRabbit | Dec 16, 2004 1:39:52 AM

In the interest of transparency, I think it behooves all those who doubt the validity of Matt's point to answer two questions:

1) Do you believe there is a housing bubble?

and if the answer is no

2) Do you have any personal stake in there not being a housing bubble?

Posted by: Cal Worthington | Dec 16, 2004 1:42:37 AM

I think a lot of people responding to my first post on the falling rent/buy ratio were missing the point.

Now Brad Delong, a bona fide economist, says the rent/buy ratio is too crude a measurement because it doesn't take into account the impact of interest rates. I'm not a bona fide economist, but that seems wrong to me.

You can argue about a lot of things, but here it is a bit pointless to doubt the Prof. You could ask for a decent explanation though. That's where most economists fail.

Posted by: not an economist either | Dec 16, 2004 1:47:45 AM

There also may be some tax reason to avoid recognizing the apprectiation in the rental unit.

Posted by: Sebastian Holsclaw | Dec 16, 2004 3:29:49 AM

"Now Brad Delong, a bona fide economist, says the rent/buy ratio is too crude a measurement because it doesn't take into account the impact of interest rates. I'm not a bona fide economist, but that seems wrong to me."

You may not be an economist, but we trust in your reading comprehension skills.

The key passage from Delong is this:

"But I do know that the ratio of 30-year mortgage payments to rents is much more likely to be a useful indicator than the raw ratio of house prices to rents."

That should be a parsable senetence, and it is quite correct.

Posted by: Petey | Dec 16, 2004 3:42:28 AM

Ravi is right that Delong is right.

When interest rates go down, a stable $1000 payment in either rent or mortgage is worth more to the landlady or bank.

When interest rates go down, and the value of the house goes up, the amount the landlady could get per month by getting cash for the house and buying a cd with that cash may stay about the same since the value and the interest rates are cancelling each other.

So falling interest rates should, in theory push rent down eventually.

But, in the meantime, the home mortgage market responds faster to interest rates than the rental market.

That means mortgage payments went down more quickly than rent payments. That means rational buyers saw and took/are taking advantage of a temporary bargain.

That is what caused a surge in ownership in the short and maybe medium terms.

As the rent market catches up, the buy/rent or mortgage payment/rent payment ratio will return to its regular equilibrium determined by the same things its always been determined by.

So there is a portion of high home prices that are directly related to the low interest rates. That portion is real and here to stay as long as the low interest rates stay. (ha!)

And there is a portion of high home prices that is the result of refugees from the slow-adjusting rent markets bidding against each other. That portion is pure bubble.

Posted by: Jeffrey_Boland | Dec 16, 2004 3:46:17 AM

Oh, and there is the fact that you can "lock in" an interest rate for 30 years which is very hard to do with rent. That means that if you guess we are at long-term low interest rates, (a very reasonable guess) there is an added incentive to buy now.

If everyone guesses that at the same time and bid against each other, they all lose the benefit in the form of bidded up high prices.

When people stop guessing that, they'll get out of the market and prices will go back down.

I'm not quite sure that counts as a bubble.

Posted by: Jeffrey_Boland | Dec 16, 2004 3:51:46 AM

It doesn't precisely, but I just read a paper about some nonspeculative bubbles that nonetheless pop -- so Prof. DeLong could be totally right about the opportunity cost of selling vs. continuing to rent and still not foresee a bubble pop.

Posted by: Kimmitt | Dec 16, 2004 4:47:54 AM

Some people commented (on your previous post) that they didn't expect house prices to fall precipitously, because the number of people selling houses is a fairly elastic variable. That is, people who want to trade up won't be able to when prices fall. This may be true, if prices aren't too overinflated. The housing bubble that burst in the NYC area in 1987 didn't involve a precipitous fall; house prices declined by maybe 15 percent over a couple of years, and then remained flat for around five more, before starting to rise again (and they are currently continuing to do so).

And at the really high end of the market, from where people don't trade up much, this elastisticity isn't there (and I have the impression that prices there really did fall quite a bit more, although I'm not completely sure since I didn't follow this part of the market closely).

And of course, 15% is a really significant fall when you have a mortgage for 80% of the house's buying price.

Posted by: Peter | Dec 16, 2004 4:56:15 AM

But I do know that the ratio of 30-year mortgage payments to rents is much more likely to be a useful indicator than the raw ratio of house prices to rents

Hmm. I disagree. We are talking about rental property here, right?

So, let's say that you have 200K to invest - maybe you got it by mortgaging your primary residence or maybe your uncle died and left it to you - but that's irrelevant. The best ROI (adjusted for the risk level and inflation) will determine the price you would be willing to pay for a property.

So, it depends on many things: rental income you can extract, stock market performance, interest rates (bonds and CDs you could buy instead), tax shelters and so on - the entirety of investment situation.

Posted by: abb1 | Dec 16, 2004 5:00:16 AM

First, I think the portion of mortgages which are adjustable-rate is now up to about 37%, which is interesting given the current direction of interest rates--it speaks to people trying to buy as much as they can afford (so they need the lower adjustable rates to qualify), which seems to me to be some evidence of speculation.

It is true that buying a house with a fixed-rate mortgage potentially locks in a large portion of your housing costs--this is good if you anticipate rising housing costs, whether those costs would be caused by higher prices or higher interest rates.

While the rise in prices is surely largely related to the fall in rates, I don't think anticipation of higher rates is a good reason to buy a house for most people.

First, you could be wrong.

Second, if rates do go up substantially, given that people are stretching to buy now, prices will probably adjust downward, and you will still be able to buy a house.

Third, the lock-in only lasts as long as you keep the house. Since most people don't seems want to stay in the same house for 30 years, for those people the lock-in is not as valuable as it might appear.

Posted by: matt wilbert | Dec 16, 2004 5:06:07 AM

"The best ROI (adjusted for the risk level and inflation) will determine the price you would be willing to pay for a property."

Of course. And since most people buy property using mortgages, interest rates determine the true price of the property.

Posted by: Petey | Dec 16, 2004 5:16:16 AM

Hmm, I am not sure. This would be the same as to say that the interest you're paying when buying stocks on margin determines the price of the stock. I don't think it does to any significant degree.

Again, I am talking about the rental property universe only. Mortgage rates certainly do affect the price you'll pay for your primary residence and this maybe what's driving up the prices of the RE as a whole. In this is the case the rent/price imbalance is indeed real.

Posted by: abb1 | Dec 16, 2004 6:02:00 AM

"This would be the same as to say that the interest you're paying when buying stocks on margin determines the price of the stock."

Most mortgages are far more leveraged than the SEC permits on equities. Over the life of an average mortgage, you spend more on interest than principle.

"Again, I am talking about the rental property universe only. Mortgage rates certainly do affect the price you'll pay for your primary residence..."

Huh? Why would rental properties any different?

Posted by: Petey | Dec 16, 2004 7:08:04 AM

Maybe your landlady likes being a landlady -- the way some restaurant owners like running restaurants -- mixing avocation with income.

Posted by: Jeffrey Davis | Dec 16, 2004 9:04:43 AM

If you could somehow mold your theory so as to endorse the landlady's fixing our waterheater, now that would be useful.

Posted by: Kriston Capps | Dec 16, 2004 9:06:49 AM

My answer? She's an astute woman and has thought through the issue and wonders, if she sold, "What would she do with the cash?"

Posted by: David Sucher | Dec 16, 2004 9:15:30 AM

I'm beginning to think that drawing any conclusion from this statistical indice makes about as much sense as guessing at the fertility rate by measuring women's waistbands. OF COURSE there is a bubble- when young people are driving around in $60,000 cars buying $600,000 houses, you know this is a bubble. SO WHAT? What did you think the "business cycle" or "normal market flutuations" was composed of?

For example- a lot more conventional homes will qualify for conventional financing now compared with 30 years ago. This has one effect on house prices. Most mobiles over 15 years old can't be financed at all. This has another effect. Etc etc. Quantitatively qualify your remarks and you'll have the material for a post-grad degree. Make a good guess, and have the balls to be financing one deal while you're filing bankruptcy on another, and you'll be rich.

Maybe Matthew is just in the agonizing throes of wondering whether he's missing a ride in a balloon, or staying safely on the ground. I know the feeling.

Posted by: serial catowner | Dec 16, 2004 9:24:42 AM

Third, the lock-in only lasts as long as you keep the house. Since most people don't seems want to stay in the same house for 30 years, for those people the lock-in is not as valuable as it might appear.

Very true. Which is why refinancing at a lower interest rate only makes sense if you're fairly certain you'll be in the house long enough to at least recoup the cost of a refi. (Other considerations, such as loan consolidation, aside.)

I think Brad DeLong's point though about the 30-year mortgage rate being key is spot on, because that's the number most home buyers use to determine how much home they can buy. Lower interest rates therefore make it possible to borrow more money, and pay more for a home. When rates rise, it will lower how much your home is worth to another buyer. If interest rates rise far enough, fast enough, something very much like a bubble would pop and home prices would drop.

Cars aren't immune from this either, and those buying $60K cars may be in for a shock when the amount they owe on the car is more than the car fetches on the market.

Posted by: David W. | Dec 16, 2004 9:49:40 AM

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