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.