Should An Economist Analyze Housing?
The conventional wisdom (i.e. what my dad and his buddies would tell me) is that, so long as you have decent credit and plan to stay in the area for a few years, it is crazy not to buy a house (rather than rent) because you can deduct the interest on your mortgage. Especially in the first few years, when you are paying tens of thousands in interest payments, that tax advantage equals hundreds or even thousands of dollars in extra take home pay per month.
Yet this seems too easy. Wouldn't economics tell us that it can't be true that "only a fool would rent"? In particular, if buying is so much "obviously" superior to renting, then market prices should change to reflect this. So more and more people buy property for the tax advantage and then rent it out. Nobody wants to rent (following the conventional wisdom). This happens until rental rates (compared to mortgage payments) for comparable pieces of property fall until people are indifferent between renting or buying. In essence, the landlord is giving the tax deduction to his tenants in the form of lower rents. (One thing I'm assuming is that landlords can claim this as a deduction, even if they don't live in the building. Is that true?)
Is this a sound argument? Granted, my Chicago-esque analysis is leaving out all sorts of real world considerations (imperfect knowledge, credit constraints, no such thing as true indifference, etc.). But as a first pass, do people generally agree with me? E.g. wouldn't it be silly if someone said, "Oh the government just started subsidizing farmers, so only a fool would go into a different profession"?
Comments (23)
My gut feeling is that you're right and there is something wrong with the common "wisdom" in this respect, but the tax issue is more complicated than you paint. The "break" you get on mortgage interest is only a break in the sense that it is a deduction allowed for a non-business expense. On the other hand, if you own property entirely for profit generating purposes (i.e., you don't reside there at all), you can generally deduct all the costs associated with generating that profit - it's a business expense. So, in fact, absentee landlords should actually be able to deduct more than simple homeowners (the case of resident landlords, IIRC, gets kinda complicated in determining to what extent the real estate is considered business and to what extent it is considered residence).
Part of the answer may simply be the high cost of maintaining rental properties in our regulated economy keeps rents high, as noone will maintain a loss on a rental property for long, thereby driving marginal units off the market, reducing supply.
Published: September 13, 2006 9:29 AM
http://www.patrick.net/housing/crash.html has a great reply to the conventional "wisdom":
"It is much cheaper to rent a house in the San Francisco Bay Area than it is to own that same house, even with the deductibility of mortgage interest figured in. It is possible to rent a good house for $1800/month. That same house would cost about $700,000. Assume 6% interest we can see that a buyer loses at least $4,936 per month by buying. Renting is a loss of course, but buying is a much bigger loss."
"Under current conditions, a renter would be able to live in a Bay Area house for 30 years, then buy that $700,000 house outright with the saved principal payments and have avoided $810,846 in interest payments. Rent would be only $648,000 over those 30 years, so the renter comes out at least $162,846 ahead. See any "amortization table" if you don't believe that interest will cost more than the house. This doesn't even count the huge losses the owner will suffer as the value of his house falls year after year for the next decade or more, just as in Japan, nor does it count property taxes, insurance, and maintenance."
Published: September 13, 2006 9:30 AM
the answer of course, is that it depends. You might get to deduct mortgage interest but you're still paying it, and possibly also mortgage insurance, and property taxes, and maintenance. It's not at all obvious that these things are still a better deal than renting, especially for a single, even after equity appreciation.
this page nicely summarizes the issues, and has a link to an open document format spreadsheet to calculate scenarios.
http://echang.freeshell.net/buyrent.html
Published: September 13, 2006 9:36 AM
Semi-relevant point: a guy where I work builds and rents out apartments as a side business (yes, somehow he can do that plus his full time job). He points out that if there were no mortgage interest deduction, people could accomplish the same thing alternate ways. Say there's a pair of people, A and B. A buys a house a rents it to B, and B buys a house an rents it to A. Their rents roughly cancel, so there's little transfer between them. Since it's now a "business" the interest is an expense and thus tax-deductible. And the only way to remove that tax deduction would be to tax businesses on revenues rather than profits -- which would be crazy, even for the taxman.
More relevant to your point, you are (true to character) comparing apples and oranges. In your dad's supposition about renting, he said, "as long as you have good credit and won't move for a while" *then* renting is stupid. (And there are more proviso's you can add -- that you're okay with lack of illegals for cheap landscaping and having responsibility for repairs, that real estate won't soon collapse in value and more.) You then compare it to saying, in a regime of farm subsidies, "only a fool would not go into farming". But the analagous comment would be "only a fool who could afford land at market rates and could farm well enough such that he would prefer the farm profits plus subsidies and didn't mind mooching off other taxpayers etc etc etc would not go into farming".
In both cases, a monetary advantage makes something more worthwhile, and in both cases, as long as certain preconditions are met, become "obviously" better than your alternative. The problem with your dad's comment is that he (reasonably) assumes that a bunch of other preconditions are met, while he can't be so sure about all those pre-conditions for farming. He wouldn't casually assume that you like farming. He would, however, casually assume real estate prices won't soon collapse, or that you know how to repair, or find a repairman, for damages to your home, the absence of ability for which would make renting preferable.
I would also add that the long term return on equities is historically higher than the long term return on real estate, and far more liquid, which many discussions on this topic leave out.
Published: September 13, 2006 9:37 AM
to follow up on Person's comment, the conventional-wisdom advocates of home ownership vs. renting seem to implicitly assume that you're going to squander the monthly savings of renting vs. a mortage payment. IOW, they look at home ownership as sort of a forced savings plan. The conventional wisdom never takes into account that you might employ those funds in an investment that might earn you a greater return than equity appreciation.
Published: September 13, 2006 9:50 AM
If I may chime in, rent rates are reset every year or two versus a very permanent 30 year mortgage.
I would think the dynamic between renting and buying would depend on who is renting houses. To rent a house you first have to own it. Why would someone rent a house if the monthly rent does not cover the mortgage + maintanence expenses? I think the only way someone would rent out their house is if they bought the house at a low price and then housing prices soar. Then new people on the market faced with the decision between buying and renting are confronted with the higher housing prices (forced to rent). Renting for the old owners is profitable, but not profitable if the new entrants buy property now and rent.
You don't buy houses at the top of the credit cycle (house price top), but you rent instead. This way, if housing prices drop you won't suffer because rent rates are reset.
Similar to fixed income assets, it is not really a matter of renting or buying, but how long does said home person plan on living in said residence (fixed income equivalent to investment horizon). If you plan on living in the house for longer than 30 years (or length of mortgage) it might make sense to buy as you won't need to worry about monetizing any changes in the house price. If you plan on living there for less than 30 years, then buying the house would open you up to interest rate/house price fluctuations. I am saying this from the perspective of managing cash flows. (rent = short duration/low sensitivity to IR/HP vs buy = long duration/high sensitivity to IR/HP)
So after this long diatribe of mine I hope somene can piece together what I think I am thinking of, but can't express.
Published: September 13, 2006 10:06 AM
Ya gotta figure in inflation. Real estate does a pretty good job of keeping up with it.
Published: September 13, 2006 10:33 AM
The tax deduction you are writing about I believe only applies to your own house. There are other tax breaks for owning a house, such as being able to roll any capital gains into another property and defer the taxes. While you are correct that theoretically economics should balance this issue to a degree, by limiting the tax break to owner occupied residents the state is effectively directing a tax break against renting. Once the state begins to use the law to favor various economic decisions things get screwy.
Published: September 13, 2006 10:35 AM
Two more slightly tangential comments on the issue:
1) When Robert_Murphy asks whether economists "should" analyze housing, it reminds me of a debate I had with someone a while ago about the minimum wage. I made the standard argument, "If a law can increase worker compensation simply by mandating pay, why couldn't you accomplish the same thing with e.g. a $100/hour min. wage?" What amazed me was the response. Someone said, essentially, "That's invalid. Economics now uses marginalism. Marginalism is about small changes. Economists only look at the effects of small changes. An increase to $100/hour is a large change, so it's an invalid argument." Yes, that's right -- someone actually though that acceptance of marginalism means economists literally cannot appropriately comment on the effect of any large change in the economy, and thus exempts them from proofs by contradiction!
2) About mortgages: most people would accept that home is "an investment". Yet they also believe that you should never borrow to invest. What gives?
Published: September 13, 2006 10:52 AM
Person,
The guy at your work doesn't paint a realistic picture - why? Because if people would do that absent the INTEREST deduction, they should be doing it now absent the PRINCIPAL deduction (or depreciation). It's an interesting theoretical loophole, but it's really not attractive enough to overcome the headaches and risks it creates (you are more or less locked into a relationship with B).
Amazingly enough, I agree with most of the rest of what you said (my only minor quibble is that any attempt to gauge long term returns, in either equities or real estate, are fraught with inaccuracies due to money supply expansion. I'm not saying you're wrong, just that you're too certain.)
This
"most people would accept that home is "an investment"."
however, is interesting. "Home" is in fact not an investment, but a consumer durable. If you sell it, you must find another (even if you're selling to go rent). Also, you wear it out as you use it - it actually loses value over time if you don't maintain it. Finally, it doesn't produce surplus value to you unless you rent out parts of it.
RogerM,
I once read a study that found that 30 years after the industrial revolution began in England, the only people who retained wealth were the landowners in the area - the entrepreneurs had all subsequently busted on one project or another. The only risk in holding real estate is the risk created by taxation and regulation.
Published: September 13, 2006 1:40 PM
The conventional wisdom (i.e. what my dad and his buddies would tell me) is that, so long as you have decent credit and plan to stay in the area for a few years, it is crazy not to buy a house
Perhaps you answered the question yourself right there. Not everyone has good credit, and not everyone can count on being in the same place for a long time. Therefore, not everyone can capture the subsidy. So, if you can capture the subsidy, you should.
Published: September 13, 2006 3:55 PM
It is not possible to analyze renting vs. owning solely in monetary terms. The "psychic" benefits from owning a piece of property did not figure into Murphy's piece or any of the comments thus far. So you can rent an apartment in a complex for less than you would pay to own a place of similar square footage in a similar location. Big deal. There is more to one's residence than monetary calculations. Any good Austrian should know this.
Published: September 13, 2006 4:48 PM
"There is more to one's residence than monetary calculations. Any good Austrian should know this."--quote
Do you want your house now or later (time preference and interest rates)? This is what I was referring to when I said,
"Similar to fixed income assets, it is not really a matter of renting or buying, but how long does said home person plan on living in said residence (fixed income equivalent to investment horizon)."
Last time I recall, financing the place of residence is the biggest issue when purchasing a new home, more than location or amenities. Of course, this is a matter of opinion, but none the less you shouldn't dismiss monetary affects as trivial.
PS Have you ever tried to buy a house in a place like Miami. I wonder if monetary affects are "no big deal".
Published: September 13, 2006 5:45 PM
The reason owning a house is generally more profitable than renting has little to do with the income tax savings. The biggest reason is that if the market goes up even a few percentage points, you earn leveraged gains through equity appreciation.
A house is a unique asset in that banks are willing to throw (fradulent paper) money at you to buy one, which they are not as willing to do for many other types of investments (ever take out an 80% loan to buy $300k of gold?). So for $30,000 down payment you can buy a $300,000 house. After a good year, it might go up $30,000 in value(10%). You will have doubled your initial down payment. (Note: this example excludes many other costs of buying, selling, and owning)
I just bought my first house after renting for a few years. I added all the costs of homeownership and all the costs of renting, figured in annual increases, and compared the two. The annual costs of homeownership were much higher, so I assumed that I would invest the difference in costs while renting. Assuming a historically modest 3% annual home appreciation and a 4% return on invested savings if renting, I will turn a profit after owning a house for 5 years. If the market increases at 7%, I will turn a profit next year. In addition, during those 5 years I will live in a freestanding house that is 1 1/2 times bigger than the apartment I was renting in a similar location.
Taxes are just one of many costs of owning a home. In my case, I pay half of what I save in income deductions as property taxes. Perhaps the biggest tax benefit is that (as I understand it) you don't pay capital gains tax on the appreciated value of your own house when you sell it, unlike most other investments.
Of course, if the market drops instead of rising, I'll end up sleeping in my car with creditors fogging up the windshield yelling at me to pay them the leveraged losses I owe them. But the housing market only goes up, up, and up, right?
Published: September 13, 2006 8:39 PM
Wrong
Published: September 13, 2006 10:39 PM
Banker, I did not dismiss monetary effects as trivial. I stated that it is not possible to analyze renting vs. owning solely in monetary terms. That is, there is more to whether one owns or rents than monetary calculations can explain.
Tim, those who think that the housing market only goes up, up, and up will be in for a rude awakening when the housing market bubble bursts. It's only a matter of time.
Published: September 13, 2006 11:58 PM
My previous comment about the housing market only going up was tongue-in-cheek. I just wanted to throw some meat to the wolves.
Another thought that speaks partly to some of the "psychic" benefits of owning a house is that you yourself can make improvements to it to generate value, unlike many other investments. I have a fixed salary, so any "extra" work I do in the office doesn't give me more income. I can't work to increase the value of the gold or stocks I already own. If I want to labor to make the value of those investments go up, I need to generate money in some other way and then buy more of the investment at its current value.
With a house, I can do work myself to directly improve the value of the investment while only spending a fraction of the value of the improvements in money. For example, I can spend $5,000 on new kitchen cabinets, work 40 hours to install them myself, and potentially realize a $10,000 increase in the value of my house. If these numbers are realistic (they're probably not), I will have earned $5000 for my 40 hours of labor, or $125/hr, tax-free.
In this way, a house can become a means for people with fixed salaries to convert their leisure time into profitable labor, while at the same time increasing the "psychic" quality of their home.
Published: September 14, 2006 7:32 AM
Well, looks like Bob got the answer he wanted. Maybe now he can go back to explaining why "to get to the top" is a bad explanation for why people walk up staircases.
Published: September 14, 2006 10:13 AM
Person wrote:
More relevant to your point, you are (true to character) comparing apples and oranges. In your dad's supposition about renting, he said, "as long as you have good credit and won't move for a while" *then* renting is stupid. (And there are more proviso's you can add -- that you're okay with lack of illegals for cheap landscaping and having responsibility for repairs, that real estate won't soon collapse in value and more.) You then compare it to saying, in a regime of farm subsidies, "only a fool would not go into farming". But the analagous comment would be "only a fool who could afford land at market rates and could farm well enough such that he would prefer the farm profits plus subsidies and didn't mind mooching off other taxpayers etc etc etc would not go into farming".
In both cases, a monetary advantage makes something more worthwhile, and in both cases, as long as certain preconditions are met, become "obviously" better than your alternative. The problem with your dad's comment is that he (reasonably) assumes that a bunch of other preconditions are met, while he can't be so sure about all those pre-conditions for farming. He wouldn't casually assume that you like farming. He would, however, casually assume real estate prices won't soon collapse, or that you know how to repair, or find a repairman, for damages to your home, the absence of ability for which would make renting preferable.
Person,
First, do we know each other? There seemed to be an unusual degree of hostility ("true to character" and the elevator crack later on) unless you and I have argued before and I'm just forgetting your handle.
Second, you haven't convinced me that the farmer subsidy was a bad example, because you are overlooking the whole point: No, subsidies DON'T automatically mean "everyone should go into farming," even if we assume everyone has equal abilities and desire for that lifestyle. The reason (as with housing) is that other things would adjust. If the gov't tomorrow announces that all farmers get an extra $10,000 per year, people would switch over until that advantage was offset by something else (land prices up, crop prices down, whatever).
Now you can wiggle out of this by saying, "I said the land had to be affordable!" but you still seemed to be missing my main point.
Published: September 14, 2006 12:36 PM
Person wrote:
Well, looks like Bob got the answer he wanted. Maybe now he can go back to explaining why "to get to the top" is a bad explanation for why people walk up staircases.
What are you talking about? Landsburg said the explanation was that you have to measure benefits in time, not distance, and I pointed out that this was mistaken. So not only is your jibe wrong, it's exactly backwards. If anything, Landsburg was saying "to get to the top [a position]" isn't a good explanation.
Published: September 14, 2006 12:38 PM
RPM:
First, do we know each other?
That depends. Do you know any persons? (Heh, heh.)
Second, you haven't convinced me that the farmer subsidy was a bad example, because you are overlooking the whole point: ... If the gov't tomorrow announces that all farmers get an extra $10,000 per year, people would switch over until that advantage was offset by something else (land prices up, crop prices down, whatever).
Now you can wiggle out of this by saying, "I said the land had to be affordable!" but you still seemed to be missing my main point.
No, I specifically called out the land prices because I got your point. It was only "wiggling out" in the sense that the concept of aerodynamic drag is "wiggling out" of problems with Newton's laws of motion. (You seem to have this practice of making objections that are pre-empted by the original speaker's statement, and then curtly dismiss that entire part with one sentence. I think I saw something you did for strike-the-root a while back when you explained about how Bush lied because Iraq didn't turn out to have WMD's, and then added at the end, almost as an afterthought, "Well, you can say it's not really lying if he believed it, but I still think he's like a bully.")
Your answer is: your dad subtly assumes pre-conditions in home-buying he wouldn't assume in farm-buying. And why do you care what laymen say? If you go to a financial advisor -- i.e., the people who help you make informed decisions about this sort of thing -- they won't automatically say "buy a house". They'll have to look at your individual circumstances. There are, however, advantages to buying a home, as new people are born, get jobs, etc., some realize this and buy a home. Imagine that: imperfect information, and markets not immediately adjusting to equilibrium forever.
If anything, Landsburg was saying "to get to the top [a position]" isn't a good explanation.
And you agree with that part. Hence, my comment.
Published: September 14, 2006 1:39 PM
Luke Fitzhugh wrote:
"It is not possible to analyze renting vs. owning solely in monetary terms. The "psychic" benefits from owning a piece of property did not figure into Murphy's piece or any of the comments thus far. So you can rent an apartment in a complex for less than you would pay to own a place of similar square footage in a similar location. Big deal. There is more to one's residence than monetary calculations. Any good Austrian should know this."
Individual subjective "psychic benefits" are immaterial to the inlcusive market rate marginal subjective valuations, which includes everyone concerned's psychic subjective benefits, reflected in the market price valuation. It's true that one individuals psychic benefit may be so great that he would not trade his house for anything else. It can only be observed, and is not constant.
But it still doesn't change the fact that what others are willing to trade for something (in this case a house) is not constant no matter what any individual's subjective valuation may be. What a piece of property can be traded for, its market value, its worth, is determined not by one individual's psychic valuation. And in that sense there is no such thing as "monetary terms" in a true economic sense. "Monetary terms" is just another word for (psychic) subjective value, is a transaction trading facilitator.
Whether you own $700,000 worth of apples or rent $700,000 worth of apples for an art display still represents market value. And if the market is only willing to trade $350,000 for those apples tomorrow, it's nonetheless a real loss of value no matter what one's individual psychic valuation may be. Those apples, or that house, gets a lot less trading possibilities when the market measures it at half of what it did before. And it's inescapable to note that if you had waited to purchase the house at half price you would have the same house giving the same individual psychic subjective value PLUS $350,000 to use for other things. Was owning the house a year or three earlier worth the cost of $350,000? Maybe. Maybe not.
At any rate there is a synthetic scenario whereupon one can defer purchase/rent out their own house for X price for Y time, such that a point exists where their psychic subjective benefit is greater, i.e. you buy your house for $100,000 cheaper a month later. That impacts your psychic valuation of the house plus what you would do with an extra $100,000 doesn't it?
Published: September 14, 2006 8:21 PM
micheal> Once the state begins to use the law to favor various economic decisions things get screwy.
Well that pretty much sums it all up.
Published: September 16, 2006 11:10 AM