Kevin Erdmann on House Prices and Rents, 8/29
plus my thoughts
If you are interested in the U.S. housing market, then I strongly advise you to follow Erdmann’s substack. On the market’s current state, he writes
Homes have taken 6-7 months to construct for decades, until 2021. It currently stands at 9.7 months.
As he points out, this is symptomatic of supply bottlenecks. With fears of rising interest rates, you would think that if anything builders would be in a hurry to complete the homes that they have under construction.
In another post, Erdmann writes,
Rents are rising at the low end (because of systematic, persistent lack of housing production). That is driving prices up. And, remember, when rents are higher, price/rents rise. For each 1% increase in rents, you always see more than a 1% increase in prices. So, as low end rent affordability gets worse, low end price affordability is even worser
I think he is basically right to point to rising rents as an indicator that the supply of housing has not been keeping up with the population. But I want to delve into the sentence that I bolded in the quote above. I agree that this seems to be the pattern, but it is not obvious to me that it should necessarily happen that way.
Suppose you want to buy a housing unit as an investment. You calculate
Profit = (rent) plus (increase in price) minus (interest cost)
If you can get $12,000 a year in rent, and if the price goes up by $8000 in the year after you bought it, and if the interest cost is $15,000, then you have a $5000 profit after one year. Note that the interest cost is there regardless of whether you borrow the money to buy the housing unit. Instead of buying the housing unit, you could have bought an interest-bearing security, and foregoing the earnings on that security is an opportunity cost. Note that rent should be net of management expenses and other costs, such as taxes or HOA fees. Note that the price increase should be net of depreciation and maintenance.
Putting everything in percentage terms, we have
Expected profit as a percent of price = (rent as a percent of price) plus (expected rate of price appreciation) minus (the interest rate)
Note that the formula uses the expected rate of price appreciation, because we do not know in advance what the appreciation rate will be.
In a competitive market, the expected profit should be just enough to compensate for risk. Let us simplify and say that expected profit should be zero. In that case, we can move the rent/price ratio over the left side of the equation, giving
rent as a percent of price = interest rate minus expected rate of appreciation
As an example, suppose that we have a $100,000 house with $10,000 rent, so that the rent/price ratio is ten percent. Suppose that the interest rate is ten percent and the expected rate of appreciation is zero.
Now keep the interest rate the same but let rent be $10,100, or one percent higher. How can the price go up by, say, two percent, to $102,000? Now the rent/price ratio is lower, at 9.9 percent. So to get the equation to balance, expected appreciation has to be 0.1 percent. 9.9 = 10 - 0.1
My point is that you get prices going up faster than rents when market participants are relatively optimistic about home price appreciation. So if rising rents always raise the ratio of prices to rents (the same as lowering the rent/price ratio), then rising rents must always cause market participants to be more optimistic about price appreciation.
I do not see why this should automatically be the case. It strikes me as something that would happen if people hold extrapolative expectations. That is, people expect rents and prices to increase more where they have gone up recently.
Extrapolative expectations are not fully rational. I would expect such expectations to lead to local housing bubbles followed by periodic reversals (the reversals might not show up in nominal terms, but only in inflation-adjusted terms).
Considering it’s size and importance, the housing market seems very poorly understood. It sure seems like we have a supply problem, but on the flip-side we are currently at a record number of housing units per capita. We apparently had new household formation during Covid but didn’t we also lose a million people? There is already talk of homebuilders pulling back on production despite extraordinary margins, how is that possible?
I don’t think we know how many people own unoccupied 2nd/3rd/4th homes and that seems relevant. Strikes me that part of the problem is when homes have rising real values (after taxes & maintenance) there is no perceived cost to hoarding.
Or maybe if you print enough money it simply looks like there are supply shortages everywhere.
In terms of what to do, better zoning is obvious but clearly can’t happen. All the “next best” ideas are basic some version of “subsidize housing and hope it produces a supply response.” That logic seems terrible - imagine subsidizing SUVs in the hope it gets us to drill more oil!?
With money itself a commodity used as a store of value with a negative real interest rate the analysis becomes different. When the real interest rate (nominal interest - inflation -- including energy and food) is negative by over -7%, as it is now), if you can borrow in nominal dollars at any interest rate less than the inflation rate , it makes sense to borrow to the max and invest in any "real" asset from land to housing or even scrap aluminum. You will make a profit of 3% or more on other peoples money that you borrow. This assumes the FEDs will keep the inflation rate high.
This would really be a bet that the FEDS will repeat the '70s and be political pawns, while allowing the real interest rate to remain negative as inflation eat the store of value in money and gives it to big debtors like the government itself. As inflationary instability of the '70s forced people to protect themselves against this theft of value with COLA (cost of living adjustments) the inflation rates became a solid double digit amount with contracts tied to inflation indexes, the government effectively stole enough "value" to pay down a lot of debt from Vietnam and the Great Society spending blowouts.
In other smaller countries when the local government debases the currency to steal value from the citizens, the citizens can shift to using dollars. What will happen when the "reserve" currency for the world is debased?
If the FEDS don't raise the nominal interest rate faster than the inflation rate there is every reason to expect the system is unstable and inflation will go the way of the late '70s making the correction impossible and transferring wealth to owners of "real" assets of all kinds and big debt holders like Trump where everything is leveraged.
With housing being a store of value available to most citizens at high leverage, negative real interest rates will increase demand creating housing shortages as it is in the self-interest of the citizen to buy more highly leveraged property than they need or desire, especially with government backed and subsidies loans typical of housing.
Running the real interest rate to inflation + 2 to 3% (a nominal 11+%) would create housing demand decreases and downsizing would create effective supply increase. Of course the huge spending debt and fiscal irresponsibility of the government will become apparent.