Explanation for buy < rent

There is a bubble, that's about it. Buyers will apply faulty logic (or none at all) in support of it. It used to be predominantly of the form "RE will rise 5% every year". Now, it tends to be of the form "the cost of capital on my risky 30% downpayment is 3% or less", "I'll compare discounted coops against condo rents rather than discounted coop rents because I'm going to fully ignore the coop ownership / sale restrictions while fully embracing the coop rental restrictions", and "I'm going to look at the overpriced crap rentals that sit for months on the market and use those as comps rather than look at the better deals because even though I'm going to make sure I get a good deal buying, I'd most certainly get a crappy deal renting".

That's about it. No amount of data will convince bubble-heads otherwise. Meh, what can you do? Just let the developers build the fancy new places, have the investors buy them at overly-high prices, and rent it on the cheap.

If Ino is correct there is a big failure in free market economy in NYC real estate. Presumably if you own RE and are renting it out and are seing what Ino is seing, you would sell. That would drive up cost of rentals while driving down cost of RE to some equilibrium. Renting is cheaper in most cases, so this is not happening. So on one hand you have a bubble in RE, and on the other you have irrational owners that rent out their properties. I think end product is some middle ground of rent increases and price decreases.

These are the reasons that came to mind, but it just seems so silly to me.

What is odd to me is that a lot of people consider RE a good long term investment. But if we are looking at long term time horizons, equities have generally outperformed by a wide margin. Plus, in a city, the stigma of renting does not exist the way it may in the suburbs.

You would think that since Manhattan RE requires the purchaser to be somewhat wealthy, personal financial advisers and the generally higher education possessed by those who can afford would lead to more rational markets.

>> There is a bubble, that's about it. Buyers will apply faulty logic (or none at all) in support of it. It used to be predominantly of the form "RE will rise 5% every year". Now, it tends to be of the form "the cost of capital on my risky 30% downpayment is 3% or less", "I'll compare discounted coops against condo rents rather than discounted coop rents because I'm going to fully ignore the coop ownership / sale restrictions while fully embracing the coop rental restrictions", and "I'm going to look at the overpriced crap rentals that sit for months on the market and use those as comps rather than look at the better deals because even though I'm going to make sure I get a good deal buying, I'd most certainly get a crappy deal renting". <<

This is the BEST POST EVER in the history of online forums!!!! LOL. Thanks for making me smile.

JButton:
Bubbles are "failures" in the sense that the market doesn't work the way it does in simple Econ 101 models. However, bubbles are endemic in capital markets. They happen regularly, and in real estate markets, contrary to the metaphor, they don't pop but end with a whimper.

Bubbles happen naturally, because buyers buy two different things: the right to live or rent the property, and the right to buy and sell the property.

The value of the first one -- usually called "fair" or "fundamental" value in the business -- is relatively straightforward and depends on rents, i.e., the value of the housing services.

However, the value of the second one -- usually called "speculative" or "trading" value -- is entirely dependent on the current buyer's guess about how much a future buyer will guess that a still more future buyer will willing to pay. That, of course, is a completely unpredictable number. The standard Econ 101 models avoid this problem assuming that usually people will simply conclude that speculative value is just as likely to reduce future prices as increase them, so generally they'll just ignore it and pay based on fundamental value.

But the simplest models are too simple. Bubbles (and panics) happen when people begin to focus on the second part, trading value. In a bubble, everyone decides that they'll be able to sell for more, because they expect that their buyer will feel the same way. Since they expect to be able to sell for more than fundamental value, they rationally decide that it is ok to pay more than fundamental value. Optimism creates optimism. Prices rise, in a self-fulfilling prophecy, as the bubble creates its own demand. Rent-buy calculators that invite you to assume appreciation at above inflation rates basically reproduce this bubble mentality.

Of course, a bubble can't last forever. Eventually, prices get so high that buyers can't borrow enough to pay them, even using their bubble profits, so the ever rising demand slows. Alternatively, some people -- never enough -- act as JButton predicts: Developers develop more supply, landlords convert rentals to owner-occupied, and owner-occupants sell and rent, so supply begins to rise to match the elevated demand. As prices level off or begin to drop, some potential buyers start to doubt their rosy prophecies that prices will always go up, so the bubble-created demand begins to drop.

RE bubbles deflate very slowly because supply adjusts very slowly. Developers may not develop if they fear that bubble prices are unsustainable, ironically making the bubble prices last longer. Or, as happened in NYC, they may convert to rentals midstream when the visions of extreme bubble profit fade. Many owners are reluctant to realize losses and (except where they were so overextended that they suffer foreclosure) most usually have the option of holding on -- staying rather than selling, subletting even at a loss rather than taking a big loss. So as the bubble stops growing, the number of units for sale tends to drop sharply, thus limiting price declines.

Demand adjusts slowly too. The slow price declines allow many bubble buyers to continue to assume that prices will continue to increase or at least not decrease and thus justify paying bubble prices even after prices have stopped increasing, so demand doesn't drop as sharply as after the dot.com bubble, for example. On the rent-buy calculator thread, for example, you can see potential buyers even now using an assumed 3% annual increase as their worst case scenario, even though historically RE appreciation tracks inflation (as theory suggests it should) and we need close to a 50% drop to get back to that trend.

Historically, even major RE bubbles have usually ended with a long period of flat (nominal) prices until inflation (and therefore rents) catch up. After the relatively small 1980s NYC bubble peaked in 1987, real (inflation adjusted) prices dropped by a third over the next 6 years, but nominal prices were basically flat.

Saiyar: Fundamental value, the first factor, depends on the rental market. The answer to the OP's question is that adjustment will happen, but prices are more likely to drop than rents to rise. The number of LLs that paid bubble prices is sufficiently small that renters don't have to pay for their landlord's excessive costs. If a LL seeks to price the rent based on the high price the LL paid, renters will rent from someone who didn't pay so much, and the bubble buyer's apt will sit vacant until the rent is lowered. So rents tend not to increase along with RE bubbles (in the current one, NYC nominal sales prices almost tripled, but rents trailed inflation). Rents are, instead, largely determined by the cost of building new units, the supply of older ones and the ability/willingness of renters to pay for actual housing services.

Financeguy, I hope you copy and paste this otherwise I hope you get a job soon.
Agree with most of what you said but you focus on one side of equation, the buyers. In the last section you talk about LLs pricing off their cost not current market value which cleary is irrational. If I were a LL I would look at current market value (bubble or not I don't care) and either price my rent off that, or if I cannot get that, just sell.

Can we get an input from a LL here? Why don't you sell your property given current rent/buy ineqality?

Yes, I also mostly agree with Financeguy, but JButton asks the same question I now have: why don't Ll eventually sell instead of bleeding cash. Eventually the market should realize the buy/rent discrepancy.

Just as Financeguy claims idle rentals will eventually be lowered in price until they rent, why aren't landlords equally as rational and refuse to pay the ridiculous RE prices until the seller drop the price on their idle units.

This reminds me of my advanced economics classes where we spoke about how the theory of the "rational" participant in an economy breaks down much more often that we think. I think people want to own just because they want to own it. The purchase price is basically a fundamental value a consumption value as a plug that represents that warm fuzzy feeling when you sign at closing.

Sorry, meant to write fundamental value PLUS a consumption value

when large LL try to sell, they have other people who understand the business crunch numbers (unlike Peter/Coopper sale).

the small LLs are so small, that they are always hoping that they will recoup the money they loss in the property. the next bubble is just a year away..

JButton: 'Can we get an input from a LL here? Why don't you sell your property given current rent/buy inequality?'

I'm not a LL, but if I were one... Given the transaction cost, low interest the banks are paying, and the lost of rental cash flow, I would only sell now if I believe I can buy the same thing back at 20% or lower price in another 2 years with similar mortgage rate. The only other reason to sell would be if I'm retiring permanently from being a LL.

Sunday:
But what about what the average LL over the long run would do? Looking at a discrete moment, especially now, is probably more of the exception than the general rule.

saiyar1, unless you are asking why ever be a LL at all, the answer is pretty much the same.

NYC is subject to some fairly extreme regulatory constraints on building and land use. Also, rent regulations have attached rules that make it harder for landlords to get out of rent stabilization / control schemes once they are in them, so coop or condo conversion is not always an option.

In a less fettered market, supply would adjust to demand as developers would bring more condos to the market and landlords would convert their rental buildings, all to take advantage of the huge premium that many NYC residents seem to be willing to pay in order to buy instead of rent. That increased supply would bring purchase prices down to something that makes more sense when compared to the rental market. But it is hard/expensive for suppliers of housing to make such adjustments in NYC. Thus, the bubble remains, or deflates only very slowly (over decades).

JButton: 'Can we get an input from a LL here? Why don't you sell your property given current rent/buy inequality?'

I think the reason here is that people don't like to be wrong. The reality is that current prices are flat to 7 years ago. Throw in transaction costs, that's another 10%. Include an 80% mortgage, and the negative carry accounts for another 10-20%. Now get into a conversation about how shitty an investment that's been, you'll get all sorts of excuses and poor rationalizations.

It's really fascinating IMO. All investors make investment that at some point or other do poorly. Good ones learn from their mistakes, acknowledge that they dismissed some risk factor they should have considered, etc. Bad ones blame it entirely on bad luck. The RE bubble-heads, however, are a special breed unto themselves: they don't even acknowledge the loss.

"NYC is subject to some fairly extreme regulatory constraints on building and land use."

This should constrain the rental market as much as the condo/coop market, so it doesn't explain why it's more expensive to buy than to rent--just why prices in NYC are generally expensive.

New construction is not subject to rent regulation. Zoning is looser in NYC (no single family on quarter acre lots here) than most of the US. And condo owners can freely switch from rental to sale or vice versa with no regulation at all. So it seems unlikely that regulation is the reason why new construction is limited.

It's a bubble. That's not the fault of real estate regulations (the banking regulators could have stopped it but chose not to.) It's the result of people who expect the bubble to continue and therefore pay (or bubble prices or refuse to sell except at bubble prices, which creates bubble-driven demand that expands faster than supply can. Professional developers take a long time to build/convert the supply to end the bubble because development is expensive and risky and takes a long time.

Long time renter here. I think there's a major emotional component to renting, finally settling down, picking a place, not having to deal with moving, or with being slave to the landlord, knowing your family can stay there as long as you didn't mortgage to the hilt. Possibly some of those are less meaningful in NYC because there are a lot of rental apartments. But also possibly because so many families move to the suburbs and own there, some of it is more meaningful as no one wants to admit to their friends that they are moving again and that their destiny isn't their own. Kind of like getting fired from a job, that sucks and is embarassing with friends and extended family, and a source of tension within the marriage, and the same thing if you are foced to move because of your rent going up too much and having a trajectory even further. Plus when you start having kids like we are planning, you start to take stability more seriously. Unfortunately the extra cost for buying for all of these things has high, but fortunately has come down significantly.

landlords don't sell easily for a variety of reasons.
tax implications of a sale are very substantial, especially if they don't have a 1031 purchase lined up.
further, the incentive to sell is low compared to the incentive to simply refi to as high an ltv as possible. especially with the rates so low.
many of the smaller family owned RE groups in the city (there are many) don't view their buildings as a financial instrument exactly. they are in the real estate business, not in the speculation business. an owner of a business whose industry is in vogue wouldn't necessarily sell just because he thinks his business is overvalued.
i'm kind of surprised everyone here so willingly concedes a bubble. nyc is extremely expensive, but there are a lot of price supports - and i would say that the rental strength empowers an owner to buy a little higher in the hopes of speculative returns. his loss is limited to what he would lose if he rented it out. overall though - prices flat to 7 years ago means a bubble?