I’ve spent a lot of time thinking about residential real estate and the general incoherence with which people go about buying and selling it. There are a number of things about residential real estate that make it different from other asset classes like equity or bonds or commodities. Each of these qualities has particular implications for the direction of the housing market.
(Residential real estate is much different than commercial or agricultural real estate. For the rest of this article, when I refer to “real estate” I am referring to owner-occupied residential real estate.)
Illusions and Delusions about Real Estate
First, let’s dispense with the notion that real estate is an investment in any real sense of the word. Very often people will refer to their house or apartment as their largest investment. What these people really mean is that they expect to be able to sell their house or apartment for more than they paid, and generate a positive return on investment. Investments are things that can generate a positive return on investment; therefore, real estate is an investment.
But this facile argument ignores many of the aspects of real estate which militate against it being considered an investment. First, most people use mortgages to finance their purchases. This increases the purchase price due to interest payments. Second, the insurance costs are often not negligible on property. Third, property taxes are a big chunk of change. Fourth, maintenance and utilities are an ongoing, and often expensive, cost. A true calculation of one’s return on investment has to take all these not-insignificant costs into consideration. A proper accounting of one’s return on investment would be [ (Selling price) / (Purchase price + mortgage interest + insurance + property taxes + maintenance + utilities) ] – 1. In order to generate a positive return on your investment you have to assume that your selling price is greater than your purchase price plus all the ancillary costs.
Real Estate and Bad Tax Policy
The tax-deductibility of mortgage interest puts upward pressure on housing prices, as it creates an incentive for people to take on larger mortgages than they otherwise could afford. Brokers often tout this as “saving money”: the interest on a mortgage is tax deductible, so you are saving money by borrowing money. But this isn’t really true: the money that you are not paying in taxes is being paid in the form of interest, which, as we saw in the previous paragraph, increases your costs, often substantially.
Additionally, the tax-deductibility of mortgage interest is morally troubling because it means that all those people who choose not to own, or who cannot afford to own, property, are subsidizing those who choose to do so, or who can. In other words, the tax-deductibility of mortgage interest is a subsidy paid to the relatively well off people who own houses and apartments. Our tax laws ought not provide subsidies to people who do not need them.
An argument in favor of the tax-deductibility of mortgage interest is that corporations get to deduct their interest payments on debt. But this isn’t really a comparable situation: corporations that raise debt often do so because they are looking to expand their operations, and debt is a cheaper source of capital, generally speaking, than equity. Expanded operations provide jobs. Creating more homeowners does not create jobs, or really serve any useful economic function in the way that companies which raise more capital do.
(It is true, however, that leveraged buyouts abuse the tax-deductibility of companies’ interest payments, and often generate no real economic benefit.)
Real Estate and Interest Rates
Mortgages are really bonds that the issuer (the homeowner) issues, collateralized by the house. Therefore, banks which loan money in the form of a mortgage are taking on a fixed-income investment. Fixed-income investments, and the asset underlying them (in this case, real property) are inversely related to the yield curve. As interest rates increase, bond prices decrease, and as interest rates decrease, bond prices increase. What this implies, of course, is that when capital is cheap, house prices soar, and when capital is expensive (i.e., there is a bout of inflation), house prices crater. (While it is true that commercial and agricultural real estate are good hedges against inflation, it is not true of residential real estate.)
How many people buying residential real estate understand the relationship between house prices and the yield curve? How many people buying residential real estate understand what the yield curve is?
Ah, but you may be saying to yourself: “Well, I have a fixed-rate mortgage, so I don’t have to worry about the yield curve!” Well, this is true, at least for now. A fixed-rate mortgage benefits the issuer (the homeowner) and so is more expensive (it charges a higher rate) in order to compensate the lender (the bank to whom you pay your mortgage payment every month). In other words, the benefit of the fixed-rate mortgage has a cost to the borrower in the form of a higher interest rate.
Now, what if interest rates increase? The fixed-rate payer ends up getting a better deal than the variable rate payer because his monthly interest payments are less for the same mortgage balance than the guy whose variable rate mortgage is suffering under the weight of higher interest rates. But, if interest rates stay at historic lows, then the fixed-rate payer is screwed, and he is paying more in interest than his less creditworthy fellow homeowner with the variable rate mortgage.
Finally, if the fixed-rate mortgagee wants to refinance his debt at any point in the future, and interest rates are higher, he may find himself paying even more in interest payments than he does currently.
All of this suggests that the relationship between real estate and interest rates is very complex. Should the government really encourage uneducated and financially illiterate borrowers to be subject to the caprices of the yield curve? Prudence suggests not.
What I have tried to do in this rather long blog post is indicate some of the complexities and distortions inherent in real estate. Real estate is no sure thing, it is subject to the caprices of both government intervention and the yield curve, and most people who buy houses and apartments are not sufficiently educated to parse all of these issues.