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The basic premise behind the panoply of government policies aimed at stimulating home construction and financing – the mortgage interest deduction, Fannie Mae and Freddie Mac, the Federal Housing Administration (FHA) loans, down payment assistance, among others – is that homeownership yields huge societal benefits in the form of improved neighborhood aesthetics, reduced crime, and more civic attachment.
The purported benefits of homeownership could actually be a classic case of reverse causality, as higher income households less likely to commit crime and more attached to the community tend to also be more likely to own homes. However, even if these social benefits are only imaginary, the basic economic proposition of “owning” a home is often assumed to be so far superior to “renting” that government policies to allow the marginal household to buy a home make sense –simply because they provide an avenue towards wealth creation.
The sense that homeownership was an essential building block to household wealth was a key psychological driver of the mortgage boom. As much as government policy was to blame for getting people to purchase homes that they otherwise wouldn’t, it is important also to acknowledge the role played by “societal coercion.” As Yale professor Robert Shiller explains, “bubbles are impossible without extreme public enthusiasm.” Individuals who would have otherwise been content to rent were often asked by friends, colleagues and acquaintances, “why throw your money away on rent?” Whereas the rent check simply vanished each month, the mortgage payment helped to secure something tangible and allowed one to participate in the upside of house price increases. If a household could afford to buy a dwelling, the prevailing wisdom went, why in the world would they be so dense as to rent? This sentiment was intensified by expectations of continued price gains in 2004-2006, when first-time homeowners worried that if they did not buy soon, they’d never be able to afford a home.
A new academic article in Real Estate Economics turns this conventional wisdom on its head. Using data from 1979 to 2009, the authors demonstrate that renting was the superior investment strategy for most of the past 30 years. Counterintuitive as the finding may be to some, it is actually quite logical. Unless someone possesses the cash necessary to buy a residence, he or she will be renting one way or another. The choice is between renting the property directly or instead renting the capital necessary to buy the property. The amount of capital to be rented is a function of house prices, while the bulk of a mortgage payment is interest, which is the rental payment on this capital. After 2 years, the typical 30-year amortizing mortgage balance has been reduced by less than 3%. This means that a household that took out a $300,000 mortgage with a 5% interest rate to buy a home has only reduced its mortgage balance by $8,600 after two years despite spending nearly $39,000 in total over this period.
Housing advocates may respond by pointing out that at least the $8,600 in this scenario went towards home equity rather than simply being squandered on rent. But, as demonstrated in the Real Estate Economics article, the principal component of each mortgage payment – i.e. the portion of the mortgage payment that goes towards reducing the principal mortgage balance instead of interest – is an added expense renters don’t have. During the housing boom, the wealth created from housing was not principal amortization, but rather large price gains on a highly leveraged asset. A 20% increase in the price of a house purchased with 5% down results in a doubling of the homeowner’s equity. These wealth gains proved illusory and were a function of the leverage involved (20-to-1 in the case of a 5% down payment) rather than anything related to housing.
They key to understanding why renting is so often superior are “price-to-rent ratios,” which reflect the difference between the monthly cost of renting or buying equivalent residences. While it is often less expensive to rent than it is to buy, the relationship can change over time causing one of the two options to be an especially (or comparatively) good deal in some circumstances. The graph below compares the Case-Shiller house price index for Miami to the Bureau of Labor Statistics (BLS) rent index for the same community. From 1999 to the second quarter of 2006, the cost of buying a home doubled relative to what it would cost to rent the same property (on an average, community-wide basis). To put this change in concrete terms, imagine a two-bedroom, 1,800 square foot condo. In 1999, it required a $1,200 per month mortgage to buy, compared to a $1,000 monthly payment to rent (a price-to-rent ratio of 1.2). For the price-to-rent ratio to increase by 2.2-times over this period it might have cost $3,000 a month (in mortgage payments) to buy the property in 2006, compared to a $1,100 monthly rent payment. In retrospect, it is remarkable that it was the household spending $1,900 per month less to live in the same property that was considered to be “throwing money away.”
Renting was better than buying for nearly all households during 2005-2007 because prices collapsed after that period. Importantly, the authors make clear that in general, renting is only the superior financial choice if the renting household has the discipline to invest its marginal savings into financial assets. Renting generates residual savings because the cash outlays tied to housing consumption (or purchase) are lower. But if renting households, or the individuals themselves lack the discipline to save this money, and instead increase non-housing consumption, any wealth gains will clearly disappear. The basic intuition is that the principal portion of mortgages is what usually leads to more wealth. But as this article shows, that’s because it represents incremental savings not because of anything intrinsic to the mortgage itself. Viewed in this light, the economic gains come not from “owning” a home but rather the forced savings generated by the principal portion of the monthly mortgage payment.
It is instructive that at the end of the analysis, the much-touted economic gains from homeownership really come from the forced savings of an amortizing mortgage. And this benefit only accrues to myopic households that would not otherwise save. Thus, the government could replicate the same economic benefit generated by federal housing policy through a simple deduction from checking accounts that could then be deposited into a tax-free savings vehicle. This is an important point to consider the next time someone argues that removing or lowering a housing subsidy will necessarily inflict an acute economic hardship on the nation.