In the paper made available at the Brookings Institute Bubble, Bubble, Where’s the Housing Bubble [pdf] two economics professors make the argument that for the most part, there is no housing bubble. because the rental equivalent of the value is the true test.

This has been a very controversial paper which was covered very well by Damon Darlin last weekend in his article Some New Math on Homes [NYT].

Its been the approach taken by the Economist for the past 5 years and it always struck me as slightly out of sync with reality. I definitely understand the need to quantify the value of residential housing, to tie the market value to something other than perhaps, an inflated sale down the block. I understand this, I get it, I really do.

However, here’s my problem with the rental to value theory from a macro perspective:

In a residential housing market, this theory of income capitalization (converting the income stream of a property to value) is only plausible if the highest and best use of the property is a rental property. In fact, the income a property has the potential to throw off can determine what its future use would be. Class C office space in a fading central business district is converted to residential rentals, for example.

However, if you rest on this concept alone, then I would think every other house in a single family housing tract, for example, should be a rental. Yet this is not the case. Specifically, upscale single family neighborhoods rarely have rentals within their housing stock.

Why do developers of rental multi-family housing tend to build a smaller mix of apartment sizes within their developments than condos (there are always exceptions, of course). Because they are different markets. If they are different markets, then they would reflect different values. Rentals tenancy tends to be more transient and there is a wider pool of these potential customers. Developers build rentals over condos if the demand is there. Why? Because they are different markets.

In other words, this approach does not consider the fact that occupants of rentals and condos have a different bundle of rights – it doesn’t consider the additional use and enjoyment an owner has over a tenant. (Perceived future appreciation, freedom to do what you want to the property, freedom to configure the property into a 1-family or some other combination of units or tear it down). How does rental income take that into consideration?

Naysayers argue that the cap rates used to convert the income stream take this into consideration. Where does that data come from (reliably) when it is not the economic driver of the market to begin with?

In some markets, like New York, 2-4 family properties, which are turn of the century townhouses, have a premium placed on those configured as 1-family properties. 2-4 family properties are purchased to have the potential to convert to single family units. In fact, the income stream for such a 2-4 family property has not capitalized into a value that equals the sales price of the property as a 1-family for more than 20 years – through several real estate cycles.

The work is important, however, because it provides a contrarian way to look at the housing market and many noted economists have gone on record to say so. However, the premise of the report seems to be flawed IMHO, but definitely a good read.

_Other coverage_
Pomona profs: ‘No bubble!’ [OCR]
There Is No Bubble! (Unless You Live In San Mateo) [SocketSite]

3 Responses to “Contrarian New Study Uses Word Bubble, Gets Attention, Misses Point”

  1. Larry Littlefield says:

    I half agree with you.

    Most of what you are getting in a house is the ability to occupy it, the value of which is determined by rent. That is the “income” portion of your return on the purchase, the rent you don’t have to pay, like interest on a bond.

    However, owners also get to “lock in” most of their housing cost by buying, a benefit renters do not get. That “lock in” factor also has a value. So for an owner, a property may be worth somewhat more than the current rental value alone.

    That’s only somewhat more, however. There still has to be some link between the “income” portion of the return and the price one pays for that stream of income by buying the asset.

    Otherwise, the buyer are banking on the appreciation of an asset that does not currently throw off the income to support it. They buyer is speculating on greater fools, in other words, or gambling that the value of occupying that housing will drastically rise. Perhaps a reasonable bet in low-rent neighborhoods about to gentrify, but a poor bet otherwise.

  2. otis wildflower says:

    Also, regarding renting vs. owning, presumably the highest rents chargeable are determined by the market’s ability to pay. That is, you can offer an apartment for $1200/mo where comparable apartments rent for $900/mo, and not find any takers since you price yourself out of the rental ‘consumer pool’. In fact, prices renters can pay probably correlate more closely with wage levels as opposed to property values, so when property values rise faster than wage levels (as is currently the case) then renting is the smarter choice until the wage/housing differential shrinks to a reasonable level (by either boosting wages or (more likely) deflating housing).

    OTOH, landlords may well balk at the opportunity cost if they can convert their rental property to a sellable home (or if it’s already like a condo/coop that they’re leasing) so renters are at risk of having their housing sold out from under them (and different states have different tenant rights packages)..

  3. Jonathan J. Miller says:

    Larry – I disagree since the somewhat more is usually “much more”. The lenders are only looking at income – Fannie Mae, Freddie Mac, etc don’t require us to present an income approach if its not the driving factor in the market – it rarely is. They are looking for their return on investment, which can be growth driven or income driven like stocks are. Its an asset whose income stream does not correlate with investor behaviors, so its all a bunch of guestimates.