Unlearned Lessons Of Housing Bubble

My Comment on Economist's View about the "Unlearned Lessons" of the housing bubble follows:

Shiller's work does not explain the increase in the home price to rent ratio. Land scarcity (real or imagined), economic boom times, bubbles, etc., should have increased rents also. The price to rent ratio index (Shiller's or OFHEO's) from 1982 to 1999 varied slightly (up and down about 10 percent) and was fairly constant. 1998 ratios were roughly equal to 1987 ratios. However, from 1998 to 2005, it rose 40 to 65 percent depending on the index, and the ratio is still above its 1987-98 levels. The property owners were giving up some of their investment returns by not charging a price equivalent rent to tenants during the period of the increase in the price to rent ratio.

Bubbles do not explain the apparent differences in behavior between owner occupied and owner rented residential properties.

Shiller is correct in that material and construction costs were not influencers of home price appreciation during the period.

Homes ownership rights contain two rights, the right to occupancy, including renting, of the structure and all remaining rights including the land and all structural modification rights.

If occupancy had increased in value, we would have seen higher rents and a lower price to rent ratio during the housing bubble.

Because construction costs are relatively constant (except for some labor variations, transportation and materials storage costs) across the nation for equivalent structures, the greatest disparity will be in land values, especially if desirability varies by geographic location and translates into different land prices. However, increases in land values are not directly observable in home price increases.

Using an example from "The Price of Residential Land in Large U.S. Cities" by Morris A. Davis and Michael G. Palumbo:

Going into the recent boom — that is, at the end of 1998 — we estimate that land represented about 81 percent of the average single-family home’s value in San Francisco, whereas in Milwaukee land accounted for a share of only 33 percent. This means that, abstracting from any changes in real construction costs, a cumulative 90 percent increase in the real price of residential land in both cities would have translated into a 73 percent increase in home prices in San Francisco (0.73 = 0.81 x 0.90), but only a 30 percent increase in home prices in Milwaukee (0.30 = 0.33 x 0.90).

Of course, the fact that the price of land appreciated at the same rate in both San Francisco and Milwaukee does not imply that both areas experienced the same sized demand or supply shock.

Rather, our point is that a simple comparison of gains in house prices might make San Francisco seem “glamorous” compared with Milwaukee, but the rapid pace of appreciation in the price of residential land in Milwaukee tells a different story about conditions in Milwaukee’s housing market.

And, it’s not just Milwaukee: As we show below, for many other cities across the country, data on home prices significantly obscure the increases in residential land prices that have been registered over the past two decades and particularly in the recent housing boom.

A reversal of land prices, even if in equivalent percentages across the US, would result in areas with higher land value to total value ratios showing greater percentage declines in home prices.

The failure of rent increases to match increases in land values could be due to a timing difference in the factors affecting the values of the two items. Rents reflect the period of occupancy and the length of the lease. It is of finite duration, usually in the present and affected by current occupancy values. Land values reflect the value of an infinite life asset. Increases in the value of the land after the termination of the lease will increase the current value of the land, but not the value of current occupancy and of current leases.

Any factors that affect the future value of land will show up as a land price increase but not as an occupancy increase. House prices would rise without an equivalent increase in rents. The timing difference will result in a higher price to rent ratio.

Positive changes in expectations of the next generation's household formation rate, such as due to relaxed immigration policies, higher fertility and birth rates, declines in mortality rates, increases in life expectancy, and higher divorce rates, etc., would affect future household formation rates and increase the value of land but not the value of current occupancy.

Home prices would increase and appear to be in a bubble, especially if expectations returned to a lower household formation rate and home prices declined.

If there were a Shiller index for residential land values as there is for houses, it would be possible to disaggregate the value of occupancy from the total home value. With that or equivalent data, comparison of current occupancy values versus future land values as determinates of the recent housing bubble and various hypotheses about land value increases would be testable.

Until a data series of residential land value becomes available, a possible explanation of the sharp increase in home prices, without an equivalent increase in rents, is that there was an expectation of an increase in the next generation's demand for housing. A subsequent negative change to that expectation caused home prices to decline.