Is Housing Too Expensive? Blame the Government

everyday economics

Maybe zoning laws are causing the real-estate bubble.
By Steven E. Landsburg
Posted Friday, July 29, 2005, at 3:40 AM PT

Elementary economics tells you that in a competitive environment, the price of a new house should equal:

the price of land + construction costs + a reasonable profit for the developer

But in most cities, that sum is not even close to what buyers are paying.

Take Dallas, for example. If you live in central Dallas, and if you could magically add a quarter of an acre to your lot size, you'd add (on average) about $2,200 to the value of your house. (We know this from comparisons of similar houses on different-sized lots.) Do the same in central Philadelphia, and your house value increases by $8,400; in central Houston, it's more like $17,600. In that sense, central Dallas land is just about the cheapest urban land you can find in this country. Among large cities, only Atlanta, Boston, and St. Louis rank lower. In theory, that should be great news for Dallas housing prices. But it's not. A house that costs $100,000 to build typically sells for $140,000 in Dallas, maybe $120,000 in Houston, and under $90,000 in Philadelphia.

Aha! say the commentators. Housing prices must be driven by something other than fundamentals. Speculators, of either the rational or the irrational variety, are the obvious culprits.

Here's what's wrong with that analysis: Housing prices have to make sense on both the demand side and the supply side. No matter what you do or don't believe about the ability of crazed demanders to bid up prices, you still have to explain why competitive suppliers don't bid those prices right back down. In other words, if the housing market is so tight that builders are making a fortune, they ought to be flooding the market with new houses—and driving down prices.

In fact, buyers' behavior is relatively easy to explain. Most of the recent explosion in housing prices has been in cities like San Francisco and Santa Barbara—in other words, in really nice places to live. It's not unreasonable to believe that, as Americans grow richer, and as technology makes us more mobile, more and more of us want to move to California. And it's not unreasonable to expect that this trend will continue, so that even a very expensive house in the Bay Area can look like a good investment.

The great mystery is on the supply side. Instead of the traditional formula "housing price equals land price + construction costs + reasonable profit," we seem to be seeing something more like "housing price equals land price + constructions costs plus reasonable profit + mystery component." And, most interestingly, the mystery component varies a lot from city to city.

Even in cities like San Francisco, where there's little room to build and land is consequently dear (on the order of $85,000 per quarter acre, compared with $2,200 for Dallas), you can't use land prices to explain away housing prices. The mystery component in San Francisco housing—that is, the amount left over when you subtract land prices and construction costs from house prices—is the highest in the country.

Edward Glaeser of Harvard and Joe Gyourko of the University of Pennsylvania have computed these mystery components for about two dozen American cities. They speculate that the mystery component is essentially a "zoning tax." That is, zoning and other restrictions put a brake on competitive forces and keep housing prices up. (Read one of their papers here.)

When you buy a house, you're not just paying for the land and construction costs; you're also paying for a building permit and other costs of compliance. You've got to get the permits, pass the zoning and historic preservation boards, ace the environmental impact statement, win over the neighborhood commission, etc. If Glaeser and Gyourko are right, that's the mystery component right there.

It's hard to test this theory directly, because it's hard to get good measures of compliance costs in various cities. But Glaeser and Gyourko did the next best thing: They measured a part of the compliance costs, namely the average length of time for a permit to be granted.

If the theory is correct, that length of time should be a good but imperfect predictor of the mystery component in housing prices. The data largely support this theory. About half of all cities are rated 2 (on a scale of 1 to 5) in terms of how long it takes to get a permit; these are, without exception, the cities with the lowest mystery component in housing prices. Cities rated 3, 4, and 5 all have higher mystery components. (A bit disconcertingly, so do the three cities—Minneapolis, Chicago, and Anaheim—that are rated 1. Peculiar as these exceptions are, there are at least only three of them, and we should expect some anomalies given that Glaeser and Gyourko's measure of zoning costs is rather crude.) You can talk all you want about crazed speculators and bubbles in housing prices, but you still have to explain why competitive forces don't bring prices right back down. According to Glaeser and Gyourko, it's ever-expanding zoning laws that get in the way. If you want to lower prices, that's the bubble you've got to burst.

Young homebuyers banking on options

No down payment, no problem, say lenders, but experts note risks

09:19 AM CDT on Tuesday, July 19, 2005

By JORDAN ROBERTSON / The Dallas Morning News

Eric Pinto and Geri Charles had good credit and wanted to buy a house. But they didn't have much of a down payment.

So the couple, both 28, turned to a zero-down mortgage to get into a $150,000 Junius Heights bungalow. They expect to sell in a few years for a tidy profit.

"I look at the house as another business decision," said Mr. Pinto, an executive at a network security company. "This is kind of a short-term investment, and we're doing things that give you instant equity like home improvements."
Their choice puts them at the forefront of two trends reshaping the U.S. housing market: They are young buyers, optimistic about quick appreciation in home prices, and they're acting on that conviction with a zero-down mortgage.

Spreading out a down payment over the term of the mortgage can be risky, experts say, especially for newcomers to the housing market. But zero-down mortgages are fast becoming the preferred mortgage for first-time homebuyers.

In 2004, 42 percent of first-time buyers financed a home without a down payment – half again as many buyers as in 2003, according to the National Association of Realtors.

"Every young person who walks through the door thinks they're never going to live in a house longer than two or three years, and they all want to do these 100 percent loans," said Craig Jarrell, president for the Dallas region of Pulaski Mortgage Co., a mortgage banking firm.

"They think their job is going to bail them out; they think inflation is going to bail them out; they always think something is going to bail them out," he said.

Whether they're using traditional mortgages, zero-down arrangements or plunking down cash, young adults are buying homes in record numbers.

In 2004, there were 3.4 million homeowners in the U.S. ages 25 to 29, a 16 percent increase from a decade ago, U.S. census data show.

And there were twice as many buyers under 25 – 1.6 million – for the same period.

"We've clearly seen buyers entering the market earlier than they did five or 10 years ago," said David Brown, director of the Dallas office of housing analyst Metrostudy Inc. "The primary driver behind that has really been interest rates."

Homeownership, of course, has long been one of the most cherished American institutions, encouraged by government policy and the U.S. real estate industry. Few would dispute the value of more people owning their own homes.

The risks
Granted, not all so-called "exotic" loans are created equal.

A zero-down loan can be useful if the home is expected to appreciate substantially, experts said.

Mr. Pinto and Ms. Charles, for example, bought in an "up-and-coming" neighborhood and estimate that their home has already appreciated more than $10,000.

"It just validates our decision," Mr. Pinto said. "Even not having anything invested, you have instant equity over the course of the year."

But there is a risk, industry experts and others say, to nontraditional financing: It allows first-time buyers to squeeze into houses they otherwise couldn't afford.

If appreciation stalls out or a job promotion doesn't come through, many of them could get stuck with higher monthly payments than they expected.

Having little or no equity in a home also exposes these buyers to other perils: What if property values drop? Or interest rates rise? Or what if the buyers don't want to stay – or can't stay – long enough to recoup their selling costs?

"If they're not putting money down and they're only going to be in their houses a couple of years, we're not likely to see a significant appreciation in those homes," said Mr. Brown of Metrostudy. "They might get a surprise two or three years from now."

Among the other loans that have experts worried are interest-only loans, where buyers delay paying down the principal, and minimum-payment loans, which offer buyers multiple payment options but could actually lead to negative amortization.

Negative amortization is failing to pay the full interest every month and thus owing more than you borrowed.

Foreclosure
Under both options, the principal doesn't get paid off evenly and buyers could get stuck with cripplingly high monthly payments if the market goes south.

One result could certainly be foreclosure and loss of the home.

"We haven't seen a correlation yet between the number of these loans out and the number of foreclosures," said Rick Sharga, vice president of marketing for RealtyTrac. "But as interest rates creep up, those types of loans will be the first to go into default."

In June, Texas had the highest foreclosure rate in the country: About one in every 635 homes was foreclosed on.

Some long-term buyers, though, prefer a traditional mortgage.

At 26, Jay Ceitlin and Kari Feinstein – he's a real estate broker and she owns a small business – chose to put down 20 percent on a $430,000 home in Preston Hollow.

They said they plan to stay in the house for many years and want to begin raising a family there.

"I'd like to be a little more conservative in times like these," Mr. Ceitlin said. "The interest-only loans make sense for a lot of people out there, especially if you're going to flip the house pretty fast. But that's just not the case for us."

With home prices in most areas continuing to rise, many young buyers said the traditional – and safer – 20 percent-down mortgages are simply out of their reach.

There are other options for buyers with little savings.

Federal loans
Experts say that first-time buyers frequently overlook government-backed Federal Housing Administration mortgages, which allow for a 3 percent down payment and for rolling the closing costs into the mortgage.

FHA mortgages have a limit of $172,632 for single-family homes in most cities, including Dallas, and $312,895 in higher-cost cities such as San Francisco and New York.

And a bill wending its way through the U.S. House would eliminate the down payment requirement for some first-time buyers seeking these loans.

Joanne Garcia, a 22-year-old mother of two, had little credit – but a good bill-paying history – when she qualified for the mortgage toward a $94,000, three-bedroom house in Arlington.

The physical therapy technician makes around $26,000 annually and said that without the loan it would have taken her several more years to save up enough for a traditional down payment.

She and her children moved into the house in April. And Ms. Garcia's $857 monthly mortgage is just $20 higher than the rent she paid on an apartment in Oak Cliff, where she lived for two years.

"I was very surprised that I would even qualify for a house at this age," she said. "For being so young and now having two kids, I feel very proud of myself. I see other people who are much older than me who are still struggling."

Waiting game
Unsure first-time buyers have yet another option: Wait it out.

Some capable young people are expressing skepticism about the run-up in housing prices, choosing instead to stay renters.

Matt Lannon, 29, clears $100,000 a year as an investment portfolio manager and could easily buy in many Dallas neighborhoods.

But he has chosen to stay in his $1,150-a-month Deep Ellum loft, which is close to work and within walking distance of nightlife, until housing prices cool down.

"I think that the market is extremely overheated," Mr. Lannon said. "I'm kind of waiting to be more of a vulture buyer. People are doing such crazy financing on their homes, I think there are going to be some good deals down the road."

HOMEBUYING 101
Here are some tips for first-time homebuyers:

Be realistic. Don't overextend yourself because you think prices will always go up or you will make more money.

Don't multiply risks. If you are already stretching financially, a high-risk loan could amplify your problems down the road.

If you have trouble making the payments, contact the lender immediately. Lenders would rather work out an alternate payment strategy than pursue foreclosure, which is more costly for them.

Be patient. There are opportunities for bargains even at today's prices. It just takes longer – and more work.

LOAN OPTIONS
Here are some risky types of mortgages that appeal to young buyers:

Zero-down: The down payment is spread out over the course of the mortgage. More than 40 percent of first-time buyers now use zero-down loans.

Interest-only: The payment on the principal is delayed. In the meantime, monthly payments only cover interest.

Negative-amortization loans: Monthly payments are less than the interest due. Homebuyers wind up owing more than they borrowed.