The continuing decline of U.S. house prices has been in the news lately, along with articles about how people love to rent. In some parts of the country, buying is definitely cheaper than renting, especially when you consider the 4-5 percent interest rates being offered. Can it be rational under those circumstances to rent?
One factor that has been covered is the high transaction cost of selling a house, perhaps 10 percent of the house price (5-6 percent real estate commission plus the cost of leaving the place vacant for 3-12 months). That’s equivalent to 1-3 years of rent. What if the person knows for sure that he or she will stay at least ten years and therefore it genuinely might be cheaper to buy. Why doesn’t he or she get out a checkbook?
Let’s consider an adjustment for the risk that, when it comes time to sell the house, there won’t be any jobs in the city or state and therefore the value of the house will be zero. If you’re a working-age renter, by definition your apartment is near a job and within a reasonably functional economy. Otherwise you wouldn’t be there paying rent! Between 1970 and 2008, a home buyer probably would not think to discount a house for the possibility that an entire city or state economy would essentially fall apart. Such things had not happened in recent memory (though they had happened, e.g., in Lowell and Lawrence, Massachusetts when the textile mills shut down and moved south; population fell and houses became surplus).
The potential home buyer today has seen pictures of Detroit, with former neighborhoods being gradually reclaimed by Nature or plowed under into farmland. Recognizing that his or her own city could become like that in 20 years time, the buyer will factor that into the price he or she is willing to pay. In the event of a Detroit-style decline, the house becomes worthless and the cost of ownership for 10 years or so effectively tripled (10 years x 5 percent is approximately equal to 50 percent of the home’s value, then add another 100 percent for the cost of throwing the house away). Suppose the buyer thinks that this has a 20 percent probability of happening. Given a typical person’s risk aversion, that might reduce the market-clearing price for a house by 25 percent.
I’m not quite sure how to test this theory. There are some parts of the U.S. where the risk of economic decline is much lower than others. For example, it is hard to imagine how Washington, D.C. could fail to prosper, even if much of the rest of the nation is impoverished. So the “discount for risk of write-off” should be near zero in Northwest DC and Bethesda, Maryland (though some neighborhoods of D.C. did decline to near worthlessness within recent memory). Manhattan seems also like a place where it is very likely there will be jobs. Perhaps Santa Monica and the nicer parts of San Francisco/Silicon Valley too (the data are pretty coarse, though, and the house market for Los Angeles overall may not correlate that well with Santa Monica when times are tough). Looking at the buy/rent ratio we would expect it to be higher in places with less of economic collapse.
has some suggestive data. Cities that seem at risk of being abandoned altogether, such as Detroit and Cleveland, are indeed theoretically very cheap places to buy. Washington, D.C. is expensive as well as some geographically blessed places such as San Francisco, Seattle, Orange County, and Honolulu. New York City, however, is only at an average ratio (maybe because Manhattan is not broken out separately?).