Jul 8, 2019

Squeezing Unqualified Borrowers

Part Seven of Kevin Erdmann's Housing Affordability Series
Kevin Erdmann Visiting Fellow

In previous posts, I outlined how a lack of adequate homebuilding has driven up rent inflation and made housing less affordable, even in cities that were oases for affordable housing during the housing boom.

There is a widespread belief that before the financial crisis, too many homes were built, and that many of them were built for unqualified buyers with low incomes. In an attempt to remedy this perceived problem, regulators in charge of Fannie Mae and Freddie Mac and other mortgage originators have pressured banks to limit their lending to borrowers with less pristine credit.

In cities and neighborhoods where incomes are low or entry-level homes are common, this clampdown coincided with substantial declines in local property values. The difficulty of making smaller loans and loans to households with lower incomes has, ironically, caused rents to rise in cities where homes are cheap to buy.

The same pattern can be seen by comparing owners and renters. Households who have been newly locked out of mortgage markets by new, tighter lending standards are forced to remain in the renters market. That market is full of tenants with fewer options, and it tends to be in low-tier markets where new supply has dried up. This means that rent inflation has been especially high in low-tier markets that are dominated by renters.

Rental Expense and Rent Inflation in Boom and Bust

As mentioned in the previous post, the rental value of homes owned by their tenants rose proportionately with their incomes during the housing boom. In other words, the portion of their incomes that would have been required to pay cash rent on their homes remained stable.

The real rental value of their homes followed a similar pattern. In other words, in line with the rising incomes of homeowners, both the real value (in terms of size, location, etc.) and the market rental value of homeowner units were rising compared to tenant-occupied units.

The housing bust hasn’t been a reversal of a housing boom that consisted of new homeowners with marginal incomes buying homes they couldn’t afford. It isn’t a reversal of that because that never happened. So what has happened in the post-crisis period?

The relative income of homeowners remains high, so while the growth in homeownership was highly focused on households with high incomes, the sharp decline in homeownership has been spread across income ranges. The net result of the boom and bust is that homeownership remains more rationed by income than it had been before the 1990s.

The rental value of houses that owners and renters live in has changed, though. The average rental value of owned homes in 2016 was about 15 percent of the owner’s income. That’s about the same that it was in 1995 and 2004. For renters, the rental value has increased from 21 percent in 1995 to 23 percent by 2004 and up to over 26 percent after the crisis.

Housing affordability is largely a problem for renters. The portion of the average renter’s income going to rent since 2007 has increased from 24 percent to 26.4 percent—an increase of about 10 percent.

Since the crisis, renters have not been consuming significantly more housing in real terms. Most of this increase is inflationary. Both the Bureau of Labor Statistics (via the consumer price index) and the Bureau of Economic Analysis (via the personal consumption expenditures price index) estimate changing prices of various goods and services. Both of them estimate that rent inflation in homes occupied by renters has been higher than rent inflation in homes occupied by owners.

In other words, landlords in neighborhoods full of rental units have increased their rents more than landlords in neighborhoods surrounded by owned homes.

The Squeeze

This happened because we have been battling phantoms. There was never a surge in low-income borrowing or homeownership. The systematic efforts since 2007 to legally block mortgage access for households with lower incomes has locked millions of American households into a renter’s market.

Prices have dropped and rents have risen in low-tier housing markets because the funding for potential owner-occupiers has dried up. Those homes are now owned by investor landlords who must charge higher rents to cover the costs of rented property, such as vacancies, poor tenants, and management costs. New supply could drive down rents in those markets, but very little new supply is built because prices of the existing stock have been driven below the cost of building.

Supply is growing in high-tier markets because they are full of high-income households who can qualify for mortgages. The new supply keeps rent inflation more moderate where there are more homeowners and local incomes are higher. According to the Bureau of Economic Analysis, the extra rent inflation in rented units (compared to owned units) has been about six percent since the crisis. The Bureau of Labor Statistics puts it at about nine percent.

Considering this set of circumstances, the idea that housing affordability is getting worse because prices are high and that the solution is even higher interest rates or tighter credit access is a disastrous misreading. It will lead to a vicious cycle of segregation between households that can qualify under today’s standards (and who then can buy ample units at favorable terms) and households that cannot qualify (and who must keep economizing while a large portion of their wages is transferred as rent to the ownership class).

There are two options. Re-opening credit markets to entry-level buyers will return the market to a more equitable equilibrium. Maintaining the market as it is will continue down the path of settling at a new equilibrium where certain households live in smaller, less adequate units, either because of size, amenities, or location.

Either equilibrium is functional. It won’t be the end of the world, either way. There will be few direct ways to compare the living standards of the coming generation to the pre-crisis generations.

Nothing about the new equilibrium will be obvious. Households with lower incomes will have smaller, less well-maintained units with longer commutes. Households with higher incomes today have better housing units. In the new equilibrium, they will be somewhat better still.

Maybe progressive taxation and income transfers can re-level the playing field. But wouldn’t it be better to let some five percent of the American populace back into the homeownership market again, similar to the way it was for decades before the crisis, and use those taxes and transfers to address other problems of inequity? This will be the subject of my next few posts.

Photo Credit: Jan Gottweiss/Unsplash.

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