Date: October 17th, 2020 4:56 PM
Author: Ruddy spectacular office
How the Pandemic is Fixing Some of the Real Estate Market’s Flaws
There are two ways to look at any kind of investment: what it does and what it is. What a stock does, for example, is bounce around a lot in an unpredictable way, with a positive skew and a positive correlation to other risk assets. What it is, though, is a residual claim on a company’s assets: after paying off employees, suppliers, creditors, and the taxman (in roughly that order), the remaining money belongs to shareholders. These approaches aren’t contradictory, but they do get to an answer in different ways.
Housing is in an odd category as an investment. Unlike purely financial assets, it pays a return in consumption, not cash. And even as a financial asset, it’s a strange one. An American buying a home with a typical mortgage—fixed-rate with prepayment option—circa last year was getting:
Continuous income in the form of shelter;
An asset that rose in price with a) inflation, and b) conditions in the local labor market; and
An option to reduce their interest burden and/or withdraw equity if interest rates dropped, without the obligation to pay more or invest more equity if rates rose.
This is a very strange package of securities. If you surveyed a cross-section of voters and asked them “Should Robinhood be allowed to sell highly-levered opaque interest rate derivatives?” a fair number of people would say no. But your bank will sell you those derivatives by default.
Historically, housing as an investment has a mixed track record.
A mortgage gets paid down over time, so it’s a way to make people save money by default.
Homes have appreciated over time. While their absolute returns aren’t great, the levered returns are fine, and a levered position that’s immune to margin calls is a good source of returns.
For people who could get priced out of a neighborhood, owning their home is a good hedge. There was a time when teachers, police officers, factory workers, and other Richard Scarry characters could afford to live in places like San Francisco and Manhattan. As those cities got more dominated by superstar industries, it was less and less tenable for people who didn’t work in those industries to pay rent, much less own their own homes.
A mortgage is leverage, and housing is consumption. Borrowing to fund consumption—even borrowing in order to buy future consumption in bulk—is generally not ideal.
Homes have appreciated in the aggregate, but in specific cities and neighborhoods, they’ve performed very poorly as investments.
Those neighborhoods are also where people work. The counterpoint to someone who can afford to stay in Park Slope because they bought their home decades ago is someone who can’t afford to leave Detroit for the same reason.
The commission on a home sale transaction is generally 5-6%, and closing costs are another 2-4%. (Since these are costs associated with the transaction, the economic incidence is independent of legal incidence—they’re a cost of doing the deal, so they’re borne by buyer and seller. And since most current buyers are future sellers, it makes sense to assume an equal split on average.) Since the median down payment is 5-6%, this implies that most homebuyers are paying total transaction costs close to the amount of equity they start with. At the median home ownership duration of 13 years, someone who makes a round-trip transaction (buying one home, then selling it) pays a transaction cost that works out to around 0.65% of assets per year. Not terrible as far as asset management fees go, but not a steal, either.
High rates of home ownership are also a mixed bag socially. At one level, they’re the single most common way people experience capitalism—tapping financial markets to buy something, taking care of it, and then selling it at a higher price. And they make people more literally invested in local communities. But the more levered buyers are, the more widespread home ownership turns into widespread real estate speculation instead. And homeowners can vote in favor of their own interests, one of which is reducing the supply of homes to raise the value of their biggest asset. That option to refinance a mortgage has an important side effect on global interest rates: when rates drop, mortgage borrowers refinance, but mortgage lenders generally borrow at fixed interest rates. To stay hedged, they have to buy long-term debt in response—which pushes rates down further. All this affects the US treasury bond market, which is the closest thing the world has to a global benchmark for the price of money over long periods. So the entire global financial system is more volatile specifically so American homeowners can benefit from interest rate cuts.
All of these complexities are very much pre-Covid framings.
Today, home ownership is actually a much less economically dangerous choice, both for the marginal buyer and for the economy as a whole:
The marginal homebuyer today is much more likely to be a remote worker leaving a high cost-of-living city to settle somewhere cheaper. They’re in a better position to pay a mortgage than the wave of new homeowners in the early 2000s.
These workers' incomes don’t correlate with local housing markets. If big investment banks had laid off workers in 2019, it would have hit housing prices in Manhattan, Jersey City, and Greenwich. Today, it’s a smaller hit, spread out over low-tax states like Florida and Texas, places with lots of vacation homes like Hilton Head and the Poconos ($, WSJ).
Some of these new homeowners plan to stay where they are for a while, even permanently, but others are already planning to return to big cities when it’s safe. The latter group is less likely to vote for restrictive zoning.
A pre-Covid trend that accelerated soon after the pandemic hit is the rise of institutional investors who buy single-family homes. These investors make the housing market function more smoothly, because they’re able to bid for distressed assets when other investors don’t have access to capital. This makes housing prices overall less volatile. And the related rise of the iBuyers further dampens volatility (see my Opendoor writeup for more).
Interest rates are exceptionally low right now. There’s no law of nature that says they can’t go lower, but as they get closer to zero, central banks try out less conventional forms of monetary policy. This makes refinancing smaller future risk, so mortgages don’t add extra volatility to long-term interest rates.
Every crisis causes some harm and obliterates some complacency. Usually, they’re harmful on balance, although there are happy exceptions (as it turns out, Sputnik was not a big national security risk, but the moon landing was a direct result of it). Covid is definitely on the net-harmful side of the ledger, barring some unlikely developments. But some Covid-induced shifts are unambiguously positive. Housing is still not a great investment, but a confluence of pandemic-related changes have indirectly conspired to raise it to the level of okay.
 There are exceptions to this. Chuying Agro-Pastoral Group paid a bond in ham, and there used to be an OTC-traded winery that paid a dividend partly in coupons for their wine. But in general, financial assets are cash-in, cash-out.
 Perhaps the most extreme example of this was in San Francisco, where a revolutionary terrorist group was able to afford San Francisco housing and bomb-making supplies in the 70s with a few of them working part-time jobs. This is not the most memorable detail in Days of Rage, but it’s certainly the one that best illustrates how much the world has changed since then.
 Here’s the mechanism: if you own a portfolio of mortgages, i.e. you’re the lender, you’re probably borrowing money to fund that portfolio. If you don’t want to take risk on interest rates, you match the duration of your borrowing to the duration of your portfolio. For example, if your mortgage portfolio’s average duration is 8 years, you’ll borrow with a similar duration. If rates decline, the duration of those mortgages goes down, because they get prepaid (which turns them into cash, with a duration of zero). But the duration of your debt goes up. So you buy duration to hedge, by purchasing treasury futures. Which means that whenever bonds go up, hedgers have to buy more bonds. Normally there are plenty of markets where hedgers have to adjust positions, and it nets out, because people on the other side of the trade are hedging in the opposite direction. In this specific market there’s a huge pool of borrowers who will never dynamically hedge, and a huge pool of lenders who have to, so the hedging trade is one-sided.
 Two that come to mind: a radical shift in public attitudes towards drug research, leading to more drugs developed faster and cheaper, which could potentially produce cures for unrelated diseases. And, a much more prosaic possibility: that for the next generation or so, people will mask up and stay home every flu season, and the R(t) of the seasonal flu will permanently decline.