HOT AND COLD MARKETS IN RESIDENTIAL REAL ESTATE
The study originated when one of the co-authors entered the residential real estate market to buy a home and started became aware that there seems to be a regular cycle during which there is more activity in the summer when prices are higher than in the winter months when prices are lower. This is a puzzling scenario because it begs the question: Why would people enter a market during a period when it is known that prices will be higher? Why do they not wait until the winter when they know that prices will be lower. And on the flip side, why do sellers sell during the winter season when they know that prices will be lower?
The pattern of higher prices and more activity in the summer, and lower prices and less activity is so ingrained in the market that In the US the FHFA produces two house price indexes; one that is the actual price and the other that is seasonalized. This means that the FHFA is reporting housing prices as though the cyclicality of the seasons does not exist.
The study looked at how big was this seasonal impact by looking at the raw data and not the seasonalized data to determine what is the difference between the summer and winter months for house prices. They found that the difference between the summer and the winter months is around 4.5% – a significant difference in pricing between the seasons – and that this difference has remained consistent for at least two decades.
The study found international differences in the seasonality with the UK having higher price differences summer over winter, and found that there were regional differences. For example, major California cities experience an 8% variance from winter to summer seasons. This is a very significant price difference, one season over another.
Similarly, the seasonality impacted the transactional volume with summer months experiencing over two and a half times more transactional volume than the winter months i.e. a 150% increase in volume.
The study thus put specific numbers on this known seasonality in the market, and then set out to explain why this was happening – why would anyone buy in the summer when prices were higher, or sell in the winter when prices were demonstrably lower. To answer this question the researchers considered the motivation for participants in the housing market. Typically, these are people who wish to live in the house that they buy – not always, but for the most part this is true. On average in the US and the UK, people tend to live in their homes for around ten years. [This trend is increasing in the US and has been discussed previously by economist Jordan Levine of the California Association of Realtors in a prior podcast].
The process of buying a house is costly on many levels. It is time consuming, stressful, and, of course, costly in financial terms, so when buyers look they tend to pay a lot of attention to the process and to take care in ensuring that the house they choose is one in which they will likely be happy to live for up to a decade. The extent to which a house suits a particular person is very specific to that person – one person might love a house for a number of reasons that another person might not. The result of this differentiation is that for someone who likes a specific home, they may be willing to pay more than the person who likes it less.
This concept that the same home can enjoy different valuations depending on the individual’s perception of that home is what the researchers called the ‘match quality’ of the home. If a person likes the home they will be willing to purchase the home for a price higher than other people might. This is the first building block of the theory underpinning the study.
The second building block of the theory is that where you have a market where the match quality is important – like, perhaps, the jobs market or the marriage market – when things are so specific to the pair, then what you want is that naturally in an environment where there are more choices around it will be more likely that the buyer will find a better match. This is called the ‘thick market effect’ where in a market with more choices you are likely to find something that you really like. In the case of a house, as perhaps with a job or a marriage candidate, when you find the right match you will be willing to pay more for it primarily because you like it that much more.
Likewise, as a seller, if you sell in a market where buyers are going to like your house more, then you will have the expectation that you will get a higher price. This is the second building block of the theory.
When you put everything together, consider the circumstance when there is a small amount of people who want to buy a house in the summer. Perhaps because of the school calendar, or because summer is a better time to look for houses because there is more light, or because people get married in the summer. Whatever the reason, even this small amount of people entering the market triggers other people to come in because it means that there will be more choices for them as well.
So what we see is higher prices in the summer because the quality of the match between buyer and the homes that they find is higher and so they are willing to pay more, and also they are more likely to find that perfect match because the number of available options is also higher. This now brings us back to the question why is it that buyers, knowing that prices are lower in the winter, why do they not buy in the winter? Well, if the buyer cares about the quality of living in the house then they value having more choices. If they wait until the winter they may not have same choices and so may not be able to find the home that best suits their needs.
CONCLUSIONS AND RECOMMENDATIONS
As a buyer, if you are picky about what you are looking for and are looking for something very specific, then you should wait until the summer when there is more choice and be prepared to pay more for that perfect home. If not so picky, then wait until the winter season when you can get a better price on something that may not be quite perfect for you, but that might offer better value for money.
As a seller, if you have a house that has a lot of special features then you should sell in the summer season because there are more people around looking for a home and you are going to be more likely to find someone who values those many features and will be willing to pay for them. If you house is, for example, a new build surrounded by homes that are very similar or otherwise does not have particularly special features, then there is no need to wait.
The central bank of a country is tasked with changing interest rates and changing the money supply to try to smooth out economic fluctuations to prevent runaway inflation and to keep employment at full growth. Their task is to stabilize the national economy and the way that they do that is by moving around short-term interest rates.
Until recently central banks have had a very strong reluctance to have negative interest rates and from an intuitive perspective this would make sense yet during the great recession that started some ten years ago, the federal funds rate were lowered to next to zero. This left very little maneuvering for the Fed as it tried to stimulate the economy. Attention, therefore, started to drift away from short term interest rates which were at close to zero percent, towards how to lower longer term interest rates that you might see on long term treasuries at around four percent or mortgage rates around four to five percent.
That is harder to do because the way that the Fed controls short term rates is it changes the rates that it charges banks trying to get overnight loans from the federal reserve. To influence long term rates, the federal reserve entered the market and became a voracious buyer of long term debt. During QE1 (the first round of quantitative easing), the Fed signaled that it was going to buy long term (30 year) mortgage backed securities. This has the effect of bidding up the price of the bonds which in turn pushes down the yield on the bonds which will be passed through to the corporate sector, and to the household sector. The economy would thus be stimulated by the fed’s acquisition of ten year treasury bonds and Fannie and Freddie mortgage backed securities, because long term investment decisions such as whether to purchase a house or build a multi-family apartment building or a factory will be facilitated as a result of having lower long term interest rates.
But the question is, does this really work and if it does, how does it work exactly because without seeing the full scope of consequences of such monetary policy there may be unexpected consequences that are more damaging than the problem we were originally attempting to solve. At Berkeley university there is a vast database of anonymized data on properties, on mortgages, and on refinances that is used to assess the impact of these policies on the market.
Palmer looked at who was refinancing, who was taking advantage of these lower interest rates, who is purchasing homes, and what kind of refinancing is going on in what volume, and link those behaviors to monetary policy to see what kind of effect the various QEs were and are having on the economy. Palmer looked at the effect of QE1 where the Fed was buying mortgage backed securities, and QE2 where the Fed looked at buying ten-year treasuries, and then at QE3 where there was a return to acquiring mortgage backed securities in addition to treasury debt. This left the question was one of these strategies more effective than another and if so why.
Quick aside. Fannie and Freddie buy and guarantee residential mortgage loans that meet several criteria. The loans must have at least 20% down payment, for example, it has to be below the ‘conforming’ loan limit which is in the neighborhood of around $500,000. If it a loan is higher than the defined conforming limit, it is ineligible for purchase by Fannie or Freddie. The Fed is restricted to buying loans guaranteed by Fannie and Freddie so for those communities where house prices are substantially higher than the conforming limits, then the mortgage amounts will be higher also so the theory is that these communities would not directly benefit from the QEs which were restricted to only buying conforming loans. They would not see interest rates come down nearly as much as those communities where loan sizes fell within the conforming loan limits. This allowed Palmer and his colleagues to compare the behavior of communities directly affected by the QEs, i.e. those communities with a predominance of conforming loans, with those less directly affected, i.e. those communities with higher home prices and consequently non-Fannie and Freddie loans.
What they found was that the reason that QE1 was so effective was that it was able to inject capital into the household sector by enabling people to refinance their homes at lower interest rates. QE2 was not nearly as effective because the Fed was only buying treasury debt and so could not drop liquidity into the household sector with nearly as much effectiveness as when buying Fannie and Freddie debt. When, in QE3, the Fed returned to buying mortgage backed securities it was not nearly as effective as it had been during QE1 because the economy, in some sense, did not need it quite as much as it had.
Going forward there is less likelihood that the Fed will continue with quantitative easing. As mortgages are paid off because someone sells their home or otherwise pays down their debt, the Fed reinvests the principle that is paid back by buying more Fannie and Freddie debt. One way to taper off the QE stimuli to slowly increase long term interest rates is to stop buying back Fannie and Freddie loans with principle that is paid back. As this happens, the long-term end of the yield curve will start to see an uptick in interest rates and consequently pricing will start to soften and cap rates will go up.
The origins of this research came out of personal experience renovating homes and then putting them on the market and wondering what were the dynamics at play when an agent lists a home for sale: What are the agents’ incentives, what kinds of services do they offer, how do they get paid. This led to the question of misalignment of interests between the sales agent and the homeowner. The agent only gets a small percentage of the sales price ‘on the margin’ i.e. the last few thousand dollars of sale price earn the agent a minimal additional fee, and so do they really work for their clients to get the best price possible.
The theory is that the dynamic really changes when there is an offer on the table. At that point the agent has earned 98% of the commission they are going to earn. If they recommend to a seller to hold out and wait for another two, three weeks for a better offer, and consequently have to incur time and money expenses showing the home, advertising etc., the amount of incremental commission is not worth it to the agent – even if the additional sales price is worth it to the seller.
Recognizing that agents also sell their own houses, the study set out to test this theory by looking at how agents perform when they sell their own houses versus how they do when they sell on behalf of clients. This data is readily available because agents are required to report when they are selling their own home as a mandated disclosure. The insight this perspective brings is akin to seeing what physicians a doctor takes her own family to, or what does a car mechanic do when they work on their own car.
In short, the study gives an opportunity to see what the expert does when they serve themselves, versus when they are hired to do it for a client.
The way that agents are currently compensated creates a misalignment between the agent’s incentives and the home seller’s incentives. When a home is sold, there is a commission that is paid to the agent of 5-6% that is split with half of that going to the seller’s agent and half going to the buyer’s agent, and then the agent has to split again with their brokerage which differs from company to company, and from agent to agent, and in all cases reduces the share of the commission to the individual agent. If we assume that the broker split is 50%, then the share that the listing agent gets somewhere between 1.25% and 1.5% of the total sale price.
Now you may think that this is what you want; that as the sale price goes up for the home, the agent is compensated more because they get a percentage of the sale price as their commission. So you might think that the motivations of the agent and of the seller are aligned, but it is the magnitude of the incentives on the margins that creates the misalignment.
SAVINGS ARE SIGNFICANT
Let’s say you get an offer of $637,000 for a home. At that point the agent has earned around $17,500 in commission. To get an additional 4% for the sale of the home would add over $25,000 to the sale price that would go straight into the seller’s pocket, but would earn the agent only an additional $350. That $350 is only 2% more commission for the agent and in nominal dollars. This is just not worth the extra effort working for two or three weeks more, doing more showings and open houses, and continuing to advertise the property. The agent would rather recommend to the seller that they accept the offer, take their commission, and move on to the next deal – but the seller would clearly be better off with the extra $25,000. The problem is, therefore, that the commission rate returns on the margin such a small amount to the agent that gives them such a low incentive to proceed relative go the home seller.
The researchers looked at this typical case and compared it to what happens when an agent sells his or her own house. In this case it is the agent that is getting the lower offer and has the option whether or not to take it or to wait for the higher offer.
When agents sell their own house they keep the house on the market for about 10% longer and they end up selling it for almost 4% more than an otherwise identical house when representing a client.
These findings are amplified where the information available to the seller is less. For example, in an area where all houses are very similar, say in a tract home where the neighbors’ houses are almost identical, sellers see what nearby homes are sold for and are better informed about the value of their own home so they are going to be less inclined to accept a lower price. However, where homes are very different in an area, it is harder for a home owner to predict the value of their house and so they are more dependent on the agent’s advice and likely more inclined to take an early offer that may be lower than they otherwise could get. This is exactly what the study found; that where homes are less similar, agents sold their own homes for proportionally more than when they sold their own homes in areas where homes were very similar.
So what is going on where you have this uniformity of commission structures nationwide that has persevered despite the pressures of a competitive economy? There seems to be something ‘special’ about needing two agents in the transaction; one on the buy side and one on the sell side. This two-agent structure makes the model ‘stickier’ than has been seen in other industries, such as the travel agent industry, or the stockbroker industry where there is only one agent involved.
In the travel industry, once technology allowed for efficient disintermediation of the agent and it became possible to book a flight or a hotel directly, there was nothing to stop consumers from going straight to the airline or hotel. Similarly, with the stock broker; as soon as the consumer could buy stocks directly using their computer or telephone bypassing the agent, the agent role became redundant.
This is harder when there are two agents involved, one on each of the buy and the sell sides of the transaction. In this case while you may have a model that evolves that disintermediates the sales side of the equation, or sharply reduces the cost in some way to the home seller, you still have a buy side agent to contend with. This buy side agent may be reacting to the new model and resisting the changes that they are seeing to their industry by steering their clients away from homes that are put on the market in a way that is unfavorable to their own interests i.e. the reduced commission or full disintermediation model where sellers don’t need a listing agent at all.
Evidence of this is found in other research conducted by the same authors that compared the sales prices of agents who use a flat-fee model with those of agents who use the full commission model. The flat fee agents were able to sell for as much as the full commission agent but it took longer to achieve this result. This indicates steering by buyer agents away from the listings of flat fee agents. That said, this result also shows that although the sales price was not higher, the net return to the home seller was higher because they did not have to pay the full commission of the selling agent – they just paid the lower flat fee.
While steering clients away from a home because an agent does not like the listing agent’s business model is unethical, possibly illegal, its illicit implementation does serve to enforce the existing full commission model on the industry in general and may help explain why the real estate industry has these commission rates nationwide that vary very little.
YOUR (BUYER) AGENT IS NOT FREE
One factor holding up the disruption of the industry is this notion that buyers have that the agent representing them is free: They are not. While the seller does, technically, pay both buy and sell side agents, the seller is using buyer money to pay them. Buyers assign excessive authority to their agent because contractually it is the seller who is paying the buyer agent and so, technically, not a cost to the buyer. However, this is not how the transaction works economically and it is indeed the buyer who must find a larger down payment, and a larger loan to consummate the transaction in order to provide enough funds to pay the buyer agent also.
Syverson and Levitt found that the magnitude of the sales price difference between the commissioned agent selling their own property and the commissioned agent selling a client’s property became smaller over time. It was more pronounced during the early periods of the study’s data set, the early 1990’s, and less so in the later period, the early 2000’s. This indicates an erosion of the commissioned agent’s exclusive ownership of market data and an increasing sophistication on the part home selling public. As the availability of home sales data has become ever greater, the information gap between the agent and the home seller has reduced, and the consumer is now more alert to the value of their own home and less likely to take an offer simply because an agent insists it is likely their best option. Whether this phenomenon has reached the point at which the fee based agents’ rise in the market is imminent remains to be seen.
Attitudes to marijuana have changed dramatically over the last 50 years. In the 1950’s only 12% of people interviewed approved of marijuana, but in recent Gallop polls that number has increased to over 60%. Now there is a majority of adults in the U.S. support the legalization of marijuana, and as opinions have shifted over the last couple of generations so, slowly, have regulations especially on the State level. As of time of publication, there are 28 states plus Washington D.C., that have legalized medical marijuana, although on the federal level marijuana is still classified as a Schedule 1 drug and deemed illegal to possess or consume.
As medical marijuana has become legal, some states have begun to legalize recreational marijuana. Currently (as of time of publication) there are eight states plus Washington D.C. that have legalized recreational marijuana, and the first two to do this were Colorado and D.C.
While the standard pros-and-cons arguments have not changed – opponents claiming that marijuana is a gateway drug, proponents arguing that removing it from illicit trade will reduce crime – no-one has really conducted any empirical research yet on the impact of legalization simply because, until recently, there has been no data to analyze.
Effect on Home Prices
The current study adds to the debate by addressing a very specific question: What happens to home values (single family residences) in the neighborhood of a store that converts from being a medical marijuana store to one that is permitted to sell for recreational purposes. What makes this paper’s results so important is that in examining the impact on single family homes values, what the study does is to flatten out the positive and negative effects of having a recreational marijuana store nearby, and to examine the net effect on home prices. In other words, home prices changes likely capitalize the overall impact of bringing a store to the neighborhood by accounting for the impact of both negative and positive effects.
Denver, Colorado provides a good location to examine because, one, it was one of the earliest to legalize recreational marijuana so has the longest history for this that can be studied, and, two, Denver provides a rich source of publicly available data. For other states and cities considering legalizing recreational marijuana, the results of the current study provide a finding that might be of use in making legislative decisions about whether to approve.
The study’s objective, therefore, was to study whether or not there is an impact on a neighborhood’s home values, and, if there is, to what extent is there an impact…
Marijuana in Colorado
Background. In Colorado in 2000 the state legalized medical marijuana but kept the industry very small to limit early growth. This changed a few years later and the state started to relax legislation allowing for the industry to start to flourish, and by 2012 it had become so widely accepted that when Amendment 64 to legalize recreational marijuana in the state’s constitution was put on the ballot, it passed. This allowed for the beginning of recreational sales to start in the beginning of 2014, a little over a year later.
As the state developed a process for managing the expansion it became clearer where these retail marijuana stores were going to be located. By the end of 2013 precise locations that would get licenses to sell recreational marijuana had been identified, and those locations were to be a subset of existing medical marijuana stores.
In December 2013, when the list of approved sales locations was released, the researchers looked at these locations and drew circles starting at a 1/10th mile radius and moving outwards at incrementally greater distances. A tenth of a mile is about a city block – so, at this distance, the impact on a single location would encompass approximately a four-block area (one block in each direction).
House Prices Shoot Up 8%
What the study found was there is a benefit on home values on a very localized basis. Homes within a one tenth mile radius of a newly designated recreational marijuana store go up roughly 8% more relative to homes situated further away; homes situated further away experience neither a negative nor a positive effect.
Why Do Prices Go Up?
From a statistical and methodological perspective, the result shows a strong causal effect: Convert a medical marijuana facility to a recreational one, and home prices within a block radius will shoot up relative to homes situated further away.
What the study does not do is explain why that happens. Why do you think it might happen? Is it:
The researchers had anticipated a negative effect going in to the study, so were surprised results that so confidently show a positive effect on home values. As the debate advances in other states as to whether to legalize recreational marijuana, the results of this study should point to at least one positive impact where, in all likelihood, there is a tendency to erroneously predict a negative one. For those ‘not-in-my-back-yarders’, understanding that their home values could go up substantially might help in taking a different view on the possible impact.
... investing in higher cap rate properties, in less expensive markets nationwide, consistently deliver higher returns on a risk adjusted basis than focusing on quality properties in expensive cities. These results underscore the idea that Value Investing is as valid for real estate as it is for most other asset classes, be they stock, bonds, commodities, etc. and point to alternative real estate investment strategies you may want to consider further.
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The question of whether low cap rate or high cap rate properties are better investments goes back to Warren Buffet’s idea of value investing. The basic tenet of value investing is to invest in assets that are undervalued in some way; those that are not necessarily the most glamorous investments, but that are undervalued for some reason, and to invest in those.
All kinds of academic studies going back to the 1980s that have found that value stocks generally outperform growth stocks. More recently other asset classes – stocks, stock indices, currencies, commodities, bonds – all have been examined to compare how value investments perform relative to growth investments and these too have consistently shown that value investing outperform growth investing. But Geg MacKinnon and his at the Pension Real Estate Association (PREA), and his co-authors, realized that this same effect had not been examined yet in real estate and their study fills this gap.
Typically for most RE investor, when you talk about value you talk about whether the price is high or is it low and the core measure of this is the capitalization (‘cap’) rate. Initial question, then, is ‘do high cap rate properties do better than low cap rate properties’. Though this is a basic starting point, it is one that is very applicable to investors and investment managers as far as how they define their investment strategy – which kind of property, high or low cap properties, to invest in.
The first step in the analysis was to take National Council of Real Estate Investment Fiduciaries (‘NACREIF’) data and categorize the assets in their dbase according to those with high and those with low cap rates. First the researchers controlled for both time – when was a cap rate measured (1970s vs. 1990s for example) – and then for location; where in the U.S. was the property located. Each property in the dbase was then compared to the average at the same time and place for other assets in its class, be it office, apartment, industrial etc. Once that task was completed, the top 30% were defined as having high cap rates, and the bottom 30% were defined as having had low cap rates. Every asset was then analyzed for how it performed over time, and the results were consolidated to see how the assets with different cap rates performed relative to others.
Results show that low cap rate investments are significantly better investments than low cap rate properties. This result holds in absolute terms, in risk adjusted terms, holds across property types, across time.
The (statistically significant) results are, on average:
Of course, the next question is, well, what about risk? Risk was addressed in the study by looking at the frequency by which these results held true over the course of the study period – 1979 - 2010. The upshot was that higher cap rate assets (cheaper properties) consistently outperformed low cap rate (expensive properties) more than 70% of the time across all property types.
Here are the specific results:
Summary: Higher cap rate properties (cheaper ones) consistently yield higher risk adjusted returns.
Is it better to buy a cheap property in an expensive market, or is it better to buy an expensive property in a cheap market? Put another way, are you better off going to Manhattan, which is a high cap rate, expensive market, and buying a cheaper property, or are you better off going to Cleveland or St. Louis or someplace like that, that is a cheap market, and get a relatively expensive property.
What was discovered in the study was that if you look at cheap metropolitan areas, in, say, office for example, i.e. those with the higher cap rates, and you look at properties within those markets with lower relative cap rates, i.e. those that are relatively expensive for the cheap metro areas, what you find is that those types of properties historically enjoy a return of 5.3%. However, if you look at low cap rate markets i.e. expensive market, and you look at the higher i.e. cheaper properties there, the average return there is 4.6%. In short, relatively expensive office properties in cheap markets do better than cheap office properties in expensive markets. For apartments relatively expensive properties in cheap markets do about the same as average properties in
From the value investment standpoint, what applies fairly universally across all property types is that high cap rate investments do better than low cap rate ones. There is a very distinct pattern across the country where cheaper metros do better than more expensive ones on average. If you look within metros, what you find is that the cheaper properties do better than the more expensive ones. So, no matter which way you look at it, high cap rate (cheaper) properties, do better than low cap rate (more expensive) properties.
The typical fund manager will only look at the big major markets, i.e. the higher cost (lower cap rate) markets, and will concentrate on the highest quality properties which, presumably, have the lowest cap rates. But these are not the assets that are going to be delivering the highest risk adjusted returns when applying value investing principles. While some may consider it counter-intuitive for real estate because investing in the ‘highest quality assets’ is the accepted standard, it is, actually, totally intuitive to apply value investing principles to real estate because it works across all other asset classes so why not in real estate also.
The idea of investing in a more expensive property in order to maximize returns is premised on the assumption that these kinds of assets will deliver higher capital appreciation that will compensate for the lower yields. But that is not what this study finds. What the study finds is that not only do expensive properties not experience capital appreciation sufficient to compensate for their lower yields, but, in fact, cheaper properties appreciate at a faster rate than do more expensive ones.
In a sense, therefore, it is a contrarian tale of investing in markets and properties that other people – or at least the larger institutional investors – are not. And it is precisely that lack of attention from the bigger investors, institutional, sovereign wealth fund investors, that drives the result.
AMANDA HITE, PRESIDENT, CEO STR
Amanda Hite joined STR in Jan 2006 when the company had one office in Hendersonville with 65 people. She became president and CEO in 2011 and in that role sets company policy and strategy while overseeing daily operations and implementing initiatives for STR's family of companies: Hotel News Now (HNN), based in Cleveland, Ohio and STR’s international headquarters, in London. She is a member of the boards of directors of the U.S. Travel Association (USTA) and the Hendersonville Chamber of Commerce. Today STR has 300 employees worldwide, with 170 situated at the corporate headquarters in Hendersonville, Tennessee, an international office headquartered in London, a regional office in Singapore, and, in total, 16 offices in 15 countries... and a network of 57,000 contributing hotels worldwide. Hardly any wonder they are the most important voice in the industry.
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THE STR REPORT
The STR Report was originally called, and continues to be called, the “Smith Travel and Accommodation Report”. It is the aggregation of data voluntarily supplied by hotels to STR that describes how a set of competing hotels , the ‘compset’, is performing financially relative to a client hotel. In short the STR report provides a competitive set benchmarking tool to a hotel operator by comparing it against those other hotels that it sees as being competitive to itself. Hotels provide their financial results to STR and in return are given market level data at no cost. Or STR will provide compset data to hotel operators who by such data.
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REVPAR – A MEASURE UPON WHICH BONUSES ARE BASED
The key data points that hotel s look at are occupancy and the average daily rate, but the key metric that drives decisions is what is called ‘Revpar’, or, revenue per available room. This is calculate by looking at total revenue divided by the total number of available rooms. The Revpar index is the metric that most hotels use to evaluate their own performance. Having been in the industry for over 30 years, STR knows that all staff meetings for hotels are usually planned around the delivery of their STR report and in many hotels the general manager’s bonus is tied to performance against the Revpar index.
HOTEL INDUSTRY: NEVER BUILT ITSELF INTO A RECESSION
Unique, perhaps, in commercial real estate, the hotel sector has ‘never sent itself into a downturn through overbuilding.’ Any time the sector has had a downturn it has been brought about by external macro-economic factors, and not through the building of excess supply. And each time there has been a downturn for hotels, the impact has been more dramatic than the last time. This is likely due to the continuing improvement in the availability of data in the industry, both on the consumer side and the operator side. When a consumer wants to book a room, there are countless ways that they can find different rates for that same room. Similarly, when an operator sees a competitor reducing rates next door, they can adjust their rates almost simultaneously and this can lead to a more rapid and precipitous drop in rates and bookings and consequently in the all important Revpar measure.
After the last downturn, the transient demand for rooms came back quickly, but room rates did not climb as quickly as had been expected. Hotels are selling more rooms than ever before in the industry, but there are more rooms to sell than ever before, so the hot topic is the new supply and what will be the impact of that supply as it comes on stream.
GROWTH OF 2% FORECAST FOR 2017
In total STR tracks in-construction, final planning, and planning phase pipeline, which are the ‘under contract’ pipeline. As of June 2017, there are 580,000 rooms under contract, meaning planned to be built… though possibly not all of those will actually end up being built. Of those that are actually in construction and coming out of the ground, there are 189,000 rooms in America currently actually being built – which is an 18% increase over where the industry was a year earlier in 2016. In fact, every year for the last five years the industry has seen that growth increase. The prior peak of under construction in 2007 there were 211,000 rooms under construction – so only about 22,000 off that prior peak of new, under construction rooms.
There are 1.8 billion room nights as of April 2017 to sell, of which 1.2 billion were sold. Growth rate for supply is 1.7% for the 12 months to April 2017, although the total growth rate for 2017 is going to end up around 2% i.e. 2% more rooms in 2017 than in 2016, in the US. In the prior cycle, in 2006, there were a lot of rooms being closed to be used for other, non-hotel, purposes, but this time around this trend is not as pronounced – only around 25,000 or so rooms being closed in a year now, compared with 2006 when some 40,000 rooms were being closed and repurposed.
LIMITED SERVICE DOMINATES GROWTH
Of the rooms being built today, and there are lot, are mainly in the upper-mid scale, and upscale rooms ‘chainscale’ with 65% of all rooms in construction in these two segments. And those are the limited/select service segments, i.e. Courtyard by Marriot, Hampton Inn, Holiday Inn Express… not full service, no restaurant, room service and the like. And so because most of the rooms coming on are of the limited service kind, this may be contributing to the slower than expected growth in revpar despite the increase in number of rooms.
Construction in top 26 markets is showing some very fast growing cities. Nashville, for example, has 13% of the existing market coming on stream, New York has 14% additional to the existing supply in construction – this compared with only 2% nationwide. New York has been top of the list for the last three years. As an operator in New York it has been challenging because so much supply has come into the market – with almost 16,000 additional rooms currently under construction just in New York, which is an additional 14% coming into the market.
IMPACT OF AIRBNB
So how does this considerable growth in hotel rooms tally with the growth in competitive options like Airbnb and the like? Well, a lot of times those folk coming to stay in an Airbnb room in New York, for example, may simply not have been able to come to the city before and stay in a hotel, so to that extent it is expanding the market for travelers, rather than splitting the market. Millennials and the so called ‘experience economy’ are boosting demand in ways not before seen, and hotel rooms are being sold at volumes more than ever before. People are travelling more than ever before – not the group business – but the single traveler traveling either for business or in pursuit of experiences away from home. And the trend is that people are traveling not just during the traditional summer months, but throughout the year which further broadens demand.
Societal changes are being reflected in the supply coming on of limited service hotels where travelers do not necessarily want a full service restaurant to go sit down in in their hotel, they would rather go out and ‘live like a local’ when they go out. They like having an inviting lobby to sit down in and have drink, with perhaps some light food, but are there to experience the people around them. They want free wifi included in the room rate that is provided to them, and this is also a reflection of the way that work habits are changing also. With more employers allowing staff to work from home or remotely, and people becoming more accustomed to working wherever there is free wifi, this has also had an impact on the demand for travel and the kinds of things that such travelers are demanding when they are on the road. And this trend is being seen in the kinds of hotels that are being built i.e. those that accommodate that kind of traveler.
STR is forecasting slowing growth overall, with a negative occupancy growth rate for the end of 2017 because of all the new supply coming into the market – new supply of 2% but negative occupancy growth as demand catches up with the new room supply. Revpar is forecast at around 2.5% for 2017, and average daily rate (ADR) being at around 2.2% increase over 2016. The trend for 2017 and 2018 is that for any kind of revpar growth, the growth is going to have to come from ADR growth because, although the demand is there, occupancy rates are going to decline because of the new supply. So this presents an area to watch: As occupancy rates decline, it is counterintuitive to increase prices in order to maintain the all important revpar. That said, there were two periods during the 1990’s where this phenomena was seen i.e. where there have been declining occupancy but increasing ADR. STR expects that this will be repeated in the current market.
STR is a focusing on shifting from an email delivery system to an online delivery system for the data that they produce, including improvements in intuitive visualizations and presentation of the data for clients. The company is also expanding even more rapidly around the world. Currently they have 57,000 hotels that participate in the STR program internationally, with the largest country outside of the US being China that overtook the United Kingdom in that position two years ago. The Asia focus will continue to grow, as well as a move into South America in 2017/2018.
APPRAISALS CONTRIBUTE TO BOOMS AND BUBBLES? HOW?!
Appraisals contribute to bubbles and exacerbate downturns? How could that be? Well, the Federal Reserve Bank knows and, in today’s podcast, explains just how.
Over the last couple of weeks I have been investigating how to set the listing price for a home when it is put on the market, and the impact that a listing agent might have on that process, and have concluded that setting the asking price at around 3-4% above market is the optimal level at which to maximize sales price while minimizing time on market. Be sure to listen to these at national real estate forum dot org, or NRE Forum dot org.
All that is just fine, but how is market price determined? During the recent downturn banks were expected to ‘mark to market’ their loan portfolios, but the challenge came in determining what market value was. How do you do that when the market is in tremendous flux, or even when it isn’t? Well, there are a few ways. One is to actually market a property thoroughly and whatever is the highest deliverable bid becomes the definitive market value, you could get a broker’s opinion of value, or, you could either write or get an appraisal.
I have always been a skeptical of the third party appraisal process, because I only ever conduct my own due diligence – in other words, conduct my own appraisals – to establish a property’s value. Third party appraisals are only relevant for banks and even they only use them because regulations mandate that they do.
FEDERAL RESERVE BANK GUEST, LEONARD NAKAMURA
It my great pleasure to introduce to you Dr. Leonard Nakamura, who is vice president and economist at the Federal Reserve Bank of Philadelphia, and who very kindly shared with me his unique view of the extent to which the appraisal process can impact the housing market overall. Though I am sure you already know, the Federal Reserve Bank is tasked with implementing monetary policy and, as lender of last resort, is also responsible for monitoring and regulating the entire banking system. Dr. Nakamura’s perspective on appraisals is, therefore, not only extremely interesting, but also provides insights into this ubiquitous component of the housing market that you have doubtless not before considered. This is a rare opportunity to hear from one of the foremost experts in our banking system so please tell your friends and colleagues to go to NREForum dot org and just hit play to hear him and my other guests.
Oh, and be sure to listen to the end of my conversation with Dr. Nakamura for some personal insights into his fascinating background.
[That’s Walt Wriston, W.R.I.S.T.O.N. As CEO in the late 1970s, Wriston was famous for having changed the name of the bank from First National Bank to Citibank and for having launched the Citicard pioneering, as it did, the development of the now ubiquitous 24 hour ATM machine.]
Fascinating. In the period before the market tanked in 2009, 2010, and while property values continued to rise relentlessly, an overestimated appraisal was insulated from repercussions because, well, prices kept rising so they were never wrong. As a consequence, in the refinance market, which accounted for much of the lending in the pre-downturn period, appraisers became accustomed to over estimating house prices. This contributed, in part, to the run up in house prices. Once well intentioned regulations were implemented that put stricter guidelines on the appraisal process, the pendulum swung the other way and a higher proportion of appraisals started coming in below market price, causing both purchasers and refinancers to fail to conclude their transactions. This may have further exacerbated the downturn by making it harder than it already was to finance home purchases and so inadvertently propelled an already steep decline in property values.
I never thought of the appraisal process as having the potential for anything but an impact on individual loan transactions. It never occurred to me that, when viewed as a systemic cog in the entire industry, that they actually contribute to the swings both up and down in the market, so I am most grateful to Dr. Nakamura and the Federal Reserve Bank of Philadelphia for taking the time out to share this aspect of their work with us today.
If you also found this an interesting perspective please do share this on linked-in book, or facechat, or twittering about it if you have the inclination. And please tell your friends and colleagues to check out the website www.nationalrealestateforum.org or www.NREForum.org where all you need to is hit the play button to hear the latest episode.
CALIFORNIA HOME MARKET SAME AS MID 1990'S IN SALES VOLUME - BUT WITH 100,000 MORE REALTORS ACTIVE IN THE MARKET
Good start in 2017 to the housing market (with particular reference to California). Growth of around 4-6% in home prices in the beginning of the year, which is good, but only around 420,000 sales in the volume terms which is the same as it has been over the last 7-8 years – and indeed about the same as during the 1990’s when the economy was much smaller and with far fewer jobs than there are today. This speaks to the difficulties consumers have in finding a home (more consumers, less transactional volume relative to the number of people looking), and also to the challenges real estate agents face in competing in the open marketplace. [n.b. there are over 100,000 more licensed RE agents/brokers in California today than there were in the mid-1990’s, yet they are handling the same transactional volume].
This issue is one of limited supply in California. Economically the state has outperformed the overall economy for over 6 years, in terms of new jobs and income growth. Inventory is the issue. So you are seeing considerable demand for housing, but little supply and so prices are being driven up relentlessly to the point that they become unaffordable. This forces people to choose between being a homeowner or buying far away from jobs and having a two hour commute each way to their places of work. Remarkably, the number of homes available for sale on the MLS state wide is 16% lower than it was last year, and yet sales growth is up 2.6% [presumably meaning that what is on the market is selling very quickly relative to last year – another indicator of very strong demand relative to supply]. This may be partially as a result of consumer concerns about rising interest rates, with buyers moving rapidly to purchase what is on the market quickly to avoid being caught with higher rates. So this begs the question whether or not the pace of sales growth can be sustained as rates start to rise as people feel the urgency to buy ahead of rate hikes diminishes.
LACK OF INVENTORY, AND HIGH DEMAND DRIVING PRICES UP
Another indicator of the lack of inventory is the amount as measured by months of supply. This is a metric used that projects the amount of time it would take for all existing homes on the market to be sold out if no other homes were put on the market. As of syndication of this episode (April 2017), supply is around 4 months where historically it is more common to see 7-8 months i.e. supply is running at half what it would be excepted to be. This is a particularly acute problem at the bottom of the market.
If you break that out by price levels, you see that below $500,000 price level, supply is at 3-3.5 months, whereas for properties selling at above $1MM, supply is much higher at around 11 months. What this means is that at the lower, entry level end of the market, the demand is extremely high, and supply very low. Sales in the below $500,000 level are down over 20% and over since last year – simply because the supply is not there.
DEMOGRAPHIC FACTORS RESTRICTING SUPPLY
Demographics is a huge part of the problem. Historically, we have seen turnover at around 8% i.e. of the total housing stock, 8% will sell in any given year, but that is currently around 4.2% - half what it used to be. Demographics play a huge role in that with a lot of long term homeowners, with over 70% of all homeowners 55 years old and above having not moved this century. For the first time in 30 years of conducting research on how long people own a home before selling, C.A.R. discovered that the average time homeowners stay in a home is over 10 years – instead of the 5 years as it used to be. Probably demographics drive this with baby-boomers not wanting to move on even though they are living in homes that are too large for them. But there are some policies and structural challenges also, that incentivize people to stay in their homes. Interest rates are at an all time low, pretty much, so most folk, who can, have refinanced so the prospect of moving – and taking on higher rate debt – is not so attractive.
TAX INCENTIVES ADD TO SUPPLY CONSTRAINTS
The Prop 13 factor also dis-incentivizes homeowners from selling. Prop 13 restricts property taxes to a set percentage of the last sale price, plus a maximum 2% increase per year. With property prices rising as much as they have, there has been a de-coupling between home values and property taxes. This means that moving to a new home at a much higher price (even if the prior home can be sold for far more than the original price and for the same as the purchase price of the new home), results in a dramatic increase in property tax liability as the basis has now increased to market value. Thus the incentive is to stay in your home rather than move. Plus, anyway, with such low inventory, where would homeowners move to?
So the trend has been to pump money into existing homes with remodeling work, rather than to move to a new, perhaps smaller, home. All indications is that low turnover and tight inventories are, perhaps, here to stay, at least for the foreseeable future.
SINGLE FAMILY HOMES AS RENTALS
In addition to the fundamental lack of new construction to accommodate demand is the switch during the last recession from homeownership of single family residences, to rental of these same properties. Vacancy rates for these homes are amongst the lowest in the nation, and rents are being driven up. Homeownership was just not an option for a lot of people coming out of the great recession because of tarnished credit due to bankruptcies or foreclosures, so this cohort was forced into becoming renters. C.A.R. estimates that upwards of 700,000 single family homes were taken out of the ownership pool and put into the rental pool as a result of the last downturn, further restricting inventory available for sale. C.A.R. sees upward pressure on rents to continue signaling even more demand for single family homes as rentals rather than for ownership.
There is a need for at least 170,000 new units per year to be built just in order to stay level with population growth, not including the accumulated housing deficit that has been building up over the decades. Unfortunately, this volume of construction has not been seen since 2005 so the deficit just keeps on building.
This factor adds further to the affordability problem that Californian’s face for housing. Affordability is a measure of the relationship between average income with the cost of paying a mortgage when buying a home for the median home price. The house is deemed affordable if the homeowner is using 35% of their total income to pay the mortgage – i.e. if a homeowner is paying over 35% of their income on the mortgage they are deemed to be ‘house burdened’ and the house is not affordable for them. Currently, the affordability level in California is only 31% meaning that only that percentage of households can afford to buy a house by this measure. California is particularly expensive, with the rest of the nation enjoying, on average, 60% affordability by the same measure.
MORE JOBS CREATED, BUT FAR TOO FEW HOMES BUILT TO MEET THIS ADDITIONAL DEMAND
There is a continuing trend for affordability to head down, especially with interest rates going up, it could be possible that only 25% of California homeowners could afford to buy a media priced home in the state. This would be an all time low. This problem is accentuated by the lack of development of new homes. Since 2010, Los Angeles county has added around 483,000 new jobs, but only permitted around 100,000 new homes. Even this might be misleading on the permitting side because some of those 100,000 new home permits were, in fact, for replacement of older homes that were torn down, and so consequently not adding to housing stock. Not a net gain of new houses, but it is a net gain of new jobs. This even further exacerbates the housing affordability crisis in California and especially if mortgage rates hit 5% or 6% affordability could drop to below 25% of households – especially as prices continue to rise due to high demand and under supply.
With homeownership dropping to historic lows, California is moving towards becoming a majority renter state.
MULTI-FAMILY HOUSING PRICES ARE PEAKING NATIONWIDE
Professor Mueller’s latest real estate cycle monitor analysis shows that in all of the 55 MSAs he studies, apartments are at the very peak of their cycle, and on the verge of turning downward as supply pipelines come on stream, outstripping demand. A few cities have tipped over already and are seeing negative rent growth, and in one notable case, Houston, the multi-family residential property sector is close to being recessionary.
POSSIBLE 25% SPIKE IN PRICING IF TAX CHANGES IMPLEMENTED
Of course, there could be a dramatic spike in values of all these properties if the tax breaks Professor Mueller discussed come to fruition, but we will have to wait see how that plays out in Washington.
THREE KEYS TO PROTECTING FROM REAL ESTATE DOWNSIDE
And of course, it is worth being reminded of the three keys to weathering another real estate storm, whenever it might come: quality buildings, good tenants, and low leverage. These may seem obvious, but as Warren Buffet says, ‘only when the tide goes out do you discover who’s been swimming naked’, Taking into account the stage of the cycle as we are now, especially in multi-family, the timing might be good for taking stock and making sure that all of your assets are covered.
Last week I spoke with Chairman Robert O’Brien of Deloitte about the future of real estate. Today I consider the past, and reflect upon the importance of historic preservation. My guest in this episode, Michael Tomlan, is professor of historic preservation and planning at Cornell University, and, especially if you have any interest in attending Cornell to do some graduate studies in real estate professor Tomlan is definitely the man you want to know because he also chairs the admissions committee.
DELOITTE: ONE OF WORLD'S BIG 4 ACCOUNTING FIRMS
My guest today is Bob O’Brien of Deloitte. Deloitte, one of the ‘big four’ accounting firms in the world is a vast international network that provides ‘audit, consulting, financial advisory, risk management, tax, and related services to select clients.’ The firm was founded in 1845, in London, so they must be good, and today they employ nearly a quarter of a million people worldwide. They are the 6th largest privately owned organization operating in the United States, and in 2016 the company earned nearly 37 billion US dollar in revenues. Mr. O’Brien is Vice Chairman and partner of Deloitte, and heads up their Global and US real estate practice.
He is my first guest from industry instead of academia although, if you wait until the very end of today’s podcast, right after my usual sign off, I have included some outtakes of my conversation with him in which you will discover that although he is from industry, his amazing company also has its own university, Deloitte University, and Bloomberg have compared the training center as 'Deloitte's Disneyland.'
Mr. O'Brien very kindly shared his insights derived from the collective intelligence of his firm of 250,000 people plus their clients, into five areas in which the real estate industry will see profound change in our lifetimes: mobility, and the impact of autonomous vehicles, health and welfare, and the provision of new standards of care for employees, the internet of things, and the integration with where we live and work and what we do on a daily basis, 3D printing and how retail may evolve to better compete with the online shopping experience, and intelligent buildings where analysis of use patterns will lead to greater efficiencies and predictability.
What is particularly fascinating is that, with the pace of technological change, as real estate developers and investors, we really need to be thinking now about the projects we are building and for which we expect will have up to 100 year lifespans or even longer. We are living in an era where the real estate industry needs to collaborate with the technology industry, or risk planning and financing developments that could become obsolete before they have even been built. The importance of a cross disciplinary approach is paramount, and those institutions that have the vision to recognize and prepare for this, will be the ones that lead us into the next generation.
Today's podcast is the first in which I experiment with outtakes after my sign off. Listen in to hear Mr. O’Brien talk about the Deloitte University and share some of his other thoughts. Also, it is worth looking spending a few minutes watching as well as a link to a Bloomberg feature on The Edge building – it is really incredible and well worth the time spent taking a look.
Before starting today I would just like to offer a word of appreciation to those folk who are currently considering sponsorship of this National Real Estate Forum podcast series. As clichéd as it may be, your name could be here.
Do School Test Scores Influence Home Prices
Now is the time of the year when those among us with children start wondering where they are going to be enrolling those children in school next year. As a consequence the residential property market starts to heat up as people buy homes in school districts that they consider desirable. Part of the calculation in making these types of decisions is balancing the relative cost of private school with the perceived additional cost of buying a home in a good school district. But when you buy into a better school district, how much of the premium in housing is really associated with the performance results from the neighborhood schools, and how much as a result of other factors?
My guest today is Professor Steven Ross who holds the Philip E Austin Chair of Public Policy at the University of Connecticut. His research specialties focus on housing and mortgage lending discrimination, on residential and school segregation, on neighborhood and peer effects, and on state and local governments. It was, perhaps, inevitable therefore that a discussion regarding the relationship between property prices and school quality should migrate through a broader discussion regarding school policy and the impact on neighborhoods and on standards, before returning to our discussion on school standards and how they relate to house values.
As the objective of the National Real Estate Forum at NREForum.org, is to provide deeper insights into complicated issues in real estate, I hope that you will find Professor Ross’s thoughts about the issue of school quality and house prices as interesting as I do. Here is what he had to say.
Historically research saw a large relationship between house prices and local school district test scores. So for example, it was found that moving from a school district in the middle i.e. an ‘average’ school, to a school in the top 16% of schools (versus being in the top 50% - i.e. a one standard deviation from the average), this could increase house prices by upwards of 10%. But this earlier research did not take into account other factors that might be moving this needle, such as quality of the neighborhood overall. Sandra Black, in 1999, first looked at trying to account for these differences by examining house price differences in similar neighborhoods, but that were in different school districts i.e. on where neighborhoods were split by school district boundaries. ('Do Better Schools Matter?') Black found differences of only 2%, rather than 10%, where schools were in the top 16% of schools, versus those in the top 50%.
So Ross and his colleagues looked at other factors that might be impacting test scores and found a significant variable seemed to be ethnicity – that property values were more driven by ethnicity than by school scores. Property values were lower in predominately Hispanic neighborhoods, and it was this that drove values rather than test scores. One possibility is that in the earlier days when these research papers were written, that test scores were not as readily available as they are today, but more recent research has echoed the same results that a one standard deviation from the average – top 16% versus top 50% of schools by test scores - result in about a 2% difference in property values.
Giving Parents Choice in Schools Can Have a Big Impact on Property Values
Therefore, if, though small, there is still an impact on property values as a result of test scores for neighborhood schools, what is the impact on property values where parents enjoy the benefits of ‘choice’ in selecting their schools? In research where choice is a factor, what is found is that the impact on house prices is, actually, very large. If only one percent of the student body living in one district remains living in that district but chooses to go to school in a different district, then overall house prices in their district of residence rise by 1%. Put another way, the entire housing stock in their district of residence rises by 1% even if only 1% of the student body elects to attend school outside of the district. Additionally, the values of homes in the districts into which these students are now attending school, these prices fall because now their families did not need to move into the district, did not ‘need to bid on housing’ to get into the school district.
It is a zero sum to the house price market overall. ‘They are falling in the places with the best schools that presumably had a price premium, and rising in the places with worse schools that presumably had a price discount,’ says Ross. The important distinction between Black’s earlier study that showed a small house price difference between school districts with different school test scores, the latter studies are showing a significant impact in the residential housing market from allowing families to choose where to send their children to school. In fact, an important change that is seen is that the incomes of people living in those districts that have the poorer schools, actually rises when you allow for school choice. But this is not the only change: The revenues now coming into these poorer districts is also rising because higher income families are moving into the districts and so, presumably, paying more in taxes, spending more money locally, and taking greater care of their properties and neighborhoods.
The research is suggesting, therefore, that as choice is given to families as to where they send their children, it has a powerful impact on property values across neighborhoods. This results in a tendency to see lesser concentrations of neighborhoods with wealthier makeup as distinct from poorer neighborhoods. Neighborhoods, in short, become less polarized across income and socioeconomic factors.
From a policy perspective, school test scores are not that important as a determinant of house prices. Moving one standard deviation in quality of school (from top 50% to top 16%), has less of an impact than adding a bathroom, for example. But it does have a big impact on who is willing to live in a particular jurisdiction, which itself can have a big impact on a neighborhood, and that when you allow for choice, this bifurcation of neighborhood differences between richer and poorer, is ameliorated. On the other hand, if you are a planner and you want to see neighborhood improvements, improving school quality does have an impact because it draws in people of higher socioeconomic standing, and this can lead to improvements in neighborhood quality. So one way to improve an area that is in decline, if improving the schools is too long term or financially impractical, might be to allow for residents of that area to choose which school to go to. This would also draw in higher income residents, which in turn would improve the area. But although ‘choice is a win’, it may simply allow for neglect of already failing schools.
When you look at the improvements in student performance from those kids who win lotteries to get into better school districts, we see unequivocally that those kids do better. So the experiment with choice combined with magnet and charter schools seems certainly to be working. That said, there are a limited number of resources and so kids are going to be left remaining in the public schools in those districts with lower academic standards, and the big question is how to accommodate these kids.
One way to do this is to impose high stakes testing on schools and results have shown that this has a substantial positive impact on the quality of these lower standard schools. Accountability does work and adapting a common core, ‘the’ common core, seems not an unreasonable approach in determining what kids need in the workplace to be productive and of value to them as they seek employment once they graduate.
Influence of Department of Education (Federal) on Local Schooling is Limited
From a national policy perspective, however, the government does not have much of an impact on education because most spending is driven at the state and local level. The way past administrations have attempted to maneuver states in the direction they have wanted, is to have been to offer grants to those states producing results that align most closely with their own goals – which in the case of the Bush and Obama administrations, has been in the area of accountability. These administrations looked at proposals from the states that articulated how they were going to deal with failing schools, including title one schools, and those that failed ‘no child left behind’ standards for two years in a row that then went to choice options, for example.
The Obama administration started to look at teacher evaluation, where student test score improvements were deemed reflective of teacher performance and grants were to be allotted accordingly. Seems that now many of these grants, under the Trump administration and Betsy DeVos, is going to be oriented towards how states are going to be allowing for choice. And, as discussed, this is going to bring with it the possibility that there will be more dramatic shifts in housing prices across neighborhoods depending on whether you are a more affluent neighborhood with good schools where prices may seen downward trends, or in a poorer area where house prices may tend upward. So this could lead to gentrification of inner city areas, and to the extent that parents can choose where to send their kids to school, there might be more flexibility on where families choose to live, which in turn could lead to less segregation across socioeconomic and ethnic lines.
But what was seeing come from the Department of Education under DeVos is a enabling of choice but not necessarily within the public school system, but within the private school system, like charter schools. The administration is also talking about allowing for ways to navigate the idea that incentives can be provided for faith based schools to attract students also. The way they are talking about doing this is by providing tax credits so that someone can make a wholly deductable donation to a faith based school that is a 100% deduction against their tax liability.
On the face of it this is a good thing. Provide a mechanism whereby people who cannot otherwise afford to go to a private school may be able to get in because that school now has a scholarship fund available to it. The problem is the tax credit, which is not equitable, especially if it is a 100% tax credit, even it is capped, this means that private schools can go to donors and solicit donations that will cost the donor nothing, because it is just a reallocation to that school of dollar for dollar taxes that the donor would otherwise have been paying anyway. The enables the private citizen to decide exactly where these tax dollars are to go and this has been largely how DeVos has been promoting her programs.
Neighborhoods, not Schools Drive Property Prices - Unless Parents Are Given the Choice Option for Schooling
But that is a fuller discussion for another day. Returning to the question of the relationship between school quality and house prices, the conclusion is that the relationship is, actually, small, and is in fact more driven by who is living in the districts with the good schools. And that with the implementation of choice for families as to where to send their kids to school, the impact on house prices is likely to be much higher, and so certainly something to watch for in the coming months and throughout the years of the school career of your children.
Well. What do you think? I really would like to hear your thoughts about today’s podcast, and, if you like the podcast, to share them also with friends and colleagues on Facebook, or Twitter or Linkedin, as well as any of the other platforms on which the Forum is syndicated. You will find links to all these social media options on the website at NREForum.org.
Professor Ross offers plenty of insights that give depth to understanding the complicated topic of how to fund schools, and what the impact is on house prices as a result. While it may cost a little more to live in a school district with higher test scores, the extra cost is driven in large part by the socioeconomic characteristics of that neighborhood, and less so by the test scores themselves. Watching for where the opportunity to choose which school your children attend might provide you with better value for money in terms of housing, and equally, if you are already in a good school district and choice is offered in your area, you might see your home value negatively impacted. Also, I am looking forward very much to hearing more about the new Education Secretary, Betsy DeVos, and what her plans will be for funding private schools through the resources available to her at the federal level.
Thank You For Considering Sponsoring the NREF Initiative
As I draw to a close for this week, here is a brief reiteration of my gratitude to those folk who are thinking about supporting this podcast. Your sponsorship will enable world class research from the top universities and scholars in this country – and consequently in the world – to be shared by the wider real estate industry to the benefit of all. Thank you sincerely for considering the opportunity of sponsoring the National Real Estate Forum initiative.
Download Professor Ross's research papers:
This is the abstract taken from a study conducted by Professor Christopher Palmer and his colleagues entitled, 'Housing Market Spillovers: Evidence from the End of Rent Control in Cambridge, Massachusetts'. As follows:
'We measure the capitalization of housing market externalities into residential housing values by studying the unanticipated elimination of stringent rent controls in Cambridge, Massachusetts, in 1995. Pooling data on the universe of assessed values and transacted prices of Cambridge residential properties between 1988 and 2005, we find that rent decontrol generated substantial, robust price appreciation at decontrolled units and nearby never-controlled units, accounting for a quarter of the $7.8 billion in Cambridge residential property appreciation during this period. The majority of this contribution stems from induced appreciation of never-controlled properties. Residential investment explains only a small fraction of the total'.
The following is a (slightly edited) transcript of the podcast with Professor Palmer discussing the impact on both rent controlled and never-rent-controlled housing when rent control is eliminated from a housing market. The short story is that all house prices benefit from the removal of rent control – so the implication is that if you live in a rent controlled market and own the home you live in, your property value could be lower than it should be simply because there are rent controlled properties around you. Dr. Gower first asked Professor Palmer about the background to the rent control study.
Professor Palmer: Well, I’ll give you some back story that is a curiosity and kind of an interesting story. I grew up right outside of Cambridge and the summer after my freshman year of college, I got a job as a research assistant for an MIT researcher who is trying to understand a little bit about the aftermath of rent control. My first job academic research was driving around Cambridge trying to figure out if the renovations that I had in my database that were purportedly done in response to end of rent control were actually plausibly connected to rent control.
A couple of times I found a building that had been multifamily and they put in a gas station on the ground floor and it was listed as a $2 million renovation. Not surprisingly we dropped that from our database because we were able to ascertain that a gas station on the ground floor is not plausibly a causal effect of the end of rent control, but something that would have probably happened anyway and to call this a renovation boom as an effect of the end of rent control was not right.
That was my first foray into rent control and studying its aftermath in Cambridge. And Cambridge provides an incredible laboratory to study rent control. Let me tell you a little bit of the details behind how Cambridge instituted rent control, and what their rent control regime was like. One thing that is very interesting for communities that have rent control in the United States right now is it seems like a policy that comes but never goes away, and so it’s interesting as a case study that rent control actually ended at one point in Cambridge.
Like many communities in the United States, Cambridge and the Boston area had various regimes of rent control, a lot of them coming from the post war housing boom. The intuition was that law makers were saying, look, it’s so hard for people to find an apartment that’s affordable in this city, let’s cap the rents. A lot of the legislation when you read it says we’re enabling our rent control regulation to address the housing shortage.
That ends up from an economist perspective being exactly backwards. You have a shortage so you are going to put a price ceiling on it and so there are now even more people that want to live there and fewer people that want to provide housing. It ends up being a somewhat backward policy so every freshman in college taking Econ 101 learns that price ceiling and rent control is the most iconic example of reducing the quantity and quality of available housing.
There are more people that want to buy, that want to rent a unit because the rent is now below what market is, so you have more people that are interested in buying this great deal. Then you have fewer landlords who are interested in providing their units, and also fewer landlords who are interested in fixing up their units to market standards.
That had been the traditional analysis and what we took advantage of is in 1994 the entire state of Massachusetts voted as to whether rent control should be legal per se; or allowed in the state of Massachusetts. Now this is a very curious thing to do because only three towns Boston, Brookline, Cambridge had any rent control to speak of. For years the landlords in Cambridge would put on the local ballot that they wanted to get rid of rent control. Not surprisingly Cambridge is predominantly renters with approximately a 60/40 split, or even more, with renters to owner occupants.
The renters are going to be in favor of rent control and, as Cambridge is also known affectionately as the people republics of Cambridge, [you can tell that it is] a fairly progressive place they are going not surprisingly vote in favor of the little guy, the tenant. Every time they put it on the ballot rent control would resoundingly lose.
But the landlords in Cambridge and in Boston and Brookline got smart in the early 1990. They rebranded themselves as a small property owners association. When they did that it was less about taking money from the evil absente corporate landlord and giving it to the little guy tenant that deserves to live here because he or she is a public school teacher or somebody that works at city hall or an artist; someone that we think is important to the kind of community character that we have.
Their rebranding transferred [the approach] from the big buy to little guy and they said, look these small property landlords that own five or six units; this is their livelihood, and they take good care of [their properties] and this is also their inheritance for their kids. They are as deserving as the tenants, and just as important a part of the community as the tenants are.
So that was one thing that was affective, but also putting it on the state wide ballot was a curious move that ended up paying off. Then you had people in kind of the tony suburbs of Boston and also rural western Massachusetts voting on whether Boston should be allowed to have rent controls. It was a fascinating election and the landlords ended up winning 51% to 49% with Cambridge voting overwhelmingly to keep rent control, but being overruled by people who were relatively unaffected by rent control.
That provides us this natural experiment where all of a sudden January 1st, 1995, rent control is gone in Cambridge and we can see what happens, and, it being the modern era, we have got unit level data on assessed values and renovations. We have data on when a house is sold, how much it was sold for, what the dollar per square foot was – the composition of these various homes. We can compare and contrast neighborhoods across Cambridge and we can answer a couple of fundamental questions that everyone always believed about rent control such as does it keep down rent, does it create a shortage, does it reduce the quantity of housing, the quality of housing? But then we are able to go one step further and address the question that was fascinating that no one ever had really been able to get a handle on which is, what’s the effect of rent control on the neighborhood? If I’m an owner occupant and live next door to a building that’s rent controlled, am I affected in some way. [Here we can] get at what economists call externality – the externality mechanism.
That was a very interesting piece of the study. We are able to ask, what’s the effect on you, as an owner occupant, of living near rent control. The punch line is that after the end of rent control there is a lot of residential turn over. There are a lot of renovations and [increases in] property values. [Prices] are increasing everywhere in the late 90s in the Boston, and especially in Cambridge, and we have this excess return for property in Cambridge not only amongst stock that was now capitalizing a much higher future rent stream, but also for never rent controlled properties. Owner occupied properties, single family houses, condos, things like this that had not been rent controlled [we saw that they also] appreciated a lot. Over the course of next 10-years there is an extra $2 billion of property value that’s created in Cambridge, and most of that is actually coming from stuff that had never been rent controlled, but appreciated in response to an improving neighborhood.
There are two sides to this, of course. If you are a tenant advocate and affordability advocate you can say, look, there is proof here that when we get rid of rent control property values go up, rents go up, things becomes less affordable – and that is absolutely the case. I think a flip side argument was to look at how much value was unlocked to owners, to people that wanted to move in and now could move in because there wasn’t as much of a shortage it was easier to find a unit in Cambridge that meant that you are bidding up rents, you are bidding up property values.
But there are people that would have been willing to pay more than what other people were paying to live in Cambridge and now have the opportunity to do so, kicking off a bit of a renaissance in Cambridge. And you know, other work since then has shown that crime went down in these areas as well as the people that move in start to take extra precautions. The people that move in seem like they are more likely to call the police when something sketchy happens or install a private security system and things like this that change a little bit the character of some of those neighborhoods. That’s the rent control study in a nut shell. It’s been fascinating to work on and also to think about how it applies to other rent control initiatives that have been on the ballot across the country in recent years.
Dr. Gower: It is fascinating. Did you look at demographics as well and how the demographics in Cambridge changed?
Prof. Palmer: One of the things that was interesting as we [have] presented this, [is that] somebody would say, well you know I can tell you signs of the character changing is that my favorite dive bar, my favorite pub is now a yoga studio. We looked at the business composition as well; are we seeing more whole foods and fewer bodegas? Are we seeing more coffee shops and fewer dive bars?
We also looked at demographics to see what’s the age mix up, what’s the racial ethnic mix up, and one of things we see is we do see some more students moving into the area. They would be living in other communities but for the end of rate control it seems like. And we do see fewer families with kids living there to some extent. We also see fewer retirees living there. [This is because it] became advantageous if you were retired and you were living in a rent controlled apartment that was three bed rooms and you raised your family there, that now you are “over housed.” As your rent began to increase there was an incentive for you to find a more advantageous situation for you and then turn that over to some other family or to some other group of roommates. But to be honest the demographic changes we saw were not as dramatic as what we were seeing in the housing market.
Dr. Gower: Very interesting. What about from a municipal perspective was there any impact on tax revenues as a result of the increase in properties values and slight demographic shift?
Prof. Palmer: There was absolutely. As property values go up, Cambridge is able to capture a lot of that revenue and they are able to capture it in two ways. One, even if they kept their property tax rate the same they are able to have much higher evaluations; they are bringing in a lot more revenue. But, two. that actually allowed them to lower property tax rates, so that the effective rate was not growing nearly as high for cash constrained owners and so that was a benefit to the resident in two ways. One, there is higher revenue intake, but also they are able to lower tax rates. Cambridge has a split property tax system with commercial, industrial, and residential tax – the different rates also gave them some extra flexibility. But that’s allowed Cambridge to enjoy much lower property tax rates historically and certainly that gap was accelerated in the aftermath of rent control relative to surrounding communities from a municipal perspective. [Additionally], the Cambridge police department [reported that] they have been excited about what they see as improvements in criminal activity in Cambridge. There are definitely some wins for the town’s fiscal health and the town as a whole.
Dr. Gower: What are the implications, then, for other people in other parts of the country that are either facing rent control that they don’t want to see, or lobbying for rent control?
Prof. Palmer: Rent control is a very touchy issue because it’s so instinctual to see people that you care about that seem like they are an important part of your community being priced out because they can’t afford their rent any further. You would like some kind of quick fix for that and you would like to favor the people that are living here now. The people that we are attached to, the proverbial artist or public school teachers or municipal workers, working class people.
Often people are motivated by seeing their kids trying to get into an apartment and wanting to live in the community where they grew up and having a hard time doing that. There is this very sensible sympathy and knee jerk reaction that says, well let’s just try to cap rents. One of the problems with that is it’s a Band-Aid on a gushing wound in a lot of cities that have an affordability crisis. Take the Bay area, for example, it’s taken us decades to get to the affordability crises that we have now in many Bay area communities. It’s just not feasible that we’re going to be able to undo a crisis that’s 30-year in the making with a quick fix.
So there are all these unintended consequences from doing rent control. It’s also a little bit too blunt of a policy in that it targets a lot of the wrong people. The statistics are that in San Francisco for example one in four renters in rent stabilized apartments are making more than six figures. So they are making more than a $100k and that’s because rent control, as an economist would say, is not means tested. It’s not a program where you have to submit your tax returns and show that you don’t have the means to be able to afford market rates, and therefore you are deserving [of], and qualifying for this affordable housing. Instead it just limits the rent growth for everyone and that gets some of the people that really need it and some of the people that don’t need it, and it also misses some of the people that do need it.
There are just a variety of leaks through the rent control system and problems with it. That said, it is something and lot of people would [rather] do something than nothing. If it has some unintended consequences and some side effects they still see it as being able to benefit a tangible number of people. In a lot of communities the solution, if you don’t want to be priced out of your area, is to lock in your rent by getting a fixed rate mortgage and buying a home. In a community like San Francisco or many parts of Los Angeles or New York or some of areas of Seattle – a lot of our most expensive places – being an owner occupant is just not feasible because of the difficulty of coming up with not only a down payment on very expensive house prices, but being able to afford that regular mortgage payment. So then that leads people to be lifelong renters and lifelong renters are very susceptible to changes in rent.
Any way those are some of the issues that I think people think about in communities across the country when they are thinking about affordable housing policy.
The link to the original rent control study is here: Housing Market Spillovers: Evidence from the End of Rent Control in Cambridge, Massachusetts
I am Doctor Adam Gower, and this is the in-depth podcast about advancing the real estate industry, by bringing together academia and real estate professionals to define the future of the industry, and not be driven by it.
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