Sep 20, 2022Liked by Arnold Kling

Great post. As I have been in this business for 20 years (albeit, in apartments, not houses), I definitely have some thoughts on this subject.

1. "The market clears when the rent is such that there is neither excess demand nor excess supply." Correct. That's Econ 101.

2. "The purchase price of a housing unit reflects rent-buy parity" I would say this is approximately correct, but not always. For many reasons, a business of buying homes for investment purposes is not always a great idea. Most people buy houses to live in them, not rent them. For various reasons (e.g., tax treatment, less wear-and-tear for owner/occupied houses, etc.), the economics of owner/occupied homes is not the same as homes owned for investment purposes. As an analogy, think of the differences between owning your car for your own use, versus renting it out. Renting your car out to 3rd parties is usually a bad idea, economically speaking.

3. "But I think that in most cases rent control is not binding at the margin." Probably not true. It is correct that many investors ignore rent control, but they do so at their peril. Rent control essentially turns an equity investment into an investment where the upside is capped. This dings your returns considerably.

4. "Properties that might otherwise be rented might be converted to condos if that is a way to evade rent control." Wrong. The clever folks who draft rent control ordinances have definitely thought of this. Almost all rent control ordinances have strict and very thorough restrictions on conversions.

5. "I think it’s mostly luck. If you buy right before something unexpected happens that makes your property more valuable, it’s easy to make money." Sort of. But prices of privately owned real estate tend to be "sticky." This presents an opportunity for long-term investors who are patient. There is a small group of investors of privately owned assets (real estate included) who focus on buying during periods of distress. This group almost always succeeds. Admittedly, this is a small group, but not tiny. Returns among members of this group is due more to skill than luck.

6. "the ratio of rent to price should differ primarily because of expectations of price appreciation." This sounds logical, but I have not found it to be the case. In my experience at least, most real estate investors don't forecast future rents very far into the future. As a result, they don't place much emphasis on price appreciation. Not exactly sure why this is the case. Use of leverage is probably part of the story.

As a side note, your emphasis on the "rent to price" ratio is not exactly correct. Most real estate investors value purchases based on a ratio of price to cash flow (unleveraged), not price to rent This may seem like a subtle distinction, but it is not. I once had a conversation with one of my buddies from MBA school, and he told me about his awesome plan to buy up houses in Fresno California, then rent them out. He cited the low "price to rent" ratios. This is a really smart finance guy, but with no in-the-trenches real estate experience. I described to him how operational expenses in Fresno will be about the same as in the San Francisco Bay Area, but rents will be about a third that number. Consequently, the operating margin (think EBITDA margin) will be WAY lower in Fresno. Thus, you want to look at the ratio of price / unlevered cash flow. Most real estate investors know this, and thus this is why the price/rent ratio is MUCH lower in Fresno than in say Palo Alto.

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The legal requirements for renting can change in ways that drive the prices of renting and buying apart. For example, my wife's folks live in Philly, and they have a house they used to rent out, but has been sitting empty for a couple years. The last tenants decided they didn't want to pay rent anymore, and it took a long time to get them out of the place, with no help from the law. Now, to make up for the uncertainty of actually getting paid rent they could increase the amount they charge, or they could sell the house and try to get the money now. The former increases average rents, the latter lowers average house prices, especially as every landlord in Philly saw similar incentives over the last few years.

I would also add that renting is not an equally valuable substitute for buying for some people, and that is going to tend to drive prices apart for them. I don't know how big a deal that is, and whether it is mostly a rural thing and not an urban thing, etc. I do note that your list does not include maintenance as a cost, however, which is a huge cost of ownership (or a merely large one if you do it yourself). Conversely, trying to get the landlord to do maintenance, much less improvements, you want done might be a huge cost too, but a different sort. Overall I am a bit skeptical of tying rental prices to ownership prices too tightly, but that might just be a function of growing up where renting isn't common.

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Good point about expectations of future price increases driving current housing prices (and demand). In one of his articles Kevin Erdmann cites data that in 2007-2012 rents did not fall, despite the collapse in house prices. One reason for this could be the difficulty in renters qualifying for loans. Another factor is that renters saw home prices dropping and chose not to buy fearing the asset would continue to depreciate.

I find Erdmann's argument that rent drives home prices unconvincing. Rents are an indicator of housing valuation. What changes how people value housing? Supply and Demand and all related Economic principles.

If rents are higher I would expect house prices to be higher. If rents are rising I expect house prices are also rising. But not if interest rates are also changing. Currently house prices are dropping and rents are not because higher mortgage rates are decreasing mortgage affordability.

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There is a fairly large difference between single family homes and multi family units. The average new single family home is about 2400 square feet while the average new multi family unit is just over 1000. Those look like very different markets.

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Cool, very relevant BBC video on Crabs Trade Up for Bigger Shells:


Lesson: building a Big House helps far more people than building a small affordable starter house. Tho this doesn’t say what’s the best use of $1,000,000 in new house construction.

Unless the living & sleeping use value of the house is separated from the investment value, I’ll be skeptical of the analysis. “The market clears when the rent is such that there is neither excess demand nor excess supply.” Defining equilibrium as market clearing, and market clearing as neither demand nor supply in excess, and calling that equilibrium … is circular, and the circularity doesn’t end by adding rent prices into the circle.

The price is going up, going down, or stable. For some period of time. That there is a relation between rent prices and house prices is inevitable, but it’s not clear that one always drives the other or, in different markets, rents might drive/ lead price changes and in other markets house prices might lead (the latter is my belief, tho Erdmann argues for rents as drivers.)

The macro question is whether the USA should be building more houses, and I agree with Erdmann that it should, and Arnold doesn’t address that Q. But I don’t follow Erdmann’s logic. Not even reading his post, nor even his good, old, blog.


Erdmann’s last post there in April was a well discussed disagreement with Kevin Drum. Drum claims there’s not really a housing crisis in a couple of posts:



This second post has even MORE good charts than Erdmann.

Drum notes: “since 2000 the number of persons per housing unit—has gone down.” Thus, the crowding we’d expect to see with a shortage is not there.

Erdmann has a great note in his old blog about how much work it would take a skeptic, like me, to go thru his logic. So I’ll stop.

I think about 90% of Americans would prefer to occupy a house they own/ are buying, and it’s only about 62% now. The USA should be building more houses until those two numbers converge. Marriage & its lack, kids, crime, job locations – all these details are important at the micro.

It should be easier for house builders to make money – it’s hard now for house flippers, but that’s not such a problem.

As interest rates increase, loan costs increase, so buyers' monthly payments can afford less loan - house prices will go down. Flippers will stop buying (as in 2006-2008), and many investors who were planning on renting will be selling at a loss. Builders will stop building.

I'm sure these lower house prices, first, will also drive down rents (contra Erdmann?).

And more folk who want to buy won't be able to. Many who could buy will choose not to -- it's a bit silly to buy an asset while its class is on its way down, tho none know where the real bottom is.

Counter-cyclical fiscal & regulatory policy to encourage more building of new houses would be the best way to reduce the problems of the recession/ reduced production & fewer jobs that higher interest rates are causing. Of course, those higher rates are needed to reduce the inflation already caused by bad prior fiscal & regulatory policies.

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