Bubble or Fundamentals?

With that Shiller article getting so much attention from around the blogosphere, I wanted to share something I learned from the comments to my Bubble post. Tanner pointed out a key fundamental which changed - the exclusion from taxation of $250K for single and $500K for couples of capital gains on the sale of your primary residence.

Basic marginal analysis shows us how this contributes to higher prices. Improvements on a house you are going to sell are short-term investments w/ some payout. Not having to pay taxes on those gains increases the profits of all such projects, hence some formerly unprofitable improvements will become profitable. Hence homeowners planning to sell will do more of them, hence more expensive houses.

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I think the capital gains

I think the capital gains tax factor is less significant than the availability of low-interest loans, being handed out without much regard to risk--the lenders don't care much about risk because they just turn around and sell the loans, ultimately to the GSEs (Fannie Mae and Freddie Mac), which repackages some as guaranteed mortgage-backed securities (which everyone assumes the U.S. government will cover if necessary) and holds the rest. The GSEs are holding about $1.5 trillion in retained debt. China has bought about $144.5 billion of GSE bonds (mortgage backed securities), comparable to the $150 billion in U.S. Treasury debt they hold.

When the bubble pops, will the GSEs have to be bailed out? Freddie Mac restated earnings by a few billion dollars in 2003 and ousted its executive leadership; Fannie Mae's similar restatement will occur in mid-2006 and just announced today that it has some senior execs on the way out.

I'm sure the tax laws are in

I'm sure the tax laws are in play here, but what about the bubble in England and Australia and overall globally for the western countries?

Abe - it's not just a

Abe - it's not just a question of improvement, but on any way that you can spend money to increase the selling price of your home. This includes cleaning it up better, having fancier open houses, making a nicer MLS listing, whatever. Decreasing the capital gains tax increases the return of every single thing that you do to increase selling price! And some of these things are surely continuous and have diminishing marginal return, therefore some of them are going to become profitable.

Ian - Excellent point, although I'm not sure rent captures the value of the house to the owners. I would say rather that the two components are the value you get from living in it, and the profit you get from selling it. The former is the same, the latter has increased, therefore price must go up. (and you are right that rental prices have not changed in nearly the same way - they've been down since the bubble, while houses have been up).

Another way to think about

Another way to think about how lower taxes increase value is viewing houses like stock - both have yields, the components of which are dividend payouts and capital gains. ("dividends" in the case of houses would be the amount of rent that is chargable for it.)

If the after tax yield rises, the value of the home must rise to compensate, in order to drive the yield back down to the market rate.

I would agree with Abe Heward that home improvement probably has little to nothing to do with the phenomenon.

One more interesting thought - the tax law change reduced taxes on price appreciation, but not on rental income - I would expect therefore that prices would rise but that rental rates wouldn't be affected the same way. Similarly to how stocks started paying dividends again after the tax law stopped discriminating in favor of capital gains, tax law changes for housing should change the yield mix.

Abe's right- appraisers

Abe's right- appraisers really only consider square footage as an improvement, and California actually heavily regulates what you can add in terms of ft^2. I know and deal with plenty of people who invest in houses for a living and very few of them do any improvements to speak of, unless they are the special "rebuiler" homes that some people are into. I think the idea is that just living in the house for a year or two provides the most amount of profit. A related question- do austrians think that profit is a function of the marginal productivity of capital? Because if so that's wrong.

Taxes and Real Estate

Taxes and Real Estate Bubbles
One of the principles I try to teach my students is that taxes are important, since it's after-tax cash flows that matter. Patri Friedman at Catallarchy makes an excellent point that can be used to illustrate this concept. He argues that the real est...

My question is: what

My question is: what improvements have all that significant a payout?

For example, adding Moen fixtures to your bathrooms is expensive, and they certainly don't provide much---if any---ROI at the time of the sale.

Neither does new carpeting, new roofing, new central air, etc., unless those items are completely trashed and in need of replacement anyway.

Home buyers aren't really paying attention to the little details when they're looking at houses to buy. They want a clean place that is move-in ready, in a good neighborhood that is close to where they work.

The only home improvement I'm aware of that adds significant and consistently profitable value to a home is additional square footage.

So, a test of Tanner's hypothesis might be to look at the average home price *per square foot* over the past decade and see how *that* figure has been changing. I wonder if anyone has those figures.

If packaging doesn’t

If packaging doesn’t increase the sales price, then most companies in the world are wasting money on part of their marketing departments. The more people that are interested in a property, the more likely you are to increase the selling price.

as I wrote, sales price is severely limited by appraisals which don't take carpeting into account. You may value a home that appraises for 250,000 at 300,000 but no bank will loan you that money and as such you generally can't get it.

matt

Well, first of all, its not

Well, first of all, its not clear to me that the cost of the carpet is deductible. So the tax hit is not 50% of $1000, but 50% of $3000. So in the example you gave, the $2000 carpet would have to bring in more than $4000 of benefit w/ 50% taxes to be worthwhile. you can see that as the tax rate goes to zero, the necessary return for the carpet to be worthwhile goes to $2000. A carpet that returns $3000 costs $500 at 50% taxes, and returns $1000 at 0% taxes. So you can see that if the cost is not deductible, taxes make a huge difference in how many improvements are worthwhile.

Even if the capital costs are deductible, there is time and effort and so forth that goes into putting in the new carpet - which are not deductible. Suppose it takes 10 hours of my effort to put in the carpet. @0% taxes, I make $1000, which is $100/hour. @50% taxes, I make $500, which is $50/hour. At some point, the return crosses over the value for my time.

Leaving aside the question of the effectiveness of open houses in a home’s sale (as a former Realtor, I think they’re completely useless for anything except finding clients - and even in that they’re basically an enormous waste unless you happen to be an agent who is young, charismatic, and female), the items you mention above are things that will (hopefully) lower transaction costs (e.g., reduce time on market), but will not raise the selling price. The selling price is determined by the market, not how nice the MLS listing is.

Uh, what? If packaging doesn't increase the sales price, then most companies in the world are wasting money on part of their marketing departments. The more people that are interested in a property, the more likely you are to increase the selling price. And besides, my argument doesn't depend on any specific method of increasing price, merely that there exist enough different methods that some will move from unprofitable to profitable when the tax changes. I could brainstorm dozens of methods, surely some of them work!

Abe- a complicating factor

Abe-
a complicating factor is simply that a 2000 dollar new carpet job doesn't affect the appraised value at all (in most cases.) As you probably well know, the appraisal value is instrumental in buying a home because the bank who loans you the money isn't about to use your subjective valuation, and while you may like the carpet WaMu isn't about to loan you 3000 more dollars because of it.

Patri and Abe,
I certainly don't see how taxation fits into it, though because if property values aren't affected by most improvements, then capital gains is also unlikely to be affected. It will make your house more likely to be sold, but it shouldn't change the selling price very much and as such your improvements still have a positive affect unhampered by capital gains. In the case that it does change the sale price, the capital gains tax effect should just figure into that individual's cost benefit analysis before he or she makes the improvement. Capital gains are simply a contexual fact. If you build a sandcastle, you might argue that the higher you build it, the more sand will be swept away by the wind (which is true) but that's something you should consider before building the sandcastle, not something to blame on the wind.

Matt

Patri, ...This includes

Patri,

...This includes cleaning it up better, having fancier open houses, making a nicer MLS listing, whatever. Decreasing the capital gains tax increases the return of every single thing that you do to increase selling price!

Leaving aside the question of the effectiveness of open houses in a home's sale (as a former Realtor, I think they're completely useless for anything except finding clients - and even in that they're basically an enormous waste unless you happen to be an agent who is young, charismatic, and female), the items you mention above are things that will (hopefully) lower transaction costs (e.g., reduce time on market), but will not raise the selling price. The selling price is determined *by the market*, not how nice the MLS listing is.

I hope you'll excuse my confusion, here, but could you explain the connection again? I'm not seeing it. As a seller, why do those things in the absence of the tax but not in its presence? Isn't a home seller interested in getting the highest price, always?

If putting in new carpet, for example, costs you $2000, but gives you a return of $3000 on the home's price, aren't you going to do the improvement regardless of whether the tax hit on that thousand dollars is 0% or 50%? A $1000 profit is great, but $500 is still better than nothing.

Matt27 - The carpet thing

Matt27 -

The carpet thing was an admittedly poor example, strictly for illustration. I apologize.

Patri -

Well, first of all, its not clear to me that the cost of the carpet is deductible.

It's 100% deductible, but just so we don't get bogged down in quibbling over trivia, I'll concede the point, because I basically agree with the rest of your first paragraph (after all, I'd have to be crazy to take on the whole of marginal value theory).

Regarding our second point of departure, let me clarify my perspective a bit.

The price per square foot of a given house is largely determined by its location. It's going to have a potential selling price that is roughly in line with its neighbors.

Let's say your house is in a neighborhood with an average price of $100/ft.^2. When you sell it, there's all sorts of things you can do to drive that price *down*. If you don't mind selling for $50/ft.^2, then take a dump on the living room floor, put holes in all the walls, break all the windows, invite some crack addicts to room with you, etc. Get creative (some of my tenants sure did).

On the other hand, you can write award-winning MLS ad copy, clean until everything sparkles, make the place smell like cookies, install gold-plated Moen fixtures, Neptune washer-dryers, etc., but you're never going to get the sale price up to $150/ft.^2. It just ain't gonna happen. What *is* likely to happen in that situation is: you'll find a buyer right away - and one who will give you your asking price and won't nit-pick after the inspection. If you're really lucky you'll find two buyers, have a little bit of a bidding war, and get a little *more* than your asking price. But, as Matt27 said, appraisers and banks are going to be leery of prices that are significantly out of line with the rest of the neighborhood.

To bring this all back around to the original issue, I'll reiterate that the whole point I'm trying to make is that home improvements seem an extremely unlikely driving force behind the recent run-up of home prices. Patri, do you think that another empirical test of your hypothesis might be a sort of "stickiness" of home prices around the $250K and $500K marks?

[T]o argue against my thesis

[T]o argue against my thesis you have to argue not merely against capital improvements, but against there being *any way* of spending money to increase sale price.

No, I don't. That would be a stupid position to take. I've obviously done a poor job articulating my argument.

For those home improvement projects that are profitable I wholeheartedly agree with you. The sad fact is, though, that other than adding square footage (as I mentioned in my first comment) or a second bathroom to those older one-bathroom homes, the vast majority of home improvement projects - especially the luxury improvements that you list - aren't profitable at all. They are big losers. For every dollar you spend on granite counter tops, you'll be *lucky* if it increases your home's value by 25 cents. Proof of concept: you don't do a luxury refurbishment on the place next door to the crack house.

So, people aren't *not* going to do them because of taxes, but because there's no money to be made. Conversely, people aren't going to do them because there is no longer a tax and now they're profitable, but for the reasons they've always done them: they want their house to be a nicer place to live.

Matt & Abe - to argue

Matt & Abe - to argue against my thesis you have to argue not merely against capital improvements, but against there being *any way* of spending money to increase sale price. I'm not a real estate expert, but I just don't buy it. I find it inconceivable, in fact, that there are not a huge variety of different ways to spend money to increase the sale price.

Take my house. It towers over others in the neighborhood because it had a second story added on later. That increased square footage made us willing to pay substantially more for it than other houses around. Nor was the bank the least bit reluctant to lend us the money - after all, it was a bigger house.

People pay more for granite countertops. They pay more for marble bathrooms. They pay more for pools. They pay more for decks. They pay more for extensions which add ft^2. The price of a house is not fixed!

In the case that it does change the sale price, the capital gains tax effect should just figure into that individual’s cost benefit analysis before he or she makes the improvement. Capital gains are simply a contexual fact. If you build a sandcastle, you might argue that the higher you build it, the more sand will be swept away by the wind (which is true) but that’s something you should consider before building the sandcastle, not something to blame on the wind.

I think you are missing the fundamental point here. Lets suppose that the improvement has a 10% return - costs $1000, increases sale price $1100, takes 2 hours labor. @ 50% taxes, w/ costs deductible, this earns $100 *0.50 = $50 in 2 hrs = $25/hr. @ 0% taxes, it earns 50$/hr. Isn't it a simple fact of economics that someone is more likely to do something for $50/hr than 25$/hr?

Saying capital gains is simply a contextual fact is like saying that income tax is simply a contextual fact and won't change anyone's employment behavior - which I expect you'll agree is not at all true. What's the difference?

Hey man, when you're right,

Hey man, when you're right, you're right. At least I didn't call you an idiot! :grin:

But, as Matt27 said,

But, as Matt27 said, appraisers and banks are going to be leery of prices that are significantly out of line with the rest of the neighborhood.

you sure you want to agree with a crack smoker?

http://catallarchy.net/blog/archives/2005/08/25/gas-caps/#comment-86682

Ian, The affect of lowering

Ian,

The affect of lowering taxes on rental income is not at all the same as that of lowering taxes on real estate capital gains. When a house is sold under favorable tax conditions, the sellers would be willing to have spent more time and money improving it, expecting a better return. But home buyers, in turn, are willing to pay more, because they will get to keep more out of whatever profit they expect to make when they will be selling the house.

When taxes on rental income are lowered, tenants have zero incentive to pay more. It's not as if paying higher rent will give them the right to enjoy the effects of the lower tax in the future, the way paying more for a house does for home buyers.