Tag Archives: rental properties

A Little More on Wealth Accumulation and Homeownership

Last week’s posting (Homeownership Leads to Greater Wealth Accumulation: But How?) concentrated on how homeowners, on average, accumulate more wealth than renters. The gist of the posting was that in an environment where most do not save homeownership creates a “forced piggybank” for owners through amortization of their mortgages and prepayment of principal. This conclusion comes from ongoing research being conducted by Beracha and Johnson. [i] Additional evidence indicating that homeownership is really a savings vehicle is provided when Beracha and Johnson’s Buy vs. Rent model[ii] is employed to estimate the probability that renting is the superior economic decision and leads to greater wealth.[iii] In particular, Beracha and Johnson balance the benefits of ownership against the costs of homeownership and compare wealth accumulation through home equity against wealth accumulation through investments created by a comparable renter. [iv] The model assumes an eight year holding period. [v]

Through thousands of Monte Carlo simulations (an advanced statistical technique where past outcomes are used to predict future results), Beracha and Johnson are able to derive the probability that renting will outperform homeownership in terms of wealth accumulation for each of the 30 plus years of the study. When the probability for a given year is 50%, there is no clear winner between ownership and renting. When the probability is greater than 50%, renting wins. When the probability is less than 50%, ownership wins. The results are presented in the graph below:

Probability That Renting is Preferred to Buying - graph

The top line in RED depicts the probability that renting will outperform ownership in wealth accumulation assuming that renters reinvest rent savings (difference between rent payments and mortgage payments). Clearly, over the vast majority of the study period and under this very strict assumption of reinvestment of rent savings renting provides the greater probability of wealth accumulation.

The bottom line in BLUE, however, depicts a different and perhaps more realistic outcome. In particular, when renters are not forced to save and reinvest their rent savings and are instead allowed to spend on consumption, ownership becomes the probability winner in all of the wealth accumulation races.

Implications

Evidence is continuing to mounting that renting is a better path to wealth accumulation in a strict “horserace” between buying and renting where renters are forced to reinvest any rent savings. Therefore, for those that have the discipline to monastically reinvest rent savings, renting is probably the better path to wealth accumulation. However, in perhaps a more realistic setting where renters can spend on consumption (beer, cookies, education, healthcare, etc.), ownership is the clear winner in wealth accumulation. Said another way, homeownership is a self-imposed savings plan on the part of those that choose to own.

ENDNOTES


[i]Eli Beracha and Ken H. Johnson, 2012, Beer and Cookies Impact on Homeowners’ Wealth Accumulation, ongoing research.
[ii]Eli Beracha and Ken H. Johnson, 2012, Lessons from Over 30 Years of Buy Versus Rent Decisions: Is the American Dream Always Wise? Forthcoming in Real Estate Economics.
[iii]The model results simply need to be inverted in order to interpret the results as to when buying leads to greater wealth accumulation.
[iv]See Beracha and Johnson (2012) for exacting details of their Buy vs. Rent model.
[v]The holding period can be varied with little change to the results. This issue will be addressed in future postings.

© Copyright Ken H. Johnson. This material may be freely duplicated and republished under the following conditions: (a) the author’s name must be clearly visible; (b) the author’s journal affiliation must be clearly visible; and (c) the author’s university affiliation must be clearly visible. Otherwise, this material may not be reproduced in any form without the written consent of the author.

Homeownership Leads to Greater Wealth Accumulation: But How?

Several real estate economists have shown that the average homeowner accumulates more overall wealth than the average renter. [i] However, it is not clear how this is done. Is it that owned property usually appreciates at such a rate that after considering leverage returns to ownership are extraordinarily high? Said another way, might homeowners accumulate more overall wealth because ownership is a great levered equity creator through property appreciation? Or, is it that owners acquire greater wealth, on average, because they are systematically paying down a mortgage thereby creating equity thanks to loan amortization? In other words, paying off property creates wealth.

In ongoing research being conducted by Beracha and Johnson,[ii] these and other questions concerning homeownership and the accumulation of wealth are being investigated. In earlier research, Beracha and Johnson show that renting is the superior investment strategy; however, in this earlier strict horserace between buying and renting, a very bold assumption is made. Specifically, it is assumed that any rent savings (from lower rent versus mortgage payments) are reinvested without fail and after balancing all of the costs and benefits from ownership and comparing them to renters’ portfolios from reinvesting rent savings, renting wins.

The question, however, very quickly becomes that in a setting where Americans generally save less than 5% of their disposable income, is this assumption realistic and how might the removal of this reinvestment decision alter the outcome of the horserace between buying and renting? As part of their current research, this question is directly addressed. In particular, Beracha and Johnson find that after allowing renters to spend any rent savings on consumption (beer, cookies, healthcare, education, etc.), ownership leads to greater wealth accumulation, on average. The graph below highlights this finding.

Renters' Portfolio Values Divided by Owners' Sales Proceeds - graph

The graph looks at the ratio of renters’ portfolio values to owners’ proceeds from sale for the entire U.S. between 1978 and 2010 both with strict reinvestment of rent savings and without reinvestment of rent savings.[iii] Clearly, numbers greater than 1 indicate that renting leads to greater wealth accumulations, while numbers less than 1 indicate that homeownership creates greater wealth, on average.

When renters are forced to reinvest (top line in the graph), the results confirm the earlier findings of Beracha and Johnson (2012). That is, in a strict horserace between buying and renting, renting wins in the vast majority of cases. However, when renters are allowed to spend rent savings on consumption (i.e. economically act like the typical American consumer), homeownership wins in virtually all instances. Notice that in the bottom line of the graph (no reinvestment), the renters’ portfolio values divided by owners’ sale proceeds is greater than 1 for only four of the 32 years of the study. Thus, when renters are allowed to spend rent savings, homeownership is the clear winner in the wealth accumulation horserace.

Finally, in the same current research, Beracha and Johnson find that allowing for property appreciation rates to increase as much as 20% over their actual historic values results in virtually no change in the outcomes concerning wealth accumulation. That is, property appreciation contributes only marginally to wealth accumulation.

Implications

Without proof many have speculated about this outcome for years. However, there is now actual quantifiable evidence that homeownership is not the great levered equity creator that it has so often been touted to be. Instead, it appears that homeownership creates extra wealth mainly through its ability to force owners to save rather than through property appreciation. Thus, homeownership appears to be a self-imposed saving, which through time leads to greater wealth accumulation as compared to comparable renters. In short, buying a home makes Americans save.

Who says that Americans are horrible savers? Apparently, we are not. We have simply been saving through our homes rather than putting our savings in the bank.

ENDNOTES


[i] Homeownership is the most viable path to wealth creation for the majority of Americans. See Engelhardt (1994), Haurin, Hendershott and Wachter (1996), and Rohe, Van Zandt and McCarhty (2002), among others.
[ii] Eli Beracha and Ken H. Johnson, 2012, Beer and Cookies Impact on Homeowners’ Wealth Accumulation, ongoing research.
[iii] The research assumes 8-year holding periods. When the holding period is allowed to vary between four and twelve years, the results change only marginally. Thus, holding period has very little to do with the results.

© Copyright Ken H. Johnson. This material may be freely duplicated and republished under the following conditions: (a) the author’s name must be clearly visible; (b) the author’s journal affiliation must be clearly visible; and (c) the author’s university affiliation must be clearly visible. Otherwise, this material may not be reproduced in any form without the written consent of the author..

The Ship Appears to be Turning

On October 31, CNN Money reported: “Home prices headed for triple dip”. Reporting on information provided by Fiserv (a financial analytics company), a 3.6% fall in prices on a national basis is expected by next summer. This will result in the Case-Shiller Home Price Index falling to 35% below its peak in 2006 and marking a triple dip in U.S. housing markets. [i]

Say it ain’t so! Is housing set for a third dip in five years? This depend on factors being in place to lessen the impact from market anxiety brought on by worries over a pending wave of foreclosures and the U.S. debt crisis, which we will start to hear more about shortly.

So, what are these factors and what do they tell us? These factors are really fundamental drivers that encourage individuals to buy versus rent their personal residences. They are sometimes referred to as housing affordability measures. The price to income, mortgage payment to income, and a buy versus rent analysis for various markets provide strong evidence that factors are in place to encourage home ownership or favor renting depending on the resulting measurements. In ongoing research being performed by Beracha and Johnson, these measures are at record levels in favor of buying. [ii] In fact, the price-to-income ratios in 23 of the 50 states are at 30-year record lows. The payment-to-income ratios are at 30-year record low in all 50 states. A buy versus rent analysis performed in 23 of the nation’s largest metropolitan areas also indicates that hurdle rates (the rates at which potential buyers are indifferent between buying and renting) in all 23 cities are below 25-year average appreciation rates. All of these results strongly favor purchasing.

What about per capita income and present day prices (relative to past prices)? Presently, U.S. per capita income is on the rise again and has regained to the level of 2007 (roughly $40,000 per person), while prices of homes on the other hand rest at 2002 levels according to the Case-Shiller Home Price Index. What about mortgages rates? Presently, 30-year fixed rates are at near-record low levels.

So, let’s put this all together. Housing is presently more affordable than at any time in the last 30 years. While income is only at 2007 levels, home prices are even lower coming in at 2002 levels. All of these factors set the stage for many individuals to favor purchasing over renting. Thus, while there are grave concerns over the overall health of the economy, fundamental drivers now appear in place to staunch any further significant plunges in home prices.

The ship appears to be turning. [iii]

ENDNOTES


[i] See http://money.cnn.com/2011/10/31/real_estate/home_prices/

[ii] Beracha and Johnson (2011) –  ongoing research.

[iii] This conclusion obviously assumes nothing unprecedented and catastrophic occurs such as the removal of the home interest deduction to combat the national debt or the often predicted foreclosure tsunami actually finally occurs.  While the likelihood of both is worth mentioning, neither is very likely.

© Copyright Ken H. Johnson. This material may be freely duplicated and republished under the following conditions: (a) the author’s name must be clearly visible; (b) the author’s journal affiliation must be clearly visible; and (c) the author’s university affiliation must be clearly visible. Otherwise, this material may not be reproduced in any form without the written consent of the author.

Foreclosures into Rentals

On August 10th, The New York Times reported: “Uncle Sam wants you — to rent a house from Uncle Sam”. The gist of the story is that the Obama administration is seeking ideas on how to convert the federal government’s inventory of foreclosed properties into rental properties that can be managed by private enterprises or sold in bulk. The goal here is to stabilize housing markets around the country that are suffering through a wave of foreclosures. Today, rumors of turning foreclosures into rentals surfaced again. Is this a good idea? If so, how should such a program be organized and managed? What are some of the potential downfalls of such a program?

To begin with, this is, in general, a good idea for a number of reasons. First, vacant non-performing assets (empty properties) will begin to provide returns and thus mitigate total eventual losses to lenders and thereby lower the tab to all. Second, the program should slow down the flood of foreclosed properties and should help stabilize pricing as traditional home sellers will now have fewer foreclosures to compete against. Third, the program would allow lenders (Fannie, Freddie, and others – perhaps the original lender) to time the selling of foreclosed properties, which would assist in stabilizing the housing markets around the country.

If turning foreclosures into rental happens, what should not be done? Renting to the previous owners should not be allowed as this would create significant conflicts of interest, which could easily lead to a deluge of lawsuits resulting in the failure of the program. Additionally, social engineering should not be allowed. Let the marketplace decide rent levels.

Where might problems arise from turning foreclosures into rentals? Though they are very similar, foreclosure laws vary by state. One general commonality among the various laws is that the lender must mitigate the loss to the previous owner through a timely resale of the property. These laws can be thought of as the Milton Drysdale deterrent. It is simply not in the best interest of society to allow lenders to foreclose on property, ride out the tough times, and then resell at a huge profit. However, these laws never contemplated a situation where foreclosures would be as rampant as they are at present. Regardless, if the federal government, through Fannie, Freddie, joint ventures with outside investors with Fannie and Freddie, or even the original lenders themselves, becomes a landlord looking for a better environment in which to sell, the likelihood of lawsuits over violations of state foreclosure laws is almost certain. That is to say, we will probably have “Robo-signing II”. Thus, the big question is will Congress be willing to back turning foreclosures into rentals with a federal law that overrides state foreclosure statutes.

Four years ago, I told a graduate audience that banks should get ready to manage properties in order to mitigate losses from the coming real estate crisis. However, state laws would probably prevent this and that federal legislation was needed to allow for lenders to manage and/or re-sell property in a way that balanced market stabilization with mitigating losses to the original owners. Is turning foreclosures into rentals a good idea? Yes, the idea is sound. The only surprise is that it took this long to get around to considering this eventuality.

© Copyright Ken H. Johnson. This material may be freely duplicated and republished under the following conditions: (a) the author’s name must be clearly visible; (b) the author’s journal affiliation must be clearly visible; and (c) the author’s university affiliation must be clearly visible. Otherwise, this material may not be reproduced in any form without the written consent of the author.