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A Conceptual Starting Point for Housing Affordability and Public Policy

Summary:
The old saying goes: “all real estate is local.” This is as true as it ever was. However, one could say the same thing about, say, corporate investments: “all investment returns are local.” This could be just as true in theory. And at some point in history, it would have been true in practice. Before ETFs, passive mutual funds, and ultra-liquid stock markets, investing was about picking the right individual investments. Today, because all of those options exist, investment returns don’t have to be “local.” A prudent investor owns a diversified basket of corporate equities, and their investment portfolio is not local at all. Diversification is possible because of liquid markets for diversified securities. But a prerequisite for those markets is having a language. And a prerequisite for that

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The old saying goes: “all real estate is local.” This is as true as it ever was. However, one could say the same thing about, say, corporate investments: “all investment returns are local.” This could be just as true in theory. And at some point in history, it would have been true in practice.

Before ETFs, passive mutual funds, and ultra-liquid stock markets, investing was about picking the right individual investments. Today, because all of those options exist, investment returns don’t have to be “local.” A prudent investor owns a diversified basket of corporate equities, and their investment portfolio is not local at all.

Diversification is possible because of liquid markets for diversified securities. But a prerequisite for those markets is having a language. And a prerequisite for that language is having data. In order to functionally trade on a diversified basket of equities, one needs to be able to consider concepts such as the earnings projections for the S&P 500.

There are still firms and investors that are local: small business owners, cottage industries, venture capital, and so on. Yet because the data and the language for a diversified market exist, financial analysts talk about even those investors in the language of the diversified market. Financial terms of art— like  various “spreads” or “alpha”, for instance—describe returns according to how they differ from risk-free or diversified portfolios.

To an extent, “all real estate is local” is a statement about rhetoric and analytical conventions as much as it is a statement about any tangible property of the market.

Owner-occupied housing is the definition of an asset class that is “local.” In practical terms, the tools and language of diversified investing don’t apply. Homeowners can’t diversify, and they don’t necessarily need to know the rental values of their homes.

Yet, as new sources of data develop for real estate, new language becomes possible. If we are willing to use that new language, it can produce ways of understanding how housing markets work.

One way to move in that direction is to take the idea of rental value seriously. In today’s discourse, it is common to hear claims such as: since housing is an asset that depreciates and requires maintenance, it is an expense, not an investment. Or: “housing can’t both be a good investment and be affordable.”

Both of these statements come from a rhetorical neglect of rental value as a source of return for homeowners. Imagine saying that a factory is a bad investment because it depreciates and requires maintenance.  Imagine saying that stocks can either be cheap or a good investment, but not both.

This sort of discourse suffers from a dearth of market language. Real estate values come entirely from rental value, just as the value of corporate equities comes from profits. When so much of the discourse regarding real estate never grapples with rental values at all, it isn’t surprising that holders of the conventional wisdom about volatile housing markets easily turn to explanations that blame creditors, irrational buyers, or unqualified borrowers. Where else can we expect conventional wisdom to end up when we don’t even have the language to describe real estate markets based on fundamentals like rental value?

Putting rental value at the center of our understanding of housing markets can be transformative. This is especially true about the concept of housing affordability. Affordability is about rental value. If a unit is affordable for a household as tenants, it is likely to be affordable for that household as owners.

Financial instruments should be constructed with the goal of rent afforability in mind, rather than as instruments meant to create hurdles between tenancy and ownership. This is especially true given that homes in entry-level markets systematically sell at lower price/rent levels than higher priced homes do. Because of this tendency, homeownership can be especially valuable for households who most need affordable housing.

Understanding this value and the systematic returns that homes provide leads to a somewhat paradoxical conclusion that (1) homeownership is usually a good investment, and (2) the smaller the investment, the better. In other words, an owner-occupied home with a low rental value can be a great investment, but the downside is that it requires living in a home with a low rental value.

The various posts in this series have considered housing affordability with a focus on rent. This focus has led me to the following policy suggestions: we should (1) maintain relatively high property taxes, (2) reduce or eliminate income tax benefits of homeownership, including the non-taxability of the rental value of owned units, (3) eliminate urban supply constraints, (4) reduce regulatory barriers to mortgage lending, especially in low tier markets, and (5) encourage innovation in real estate markets that reduces transaction costs.

In the aftermath of the housing bubble, a fear of building and of lending led to severe shocks in both the homebuilding and mortgage lending markets. This has led to the loss of millions of jobs in the construction sector, the loss of trillions of dollars of home equity, the loss of millions of potential new homes, and the loss of hundreds of billions of dollars from tenants stuck in undersupplied and overpriced rental markets.

Preliminary to all the debates about the potential pros and cons of generous lending and building, there is one undeniable fact: new building and lending will lower rents. That fundamental fact has important implications for the housing bubble, the crisis, and the stagnant post-crisis housing market.

The dialogue about the crisis has lacked that foundation because we lacked the language for it. Introducing that language can meaningfully change our approach to housing markets.

In my attempt at this framework, introduced in the preceding posts, I have been led to question the central role that mortgage regulation has taken in our attempts to tame the housing market. It appears that a market with more generous lending, more access to ownership, and more access to housing in prosperous urban markets can create a more equitable and stable disposition of shelter. A thoughtful approach to the significant costs and subsidies created by property taxes and the income tax code can further provide stability and equity.

In all these questions, a prudent starting point is to ask “how does this affect rents?” and “are rents being paid in exchange for capital investments, public amenities, or monopoly power?” Rents and prices will have systematic relationships that give us clues about these fundamental questions if we look for them. 

Price should be a secondary consideration rather than the central concern. Where high prices are related to fundamental problems, they will likely be related to high rental values. Addressing high home prices must begin with addressing high rents, including the rental value of homes whose tenants happen to be the landlord.

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