Impact of Rent Control: $325,000 per Unit

San Francisco has strong rent-control laws. Once you put a tenant in a rent-controlled apartment, you can't raise his rent by more than about 2% per year, and you can't evict him except under special circumstances. Meanwhile, there is never a shortage of people who are looking for a place to live in San Francisco. That combination of laws and circumstances is guaranteed to depress the value of residential property, at least as far as property owners are concerned. But what is the financial impact? Here’s a way to think about it, based on recent sale prices.

The first clue that rent control depresses property values is that vacant apartments are usually worth more than occupied apartments. A vacancy represents an opportunity to replace an outgoing tenant (who typically would have been paying less than market rent) with someone who is willing to pay full price for a home. Take a look at the chart, below, which shows median prices for three-unit buildings sold in San Francisco since 2005.

The median price difference between an empty three-unit building and a full one is $265,000, or approximately $90,000 per unit. Roughly speaking, that’s the value of a one-time opportunity to increase the rent to current market value. (How much of an increase are we talking about? Apartment buildings typically sell for about 14 times gross rent, so $90,000 of extra value equates to about $535 per month of extra rent.)

Unfortunately for property owners, the impact of rent control is much greater than $90,000. Installing a new tenant usually will result in higher rent, but the new tenant will benefit from the same 2% annual limitation on rent increases as the old tenant. For comparison purposes, market rents in San Francisco historically have increased at around 4% per year. At those rates, the new rent will be 10% below market in only five years.

It’s straightforward to calculate the cost (in present value terms) of a 2% annual limitation on rent increases. However, it’s easier (and probably more reliable) to work with current market values. Specifically, since condos are exempt from the most onerous aspects of rent control, we can estimate the impact of rent control by comparing condo prices to apartment prices. Take a look at the chart, below, which shows the median price per unit for occupied apartments, vacant apartments, tenancy-in-common (TIC) units, and condos.

The price difference between a vacant apartment and a condo is $355,000. To be fair, some of the difference in price is attributable to differences in quality. As indicated in the chart, TIC’s typically sell for around $120,000 more than vacant apartments. Since there is very little difference (from a legal point of view) between a TIC and a vacant apartment, we should attribute most of the $120,000 price difference to quality improvements that generally are made when apartments are ‘converted’ to TIC’s.

That still leaves a difference of $235,000 to be accounted for. That’s the typical price difference between a condo and a TIC. The most obvious reason for the price difference is that interest rates on TIC loans are higher (by around two percentage points) than interest rates on condo loans. Ultimately, however, the price difference is attributable to rent control. Why? A TIC owner could reduce his interest rate simply by converting his TIC to a condo. However, the City makes condo conversion difficult, precisely because condos are largely exempt from rent control.

Adding it all up, the impact of rent control comes to roughly $325,000 per unit. That’s for the special case of three-unit buildings, but the impact is likely to be similar for other buildings. I wonder if the creators of rent control had any idea that they would be imposing such a large burden on property owners.

TIC’s Are Still Attractive for Developers

Developers have been buying San Francisco apartment buildings and converting them to tenancy-in-common (TIC) buildings for years. That’s because owner-occupiers are willing to pay more for homes than investors are willing to pay for rent-controlled apartments. Take a look at the chart, below, which shows historical sale prices for TIC’s and multi-unit (apartment) buildings.

TIC prices leveled out at around $500,000 in 2005, and have remained fairly stable since then. Over the same five-year period, multi-unit building prices have hovered in the neighborhood of $250,000 per unit. In other words, TIC’s have been selling for roughly twice as much as apartments. The price premium is easier to see in the chart, below, which shows the per-unit price difference between TIC’s and apartments.

What I find surprising about this chart is that the TIC price premium does not seem to have diminished over time. It dipped modestly in 2008, but has since bounced back to around $250,000 – the same level that it achieved during the peak years of the housing boom.

If I had several hundred thousand dollars in cash and were looking to invest in San Francisco real estate, I’d think about buying an apartment building and converting it to TIC’s. It’s not cheap to remove tenants and renovate a building, but it doesn't cost $250,000 per unit.

Short Term Rates Likely to Stay Low for Another Two Years

Short-term interest rates are basically at 0%. That’s good news for borrowers with floating-rate loans (which are tied to short-term rates), but how long will it last?

In January, Paul Krugman estimated that short-term rates would remain low through the end of 2011. He based his estimate on historical precedent: The Federal Reserve typically doesn’t start raising rates until two and a half years after recessions end. (At the time, most people were expecting the current recession to run at least another six months.) Now Krugman has made a more careful estimate, based on economic principles rather than historical precedent. His new estimate: The Fed can wait at least another two years to start raising rates, and probably longer than that.

Krugman’s argument is based on two common economic rules of thumb, namely, the Taylor rule and Okun’s Law. His argument is simple, but I thought it would be helpful to explain his rules of thumb.

The Taylor Rule

The Federal Reserve has two distinct mandates, namely, to maintain price stability as well as full employment. The primary tool for achieving these mandates is the federal funds rate. When inflation gets too high, the Fed increases the Fed funds rate in order to slow the economy and dampen inflationary pressures. On the other hand, when unemployment gets too high, the Fed cuts the Fed funds rate in order to stimulate the economy and increase demand for labor. Adjustments to the Fed funds rate are decided by the Fed’s Board of Governors, but a Stanford Professor named John Taylor devised a simple rule that historically has done a good job of mimicking their decisions.

One version of the Taylor rule says that:

Fed Funds Rate = 2.1 + 1.3 x Inflation – 2.0 x Excess Unemployment

Excess unemployment is defined as the difference between the actual unemployment rate and the ‘natural’ rate, i.e., the rate that would prevail if the economy were operating at its potential. Take a look at the chart, below, which plots the Taylor rule formula along with the actual Fed funds rate.

The Taylor rule does a pretty good job of explaining the past behavior of the Federal Reserve. The largest deviation between the rule and the Fed funds rate occurred between 2004 and 2005, when the Fed held short-term rates well below the level suggested by the Taylor rule. (The Fed was criticized at the time – partly on the basis of the Taylor rule – for helping to inflate the housing bubble by keeping rates too low for too long.)

The September unemployment rate was 9.8%. The natural unemployment rate is estimated to be about 4.8%, so excess unemployment is around 5%. Meanwhile, inflation has been running at around 1.6% (and appears to be trending down). If you plug those numbers into the Taylor rule, you get a Fed funds rate of -5.8%. Negative interest rates can’t exist in the real world (people would hold hard currency rather than lend it at negative interest), so the Fed has settled for the next best thing: 0% interest.

As long as the Taylor rule yields a negative result, the Fed will presumably want to keep the Fed funds rate at 0%. So when will the Taylor rule yield a positive result?

Krugman argues that inflation is unlikely to increase during the next couple of years. (Given the amount of idle capacity in the economy, it will be some time before competition for resources puts upward pressure on prices.) Assuming that he’s correct, unemployment must fall to around 7% in order for the Taylor rule to yield a positive result. How long will that take? That’s where Okun’s Law comes in.

Okun’s Law

Increases in population and improvements in technology drive long-term increases in economic output. Over shorter time periods, changes in output are also influenced by changes in the intensity with which resources are used. In particular, if there is a surge in the percentage of the population that is working, there will be a surge in output as well. Or to put it in more familiar terms, GDP generally rises faster than trend when the unemployment rate is falling. It turns out that this relationship can be readily quantified, in the form of Okun’s Law.

Take a look at the chart, below, which plots changes in unemployment against changes in GDP over the last 40 years.

Each data point represents a calendar year between 1969 and 2008. If you fit a line to the data, you get the following equation:

Change in Unemployment = - 0.4 x ( Change in GDP – 3% )

As an example, if GDP rises by 4%, unemployment should fall by 0.4%. (Incidentally, the equation also says that if GDP rises by 3%, unemployment shouldn’t change. In other words, the equation implies that 3% is the trend rate of GDP growth.)

With the economy coming out of recession, GDP is likely to grow faster than trend for the next few years. How much faster? Krugman suggests that 5% is a safe upper bound for GDP growth. (I agree. Full-year GDP growth has exceeded 5% only once in the last 30 years. Most economists expect the current recovery to be slower than normal.) With 5% GDP growth, Okun’s Law says that the unemployment rate will fall by 0.8% per year. With unemployment currently at 9.8%, it will be another three and a half years before the recovery pushes unemployment down to the 7% threshold which would justify a positive Fed funds rate.

Note: Krugman’s two-year estimate was based on a more conservative set of assumptions. I assume that his conservatism was intentional. In any event, my goal is to help explain his reasoning, not to quibble with his numbers.

What does this mean for homeowners? Most floating rate loans are tied to LIBOR, which is driven by the Fed funds rate. Krugman’s argument suggests that borrowers with floating rate loans can breathe easy for at least another two years, and probably a good deal longer than that.

Residential Sales Down 55% Since Bubble Burst

People are always asking me, "How's the market?" Here's the simplest answer I know. Take a look at the chart, below, which shows the annual value of residential sales in San Francisco over the last fifteen years.

Sale prices didn't peak until the spring of 2007, but sale volumes started falling in 2004 (see this earlier blog entry). Stated in that way, the historical trajectory of the market may be difficult to grasp. The story becomes simpler, however, when prices and volumes are combined: After peaking at $8.0 billion in 2005, residential sales have fallen in every year since. Through the first eight months of 2009, sales are running at an annualized rate of only $3.6 billion. In percentage terms, that amounts to a 55% decline since the housing bubble burst.

That's how the market is doing.

Job Seekers Outnumber Openings Six to One

Today's New York Times has a discouraging story about the job market. According to the Labor Department, there are 14.5 million people officially unemployed, but only 2.4 million full-time permanent jobs open. That means that job seekers outnumber openings by a ratio of six to one. By comparison, the jobs-to-openings ratio never even reached three-to-one following the dotcom bust. (Unfortunately, the Labor Department didn't start tracking job openings until 2000, so we don't know what the ratio might have looked like during previous recessions.)

As icing on the cake, the story adds that many companies have pared back working hours for their remaining employees. When demand begins increasing once again, they'll be able to expand output without creating any new jobs.

Stories of idle capacity at American companies are rife. Take a look at the chart, below, which shows manufacturing capacity utilization over the last 60 years.

Capacity utilization is running at a 60-year low of 65.8%. That's 15 percentage points below the historical average of 80.9%. Manufacturing represents only about 12% of GDP, but considering the many other examples of idle capacity, I'd say that the Times story is right. It's likely to be quite awhile before unemployment falls appreciably.

Home Prices and Land Values

At the risk of stating the obvious, San Francisco housing is expensive because San Francisco land is expensive. Take a look at the chart, below, which shows historical sale prices for single family homes and vacant residential lots in four of San Francisco's ten real estate districts.

The blue bars show average sale prices for residential lots ranging from 1,500 to 4,500 square feet. (I used the average instead of the median because the average seemed to give a truer picture of what was happening to 'typical' lot values.) The dashed purple line shows median sale prices for single family homes. The four districts represented in the chart accounted for 86% of San Francisco's residential lot sales over the last fifteen years (i.e., as far back as my data goes).

Evidently, lot prices are correlated with home prices. That's what you would expect. Construction costs don't change much from year to year, so the opportunity to build a new home becomes more valuable as home prices rise. That causes developers to bid up the price of buildable lots. (Conversely, the high price of buildable lots prevents would-be homeowners from avoiding high home prices simply by buying vacant land and building their own houses.)

Through the first eight months of 2009, the average residential lot price was $440,000, compared to a median home price of $600,000. In other words, 73% of the value of a typical home (in one of the four districts listed above) is attributable to the underlying land. At the peak of the housing market, land accounted for almost 80% of the value of a typical home.

The price difference between a home and a comparable vacant lot can be interpreted as the market value of the existing structure (i.e., the thing that we usually refer to as a 'house'). Take a look at the chart, below, which plots the difference between the median home price and the average residential lot price for the same four districts as before.

The series is volatile, but averages out to around $175,000 over the fifteen-year period represented in the chart. That's the value that the market is implicitly assigning to existing single-family structures.

$175,000 doesn’t go very far in San Francisco. Even the small, 1,250 square-foot houses that typically are found in these districts would cost more than that to rebuild. Why does the market seem to value them at less than replacement cost?

The answer is that they would not be replaced today. If it costs $300 per square foot to build a house that will sell for $600 per square foot, it’s clearly more profitable to build a big house than a small house. That’s exactly what developers have been doing. In the process, they’ve driven lot prices up to the point where building a small, old-fashioned house would be a money-losing proposition.

So how valuable is San Francisco land? It’s so valuable that you probably wouldn’t even consider rebuilding your current house if it burned down. You’d be destroying a great deal of value if you did.

Commercial Real Estate Is Experiencing Its Own Hangover

The housing market wasn’t the only sector of the economy to experience a bubble earlier this decade. The commercial real estate market went through a bubble of its own. Take a look at the chart, below, which shows the NAREIT price index for equity REIT’s.

A REIT is basically a real estate holding company. Provided that it distributes at least 90% of its earnings in the form of dividends, it is exempt from corporate income tax. The NAREIT index is an index of REIT prices, similar to the S&P 500 stock index.

REITs typically finance their investments with a mixture of debt and equity. Their share prices measure the market value of their equity, so they are imperfect proxies for the value of their underlying real estate holdings. On the other hand, because the shares are actively traded on public exchanges, the quoted prices provide a current snapshot of what’s going on in the commercial real estate market. (In contrast, popular housing market indicators such as the Case Shiller indexes are published only once a month, with a two-month lag.)

REIT prices rose by more than 100% over a four-year period beginning in 2003. Following the peak in early 2007, prices fell steadily for the next two years. During that period, REIT earnings actually increased at a healthy rate. Prices fell because investors were concerned that future earnings might be lower. In the fall of 2008, they were proved right in a spectacular way. Over the course of just nine months, earnings (and prices) fell by almost 50%. Take a look at the chart, below, which shows an index of dividends for the NAREIT index.

Dividends didn’t peak until mid-2008. Since then, they have fallen by 46%, and are now at their lowest level in more than 20 years. Remember, REITs are required to distribute at least 90% of their earnings in the form of dividends. So the decline in dividends will have been closely paralleled by a decline in earnings.

The dramatic fall in earnings suggests that REITs will have increasing difficulty servicing their debts. Here in the Bay Area, for instance, the delinquency rate on commercial mortgages rose from 1% in the second quarter of 2008 to 4% in the second quarter of this year. Nationally, the default rate on commercial mortgages rose from 1.2% in the second quarter of 2008 to 2.9% in the second quarter of this year. Forecasters are calling for a continued rise in the default rate, to around 4% by year’s end.

Even if REITs successfully meets their debt service requirements, they may still face serious financial problems as a result of declining earnings. Unlike residential mortgages, commercial mortgages typically have brief terms of only 5-10 years. When a commercial mortgage is due, it must be paid off in its entirety. The common solution is to obtain a new mortgage and use the proceeds to pay off the old one. If the value of the property has fallen, however, banks may refuse to lend as much as the borrower needs to pay off the old mortgage. In that event, the borrower may face foreclosure, even if he hasn’t missed a mortgage payment.

That’s the situation that owners of commercial real estate are facing now. I don’t have hard any numbers, but the press if full of stories about borrowers in good standing who aren’t able to rollover the mortgages on their buildings. (In this respect, REITs are actually better off than most other owners of commercial real estate, since they generally use less leverage.) The result is likely to be an increased level of forced sales, which will put additional downward pressure on property values.

The NAREIT index touched bottom in February, and has risen 44% since then. As with the housing market, however, the recent bounce is primarily attributable to a collective sense of relief that the world isn’t descending into a second great depression. After all, REIT earnings are still falling rapidly, and the credit crunch hasn’t shown many signs of easing. Commercial real estate values are likely to be under pressure for some time to come.