Friday, June 15, 2012

The (Somewhat) Hidden Costs of Home Ownership

-- Posted by Neil H. Buchanan

As regular readers of Dorf on Law know, I have been doing quite a bit of thinking over the last few years about the owning-versus-renting question, in terms of personal residences. (Actually, that question is equally applicable to vacation homes, automobiles, and so on, where the details are different in each case. My strong -- though rebuttable -- presumption in every case is NOT to own.) Having reluctantly come around to an odd sort of pro-ownership position -- both as a policy matter (where I have recently concluded, in essence, that we as a society should encourage home ownership for all or for none, and it is impossible to see how to eliminate the many encouragements to own), and as a personal matter (having bought a house of my own in April) -- this seems like a good time to think about what we must do to make meaningful apples-to-apples comparisons between owning and renting primary residences. One can think in the abstract about these issues, but after living the reality again even for only a month or so, I am here to report that the world can look quite different from this side of the divide.

In response to my post announcing my purchase of a house, a former student wrote in a comment: "Best of luck with the new home. I will appreciate any updates to your analysis of 'cheapness' once you have to account for rapidly growing lawns and towering leaf piles as an owner rather than renter!" That comment was in response to my claim that the net-of-everything cost of a rather spacious house in a Maryland suburb of DC was, much to my surprise, significantly less than the cost of a nice 2-bedroom apartment in (a much less nice part of) the same town.
Indeed, this question goes far beyond the issue of lawn care.

When I sold my last house (in South Orange NJ) to move into an apartment in Manhattan, I marveled at the extreme economies of scale that were available in a high-density living arrangement. Nobody had to shovel sidewalks in winter (back when the Northeast had winters), saving themselves not only time and effort, but trips to emergency rooms (to treat the inevitable victims of over-exertion) and sometimes even morgues (for those who could not be brought back). Although my phrasing here is admittedly flippant, my point is serious. Individualized work effort has many upsides (exercise, personal fulfillment, and so on), but it also has hidden and unappreciated costs. Division of labor puts the people who are most willing to shovel snow -- and who are, therefore, more likely to be properly equipped, both physically and in terms of machinery -- in the business of shoveling snow, and everyone else out of that business.

This might seem like an unfair comparison. After all, the difference between South Orange and Manhattan is not just that people generally own in the former but rent in the latter. The bigger difference is that Manhattan has no yards, no private sidewalks, and virtually none of the items that people would need to care for personally. Maintenance of the common areas is understandably farmed out, via management companies, and so on.

That does not, however, solve the deeper question. As I have argued many times, there would be nothing (as a logical matter) stopping a management company from owning all the houses in South Orange, renting those houses to families, and then providing maintenance services as part of a rental agreement. This would take advantage of the division of labor that economists have loved at least since Adam Smith, thus reducing the time and effort necessary for any individual homeowner to mow her own lawn, shovel her driveway, and all of the other things that homeowners now routinely take on as a matter of course.

What one cannot truly appreciate until one spends a few weeks in the midst of the reality of home ownership, I think, is just how much of the economy of scale involves a reduction in transactions costs. Without a management company to do it for them, homeowners individually have to figure out how to find the best alternative to expending their own time and effort. This means finding individual contractors, calling them, having them come to the house, haggling over prices, hoping they come to do the work when promised, hoping they do the work well, and paying them. (And later, perhaps, suing them.)

This is bad enough, even for the regular maintenance issues that homeowners face, like lawn care and house cleaning. The internet is helping, too, with the emergence of sites like Angie's List (the existence of which amounts to a group primal scream: "How the hell are we supposed to know whom to hire?!"). Even so, if a person (like me) were attempting to construct an apples-to-apples comparison of owning versus renting, would that person actually remember to include these regular maintenance costs on the owning side of the ledger? (I did, of course. Occupational habit.) And of those who did remember, how many would adjust for the search and other transactions costs described above? And how would one even put a number on them? (I did not even think of this in advance, and I still cannot figure out how to do so.)

Now consider the less-than-regular costs of home ownership, which is an entirely different set of issues that renters never have to consider. First, there are the upfront costs involved in the purchase of the home. How does one distribute closing costs over the period of home ownership, when one is unsure how long that period will be? Then, there are the big, occasional maintenance items. The roof of every house has to be replaced on a periodic basis, as do furnaces, sidewalks and driveways, windows, some pipes, and so on. Some repairs will occasion decisions to improve the home, but it will be unclear how much of the money spent will show up in the resale price of the house. (The maintenance-versus-improvement divide is a knotty issue in tax law, too.)

Readers who own their homes are surely smiling wanly at this point. I am hardly describing something new (to them, or to me, given that I owned five homes before buying my current place). That, however, is the point. We limp along in a bizarre world where people spend untold amounts of time dealing with window salesmen, cleaning services, real estate agents, lawn services, roofers, pavers, handymen, and every other kind of individual contractor. Cocktail party conversations and sitcom plots are rife with horror stories of contractors who make homeowners' lives miserable. By contrast, renters benefit from a system in which they do not have to worry about how old the roof might be; nor do they have to shop for a plumber if the pipes burst.

That is not to say that rental management companies handle these things uniformly well. Far from it, of course. But that, too, is part of the point. The uncertainties on the renting side ("Will I have a super who actually responds when I have no hot water?") are nearly impossible to compare with the uncertainties on the owning side.

Finally, consider an issue that another commenter on my earlier post raised -- a point that has nothing at all to do with maintenance issues (even broadly construed). Because home loans are subject to amortization, the net cost of home ownership goes down over time. How can that be? Say that a person buys a house for $500,000, with a $400,000 mortgage. The monthly payment on a 30-year fixed-rate loan, at 4.5%, is just above $2000. In the first month of the first year of the loan, $1500 of that is interest, and the rest reduces the principal on the loan. Because of that reduction in principal, the fixed monthly payment gradually becomes more tilted toward principal, and less toward interest. The first month of the second year of the loan, the split is $1475 for interest, and the rest principal. In the first month of the fifth year, just under $1400 is for interest. In the tenth year, $1240. In the twentieth year, less than $800 is being paid toward interest, and the remaining $1200+ is increasing the equity in the house.

Because equity is equivalent to savings, it is not a cost of home ownership. Indeed, many people consider building equity to be the major benefit of buying a house. (Issues of financial diversification arise here, of course.) This means that the net cost of owning a home goes down over time. Adding to the uncertainties of how to spread the initial closing costs and infrequent (but predictably periodic) maintenance costs, therefore, is the reduction in interest cost as the time of ownership rises.

Obviously, this only scratches the surface of the issues that one could discuss, both general and specific, with regard to owning and renting. The point is that the confidence with which I (and many other economists) wave away concerns about "minor" issues like transactions costs is, especially in the housing context, truly baffling. As a personal matter, I continue to be amused by it all, managing to maintain my equanimity as I deal with yet another contractor who is supposed to be at my house at 10am tomorrow (but who knows, really?).

My bottom line is to say that my former student was right to wonder whether I was really taking everything into account, when I blithely said that the net-of-everything cost of buying was, in the specific circumstances that I faced, clearly in favor of owning. I still suspect that it was, but even as someone with so much hard-won experience, I now see that it was surprisingly easy to ignore many of the hidden non-joys of home ownership. Many are temporary, and many will become manageable with familiarity, but they are still costs on the side of owning. As a policy matter, if we are going to push even more people into home ownership, this is another set of issues that deserves serious study.


David Ricardo said...

I am somewhat at a loss to understand what I believe to be the policy position of your position, namely that personal homeownership vs renting is the best policy for everyone or is not the best policy for everyone. Obviously the situation is that renting is the best policy all the time for one group of people, owning is the best policy all the time for another group of people and there is a third group where owning vs renting is dependent upon their circumstances at a particular point in time, and market circumstances at a particular point in time.

For example, if the housing market is characterized by relatively high liquidity (houses can be sold in relatively short times) and by prices rising faster than inflation (but not so fast to create a ‘bubble’) then this tends to favor ownership over renting for those people who can go either way. If the market is similar to the current one with falling prices and less liquidity then those conditions favor renting.

All individuals are not alike. What you consider an expensive chore, i.e. maintenance, other people consider an entertaining activity. (You are obviously a city person.) And many people want to customize their living conditions and that is not possible with renting. Furthermore in addition to the point that you make about the cost of ownership falling when one has a 30 year fixed payment mortgage, we need to also recognize that home ownership is a form of forced savings.

From a policy point of view it seems what is needed is substantial financial education so that people can make the best decision for their particular situation. To try to develop a determination that homeownership is for everyone or for no one seems to miss the point.

Neil H. Buchanan said...

I appreciate TDPE's points, which he makes well. It is certainly true that people should be better educated about all financial matters, especially housing issues.

I mean something different, however, when I talk about my "policy position." The big policy question that I have been wrestling with for the last few years is whether the current pro-ownership policies should be eliminated. The problem is that the current policies are -- at least in effect, if not intent -- a mechanism by which public money is shoveled toward home ownership, favoring relatively privileged groups within society.

So, when I say "for all or for none," I don't mean that everyone should buy a home, no matter their circumstances (risk preferences, attitudes toward personal toil, etc.). I'm saying that we should either remove all pro-ownership policies (making them available to no one) or expand all pro-ownership policies so that everyone who wants them is able to take advantage of them (taking into account the realities of race, gender, etc.).

Finally, as to the point that it is impossible to customize living conditions while renting, that is currently true, but it need not be true. One could easily imagine a world in which renters and landlords routinely negotiated such things, yet in our world, even simple agreements to paint an apartment are rare and (according to friends who have done it) difficult. As a policy matter, we could pass laws designed to make it easier for renters to treat their apartments like homes -- that is, to discourage landlords from taking hard-line positions against modifications, and instead to negotiate over such things.

But that is a relatively minor part of the bigger picture. I'm not trying to put everyone into an owner-occupied house. I'm saying that, as long as we're committed to pro-ownership policies (and we clearly are), it is important to make sure that the policies that favor ownership are fair to all.

David Ricardo said...

Okay, that clarifies the issue and narrows the discussion to one of regardless of whether or not home ownership is desirable from a macro socio/economic point, should public policy encourage, discourage or be neutral (if possible, pure policy neutrality is much more difficult than people think) with respect to homeownership.

Just because an activity is beneficial or harmful does not mean public policy must become involved. For example, everyone would agree that consumption of large amounts of heavily sugared soft drinks is detrimental to health, but this may not mean a city should ban the sale of such drinks. With respect to home ownership it seems what must be determined first of all is whether or not it is beneficial for the macro economy and then secondly should public policy favor and support and subsidize home ownership.

It seems from the macro-economic view that home ownership is a benefit to a nation such as the United States. Certainly the economic progress from 1945 to 2007, fueled in some part by private housing supports that view. The large movement towards home ownership, fueled by the VA loans and by government agencies such as FHA, Fannie Mae etc. was beneficial to the post WWII economy.

Unfortunately determining whether home ownership is desirable at the macro-societal level is largely qualitative analysis. Many of the benefits of homeownership are in part impossible to quantify (neighborhood stability, quality of life etc) as are the costs (reduced labor mobility, increased risk from mortgage debt, etc.). But it just seems that as a general rule, having a large proportion of owner occupied housing is better for the United States than a large proportion of rental housing. But this does not mean that public policy should support such a goal.

Major public policy provisions that favor home ownership are in the tax code, deductibility for mortgage interest and property taxes for home owners. These provisions do favor higher income families. Low income families either do not own or do not have large enough deductions to qualify for itemized deductions or do not benefit at the margin. (The benefit of itemizing comes only from the amount of deductions in excess of the standard deduction, not from the full amount of itemized deductions. If the standard deduction is $12,000 and a person has itemized deductions of $14,000, the marginal benefit of itemizing is only an additional $2,000 deduction)

But does mortgage interest and property tax deduction really favor home ownership over renting? One could argue that eliminating these deductions is not neutral and favors renting, because these deductions are allowed for the owner’s of rental housing through a different part of the tax code (they are a business expense) and presumably at least some of that benefit is passed through to renters in the form of lower rents. Maybe allowing the deduction of mortgage interest and property taxes just makes the playing field more level between owning and renting?

One could argue that better policy could be that the deduction of mortgage interest and property taxes for individuals should be replaced with a “housing cost” deduction available to everyone, say something like a deduction for total annual rent payments or total annual mortgage payments up to a maximum, with a minimum deduction for people who own but do not have a mortgage. That might be a more neutral policy and more “fair”.

In the end though the question of whether or not a society is better off with home ownership rather than rentals, and whether or not public policy should support home ownership, and if so, how is going to be a far more subjective rather than objective analysis. And that is why it is such a difficult question at the macro level and why thoughtful people like Mr. Buchanan and the rest of us (who are probably not as thoughtful) have to wrestle with it.

egarber said...

Has anybody ever carried out an earnest "rent and invest the difference" exercise in this area?

As an analogy, I always buy term life insurance, because whole policies -- which carry a much higher premium -- just don't seem to return much on the investment side. By going term, I can (at least theoretically) invest the premium difference in say, a Roth IRA, which is a pure play on (tax free) growth.

I'm pretty sure that my choice in this area is the right call. But is it also true in the rent vs buy home context? Many say it is, but I'm not so sure. For example, it's taken as a given that rent is generally cheaper than a mortgage payment for similar property -- and the boatload of mortgage leverage would be better applied elsewhere (home properties don't appreciate enough to make it worthwhile). How valid is all that, as an empirical matter?

And of course, trying to smooth out the totality of costs into an apples-to-apples picture creates all sorts of headaches.

You've probably covered this before, but I'll ask anyway.

As for yardwork, I'll keep doing my own for now. :)

Doug said...

"Because equity is equivalent to savings, it is not a cost of home ownership. Indeed, many people consider building equity to be the major benefit of buying a house. (Issues of financial diversification arise here, of course.) This means that the net cost of owning a home goes down over time" (boldface added)

When you build equity (savings) you expect a return on that savings. In the case of housing it is implied rent. The net cash outlay goes down (assuming rates stay the same) but the cost of owning does not necessarily go down.

Cost, of course, is what you give up. You are giving up the best alternative to the investment in a house. If you invested the money you would have a return of something -- it is the difference between the return on the next best alternative plus carrying costs (all on a risk adjusted basis) which is the cost. It could very well be that housing does poorly and the alternate investment does well meaning the cost of home ownership rises over time. Think of renting and investing in a blue chip pharma company over the past thirty years versus buying a place in a Detroit suburb. What you gave up to get the house rises over time (even once you pay off the mortgage and own the house outright it could very well be that the stock portfolio would be worth far more than the house and the dividend stream far more than the implied rent).

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