Jun 3, 2019

What Are Landlords Good For?

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

Housing affordability policies in the US generally focus on price as the measure of access. In this series, I argue that this is a mistake. Rent, not price, is the key factor in housing affordability.

To understand why housing affordability policies should primarily consider rent, and why the US focus on price has proven disastrous, we need to understand the roles and incentives of three key parties: landlords, financiers, and tenants.

In this post, I will discuss the needs that landlords fulfill.

In financial terms, landlords provide three services: transactional services, capital services, and diversification. I will briefly describe each before diving more into the details below.

First, landlords bear the transactions costs of homeownership. Buying and selling a home is difficult and costly. Buyers must arrange for inspections to estimate the maintenance and upkeep costs of the home. They must investigate deeds of ownership and potential liens. Brokers and lawyers are expensive. A renter can avoid many of these costs because the landlord keeps the deed and responsibility for maintenance and upkeep. For households who only live in a unit for a few years, this is a valuable service.

Second, landlords provide valuable capital services for renters. The service of shelter that a home provides can only be consumed a little bit at a time. Almost all of the value of a given home will come from using it as shelter far into the future. But the resources that create that service must be expended when it is built. For households that don’t have significant savings or a source of credit to fund an investment in a home, landlords can facilitate that service.

Third, landlords lower the financial risk of housing for renters. Homeownership is difficult because it limits financial diversification. Diversification is a problem even for households with capital access to buy a home for long-term shelter. A home is a large asset. Even with a mortgage, the owner takes the full risk of changes in valuation. Fluctuating valuations frequently correlate with regional economic conditions, so a decline in home value will coincide with a decline in a homeowner’s income prospects. This makes owning a home risky.

Transactional Services

Transactions costs are a primary reason why households self-select into renters and owners.

Homeownership rates for households under 35 years of age are well below 50 percent, while about 80 percent of households will eventually become homeowners when they are older. One reason for that large difference is that younger households aren’t usually as settled, and high transactions costs make homeownership uneconomical.

If there are improvements in public title tracking or innovations or new efficiencies in real estate transactions, this cost will be reduced. New market-makers in real estate, like OpenDoor and Zillow, are trying to reduce these costs and create a more efficient marketplace.

These efficiencies will increase the price-to-rent ratio that homeowners would be willing to pay. This is a good illustration of the difference between rental affordability and price affordability.

The rental value of a home reflects its value over time as shelter. If new transactional efficiencies make it easier to buy and sell homes, price-to-rent ratios would rise. In a functional market, rising price-to-rent ratios should trigger new supply that would eventually bring down the rental values of pre-existing units. In the new, more efficient market, households would consume more housing in real terms of things like square footage and pay slightly lower rents, but at somewhat higher prices. And we would expect homeownership rates to rise as transaction costs decline.

More efficient markets lead to higher real estate transaction productivity. The resulting higher prices convey that information: owning a home is more valuable now, because it can be done with less hassle. Landlords would be less necessary because transaction costs would be a smaller problem, making homeownership more valuable.

Only focusing on price might tempt one to suggest that transaction cost-reducing innovation should be avoided because it would only increase prices.

As I explain in my book, Shut Out, new building is so politically-constrained in a handful of important metropolitan centers—most notably, New York City, Los Angeles, Boston, and San Francisco—that rising prices cannot trigger significant new supply. This makes urban housing a fixed resource, and it makes those important local economies a “fixed pie.” Economic growth in what I call these “Closed Access” cities mostly feeds a bidding war for the fixed supply of housing.

In a “Closed Access” city, supply would remain fixed, rents would remain level or even rise as a result of easier transactions, and the higher price-to-rent ratio created by more efficient transactions would simply increase prices.

This makes it seem coherent to object to innovation and efficiency. In a regime with fixed supply, every innovation just feeds the bidding war for limited access. The added productivity makes homeownership more valuable, but all value is captured by the previous owners as higher prices rather than by consumers of shelter as lower rents. “Closed Access” means that real estate owners pocket all the benefits from new efficiencies.

Capital Services

Capital access is similar to the landlord’s transactional services. Owner-occupied housing does not lend itself to fractional ownership, so again there is a relative disadvantage compared to landlord-owned properties.

Institutions and investors have many ways to fund ownership of multiple units. But an owner-occupier generally needs a substantial savings account or access to reasonable mortgage financing to fund a home. This puts the potential price-to-rent ratio of an underfunded owner-occupier lower than that of landlords. But the difference goes away for potential owners who do have access to capital. They can bid up the price further.

As with transactional services, innovations or regulations that make stable financing options available for families that are capable of managing the ownership of a property help to bridge that price gap. The FHA (Federal Housing Administration), Fannie Mae, and Freddie Mac are public programs that are intended to increase access to mortgages and marginally lower their cost. Such innovations or rules will tend to increase prices, decrease rents, and increase real consumption of shelter.

An effective evaluation of these programs must include an appreciation of rental value as the primary measure of affordability. They can improve housing affordability even where they may cause some price inflation. Yet, where new housing is politically obstructed, these natural benefits are blocked and the effect is to simply push prices up.

If it is difficult to imagine the effects of low transactions costs or financial innovations on home prices and rents, I find that farming is a helpful analogy. Owning a wheat field is like owning a home, and the price of the field is like the price of a home. The field produces wheat just like a home produces shelter, and the price of wheat or bread is like the rental cost of shelter.

What would happen if farming suddenly had lower costs or easier access? Maybe seed became cheaper, or laws about who could own land were liberalized. This would draw people to farming. They would be willing to pay more for farmland and to prepare more land for cultivation. There would be more farmers, and farmland would be more expensive. There would also be more wheat and bread, and wheat and bread would be more affordable.

Most households are homeowners, which makes them like subsistence farmers, but for shelter. This creates much confusion about the provision of shelter. Making it easier to be a farmer can simply mean that those who do farm will bid up the price of land, but it will also mean that bread is cheap and plentiful, and that is what is really important.

Frequently, innovations that encourage homeownership (or farming) are socially useful, not because they benefit homeowners (or farmers), but because they benefit tenants (food consumers). This observation about the character of those benefits remains true and important even if most of those tenants (and consumers) are homeowners (and farmers).

And, to continue with the analogy, “Closed Access” cities create the equivalent of a legal maximum quota on the wheat harvest.

Diversification

The service of diversification is similar to the other services. Again, the value is naturally lower for owner-occupiers relative to landlords. It differs in that there is not a feasible innovation that can reduce this problem for owner-occupiers. To attain the benefits of homeownership, one must invest in a large, non-diversified asset.

In all three cases, market frictions pull down the price owner-occupiers should be willing to pay, compared to landlords.

This leads us to a natural question: given these advantages, why don’t landlords own most housing units? That is the subject of the next post.

Photo credit: Tom Rumble/Unsplash.

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