Tuesday, March 10, 2015

Getting the Rules Right For Housing, to Fight Inequality

-- by Neil H. Buchanan

In 2011 and 2012, I wrote a series of posts arguing that the housing crisis should cause us to rethink this country's longstanding policy preference in favor of home ownership.  The titles of some of the posts should offer a sense of the arguments, e.g., "Why Have a Bad Landlord When You Can Owe Money to a Worse Bank?" and "The (Somewhat) Hidden Costs of Home Ownership." The idea was that it would be both good public policy and good business for fewer people to own homes, and instead for people to rent the home of their choice from a real estate management company.

The most important policy argument supporting my position is that housing is a terrible financial investment, in two ways.  First, housing has a surprisingly low rate of return, compared even to plain-vanilla investments like savings accounts at banks.  There are many studies that have demonstrated this phenomenon, but one analysis is especially interesting, looking at 100 years of housing prices in the U.S. and finding that the average annual inflation-adjusted return on housing is 0.1%.  As the author of that analysis correctly points out, "This doesn't necessarily mean that residential real estate is a lousy investment; it is, after all, keeping up with inflation."  However, so do a lot of investments.  In any case, if the average family thinks that housing is a such a great investment, they need to know that no one ever got rich reaping returns of less than 1% per year.

The second reason that housing is a terrible financial investment is that prices are so volatile.  No responsible financial advisor would ever tell someone to put all of their money into one asset, much less a volatile one, because if a person has to sell at a bad point in the market, they could lose a huge amount of their net worth.  No one would advocate such a strategy, that is, unless the volatile, expensive asset was called a "house," in which case suddenly everyone is on board with a financial strategy that ruined millions of families in the 2008-09 bust.

But what is the alternative?  People imagine that, if they want to rent, then they have to live in apartment buildings, whereas if the prefer to live in single-family homes, they will have to buy such a home.  There is, however, no logical reason why that has to be true.  Which is where the "good business" part of the equation comes in.  In my earlier writings, I surmised that what makes owning rental apartment buildings profitable for private companies should translate into a market in which real estate management firms rent out single-family homes.  Although there are surely some cost advantages to managing attached units (reduced maintenance costs for common areas, and so on), none of those advantages is so large or unique that a profit-seeking company could not find a way to price house rentals sensibly.

One might have thought that these were simply the musings of an ivory tower academic.  After all, everyone knows that people prefer to buy, and anyway, even people who want to rent cannot find rental houses on the market, so this is all hypothetical.

Except that it isn't.  It turns out that there has been an explosion in investor activity over the past few years in buying up distressed houses.  Some of these investors, of course, were simply hoping to buy low and sell high, at most willing to hold onto the properties for a short time in the hope that prices will rise.  Others, however, have been doing exactly what I surmised they would do: Accumulating dozens, hundreds, or thousands of houses, managing and maintaining them, and renting them out to people who want to rent their homes but also to live in a house with a yard.

There have been various news reports describing this phenomenon over the last few years.  A recent example is this New York Times article from last week, which described an emerging trend among private equity firms to provide financing for businesses that wish to set up shop as house renting companies.  Although most of the article is devoted to financial details that are of no interest here, it does note that "individual investors and small investment funds own[] 14.6 million single homes in the United States."

In a sense, therefore, this is a story about the triumph of the free market.  In response to the title of one of my 2011 posts, "If Renting Houses Were a Good Idea, Wouldn't It Already Be Happening?" the answer is that it actually is happening.  And it appears to be happening without much help from the government.  Go, Adam Smith, go!!

Moreover, although the article notes that there have been concerns about potential mismanagement of rental homes by companies that are ill-equipped to enter that line of business, the Times's reporter is sanguine about such problems: " 'We think of our tenants as our clients,' said Thibault Adrien, who four years ago raised $42 million from investors to buy hundreds of foreclosed homes to renovate and rent them out. 'If we provide them good service they will be happy and stay longer in our homes.' "

So what is there to worry about?  More families are being given the opportunity to invest their money in non-housing assets, while living in homes that are owned and managed by enlightened entrepreneurs who understand that you have to treat your customers well.  To which one can only respond: Just wait.  Adam Smith knew as well as anyone that his Invisible Hand will start strangling people if the government does not have adequate rules governing economic transactions.

It is very nice that one housing executive knows how to put a good face on his business (and might actually mean it), but that hardly proves that rental housing will be scam-free, exploitation-free, and otherwise not needing rules of the road.  Many apartment buildings are well managed, too, but that does not change the fact that millions of people are stuck in substandard rental units, with unresponsive landlords and escalating rents.

Let us, however, set aside for a moment the likelihood that the emerging market for rental houses will soon require regulation to mitigate these inevitable problems.  Perhaps the biggest "rule of the road" issue that exists in this growing market is an antitrust concern.  As the Times article noted above describes, the growth of private equity investment in house rentals is in some sense necessary because the federal government's housing finance agencies (Fannie Mae and Freddie Mac) limit their loans in this market "to true mom-and-pop investors — ones who typically own just a few homes."

So what we have here is a classic question of optimal market concentration.  Surely, there is an argument that rental houses should not be owned exclusively by mom-and-pop shops, who might be poor managers and whose cash constraints might cause them to penny-pinch when they should be maintaining their properties.  This might well be a market in which economies of scale exist, and in which consumers could benefit from living in houses that are owned and managed by larger, professionally run firms.

The concern in every such situation, however, is that concentration creates its own momentum.  If the market become dominated by a few mega-firms, the rental market could turn into an anti-competitive nightmare.  Acting as if there is no reason to anticipate such problems and to prevent them from happening would be foolish.

As a related matter, a former student pointed out to me that there is an important aspect of this story that relates to the growth of inequality in the U.S. and abroad.  In a recent interview, the economist Joseph Stiglitz points out that much of the growth in inequality over the past few generations has been driven by monopolization in various markets, and he points out that monopolization of land in particular is problematic, because it allows monopolists to extract rents from an asset that does not contribute to economic growth.  This phenomenon directly allows them to become richer without any of the wealth "trickling down" to everyone else in the form of higher wages.

It is surely a good thing that many people who would have foolishly invested in houses are no longer doing so (even if their choice is forced by circumstances).  However, it is essential that the emergence of a large market for rental houses does not give rise to exploitative rental situations, and it is especially important that this market not become yet another contributor to the intensifying inequality in our society.

8 comments:

Michael C. Dorf said...

Very interesting post. I have three observations from my experience, having been a tenant in a large apartment building, a tenant in a detached house, an owner of a condo in a large apartment building, an owner of a single-family home, a landlord of a single-family home, a landlord of an apartment in a condo building, and a landlord of an apartment in a co-op building. (The landlord gigs were occasioned by delays between moving out and selling.)

First, it is absolutely true that landlording is not a good mom-and-pop business. I can say that having received terrible service from a very small-scale landlord and from having tried to provide good service as a small-scale landlord. Whether as a renter in a large building or an owner in one, I generally had good service from management companies that took good advantage of economies of scale.

Second, the housing market is very highly segregated, not only on invidious lines like race, but also between owners and renters. Many buildings and, w/r/t single-family homes have highly restrictive rules against renting. The ostensible purpose of such rules is connected to the values of the "ownership society." I.e., people who make a longer-term investment have greater incentive to maintain their property in good order, which benefits other property owners.

Third, putting together points 1 and 2, it will take a critical mass of renters of individual homes before the norms change sufficiently that owners generally come to see renters as acceptable neighbors. I suspect that the informal and formal rules currently in place play a pretty big role in slowing the growth of the emerging market identified in the post.

Greg said...

It's interesting that you speak of home ownership as a poor investment. I generally view it as more of a case of free money, when you take the alternatives into account.

The problem I see is that you have to look at the alternative. I paid about $300 more per month to rent a significantly smaller space than the house I have now. I figure I spend about that monthly on maintenance, when the large expenses are amortized over the length of time I have been in the house.

Thus, I break even on payments when I sell the house because the alternative (living in an apartment) would cost about the same. If I have any equity at all in the house, that is essentially free money when I eventually sell. If the house simply holds its value relative to inflation, I am getting a 20% return on my "rent payments" in the early years, and the return only gets larger from there.

egarber said...

It seems to me that for this to take off, the spread on monthly cost would have to widen and stay there - i.e., where "rent and invest the difference" would really resonate. It will be hard to jar us from current norms without such a shift.

I think it's also interesting to view the matter as a global economic dynamic. There is lots of concern right now that the strong dollar could hurt growth via shrinking export profits and cheap imports. But the other side is the foreign investment that effectively finances that gap.

In the 90's, the strong dollar attracted foreign investment in equities and real estate. If that happens again, and foreign investors buy up real estate, perhaps that could propel and mature the rental model.

Still, such investment would drive up home prices and presumably monthly rent. So it doesn't address my first point. Further, demand for the dollar will also keep interest rates low, as global investors pile money into treasuries. Those low rates will make mortgages (and ownership) more attractive.

So in the end, it may just be that economic forces will work in both directions, keeping us locked into the status quo.


Julia B said...

I am in search of a new house for myself at present with the help of Interest Rates Mortgage Loans and glad that the interest rates are at their historical low. I only partly look at my new home as at investment, I just really need the place to live in. On the other hand I do invest money in a house not simply in appartment I could move in.

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