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The decision whether to rent or buy is, for most people, primarily whether they'd rather rent their housing, or rent the money for their housing. This isn't a purely financial question, of course, but it has a heavy financial component.
In NYC, due to the bubble, it has been dramatically cheaper to rent housing than to rent money for the last decade. The only way that buying rather than renting RE made financial sense was to assume that the bubble would grow forever.
Now, however, the price of money has dropped so low that details may be starting to matter.
One detail is this:
Low interest rates mean that professional investors -- rental landlords, speculators, banks, and developers -- discount future values less, which means they are willing to pay more for an asset (and its future rents) right now. The same rent projection today translates into a higher buy price than six months ago.
However, professionals are also aware that this process can reverse, and indeed, over time is likely to do so: the Fed will eventually decide that employment is high enough and raise interest rates, (especially if tax cuts and ever-rising military costs threaten an exploding deficit). Then, higher interest rates will mean that asset values will drop in the professional models.
Since asset values in the standard model depend on interest rates, and we are likely close to a cyclical low for interest rates, what interest rates should professionals be using?
Current ones do not seem to be good proxies for ones 20 years out. Or are they?
are you saying that interest rates have a direct effect on real estate prices? logically it make sense. but i don't believe this correlation is present if you look at historical numbers.
I am on board with that thinking... Its a combo of current rates and future expectation of rates. That is you can lock in future cost basis (of mortgage) but not full cost basis if you plan on holding forever (or 30 years+)... But if you might want to sell or mark to market based on current value then future rates have to be considered. I'd think its a tough thing to pin down which rate or blend of rates to use (Even if you know all future mtge rates / long term interest rate evolution)...
I've been thinking a blended price based on today's rates, and expected price based on expected rates 5, 10, and 15 years... not necessarily equally weighted... This is not an exact science. Would be interested in discussing or hearing other thoughts on this.
Why so sure rates will go up?
And if they do, isn't it likely that its because of a strengthening economy? A strengthening economy should mean greater demand for real estate and stronger incomes of the people who are renting and buying. Real estate is not a fixed income investment.
Fg's fifth paragraph ends with a very poor assumption: "the same rent projection". In an economy with higher rates because the Fed is more comfortable with growth and productivity,- rents, ability to pay and demand (both quantity and quality) should all be higher. Rather novice for a finance guy. Unless its deliberately misleading.
Well, I don't think many folks believe interest rates will longer term stay this low. Its only an argument of how long it will stay this long before going up, and when it goes up, how fast and how high. Let me know if you hear other opinions and where.
As for demand as an impact on prices, yes that is one way to look at things. As economy strengths, so does demand. If this was a pure investment play then demand may alone be the key determiner of price. And definitely in any window of time, demand alone can really move the real estate market (both in times good and bad times).
As for where is the long term fair value (fundamental pricing), I would look at housing from 2 different but converging angles:
2) Home owner
From both cases, I think a key component is how much a person can afford. This could be consider a % of income and that there may be a % people are comfortable paying to housing that can be used as a long term average. If cost of renting or owning a home is above this, the general expected trend would be up, and vice versa... As economy strengthens or weakens (jobs lost, income decreases, or jobs gained, income increases) can push housing prices up or down accordingly.
I think from income side, both 1 and 2 are similar. From cost side is where 1 and 2 differ. In case of Investor, you can have short term and long term (forever) investors/landlords. If they are longer term buying opportunistically in times of weak prices but hold forever, they only thing that matters on cost side is current interest rates and projected other costs...
If you are a home owner, you have to consider that you might sell (because you want to upgrade or have to due to relocation for work, or any other reason). Then question is what is the price of the house (and interest rates) when you might want to sell... For example, if I buy a smallish 2BR apartment, I may say that 40% chance I will move in 5 yrs, 30% chance I will move in 10 years, 30% chance I will move in 20 years. I can put those assumptions into a model and back out expected net present value and annualize the net cost (actually monthly terms).
I do see real estate mostly as a fixed income investment. Landlords/REITS see it as monthly revenue vs expenses (interest, operating)... Homeowners see it as a mostly stable monthly expense (mortgage interest minus tax savings, common charges/real estate taxes or maintenance, utilities, etc). That all said, I also agree that NYC breaks away from this a little bit. Foreign investors essentially makes nyc apartments more of commodity. (Interest therefore prices being pressured by FX rates, and global economic forces). Since these investors dont touch many coops and only a portion of all apartment sales/ownership in nyc ... I would say nyc apartments behaves as a hybrid of global/political commodity and fixed income asset.
What is your basis for assumingan increase on rates?
There's what people should do, what they actually do.
They rent when they fear next month's pay check
They buy if they think the property will appreciate
They don't buy based on the purchase price, but on the monthly payment that it becomes after a mortgage.
One can run all the rent vs buy calculators but in the end much of the buying vs renting occurs based on the above.
One corollary to the above is they sell when they fear prices are headed down
"They buy if they think the property will appreciate"
We bought because we found a home we loved and planned on living there for a long time. Appreciation never even came into the picture. We just don't care!
"One can run all the rent vs buy calculators but in the end much of the buying vs renting occurs based on the above."
In my experience, I would change that phrase to.....one can run all the rent vs buy calculators, but in the end, much of the buying vs renting occurs based on how much one wants to enjoy living in the home.
I wish people would realize that their "investment" is *actually* a roof over their heads, in an environment that is conducive to enjoying their lives.
I hear you, Lucy, I think that's great and a great bonus.. and true at the margin but in my experience saying you love the home often justification for ignoring a more economic factor.
I agree much of home ownership is about having a roof over your head. Which is why looking at total monthly cost of ownership relative to income makes sense. And doing so means as economy (therefore incomes) change, so do property value. And as interest rates change (therefore interest portion of mortgage payments) also so does property value.
You can look at 10yr interest rates over a long period of time and see that it goes up and down. Interest rates wont go to zero (other than very short period of time during market dislocation) because you can always just put the money in a mattress (why would you lend it to someone and possible lose it for no interest). Interest rates are artificially slow due to "easing" by the central banks. Once this stops interest rates will rise. Also if they undue all that buying of bonds, that will also put additional upward pressure on interest rates. Not to mention if inflation expectations increase and/or increase fear that US government debt will grow too large will increase interest rates.
Interest rates rise, inflation raises, dollar cost of purchase rises.
Anyone think that 100bpoint increase in borrowing cost is going to make a dent in price?
>Anyone think that 100bpoint increase in borrowing cost is going to make a dent in price?
What are the factors contributing to the 100bp increase? How do those contributing factors also impact real estate prices?
>I wish people would realize that their "investment" is *actually* a roof over their heads, in an environment that is conducive to enjoying their lives.
Many people do.
According to the no-arbitrage theory, interest rates today are what they are and that's what they should be using. The interest rate curve in theory should embed all future expectations of interest rate movements. While it isn't true in practice, it is the only assumption a risk-neutral investor can go by. But as an investor, you should be indifferent. Assume you purchase believing the asset value is the pv of discounted rates using the current curve. The asset is assuming producing a return (call it rental income). If interest rates rise, you get to reinvest your return in higher interest rates. Also, your cost of carry is diminished as rates rise as your carrying costs are fixed, but your income can vary based on your investment returns (arguably higher as rates increase). So while the assets market value may drop, the reinvestment income derived should increase over time if interest rates increase. Also, the value of the asset should in theory increase with inflation. The underlying mortgage is fixed, and if interest rates increase, there is an embedded inflation component. So in that case, the lender would lose out since the value of the mortgage (which is the monetary asset) is falling in value, meaning the borrower is gaining. In the end, it should be a wash unless market values of the property changes in some unintended way versus interest rates.
Markets rarely set prices based on income or whether consumers view the item as consumption or investment. Even if you want an Iphone so badly that you'd be willing to pay 5x your income for it, you don't have to.
Normally, product prices have some relation to cost of production. In real estate, cost of production is the cheapest of building new units, upgrading low quality ones, converting office to residential, or converting rentals to homeownership. If prices are above that cost, ordinarily I'd expect professionals to increase supply until they press prices back down. Slowly, of course, since the market is anything but efficient.
Of course, this isn't what happens in a bubble, when masses of people come to believe that prices will always go up. The Bubble Faithful will be willing to pay any price X because they "know" that later they'll be able to sell for X+10%. So the bubble creates its own demand. With demand effectively infinite so long as bubble buyers have assets or credit, supply can't possibly keep up, so prices are set by demand alone. However, even bubbles don't last forever -- eventually bubble buyers drive prices up to the point where solvency and credit run out or buyers lose faith. At that point, in the stock market the speculative demand dries up and prices drop rapidly. However, in RE, more commonly owners decide to hold on rather than realize losses, so inventory gets tight, and if there is enough (non-bubble) demand, prices may remain stable for a while. This appears to be where we are in NYC today: enough demand with low inventory to have relatively stable nominal prices. (In Nevada and FL, in contrast, the speculators couldn't hold on, so prices collapsed in the stock market style).
Professional developers can make money by creating new supply any time prices are above cost of production. So they will, slowly. New supply will slowly bring prices down to cost of production. Possibly very slowly, if enough secondary market sellers can resist realizing nominal losses or if professionals are worried about a sudden collapse of demand.
But the easiest way to create new supply is to sell existing rental units to owner-occupants.
The key importance of rent/buy analysis, in my view, is to determine if investors sitting on rental units are likely to view selling them as more profitable. If so, profit-seeking LLs are likely to sell, thus increasing supply and bringing prices down. Unlike retail buyers (or bubble buyers, or flight-capital buyers) these investors have no reason to pay extra for non-economic factors, so they will continue shifting units until they can no longer profit by doing so.
Even if lots of retail buyers would be happy to pay a premium for ownership, in non-bubble markets they don't have to. Professionals should be pleased to unload risk onto someone who isn't charging for it and to supply units for people willing to pay more than cost for them.
Most likely, then, prices will slowly drop until neither rents nor sales prices seem high enough to make new construction or renovation/conversion profitable and either (1) no rentals are left, or (2) professionals see no profit in converting rentals to owner-occupied condo/coops.
So for those who are interested in guessing FUTURE, non-bubble prices, the key question is how close we are to a neutral rent/buy ratio from the perspective of an investor only interested in profit-maximization. (Incidentally, since investors get fewer tax subsidies than owner-occupants, the investor number is probably well below the neutral rent/buy for an occupant: in non-bubble markets, potential buyers who don't expect to be paid for holding the non-diversified equity risk generally should find it cheaper to own than rent).
That's why I'm interested in understanding how professionals deal with cyclically low interest rates that the Fed promises to raise as soon as the economy can tolerate it. Does the profit-maximizing LL say, OMG, my rental property is now worth far more than 6 months ago, so I'll keep it a rental? Or does it say, this isn't going to last; better sell to the fools while the going is good? Do temporary low interest rates slow the arbitrage or have no effect at all?
>That's why I'm interested in understanding how professionals deal with cyclically low interest rates that the Fed promises to raise as soon as the economy can tolerate it.
What makes you think that the US Government wants higher rates ever, given that the US Govt is a huge borrower? Low rates reduce the costs of servicing our debts. Inflation eats away at the debt obligations.
As for the rest of your nonsense, if its all so rational, why was there a "bubble" in the first place?
well slap me silly upside my head, i agree with hb on at least one major point here.
there is an enormous, and i mean beyond normal comprehension in the main stream media, desire by the powers that be to keep US interest rates and treasury yields as low as fucking possible. to the point of one agency buying the morning before another entity sells. one of the funniest comments i read on an econ blog recently was that zerohedge was actually presenting the news. and not just in a narrow sense.
hasn't anyone paid any attention to japan?
bubbles are another question entirely, short term irrationality.
as an intellectual exercise, when one looks at how the emerging world has not met our expectations for never-ending gains in world consumption and thus demand for our goods, what do you consider?
it might be interesting, just in terms of how we view what regulations/protections we desire/need for our own population. romney wants to weaken insurance regulations, which is just about one of the only fucking areas that provide decent protection (and not excessive, i might add) for consumers.
and it might also be interesting to consider the increased rate of food inadequacy in india, among other emerging countries.
no need to curse
>and it might also be interesting to consider the increased rate of food inadequacy in india, among other emerging countries.
Why is that our concern?
because, you eegit, our growth is now so pegged to emerging countries. and it now seems as though the emerging countries are not doing so well at all, on many levels, but from the money hungry west perspective they are not growing domestic demand.
demand needs to increase at a very high rate for these emerging countries to maintain stability. and for them to aid our stability.
their demand has increased. It even outstrips their supply of food according to you.
their population has increased. their demand, depending on what you are talking about, hasn't increased nearly as much as one would expect in a period of 10+% yearly increases in GDP. unless you're talking about the demand of their top 10%, which not surprisingly is searching around the globe for ways to consume.
we're not doing a very good job in this global rebalancing act. on so many levels. whether or not we'll be able to right the ship isn't something i can foresee, but i'm not particularly optimistic. if we can't, i have no idea whether it will be my, my daughter's, or the next generation, that truly feels the results of this global mismanagement, or if it will be a slow bleed, but hopefully i'm wrong. i've talked to any number of optimists recently, but they haven't been convincing.
anyway, this is off topic. i found a place where the rent/buy numbers are fantastic. and financeguy, i love your posts but i totally disagree that for most people purchasing is a rent/buy analysis. lately it is more so, but at least in the past couple of decades i don't think it has been at all. i agree that generally the numbers have been much more closely aligned with income, but the desire to own isn't particularly rational.
>we're not doing a very good job in this global rebalancing act.
Who is "we"? If it's the United States, why is it our "job"?
>results of this global mismanagement
When has the globe been subject to management?
>i've talked to any number of optimists recently, but they haven't been convincing.
Remember, I haven't studied psychology, but this seems mostly a personal matter.
>i found a place where the rent/buy numbers are fantastic. and financeguy, i love your posts but i totally disagree that for most people purchasing is a rent/buy analysis. lately it is more so, but at least in the past couple of decades i don't think it has been at all. i agree that generally the numbers have been much more closely aligned with income, but the desire to own isn't particularly rational.
All humans have emotions. Emotions are entirely rational, normal and common. I agree with everything you say, except that what you really want to be saying is that the desire to own isn't based on a math formula. It is rational.
is it safe to say as rates rise, home prices will drop to compensate for the monthly payments? or will home values remain the same because as rates rise-so does the economic positions of buyers?
Neither is safe to say.
you can't just look at rates, you also have to look at relative ease of obtaining credit, the number of people with ready access to down payment cash, and willingness of investors/speculators/PE types to pick up excess stock. it is very, very hard relatively to get certain (many) loans right now.
all other things being equal, increased rates should lower prices, unless of course they result from efforts to curb inflation brought on by wage/price escalation.
hb, i like your bringing philosophy into the equation, and while i'd love to chat about emotions/utility/rational choice/globablization, i'm f'ng busy today, so another time maybe.
Remember the fed actually bought 80% or so of the treasurys sold. So the rates we see are not free market. So market theories do not apply. If they have to buy most of their own bonds to keep rates low, then they are essentially deferring borrowing. Which means at a latter date, they (fed and treasury) will have to sell more bonds... more they have to sell, lower the price they can get, higher the interest rates.
Yes, they would love to have low interest rates, as long as they are selling 100% of the bonds to the market.
Assume you have fixed monthly you want to spend on housing ($5000 to be simple) and you eye an particular coop that has monthly of $2000 maintenance, 50% deductible. How much does 1% impact price you can afford (assuming 28% marginal tax bracket)...
Tax savings on maintenance is $280, net cost is $1720. Leaving 3280 for mortgage. Here is where the math is little trickier (you need to backwards solve for it) But you can take my numbers and test them to see it works. At 3.875% (Wells Fargo been offering this rate), assuming tax deductibility of interest is using month 12, you get a mortgage amount of $860,193. At 4.875%, it drops to $786,517 (or 8.6%). If you look at 7.875%, it drops 30% to 604,322.
This drop is even greater if you don't take into account principal (after all this is equity you are building up, not an expense).
I agree (partially) that it is a roof over your head. But even with a car, which is just transportation, so people buy used civics and others new luxury cars... which car they choice is going to be heavily influenced by their income. After all I read all these lease deals for luxury cars, I can't believe the dealers would spend so much money on these ads if they didn't move alot of cars by way of lease.
Ritholtz linked to this, interesting:
HB: All rational models of capital markets predict bubbles and panics. They are part of how capital markets work. But we have no way of predicting whether we will be in a bubble or a panic at some indeterminate time in the future, so for purposes of prediction, it is often best to simply try to figure out the fundamental number around which bubbles and panics fluctuate. Just as we know that business cycles exist, but if you are trying to figure out where the economy is going to be in 20 years, you are better off assuming average growth than trying to decide if we'll be in a boom or a bust at some point in the future. Average growth might be predictable; boom/bust is inevitable but the timing can't be predicted.
AR: Of course most people don't buy or sell based on economic analysis. That's true in every market.
The standard model, however, suggests that generally prices will largely be set by suppliers who, unlike most buyers, are in this for profit and follow standard methods of calculating profit. Profit-seeking suppliers in a competitive market act in a way that tends to drive prices to cost. For that reason, we call prices that are based on replacement cost "fundamental" value. Buyers often drive prices away from this fundamental number in either direction, but over time, the profit-driven suppliers prevent them from moving it infinitely far.
Rising rates may lower prices, but will also increase monthly cost. But if rates rise along with inflation prices may actually inflate , is this plausible? I don't think it is a black and white conclusion that rising rates mean real estate prices fall. Some on this board seem to be holding out for rising rates to negatively affect prices. But 4% fixed for 30 years is pretty attractive for a buyer who plans to stay in a home 7-10 years, don't you think.
All that aside lets factor in the joy of home ownership coupled with a responsible purchase can be pretty satisfying emotionally speaking.
I thought some would find the BU piece interesting .
DC: Short term rates are always set by the Fed, and long term rates are always set by the market based on expectations of what the Fed is likely to do with short term rates. That's what "free market" means.
The Fed has said that it will drive interest rates up to prevent inflation from going over 2%, even in violation of the "Dual Mandate" law that requires them to consider unemployment as much as inflation. This conforms with their actual behavior since Volker. And the market clearly believes them -- it is predicting very low inflation and high unemployment for the indefinite future.
i actaully thought that 50% of MIT grads missing the ball bat question interesting
A buyer or lender panic could cause prices to drop suddenly, but that isn't likely. The likely scenario, in my opinion, is continuing tight inventory and high real (end-user) demand keeping prices and rents high and basically stable, thus inducing a gradual increase in supply -- new/renovated/converted units -- that very slowly brings real price down to costs.
Nominal prices are very sticky downwards, so assuming that inflation stays low (as I expect), the process will be very slow.
My OP question was about the way professionals -- not retail buyers -- calculate costs, because that's the price I expect the market to tend towards. Not quickly or directly or smoothly or efficiently. But basic capitalist incentives exert a very strong force and only friction is obviously consistently pointing in the opposite direction.
Great, so economic models don't work, and if they did work they don't apply because there too many other variables involved that don't foot into the purely economic model.
FG, i think that professionals also make self-justifying assumptions, such as projected household formations, future employment levels, etc. as you point out, real estate production and pricing can be slow to correct, particularly in a city like new york. the next wave of building here may be very interesting, as a huge amount of the ground work, so to speak, has been done for so many units (vacancy, demolition, plans, etc.), which would actually enable units to be produced at a pace more typically found elsewhere.
AR: That's why understanding the model that the professionals use is especially important. If it leads them to make a consistent error, the error itself will affect the market (just as the false model used by the bubble-heads created and sustained the bubble).
For example, if standard practice is to use current market interest rates in valuing future cash flows, then when the Fed lowers rates, all income-generating assets will look more valuable to them. And there are enough professional investors/LLs/lenders/builders that this should impact prices.
But if they use some kind of cyclical average or otherwise plug in higher rates to their models (e.g., if like DC they think current rates are "artificial"), then the Fed's efforts will have much less impact.
It'd be helpful to know which approach is "right," because truth has some gravitational force of its own.
But in the medium term, truth matters less than acceptance: most professionals will continue making the same errors they learned in school until they retire. "Science progresses one retirement at a time." (Unless the errors are so big and the market so unforgiving that they are driven out of business. But markets are rarely that efficient.)
I think people, professional or otherwise, have a remarkably fluid ability to find self-justification. I'm not sure that there is a particular level of consistency, as I think real-estate development, barring extreme circumstances, is largely end-result driven (we want to build, how and where can we best justify doing so, which is obviously an oversimplification, but i think is fairly accurate). and, if anything, this recent bubble has taught too many professionals that there can be fairly little downside to employing flawed models.
"Normally, product prices have some relation to cost of production. In real estate, cost of production is the cheapest of building new units, upgrading low quality ones, converting office to residential, or converting rentals to homeownership. If prices are above that cost, ordinarily I'd expect professionals to increase supply until they press prices back down. Slowly, of course, since the market is anything but efficient."
In Manhattan, land is the dominant input factor, accounting for anywhere from 50-80% of the value of the housing stock. You cannot add more land, and it is not costless to acquire air rights, so for all intents and purposes, housing stock is static in Manhattan
As such, fluctuations in cost of production/conversion are dominated by demand factors, not supply factors. It has little to do with the "cost of production". It has more to do with the desirability to live in the city, have a pleasant commute to high-paying jobs that cities typically offer, and take advantage of the positive externalities when civilized people congregate in high density (restaurants, theater, culture, sporting events, etc.)
I do think it is some blend/middle ground between valuations purely based on today's rates (as there are some portion of population who buy and will live there for many years, and some portion of buyers are landlords who accumulate rental inventory and don't typically sell)... But Average long term time in home is much less than 15 yrs. For NYC, is this even shorter? So future rates do matter too. (Although less if you personally buying and won't sell for then next 20-30 years -- job is stable, place you are buying fits your long term needs, and you won't want to upgrade in the future even if you start to make alot more money)
Fed's operation twist, buying Trillion+ dollars of long duration treasury and agency bonds does impact the long end of the curve... This excess portfolio, they might sell it at some point, which will cause the long end of the curve to pressure rates higher. So its not exactly free mkt right now. In fact if it the whole point of monetary policy, to impact/influence the "free" markets away from current equilibrium.
Any new "easing" we hear might come from the fed will almost surely be targeted at long end of the yield curve (not the short end). But you are right, typically the fed targets actions on the short end because it is easier and more predictable influence on overnight rates...
Remember Greenspan also tried to bring down the long end of the curve and failed to do so...
>FG, i think that professionals also make self-justifying assumptions
>I think people, professional or otherwise, have a remarkably fluid ability to find self-justification.
Is a self-justifying assumption a fancy word for self confidence? Wouldn't it be a shame if most people didn't have self confidence?
>as you point out, real estate production and pricing can be slow to correct,
What does it mean to "correct"? What is the "correct" price? What was the last time period in which prices were "correct"?
>AR: That's why understanding the model that the professionals use is especially important.
Why? When was the last time that prices were "correct" according to the model that one should plan on using the model for the next time when they are "correct"?
really, hb, do you have the answers to your questions? do you think that all the people who have lost their homes to foreclosure feel that their self-confidence was warranted? or those who felt that their retirement funds would continue to produce returns at 3+ % above inflation, as well as maintaining their base worth? you seem rather heartless, in a libertarian sort of way.
correct is a very simple term in real estate. it reflects the amount that people would spend given income if banks lend properly, adjusted for extraordinary circumstances, which we are currently awash in.
ar, welcome back. with fg riding shotgun i do think it will be a bumpy ride but lets get alan on board so equilibrium will be in its full force.
>do you think that all the people who have lost their homes to foreclosure feel that their self-confidence was warranted?
Give me a break. You pick the absolutely most irresponsible people and hold them up as an example. I don't know why, but your style is so negative. For decades and decades, people have bought and owned homes and done just fine. So more recently you have a small subset with the weakest prospects and they got stopped out, and that's who you focus on. Why?
>or those who felt that their retirement funds would continue to produce returns at 3+ % above inflation, as well as maintaining their base worth?
Actually no. I've been reading people like inododo and somewhereelse who repeatedly tell people that their money is better in stocks and cherry pick dates like buying at the bottom on March 2009. No, I'm not telling anyone to have greater than average expectations on their retirement funds. And of course that wasn't the question, so not only did you attribute something to me that's the opposite of my opinions, but you distracted from the only point we were discussing. Why?
>correct is a very simple term in real estate. it reflects the amount that people would spend given income if banks lend properly, adjusted for extraordinary circumstances, which we are currently awash in.
That's your explanation? Correct is a real estate term? Banks are evil and people are just stupid sheep?