Homeowners Make the Best Landlords
Part Three of Kevin Erdmann's Housing Affordability Series
My previous post outlined how landlords add value to the service of shelter. But if landlords presented no downsides, then no one would own their own homes. This post explains why people prefer to be to homeowners, and why our price-focused policies have frustrated affordable housing access for all tenants.
The core problem is that landlords face agency costs. When the funder, the manager, and the tenant of a property are the same person, it’s easy to make decisions about how to use and develop the property. But when they are different people, each individual must deal with a lack of information. They may not trust each other, and need to negotiate plans, expectations, and constraints.
It is often more expensive to be a landlord than an owner-occupier. Landlords must deal with bad tenants, vacancies, property management issues, and upkeep in ways owner-occupiers don’t. These costs can easily add up to thousands of dollars a year. One way landlords minimize these costs is by building apartment buildings to consolidate management of multiple properties. The cost of managing single family homes has limited that market mostly to small scale local landlords.
Many criticize programs to encourage homeownership because of the speculative nature of ownership. Over the past twenty years, homeowners in San Francisco earned much greater returns than homeowners in Detroit.
But capital gains are not the only returns to a housing investment. Except in rare instances, such as the home in San Francisco, a home’s long-term rental value is much more important than inflation-adjusted capital gains.
Even more importantly, the value of being a landlord to oneself is a free bonus for homeowners. It is that value that should be the focus of ownership programs.
In an equitable housing market, that bonus should be widely available. And since self-ownership can be a more efficient form of ownership, affordability shouldn’t be the determining factor for ownership in a developed market. An owned home should be more affordable, all things considered, for a household that might value ownership.
We know these landlord costs are significant because almost all households with access to capital and plans for long-term tenancy own their own homes. The cost of non-diversification is hard to measure. But in practice, more than 90 percent of older married couples are owners. Nearly every household who meets the profile of a potential owner becomes one. This suggests that the cost of non-diversification is much lower than the value of control.
In addition to the raw financial considerations, the relationship between a long-term tenant and a landlord presents a moral conflict. For a long-term tenant, the home develops a sense of sanctity. Yet the landlord also has an inalienable and important right to manage and dispose of her property as she demands.
Tenant protection laws can address the sanctity of the home for a long-term tenant, but these laws cannot relieve the tension. They only pit the rights of the tenant and the landlord against each other.
If the rights of the landlord are compromised it will inevitably be reflected in rising rents. The sanctity of home cannot be claimed outright. Pragmatically, it can only be purchased. That purchase is unnecessary where the landlord and tenant are one and the same.
Two recent studies suggest that the value of avoiding the costs of the landlord-tenant relationship is substantial, explaining why households so universally choose ownership.
A paper from Òscar Jordà, Moritz Schularick, and Alan M. Taylor, titled “The Total Risk Premium Puzzle,” finds that returns to real estate owners are high relative to other asset groups. They argue that this is true even after accounting for transaction costs and inability to diversify.
Looking at the same issue from a different perspective, sociologists Matthew Desmond and Nathan Wilmers find that in poor neighborhoods, where landlord risks and costs are higher and credit constraints blocking potential owners are stronger, yields earned by landlords are especially high. In other words, price/rent ratios are too low.
Both sets of researchers are saying that owning homes is a good deal for both landlords and homeowners, in practice, because of all the factors that add frictions to housing markets.
This strongly suggests that rent, not price, is the key constraint in housing affordability. Ownership typically confers monetary benefits. In functional markets where higher prices can trigger new supply, institutional developments that cause price/rent ratios to rise will tend to improve affordability in terms of rent. This is what is important for households with few options.
When considering the benefits of home ownership on the margin, the focus should be on capturing the excess yield that seems to be widely available to owners. It is this yield that is most important to marginal potential owners, not capital gains. That yield—the rental value of a property, after costs and depreciation—is captured as capital income. Or, in the case of owner-occupiers, the avoidance of the cost of renting.
But it may be more accurate to think of that excess yield as a form of patronage. A lucrative wage available to those with access to ownership. The wage is earned by performing the duties and taking the risks of a landlord. Upon becoming the owner, the wage remains, but the duties of the job can be shirked. There is no problem tenant to evict. No vacancies to fill. No complaints to manage. It’s a cushy job you can get because your Uncle Sam pulled some strings down at the bank.
Earning this “wage” every year can outweigh the risks of non-diversification and the costs of real estate transactions within a few years. There are properties in cities across the country where a reasonable mortgage payment would be well less than the rental payment for the same unit. Regulatory limits have been placed on lenders by limiting the fees or interest rates they can charge. Those limits tend to be measured as a proportion of the price of the home or the size of the mortgage.
But the more important reference for those potential owners is the rental payment they must make in lieu of that mortgage payment, and the landlord’s “wage” they must forego as long as they are prevented from taking ownership. Here, as with so many aspects of the public regulation of the consumption of shelter, regulatory protections that don’t place rent as a central factor in the affordability of housing will not allow households to access optimal affordable housing.
A focus on prices rather than rents has produced suboptimal policy approaches, both in cyclical responses to the housing boom that led to a financial crisis and in long term prudential regulations applying to home ownership. Understanding the folly of focusing on prices is key to understanding the effects of market forces and public policies on access to affordable shelter, which I will discuss in the following posts.