Who Cares About Future House Prices?

James Kwak wonders about the housing market, and price-to-rent ratios:

The fact is that most people buying houses aren’t going to be renting them out, and what they care about is the price at which they will be able to sell that house in 10 years.

Has anybody ever quantified this? Let’s say that you have a choice between renting and buying. If you rent, you just pay $1,000 a month. Alternatively, you can buy a house for $200,000, with a $40,000 downpayment, and pay that same $1,000 a month to service your $160,000 mortgage. (Let’s keep things simple and ignore things like property taxes and mortgage-interest tax relief and maintenance costs and what have you.)

Which do you choose? That’s up to you, of course, and will probably be related to the amount of money you have, and your desire to spend or invest that $40,000 on something other than a house downpayment. But to what degree does the value of the house in ten years’ time affect your decision? After all, you may or may not have any desire to sell in ten years’ time. And even if you do sell, there’s a very good chance that you’ll just end up buying another house elsewhere, which will be similarly more expensive. In that sense buying a house isn’t an investment, so much as it’s a way of permanently covering your built-in short position when it comes to the shelter market.

Similarly, if you’re inclined to rent, the key number you’re worried about when it comes to the future is not house prices in ten years, but rather prevailing rents in ten years. Buying a house can be thought of as paying $40,000 up front to lock in that $1,000-a-month rent in perpetuity. You don’t particularly mind if house prices go up, so long as that’s a function of rising price-to-rent ratios, and not a function of rising rents with a constant price-to-rent ratio.

The point is that in a normal market, the only people who really care about the nominal value of their house in ten years are the people who are essentially timing the market: buying now, with the intention of cashing out in ten years, making lots of money in capital gains, and then going back to renting. That’s a tiny proportion of the housing market. Everybody else is just paying whatever they can reasonably afford.

In a bubble, of course, things change. Then you get a much larger number of speculators, and you also get an added advantage to rising house prices: the ability to refinance your mortgage on a regular basis, taking out cash each time. In general, when a very large number of people think of houses as an investment, that’s a good sign that you’re in a bubble. When most people think of houses just as somewhere you need to pay money to live, either in rent or in mortgage payments, then that’s a much more normal housing market.

Comments

[Cold Reality:]

At last, a reasonable article about the proper rationale for home purchase.

Jul 17 03:05 PM

[speeddaimon:]

Felix,

Really interesting look at the way someone could be looking at the buy-vs-rent decision. I think you may be over analyzing it though. For me, when I finally made the decision to buy a house, there were two factors. The first was that I was flushing my money down a toilet renting. I was never going to see that money again. The other was that I wanted a yard for my dogs. Simplistic, yes, but encompasses my entire motivation behind buying.

Jul 17 05:08 PM

[Alan Young:]

Once upon a time, people could plan 20-30 years ahead, and think of a house as something that would ultimately be owned free and clear, still be home after retirement, and bequeathed to heirs.

Renters cannot accomplish this, and have no security in old age.

But times have changed. Now, no one has security anyway.

Jul 17 06:04 PM

[Uncommon_Cents:]

Good article. "it’s a way of permanently covering your built-in short position when it comes to the shelter market", I like that.

Where I'm from, nobody thinks of stuff like this though. Renters rent because they don't have a downpayment, good credit or enough income.
The folks that buy houses simply have their stars aligned, and are thinking along the lines of speeddaimon's comment.

Jul 17 10:04 PM

[John Preston:]

Historical housing statistics suggest that values will go up in the future. The fundamentals of housing suggest the same: land values increase over time; material & lablor for construction seem to cost more over time; and rent, the shelter alternative, seems to go up over time....

Real data tells us so as well. In 2002, I helped a renter finance their first home purchase, for $119,000, with payment of around $1,000. Rents at that time were 25% less, or so, for comparable housing.

Today, that same home could be valued at around $150,000 to $160,000. Rents today are around $1,000 for comparable housing.

Thats a little over 3% annual gain. OFHEO/FHFA data suggests that 6%+/- is historical average....for housing price increases...and 4%+/- is the average for general inflation...

This suggests that, over time, rents and home prices, in this very small and statistically vague sampling, rise in similar fashion....

Jul 18 09:41 AM

[markg:]

Good points made. I wouldn't be so quick to discount the tax aspect. When the post tax payment in SoCal dropped below rental cost for the equivalent house I bought one. Apparently alot of other people in Californai have the same criteria.

For me it's at least a ten year deal, and over that ten years I am sure will do fine financially.

Jul 18 01:14 PM

[whidbey:]

Felix, you devil, you are attempting to make things simple and we all know that is contrary to policy and maybe the law to make too many things too clear. The man you were talking to is the speculator who wants to buy for appreciation, but must in the meanwhile carry his investment forward to its harvest date. That is the man of the hour, where is he just when we need him?? I say give we speculators a tax credit for every investment equal to the carry costs. I know, sounds like favoritism, but it is also good policy in times like there. Please obfuscate more openly.

Jul 18 09:27 PM

[mallarde:]

In some parts of L.A. prices might be approaching rents when you add in taxes, but there are lots of factors at work. I tried to simulate everything in Excel a couple years ago, and I might (or might not) have created a good model for adjusting various factors (appreciation, equity accumulation, rate of return on invested cash that would have been used for downpayment, etc.).

I think what I find today when I mess with it (and I did earlier tonight, strangely enough) is that to live where I live (on the beach in a posh area), I could NOT afford to buy but easily can afford to rent. But in a lesser neighborhood in L.A., it might be a closer call.

[Since this is an anonymous board, I am paying $3,100 to live in a small 2-bed (about 1,000 sq. ft.) on the beach (but not facing it directly) in one of the best neighborhoods in L.A. I think if the owners tried to sell they would get $900-950K for it, which I could not afford.]

There is still some air that must seep out of the ritzier markets in L.A., and as Felix observed when rents are much, much cheaper than the monthly cost of buying you know that the market is out of whack.

Jul 20 03:17 AM

[mn33:]

a

Jul 20 11:03 AM

[jimmy46:]

I bought in 2001, after refi, I'm now paying $471 a month interest for a 4 bed 3 bath very nice house.
and the interest won't go up with inflation,
I can finally have a dog,
I can paint any color I want,
I can have a beautiful garden and back yard that's like having my own private park, etc
Renting is crappy compared to owning.

Housing starts 3 years ago were 2.3 million/year
in may they were down to 460,000.

The surplus of house will melt away very quickly,
especially when it becomes obvious to the masses.

Jul 20 12:05 PM