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Safes as Houses

Updated: Oct 3, 2020

A Modest Disquisition on the Concept of Imputed Rents, or, Why Not to Buy a Home

It seems almost an article of faith in the United States that owning a home is a rite of passage, a social class escalator, a solid investment, a hedge against inflation and king/queen-making. While we won't examine all of these claims in great--or, indeed, in the case of coronation, any--detail, we'll briefly discuss the investment case for buying your own home.

Economists have done us the favor of inventing a paradigm with which we can understand the tradeoffs involved. The theory of imputed income, and specifically imputed rents, is the idea that you contribute to your own wealth by doing things for yourself or owning things and then using them yourself. We can illustrate the concept as the money you add to your own wealth by making a sandwich for yourself instead of buying one at the delicatessen (assuming that you are a professional sandwich chef, but let's not overcomplicate the example.) Similarly, when you buy a house, you could rent that house to someone else just as much as you could live in it. Therefore, if you own your own home and live in it, you pay yourself rent to live there.

The decision whether to buy a home or rent one is identical, then, to the decision whether to buy a car or lease one, purchase a fleet of jet airplanes or pay someone else for the privilege of borrowing them. Homo Economicus, the rational actor in the theater of traditional economics, would theoretically catalogue all the costs of both and then select the one that costs less. However we know from experience-- and now, quite a bit from behavioral economics--about how cognitive and emotional biases impact decision making. Accordingly, our feelings and the mental shortcuts we take in taking decisions prevent us from analyzing the choice as might a computer or (nerd alert!) mentat.

This likely wouldn't be that big of a deal if we weren't talking about what is typically the single largest asset in a person's portfolio after the present value of their total human capital (how much their stream of future earnings is worth in the present moment.) If I were to propose to you: "Hey, let's take out a loan from the bank--say, three times your annual salary--along with all the money in your savings accounts, and invest it in a company that owns a single real estate property in your neighborhood," you'd probably say something like: "Uh, that sounds kind of risky." Yet that's exactly what buying a house is when looked at from an investment perspective: a highly levered, highly concentrated bet on residential real estate and interest rates.

Here at goodstead, we love putting calculators out there for the public to use in their financial planning, and we'll publish one at the end of this month to help you evaluate whether to buy a home or to rent where you live. In the meantime, consider this question: Can I live where I want to live for less money by renting than by buying? Make sure to include all the costs of home ownership, tax benefits (which are less than they used to be), potential for appreciation and borrowing costs in your calculations. You might be surprised to find that renting is the better financial option. You may discover, however, that buying is a great investment for you, too. You just have to do the math.

Rents and home prices tend to be negatively correlated, as they are substitutes: when the price of one increases, the price of the other should decrease. Economically speaking, they should be the equal, as Homo Economicus should be indifferent between the two strategies for getting a roof over one's head. However, short-term fluctuations in markets for houses and borrowing cause the relationship to get out of whack from time to time. Just as in stock markets emotional and cognitive bias affect prices, so too is the housing market thus affected, although typically on a longer time scale (due to higher transaction costs, search costs, and a general lack of fungibility.) So, you can beat the housing market by knowing whether it is currently cheaper to buy or to rent, and use that to your advantage. Consider the chart below:

This chart compares vacancy rate and homeownership rates in the United States on a quarterly basis. Sometimes the two travel together, sometimes they diverge. If there are more vacancies, then homeownership should be increasing; if homeownership is decreasing, then vacancy rates should be decreasing, too. Going back to the middle of the Great Recession, you can see that vacancy rate increased while homeownership decreased. This made sense as demand for housing diminished, since people were afraid to buy homes and many people moved in with friends and family to cut housing costs. By the end of the recession, the vacancy rate drops at the same rate that homeownership drops, since more people chose to rent instead of buy, which probably reflects a lack of savings and risk aversion. This trend continues more or less until 2016, when homeownership rises precipitously as vacancy rates fall. Economically speaking, this would indicate that demand for housing is increasing, and this is impacting the price of both renting and buying.

Would this mean that now is a good time to buy a house? Perhaps--however, there are a couple of things to consider. Real estate that has been put to use for commercial purposes--retail, as well as food and beverage--is currently is freefall, as COVID-19-related events see their tenants suffer extraordinary reductions in revenue. Food and beverage likely will recover, but retail likely will not, owing to secular changes that have been accelerated by the current pandemic-driven crisis. That real estate could and probably should be converted to residential real estate stock--which would in turn depress residential prices.

From an investment perspective, buying a house is as uncertain a proposition as it has been in the past, but perhaps a bit moreso because we're in the middle of huge economic changes that no one knows how will play out. By all means, buy a home for irrational purposes--to make yourself feel safe, or to gather in with close family and friends--but wait to speculate on this asset class until the dust begins to settle.

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