Sunday, May 29, 2011

Getting my head examined - a Chris Joye rebuttal

Don't get me wrong. I agree with Chris Joye on some things - lowering the inflation target (perhaps not right at the moment), pushing for a more streamlined NBN, and supporting Malcolm Turnbull's political ambitions.

But when it comes to the housing market the guy with all the numbers is happy to overlook the strikingly obvious and adores a verbal stouch with his foes - the group he calls 'housing nutters'. In fact he just recently recommended the following 

At the same time, anyone who claims that a 1% year-on-year retracement in dwelling values is a major asset-class event (cf. the share market frequently falling more than 5% on a given day) needs their head examined, with the greatest of respect. And I sincerely meant that latter caveat: you genuinely should seek medical advice if you are convinced that house prices are plummeting. 

Let's take his advice and examine what is in my head (noting that I don't believe a 1% year-on-year fall in national home prices in isolation is a concern). 

Joye often likes to draw attention to the low volatility of the housing market compared to the share market (eg here and here). But he neglects a few important differences. 

1. The housing market has at best monthly data only. Moreover each month's price data point is essentially an average. The share market would be far less volatile if you measured it that way and averaged away each month's price extremes. Not that volatility represent risk in any case. 

2. The share market is an equity market. If you want to compare like with like you need to compare the change in home equity to the change in share prices. If there is $1.7trillion in housing debt outstanding against $3.5trillion worth of housing, you can double any housing price change to calculate the change in equity of homeowners on average. Of course prices are set at the margins so perhaps for the price setting buyers and sellers the leverage, and importance of small price movements, is even greater. 

3. The negatively geared investor sets the market price (apart from the recent burst of FHBs). This means they are losing money every year. Any small decline in value decreases their equity substantially in addition to losses already incurred. 

4. The marginal homebuyer is heavily leveraged - 80% plus. This is not the case in the share market. Remember, leverage works to improve both gains and losses. 

5. The wealth effect is much stronger in the housing market than other markets, particularly due to leveraging and the sheer size of the asset compared to household incomes. 

6. Cost of home ownership is much greater than simply the interest cost. For most homes around 25% of the gross rent is spent on annual costs (refer to 3.) 

7. Housing market crashes, while they feel almost spontaneous, actually take some years to eventuate.

Irish housing - 5 years to fall 28%, or 0.41%/month

US housing - 6 years to fall 31%, or 0.38%/month

UK - 2 years to fall 21%, or 0.8%/month (and still 18% down from their peak 4 years later) 

8. Lastly, I feel sorry for anyone who shared Joye's property optimism and bought into the Brisbane or Perth property markets in the past two years.  While the share market hasn't been crash hot, 6% returns on cash has been pretty flash.

Anyway, if these notes are a sign of a mad man, well so be it ;-)

Wednesday, May 25, 2011

Wealth effect driven by the housing market

Leith van Onselen over at Macrobusiness has written a couple of very important and timely articles on the wealth effect. Put simply, the wealth effect is an increase in spending that accompanies and increase in perceived wealth.

In relation to housing, this paper suggests the wealth effect increases our propensity to consume by 9c per dollar of increased housing value (which is further supported here). So if the housing stock of Australia is valued at $3trillion (some say between 3.5 and 4 trillion), and market values increase 10% in a year, then we will spend on average 9% of the $300billion of new 'wealth', or $27 billion - with $6 billion of spending occurring prior to the end of the next quarter.

Importantly, this money is spent before it is earned by selling the asset. The easy access to home equity lending has been a contributing factor to the size of this effect, enabling households to spend their capital gains before they have been realised which increases their financial risk.

There are few readily available studies about the size of this effect in reverse, but if the same values hold in both directions we can look at some interesting scenarios.

If prices fall 2.5% nationally over a quarter then we lose $75billion of perceived wealth, with an immediate reduction in spending in the following quarter/half year of about $1.5billion and ongoing reductions in spending totalling $7billion

With about $1.7trillion of bank loans outstanding, that is about the same effect on spending as an increase in interest rates of 0.25% and keeping them there for two years (which will mean $4billion extra is spent on interest repayments per year). This of course assumes that house prices are not dramatically affected.  Indeed, if we consider that interest rate moves are likely to also bring down home prices, we can expect a much greater effect from the monetary lever.

That’s why house price falls of just a few percent can cascade into a crash so easily.

I would suggest the reason the wealth effect in relation to housing is much higher than found elsewhere is that many people who benefit/lose from house price changes are highly geared, which increases/decreases their equity more quickly for a given price change.

On this note I would add that you can’t directly compare share market volatility to house price volatility, since the share market is an equity market. To make a direct comparison you need to compare the volatility of the equity component of the housing market with share market, or the volatility of the share market value plus the value of debts held by those listed businesses to the housing market.

Tuesday, May 10, 2011

Peter Schiff predictions

Peter Schiff was ridiculed for years when he predicted that the US housing bubble and credit binge would result in a massive asset price bust and recession.  You could describe his economic philosophy as Austrian, and as the recent Keynes and Hayek rap video explains, the bust is a direct consequence of the boom, not some seperate economic event that can be avoided through government intervention.

In this early 2009 video Schiff predicts the collapse of the US dollar and makes some very astute observations that may resonate with Australians.  Enjoy.

Sunday, May 8, 2011

1980s Texas Housing Bubble Myth - A Reply

Recently the debate on the price impacts of planning regulations has been a hot topic here and elsewhere. Leith van Onselen at Macrobusiness is one of the more sophisticated proponents of supply side impacts on home prices and recently responded to a comment of mine about Houston Texas. My comment was that if Houston is an example of how responsive supply can help cities avoid house price volatility, why did Houston experience a house price bubble in the 1980s?

Leith argued that Houston's apparent price bubble was a mere blip on the grounds of price to income multiples. In his typically evenhanded fashion Leith also notes many of the demand side factors at play during that time— the oil boom, liberalisation of loan standards, and population growth. He brings together these points with the following conclusion.
What makes Texas’ home price performance in the early 1980s particularly impressive is that prices managed to remain relatively stable in the face of significant demand-side influences that should have caused home prices to rise significantly and then crash.
An additional point is made that Houston has managed to avoid the 2000s property bubble infecting most of the US and much of the world.

My reply.

Houston prices declined around 40% in real terms following the 1982 market peak—that is indeed volatile—and it took 15 years for prices to recover in nominal terms.  The Case-Shiller 10 city index has dropped by a similar amount since the US peak in 2006 (30.5% nominally). So much for the volatility aspect.

But why do prices in Houston still appear so dramatically affordable when compared to incomes?

One major reason is the relatively high property tax rate.

Property tax rates in Houston more that doubled from 1984 to 2007 becoming one of the highest rates in the US. Depending on your area you can pay between 2-3% of your properties improved market value in annual State taxes, while the US National average is 1.04%.

One would expect areas with higher property taxes to have structurally lower prices, reduced price volatility, and much lower price to income ratios.

An illustrative example is shown below. The three comparisons are intended to roughly represent the early 1980s, the early 2000s, and today. The Houston property tax rates increase from two to three percent, while the comparison taxes increase from half to one percent. Interest rates also represent mortgage rates at the time.

From these examples we can see that from just this single factor, the property tax differential, we should expect prices in Houston to currently be structurally around 30% lower than national averages (more on the impact of the property tax differential here).

An important factor at play in this example is that at lower interest rates a fixed percentage property tax leads to greater price differences. Therefore, over time, we would expect Houston to home prices to be a smaller fraction of comparable homes elsewhere as the property tax differential has a greater price impact at lower interest rates. Remember that in the table above, rents and returns are the same for each comparison - only the tax rate is different.

Of course, this does not mean that housing is lower cost. It just means that the cost of housing is borne by annual tax obligations rather than capitalised in the price. A far better comparison of whether housing is structurally cheaper in Houston would be to compare quality-adjusted rents to incomes over time and across cities.

Perhaps once the property tax differential and other demand-side factors are properly considered we will see Houston's supply-side impact on housing prices diminish to zero.

Lastly, I would add that the memory of such a deep and prolonged property price slump would be motivation enough to dampen speculative housing demand in Houston. Who in their right mind would bid up prices in Houston knowing that increased tax liability and the history of dramatic losses on the property market?

Evidence of supply-side effects on home prices remains elusive.  

Thursday, May 5, 2011

A sign of desperate times?

Saw this advertisement today in the Financial Review.  I haven't seen anything like it before but it reeks of desperation.  Is it some kind of joke?

I like the first part of the fine print "Real Estate agents tell me I can get $2.1million for my luxury home but..."

Wednesday, May 4, 2011

Rent seeking behaviour - scare campaigns

From the Hungry Beast

Housing stimulus idea

From Crikey:

Local bike paths mean higher house prices

That is one housing stimulus package I would be happy to see implemented.  From the comments section:

More accurate take on alternate headline –
Bikeways found to be desirable trait amongst urban home buyers.
Temporary shortage of bikeways elevates prices in areas with bike paths.
Once all areas have bike paths, price distortion will be nil.

Captain Planet

Demand shocks – the details

Many pundits claim that increasing population increases demand. In technical economic jargon it shifts the curve to the right. But what we rarely see is an exploration of the two types of demand shock and the different potential price impacts.

The first type, as mentioned above, shifts the downward sloping demand curve to the right. This means there are more people with the same willingness to pay.

The second type is a shift of the demand curve up upwards. This represents a willingness to pay more for the same goods from the same number of people.

It’s pretty clear from this distinction which of these factors is in play in Australian housing.

Let’s examine the first case. Consider an auction with 10 cars for sale and 50 bidders willing to pay $1000 for a car. You add another 50 people to the mix each also willing to pay $1000. If I’m not being clear enough, this is analogous to increasing population in the housing context.

When the auction is run with the original 50 bidders each car sells for $1,000. When the auction is run with 100 bidders, the 10 cars still sell for $1,000 each.

This is an extreme scenario but does demonstrate a very real point. Unless the new potential buyers are willing to pay more for the same items as the existing buyers, the price won’t rise. At most, a second price auction (the result of an English open auction with heterogeneous preferences) becomes closer to a first price sealed bid auction by the addition of another bidder willing to bid at a price between the second and first price (read up on some auction theory here).

As I said before, new buyers, even a small cohort of the total market, can influence the price level if they are willing to pay more than the existing buyers, since prices are set at the margins. Imagine our car auction once again, and we give 10 of our original 50 bidders and extra $500 to spend on the car. What is the new result? All cars sell for $1500 each to these 10 bidders. Even though they were just 20% of the original market of buyers, they dragged the price up 50%. In fact even if there were thousands of buyers willing and able to pay $1000 for those 10 cars, the ten people willing to pay $1500 would always win.

Prices are set at the margin by those with the highest willingness to pay.

This example, where the demand curve is shifted vertically to reflect an increased willingness to pay by the same number of buyers, is shown graphically in the right hand side graph above.

But, you say, the key problem here is that supply is being overlooked - in the simplified examples demand curves are horizontal and there is no supply response. But look at the graphs again. Not only is the demand curve a more acceptable shape, but supply does respond in both circumstances. In the first, where the demand profile of buyers shifts horizontally supply does respond enabling prices to remain at their equilibrium level.

However, when the demand curve shifts vertically, it doesn’t matter how much supply responds to price increases, it cannot be a mechanism to bring prices back down (except under extreme assumptions about the shape of demand and supply and the limits of peoples willingness to pay at the top and bottom of the market).

Of course, in the end this analysis is probably unecessary. The value of housing arises from the rents - its ability to generate revenue or provide a service. Since we haven’t seen rents outpace inflation significantly for any extended period in the past two decades, one must be quite certain that the cause of prices being much higher than a rational present value of future cash flows is pure demand side speculation.

Economics, Real Estate and the Supply of Land

As a general rule, economists relying on supply and demand curves without properly discussing the assumptions that sit underneath their graphs can be ignored.

Alan Evans' book Economics, Real Estate and the Supply of Land is an effort to refute Ricardian notions of land supply and rent, and offer an alternative neoclassical theory of land supply. The arguments in this book are taken by many who believe that reducing government involvement in town planning will decrease the price of housing. Evans’ reasoning is questionable to say the least, and supported by elaborate graphs with often biased assumptions and interpretations.

One of Evans’ aims is to refute the Ricardian proposition ‘that the price of land is high because the price of corn [read: houses] is high, and not vice versa’.

To do this he constructs a model economy with a fixed land supply where two agricultural uses compete for land – potatoes and corn. In the figure below we see his construction of this economy on the left, with demand for corn inverted so that the intersection of corn and potato demand determines the equilibrium share of land devoted to each crop, and the equilibrium rent of land at point A.

He then proceeds to add a demand shock to potatoes ‘for some reason’. The new blue line represents the new increased demand for potatoes which enables potato growers to bid up prices for land previously grown for corn and reduce the amount of land used to grow corn. He concludes with the following -

Now it is quite clear that the increase in the rent of land is not caused by the increase in the price of corn. Exactly the reverse is true. The price of corn has risen because the price of land has risen.
The rent for land is not solely determined by the demand for the product.

His conclusions are wrong.

First, it is still quite clear that at the new equilibrium the price of land for corn is still determined by the new higher price for corn. You could just as easily argue that every time a potato grower buys land from a corn grower he decreases the output of corn and the price of corn rises, thereby leading to an increase in the rents of land available for growing corn.

Second, he fails to notice that all he has done with the model is to demonstrate the inflation mechanism following an increase in money supply for one purpose. He increases total demand (potatoes plus corn) but shifts preferences towards potatoes so that corn demand is constant. The end result of his demand increase is to increase all prices in the model economy – potatoes, corn and rent.

Followers of Say would jump straight to this conclusion. You can’t simply increase total demand in the economy – demand is comprised of supply.

An actual demand shock, which models a change in preferences from corn to potatoes, is shown in the right hand side figure. You will notice that total demand remains constant and therefore the rents for this fixed quantity of land also remain constant.

So no, land rents do not determine prices. Prices determine rents.

Another example of poor reasoning is when Evans argues against a 100% land value tax. He argues that a tax of that nature would ‘freeze’ land development because there would be no incentive for a owner of agricultural land to sell his land to a developer for housing development, since he would not capture any of the value uplift. The rent achieved by the owner of the land will remain the same as when it is rented to the farmer – zero.

Yet in chapter 8 he argues that the value of land grows in anticipation of future higher value uses. In these cases, when the site is genuinely worth more as housing, the tax would be at a rate that reflects that higher value, and not the agricultural value. Therefore, the owner of the land will be facing a tax on the land value for housing while only receiving rents at agricultural values. As the city expands and the value of his land for housing surpasses the value for agriculture, he has a great incentive to sell or develop immediately to avoid losses.

Although I don’t support a 100% land value tax, I do support shifting the tax burden towards land and fixed rights to natural resources.

What we do learn from this book is that even the experts are prone to bias that affects their ability to apply objective logic and reason.

Thursday, April 28, 2011

Faulty Reasoning

I’ve come across some fine examples of faulty reasoning lately in two key areas.

1. Analysing the economic importance of declining environmental quality, and
2. Assessing the impact of price drops in the Australian property market.

So let us take a closer look.

Pro-urban sprawl advocates (I didn’t really know there were so many until just recently) try to shrug off the claim of deterimental impacts on agricultural production from urban sprawl due to irreversibly land use changes. For example –

Suburban Development is not destroying farmland. Smart growth activists claim farmland is disappearing at dangerous rates and that government needs to protect farmland lest we lose the ability to feed ourselves. As growth expert Julian Simon wrote, this claim is "the most conclusively discredited environmental-political fraud of recent times." United States Department of Agriculture data show that from 1945 to 1992 cropland area remained constant at 24 percent of the United States. Though urban land uses increased, they now account for only 3 percent of the land area of the United States. Today, American farmers produce more food per acre than ever before. In fact, the number of acres used for crops peaked in 1930, but because of the ingenuity and innovation of American farmers, the United States continues to produce more food on less land. (here)

Why is this argument based on faulty reasoning?