This assumes rational markets. It’s like buying a bar because you assume bar owners are making money, or buying an airline because you assume airline owners are making money. Neither do on average. Intuitively it makes sense that an investment that ‘everyone knows is a good idea’ wouldn’t be all that great. Why do landlords do it if they aren’t building meaningful equity at super high rent to buy ratios? Leveraged speculation (aka high stakes gambling). This is dangerous for the average buyer since it means the market is less reliant on fundamentals than you might guess.
To be more concrete: in expensive housing markets landlords are typically losing money, cash flow wise, in order to participate in speculation. In cheaper markets landlords typically make a bit of money cash flow wise but when you price out their time and opportunity cost this doesn’t wind up being a particularly remunerative avenue. Again, people tend to point to winners of this slot machine.
To first order you are going to be paying the same amount whether you buy or rent
in the long run averages over entire markets will approximately equilibrate. But that doesn’t matter if you’re playing against idiots with incoherent time preferences in popular markets. You’ll need to outbid someone making a poor financial decision. Cash flow wise you pay a lot more upfront (down payment plus 50% more than you would have paid in rent), which as mentioned has opportunity costs since young people are cash flow constrained (which is also why young people should be leveraged into their portfolio).
So if you are living long enough to amortize out the buying transaction costs, now we are comparing the investment in housing to the investment in the stock market.
you have to multiply out by the chance that you’ll need to move sooner, raising average costs.
basically the optimal hedge against future rent obligations
the optimal hedge is whatever grows your money the fastest in a way that isn’t correlated with your other cash flows + assets. A portfolio that is better hedged against local markets and less volatile than housing can be constructed and will grow faster than rent reliably.
In aggregate, the housing market is only slightly more volatile than markets, but buying a house isn’t buying into the housing market like an index, it’s buying one house. The data on private losses is really bad, but my best guess is that there is massive survivorship bias and failure to account for imputed rents and opp. cost at play.
This assumes rational markets. It’s like buying a bar because you assume bar owners are making money, or buying an airline because you assume airline owners are making money. [...] that doesn’t matter if you’re playing against idiots with incoherent time preferences in popular markets. You’ll need to outbid someone making a poor financial decision.
If you want to convince the reader “it turns out most investors are getting a bad deal, and are only doing it because they are idiots” then I think the burden of proof is switched, now you are the one claiming that the reader should be convinced to disagree with investors who’ve thought about it a lot more.
(I also don’t think you are right on the object level, but it’s a bit hard to say without seeing the analysis spelled out. There’s no way that nominal rather than real interest rates are the important thing for decision-making in this case—if we just increase inflation and mortgage rates and rent increase caps by 5%, that should clearly have no impact on the buy vs. rent decision. You can convert the appreciation into more cashflow if you want to.)
Why do landlords do it if they aren’t building meaningful equity at super high rent to buy ratios? Leveraged speculation (aka high stakes gambling).
The basic argument in favor is: if I want to keep living in the area, then I’m going to have to pay if the rent goes up. Not buying is more of a gamble than buying: if you buy you know that you are just going to keep making mortgage payments + taxes + maintenance, while if you don’t buy you have no idea what your expenses are going to be in twenty year’s time. (But I totally agree that buying a house depends on knowing where you want to live for a reasonably long time. I also agree that e.g. when housing prices go up your wages are likely to go up, so you don’t want to totally hedge this out.)
the optimal hedge is whatever grows your money the fastest in a way that isn’t correlated with your other cash flows + assets.
The optimal hedge is anticorrelated with your other cashflows, not uncorrelated. In this case, future rent is one of your biggest cashflows.
A portfolio that is better hedged against local markets and less volatile than housing can be constructed and will grow faster than rent reliably.
What’s better correlated with my future rent, then an asset whose value is exactly equal to my future rent payments?
It seems like your argument should come down to one of:
You don’t know where you’ll be living in the future. I think this is really the core question—how confident should you be about where you are living before buying makes sense? My guess is that it’s in the ballpark of the rent-to-buy ratio. I think people could make better decisions by (i) pinning down that number for the markets they care about, (ii) thinking more clearly about that question, e.g. correcting for overconfidence.
You may be tied down to an area, but should be willing to move out of your house if it becomes more expensive, so you shouldn’t hedge against idiosyncratic risk in this exact neighborhood. This depends on how attached people get to houses and how large is the idiosyncratic real estate risk. (Maybe this is what you mean by “hedged against local markets”?) I don’t know the numbers here, but I don’t think it’s obvious.
If you want to convince the reader “it turns out most investors are getting a bad deal, and are only doing it because they are idiots” then I think the burden of proof is switched, now you are the one claiming that the reader should be convinced to disagree with investors who’ve thought about it a lot more.
can I expect to beat the average professional investor by buying an index fund? Yes. I’m claiming you can beat the average house buyer by not buying, because houses are overall very overbought. This is expected of a market where the prevailing wisdom is ‘throw as much money as it as you can.’
Not buying is more of a gamble than buying: if you buy you know that you are just going to keep making mortgage payments + taxes + maintenance, while if you don’t buy you have no idea what your expenses are going to be in twenty year’s time.
The bounds n how well you will be doing relative to costs in twenty years time has reasonable confidence bounds whether you buy or rent, we have lots of historical data for both. Why would extrapolating from buying trends be more valid than extrapolating from renting trends? IIRC purchase prices are more volatile than rental prices overall, and this effect is stronger at the high end. To reiterate, there is a premium on buying in some markets and the premium is related to the cost of competing with other speculators.
The optimal hedge is anticorrelated with your other cashflows, not uncorrelated.
That’s right, I was wrong.
What’s better correlated with my future rent, then an asset whose value is exactly equal to my future rent payments?
I meant that you can get a better deal. You can get something that is only marginally more correlated but much much cheaper in the market.
It seems like your argument should come down to one of:
also: people should expect regression to the mean in the most expensive markets and therefore want to think twice or three or four times before becoming convinced they are getting a good deal.
Hmm, I notice that we’re making exactly opposite prediction types on two different assets. Last year I made a momentum prediction on the stock market (real returns to be around 7% in line with history), you made a regression to local trends argument (<2% growth in line with recent slow growth of underlying factors). In real estate here I’m making a regression to the mean argument (I expect housing to under perform because it has been over performing by quite a bit over the last 20 years. ) and you’re making a momentum argument...
Regression to the mean arguments tend to be reference class tennis, since regression to a particular mean is just an argument for momentum on a different time scale. In either case there’s an argument to be made about ceilings on asset prices (earnings on stocks, ability to service monthly payments on mortgages). In both cases there’s a reversion to mean argument to be made when recent growth has brought the asset price much closer to a relevant ceiling.
I think in both cases people have been surprised by how much the ceiling has gone up? In stocks corporate earnings have become much larger than people would have predicted at the same time that stability was increasing which means people were willing to accept higher multiples on those earnings. Housing is somewhat downstream of this. The strongest markets have been subject to very cash rich buyers, both tech workers and foreign capital pushing mortgages up to levels that wouldn’t be affordable to most. Living in a city turned out to be a better deal (decreasing crime and pollution and increased earnings power) than thought so people are willing to accept longer payback times on houses. There’s a question about which is more constrained and likely to hit a wall sooner. If corporate earnings go down raises and new entrants will slow down, lowering the amount of cash entering these markets. Elasticity to shocks compared between asset classes might be the thing.
edit: thinking about it a bit more, it seems like corporate profits have a lot more headroom than house prices. When house prices get too high more people do in fact rent and just choose to retire elsewhere after making massive salaries. There is less political will to force people to pay more for housing than there is to maintain corporate monopolies that ensure lack of new entrants. Companies also eventually start building housing (as google is doing now) because the calculus flips on paying workers more vs giving them more benefits (esp b/c tax structuring). I guess with corporate profits eventually people start doing more illegal end runs around monopolies.
I’m not really making a claim about momentum, I’m just skeptical of your basic analysis.
Real 30-year interest rates are ~1%, taxes are ~1%, and I think maintenance averages ~1%. So that’s ~3%/year total cost, which seems comparable to rent in areas like SF.
On top of that I think historical appreciation is around 1% (we should expect it to be somewhere between “no growth” and “land stays a constant fraction of GDP”). So that looks like buying should ballpark 10-30% cheaper if you ignore all the transaction costs, presumably because rent prices are factoring in a bunch of frictions. That sounds plausible enough to me, but in reality I expect this is a complicated mess that you can’t easily sort out in a short blog post and varies from area to area.
If you want to argue for “buying is usually a terrible idea, investors are idiots or speculators” I think you should be getting into the actual numbers.
The actual numbers are somewhat idiosyncratic but my main point is that in the process of investigating the numbers most people don’t evaluate downsides because they don’t occur to them. Once these costs are taken into account the marginal buyer will flip on the decision. In extremely hot markets you are much more likely to be like the marginal buyer rather than the average buyer.
I’m not claiming to have constructed as such, I’m claiming that with covariance data such a thing could be constructed. There are things like inverse real estate indexes, so whatever they do to construct their shares could be tuned for the same purpose.
edit: thinking about it more, wouldn’t a person want an asset anti correlated with their own future cash flows? You’d want to account for rent and unemployment and predictable changes in future cash flows. What else?
So is the bet for the construction of a financial instrument that moves like a leveraged case-shiller housing index for a selected city with tracking error + fees smaller by some factor than the average frictional costs in the buying market?
edit: oh in this model we’re mostly concerned with the rent hedging value rather than the speculative value (that being seen as mostly a thing that subsidizes the rent hedge here) so we’d really want something that pays you when the rent index deviates substantially from its trend. If we were happy with just hedging the long term trend I think that could be done cheaply with fixed income levered appropriately, but I’d have to show that it won’t suddenly change correlations under various conditions.
edit 2: I think there’s some aether variable-ing going on here. Rental market are much more liquid and display lower volatility than housing markets. So in order to purchase a hedge against rental price (cash flow) appreciation we expose ourselves to much more volatile net worth swings? That only makes sense for people with poor savings (almost all ‘normal’ people. But normal people aren’t trying to buy in the most expensive markets anyway).
Housing markets move because they depend on the expectation of future rents. If I want to expose myself to future rents, I have to take on volatility in the expectation of future rents, that’s how the game goes.
This assumes rational markets. It’s like buying a bar because you assume bar owners are making money, or buying an airline because you assume airline owners are making money. Neither do on average. Intuitively it makes sense that an investment that ‘everyone knows is a good idea’ wouldn’t be all that great. Why do landlords do it if they aren’t building meaningful equity at super high rent to buy ratios? Leveraged speculation (aka high stakes gambling). This is dangerous for the average buyer since it means the market is less reliant on fundamentals than you might guess.
To be more concrete: in expensive housing markets landlords are typically losing money, cash flow wise, in order to participate in speculation. In cheaper markets landlords typically make a bit of money cash flow wise but when you price out their time and opportunity cost this doesn’t wind up being a particularly remunerative avenue. Again, people tend to point to winners of this slot machine.
in the long run averages over entire markets will approximately equilibrate. But that doesn’t matter if you’re playing against idiots with incoherent time preferences in popular markets. You’ll need to outbid someone making a poor financial decision. Cash flow wise you pay a lot more upfront (down payment plus 50% more than you would have paid in rent), which as mentioned has opportunity costs since young people are cash flow constrained (which is also why young people should be leveraged into their portfolio).
you have to multiply out by the chance that you’ll need to move sooner, raising average costs.
the optimal hedge is whatever grows your money the fastest in a way that isn’t correlated with your other cash flows + assets. A portfolio that is better hedged against local markets and less volatile than housing can be constructed and will grow faster than rent reliably.
In aggregate, the housing market is only slightly more volatile than markets, but buying a house isn’t buying into the housing market like an index, it’s buying one house. The data on private losses is really bad, but my best guess is that there is massive survivorship bias and failure to account for imputed rents and opp. cost at play.
If you want to convince the reader “it turns out most investors are getting a bad deal, and are only doing it because they are idiots” then I think the burden of proof is switched, now you are the one claiming that the reader should be convinced to disagree with investors who’ve thought about it a lot more.
(I also don’t think you are right on the object level, but it’s a bit hard to say without seeing the analysis spelled out. There’s no way that nominal rather than real interest rates are the important thing for decision-making in this case—if we just increase inflation and mortgage rates and rent increase caps by 5%, that should clearly have no impact on the buy vs. rent decision. You can convert the appreciation into more cashflow if you want to.)
The basic argument in favor is: if I want to keep living in the area, then I’m going to have to pay if the rent goes up. Not buying is more of a gamble than buying: if you buy you know that you are just going to keep making mortgage payments + taxes + maintenance, while if you don’t buy you have no idea what your expenses are going to be in twenty year’s time. (But I totally agree that buying a house depends on knowing where you want to live for a reasonably long time. I also agree that e.g. when housing prices go up your wages are likely to go up, so you don’t want to totally hedge this out.)
The optimal hedge is anticorrelated with your other cashflows, not uncorrelated. In this case, future rent is one of your biggest cashflows.
What’s better correlated with my future rent, then an asset whose value is exactly equal to my future rent payments?
It seems like your argument should come down to one of:
You don’t know where you’ll be living in the future. I think this is really the core question—how confident should you be about where you are living before buying makes sense? My guess is that it’s in the ballpark of the rent-to-buy ratio. I think people could make better decisions by (i) pinning down that number for the markets they care about, (ii) thinking more clearly about that question, e.g. correcting for overconfidence.
You may be tied down to an area, but should be willing to move out of your house if it becomes more expensive, so you shouldn’t hedge against idiosyncratic risk in this exact neighborhood. This depends on how attached people get to houses and how large is the idiosyncratic real estate risk. (Maybe this is what you mean by “hedged against local markets”?) I don’t know the numbers here, but I don’t think it’s obvious.
can I expect to beat the average professional investor by buying an index fund? Yes. I’m claiming you can beat the average house buyer by not buying, because houses are overall very overbought. This is expected of a market where the prevailing wisdom is ‘throw as much money as it as you can.’
The bounds n how well you will be doing relative to costs in twenty years time has reasonable confidence bounds whether you buy or rent, we have lots of historical data for both. Why would extrapolating from buying trends be more valid than extrapolating from renting trends? IIRC purchase prices are more volatile than rental prices overall, and this effect is stronger at the high end. To reiterate, there is a premium on buying in some markets and the premium is related to the cost of competing with other speculators.
That’s right, I was wrong.
I meant that you can get a better deal. You can get something that is only marginally more correlated but much much cheaper in the market.
also: people should expect regression to the mean in the most expensive markets and therefore want to think twice or three or four times before becoming convinced they are getting a good deal.
Hmm, I notice that we’re making exactly opposite prediction types on two different assets. Last year I made a momentum prediction on the stock market (real returns to be around 7% in line with history), you made a regression to local trends argument (<2% growth in line with recent slow growth of underlying factors). In real estate here I’m making a regression to the mean argument (I expect housing to under perform because it has been over performing by quite a bit over the last 20 years. ) and you’re making a momentum argument...
Regression to the mean arguments tend to be reference class tennis, since regression to a particular mean is just an argument for momentum on a different time scale. In either case there’s an argument to be made about ceilings on asset prices (earnings on stocks, ability to service monthly payments on mortgages). In both cases there’s a reversion to mean argument to be made when recent growth has brought the asset price much closer to a relevant ceiling.
I think in both cases people have been surprised by how much the ceiling has gone up? In stocks corporate earnings have become much larger than people would have predicted at the same time that stability was increasing which means people were willing to accept higher multiples on those earnings. Housing is somewhat downstream of this. The strongest markets have been subject to very cash rich buyers, both tech workers and foreign capital pushing mortgages up to levels that wouldn’t be affordable to most. Living in a city turned out to be a better deal (decreasing crime and pollution and increased earnings power) than thought so people are willing to accept longer payback times on houses. There’s a question about which is more constrained and likely to hit a wall sooner. If corporate earnings go down raises and new entrants will slow down, lowering the amount of cash entering these markets. Elasticity to shocks compared between asset classes might be the thing.
edit: thinking about it a bit more, it seems like corporate profits have a lot more headroom than house prices. When house prices get too high more people do in fact rent and just choose to retire elsewhere after making massive salaries. There is less political will to force people to pay more for housing than there is to maintain corporate monopolies that ensure lack of new entrants. Companies also eventually start building housing (as google is doing now) because the calculus flips on paying workers more vs giving them more benefits (esp b/c tax structuring). I guess with corporate profits eventually people start doing more illegal end runs around monopolies.
I’m not really making a claim about momentum, I’m just skeptical of your basic analysis.
Real 30-year interest rates are ~1%, taxes are ~1%, and I think maintenance averages ~1%. So that’s ~3%/year total cost, which seems comparable to rent in areas like SF.
On top of that I think historical appreciation is around 1% (we should expect it to be somewhere between “no growth” and “land stays a constant fraction of GDP”). So that looks like buying should ballpark 10-30% cheaper if you ignore all the transaction costs, presumably because rent prices are factoring in a bunch of frictions. That sounds plausible enough to me, but in reality I expect this is a complicated mess that you can’t easily sort out in a short blog post and varies from area to area.
If you want to argue for “buying is usually a terrible idea, investors are idiots or speculators” I think you should be getting into the actual numbers.
The actual numbers are somewhat idiosyncratic but my main point is that in the process of investigating the numbers most people don’t evaluate downsides because they don’t occur to them. Once these costs are taken into account the marginal buyer will flip on the decision. In extremely hot markets you are much more likely to be like the marginal buyer rather than the average buyer.
What’s the alternative?
I’m not claiming to have constructed as such, I’m claiming that with covariance data such a thing could be constructed. There are things like inverse real estate indexes, so whatever they do to construct their shares could be tuned for the same purpose.
edit: thinking about it more, wouldn’t a person want an asset anti correlated with their own future cash flows? You’d want to account for rent and unemployment and predictable changes in future cash flows. What else?
I’ll bet against.
So is the bet for the construction of a financial instrument that moves like a leveraged case-shiller housing index for a selected city with tracking error + fees smaller by some factor than the average frictional costs in the buying market?
edit: oh in this model we’re mostly concerned with the rent hedging value rather than the speculative value (that being seen as mostly a thing that subsidizes the rent hedge here) so we’d really want something that pays you when the rent index deviates substantially from its trend. If we were happy with just hedging the long term trend I think that could be done cheaply with fixed income levered appropriately, but I’d have to show that it won’t suddenly change correlations under various conditions.
edit 2: I think there’s some aether variable-ing going on here. Rental market are much more liquid and display lower volatility than housing markets. So in order to purchase a hedge against rental price (cash flow) appreciation we expose ourselves to much more volatile net worth swings? That only makes sense for people with poor savings (almost all ‘normal’ people. But normal people aren’t trying to buy in the most expensive markets anyway).
Housing markets move because they depend on the expectation of future rents. If I want to expose myself to future rents, I have to take on volatility in the expectation of future rents, that’s how the game goes.