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.
http://economix.blogs.nytimes.com/2011/05/10/rent-vs-buy-a-longer-list/
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?).
Most of America’s neighborhoods today are suburbs built since the Second World War. Almost all of those are absolutely car dependent because of sprawl, single use platting and zoning, and massive motoring infrastructure. They can’t be easily retrofitted with transit because the population and likely work and commerce destinations are so spread out; viable transit requires a linear route that runs by large concentrations of origins and destinations.
The result is that if gas prices continue to head up to $10 and $20 as seems likely over the next few years, the outright majority of American neighborhoods will soon be facing the fate of Detroit. I don’t want to buy into that.
But of course, I live in an older, dense suburb built in the 1920s. Places like mine will become so valuable with gas at $20 I won’t be able to afford to live here anymore.
Brian: Even if gasoline prices were to reach $20/gallon, I don’t think it would have a huge impact on per-mile family transportation costs. People can use smaller cars or cars powered by something other than gasoline. What seems like more of a limit on the value of suburban life is the traffic congestion that has resulted from the growth in the U.S. population and that will presumably get worse as the population expands further. Since as a society we’ve been mostly unable to implement big systems, e.g., a transition to HD Radio, it seems unlikely that we’ll be able to install congestion pricing on our roads the way that folks have in London and Singapore. So the house in sprawl-land will come with a Mumbai- or Mexico City-style commute and that will make it less valuable.
Okay, I can imagine a future where tiny natural gas vehicles and efficient little scooters make deep suburban commutes possible even with likely upcoming gas prices. It will still be unpleasant and people won’t want to do it if they can choose otherwise. That should cause the price impact you’re looking for from urban decline.
I wonder if that decline is being priced into homes yet. The house price weakness in my MSA is more pronounced in far-out sprawl so far but our demographics are unusual.
Traffic congestion isn’t likely to get worse unless more far-out sprawl is built. It will be mitigated effectively by the switch to scooters and carpools anyway. Congestion doesn’t arise mostly from population growth but from bad land development planning and terrible transit policy.
I don’t see congestion pricing on the horizon either; people just don’t like the idea much. It’s a shame — it’s a very wise idea.
I don’t know Bombay but I used to commute in Mexico City and have many friends who still do. It was always a pleasure for most of us and getting better all the time with infrastructure improvements. It was far better than commuting in Chicago or San Francisco or Denver in my experience.
I have to agree that house prices in upscale Washington D.C. area neighborhoods are priced assuming a decade of clear sailing ahead. Last week I wrote a contract to buy a house in McLean, Virginia and I learned the hard way that it’s definitely not a buyer’s market. Whether D.C. will remain the only major market that will avoid a double dip in residential real estate remains to be seen, however.
One storm cloud on the horizon is the possibility of true federal budget cutting, leading to a loss of jobs. I think very few of our fine overworked and underpaid federal civil servants are in danger of unemployment if this happens. And, of course, many could retire at roughly 80% of their former pay. But my friends at the Executive Vice President level in defense contracting firms worry that they might have to trade in the Bentley for something a little less flashy. If the defense budget is cut as much as it should be — I know I’m dreaming — the “little people” of government contracting will take the hit. This might have a ripple effect on house prices, especially if combined with a major nationwide decline.
Another scenario is what economists call “reversion to the mean,” in which house prices drop below the long term historical average. If that happens, the additional 25% nationwide price drop you mention could be in the cards. It’s hard to imagine that places like San Francisco and D.C. will be immune to such a drop. They certainly didn’t escape the first dip which started in May, 2006.
So I think hardly anyone is 100% safe.
These days I think of homeowners as property tax hostages.
One interesting way to test your idea might be to look at communities that have one major employer or industry vs. communities that have a broad base of employers. You mentioned Lowell and Lawrence. A modern analog might be the wealthy communities around Everett, WA – they are very heavily dependent on Boeing and local suppliers to support the town’s economy. Boeing appears to be shifting operations from Washington State to South Carolina. Some might object that Boeing isn’t the only employer – the Navy base is close by. However, there are towns such as Mill Creek or Mukilteo that are close to Everett that are too expensive for most Navy families. Comparing the price premium in Mukilteo with the town of Edmonds, which is nearby but far enough south that it primarily revolves around Seattle instead of Everett, could help put some numbers in your conjecture.
I can see increasing price differences between properties in communities with better infrastructure–high-speed or even light rail access, particularly–and properties in communities without those amenities. The differences exist now, for example between suburbs of Chicago with rail links and those without and in Washington, D.C. and Maryland, but the differences will likely become greater as costs per mile for commuting increase.
As far as estimated risk of local economic collapse being monetized in home pricing, I think that happens already. Cities like Pittsburgh, which has been undergoing a structural contraction for over 40 years, with the disappearance of the basic steelmaking industry in Pennsylvania, did not see increases in home valuations even though its employment base is relatively stable; that city is dealing with continuing population decline as it becomes a city half the population it once had. I have to believe the same holds true for Detroit, although Detroit has special challenges in that it is a relatively low density urban area (and lower still in many nearly abandoned city neighborhoods.) so transit as a means to link the downtown with the suburbs would be costly by distances involved but possibly mitigated by relatively lower land values and level terrain.