Who cares about future house prices?

By Felix Salmon
July 17, 2009

James Kwak wonders about the housing market, and price-to-rent ratios:

The fact is that most people buying houses aren’t going to be renting them out, and what they care about is the price at which they will be able to sell that house in 10 years.

Has anybody ever quantified this? Let’s say that you have a choice between renting and buying. If you rent, you just pay $1,000 a month. Alternatively, you can buy a house for $200,000, with a $40,000 downpayment, and pay that same $1,000 a month to service your $160,000 mortgage. (Let’s keep things simple and ignore things like property taxes and mortgage-interest tax relief and maintenance costs and what have you.)

Which do you choose? That’s up to you, of course, and will probably be related to the amount of money you have, and your desire to spend or invest that $40,000 on something other than a house downpayment. But to what degree does the value of the house in ten years’ time affect your decision? After all, you may or may not have any desire to sell in ten years’ time. And even if you do sell, there’s a very good chance that you’ll just end up buying another house elsewhere, which will be similarly more expensive. In that sense buying a house isn’t an investment, so much as it’s a way of permanently covering your built-in short position when it comes to the shelter market.

Similarly, if you’re inclined to rent, the key number you’re worried about when it comes to the future is not house prices in ten years, but rather prevailing rents in ten years. Buying a house can be thought of as paying $40,000 up front to lock in that $1,000-a-month rent in perpetuity. You don’t particularly mind if house prices go up, so long as that’s a function of rising price-to-rent ratios, and not a function of rising rents with a constant price-to-rent ratio.

The point is that in a normal market, the only people who really care about the nominal value of their house in ten years are the people who are essentially timing the market: buying now, with the intention of cashing out in ten years, making lots of money in capital gains, and then going back to renting. That’s a tiny proportion of the housing market. Everybody else is just paying whatever they can reasonably afford.

In a bubble, of course, things change. Then you get a much larger number of speculators, and you also get an added advantage to rising house prices: the ability to refinance your mortgage on a regular basis, taking out cash each time. In general, when a very large number of people think of houses as an investment, that’s a good sign that you’re in a bubble. When most people think of houses just as somewhere you need to pay money to live, either in rent or in mortgage payments, then that’s a much more normal housing market.

Update: Great minds, etc. Karl Smith:

When people asked me about the wisdom of home buying during the bubble my stock response was, “think of your house as a place to live.”

That is, overwhelming the returns that come from owning a home are going to come from the “real dividend” of actually living in the house. In the long run prices may rise and prices may fall but your primary concern has to be keeping your family warm and dry.

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