The Finance is Too Damn High
By Andrew Dobbs
Everything we’ve said to this point begs the question of why rents and housing prices are going up if supply and demand aren’t to blame. Landlords would always like for rents to spike as much as they have in the last decade; why have they done so now and not before? If it turns out that the causes are global economic phenomena of immense scope and scale this would go a long way towards explaining the absurdity of Code NEXT or any other municipal policy to try and fix them.
This is, of course, exactly what’s happening. Most important in all of this: since the 2008 financial crisis the world’s largest central banks — the Federal Reserve, the European Central Bank, the Bank of England, and the Bank of Japan — have used “quantitative easing” (QE) to increase liquidity among financial institutions and to suppress interest rates.
This is a fancy way of saying they have printed money and subsidized large-scale private debt at levels never seen before in the history of finance. How much did they print? Numbers vary, but the most brutally honest assessment of just the Federal Reserve infusions up to 2011 estimated the total at $29 trillion. Add in another 6 years of QE before the Fed finally began rolling the process back last year and all the money from those other central banks and you are talking tens of trillions more.
Now, we know that governments (or banks) printing money causes inflation, so why haven’t we been pushing around wheelbarrows full of cash to buy a six pack? The answer is because the printed money wasn’t injected into the economy at large, it was given to banks specifically, and if you look at the prices of the sorts of things investment bankers buy the prices HAVE soared.
Stock prices, for example, have more than tripled despite effectively no growth in productivity. That is to say that we have experienced one of the most dramatic and longest lasting bull markets in history but are not actually producing much more on an hourly basis than we were during the last recession. Overall gross industrial output only increased 14% on inflation adjusted terms over the same period. This is unprecedented, and stocks have gone gangbusters because of unprecedented QE. Recent struggles in the market also coincide neatly with the unwinding of QE by the Federal Reserve in particular.
Real Estate Investment and Rising Costs
The same inflation has happened for real estate, which became an even more important investment thanks to QE. The specific effect QE was meant to evoke was a drop in interest rates, and the aggressive level of easing we’ve experienced has meant that rates are at or even below zero in real terms for the first time ever. That means that it COSTS money to save — any debt-financed investment would be better than keeping the money in the bank.
Real estate is the most common debt-financed investment, and since 2008 there has therefore been a huge influx of capital into the real estate market. This has been further driven by QE-driven drops in bond yields, as commercial real estate performance is measured by the difference between the “capitalization rate” of the property — the percentage of income generated by the property as compared to its market value — and the average yield of a 10-year Treasury Note. 10-year Note yields are down about 100 basis points since the end of the Great Recession, giving a huge boost to commercial real estate investment.
The primary vehicles for all of this investment are assets actually traded on the stock market: real estate investment trusts, or REITs. More and more is being invested in these publicly traded trusts, with the market capitalization of just the ten largest apartment-focused REITS increasing more than six-fold between Q1 2010 and Q3 2017 (by my own calculations). The entire S&P 500, by way of comparison only doubled in capitalization in that same time — the valuation of this sector is growing disproportionately.
Part of the attraction for these assets is the exceptionally large dividends they pay, and the frequency with which they pay out. REITs — believe it or not — pay no corporate taxes as long as they pay out 90% of their earnings as dividends, and many of them pay out on a monthly basis. Of course, landlords’ “earnings” come from rent, which is paid out monthly in most cases — your rent is an investor’s dividend!
REITs that don’t consistently deliver growing stock prices and thus rising earnings and dividends will be sold in favor of others that do, generating a major new structural pressure on the management companies hired by these REITs — the folks you usually write your rent checks to — to raise rents every year.
And the pressure doesn’t end there. Commercial real estate values (i.e. prices, not the value we talked about in Part 1) are typically estimated using one of two methods: direct capitalization or discounted cash flows. Direct capitalization divides the net income of the property — essentially the rent collected minus operating costs — by the capitalization rate. Cap rates are market-driven by property type and geographic area, and so they serve as a known quantity that can be related to the known rate of income to determine the price of the property.
The upshot here is that as long as cap rates are held steady — and the very same QE processes that are holding down interest rates are doing just that — rent increases have an exponential effect on property value. If a property has a 5% cap rate (0.05), then $1 of additional rent at the bottom line adds $20 to the value of the property (1 divided by 0.05). As long as a property can keep raising rents, their asset values will soar.
This direct capitalization method is actually a conservative method of estimating value, as it deals only in known variables. The discounted cash flow method is used for assets expected to produce more income over time, estimating these income increases and discounting them based on expected long-term growth and the cost of maintaining capital. There is a lot of guessing involved here, but the estimates are projected from past income growth, meaning that the longer landlords can raise rents the more valuable their property becomes. Landlords benefit mightily from conditions where rents can be raised every year, and slowing, stalling, or reversing rent growth can wipe out huge amounts of value. Again, their stockholders demand they do everything in their power to raise rents as much as possible for as long as they can.
Let’s also remember that as that value goes up so do property taxes. Now local government’s apparent allergy to actually doing anything about rents makes new sense.
Oh, and one of the key elements in estimating future income: expected vacancy rates. That means that anticipated future increases in vacancy — supply outstripping demand — undermine the value of commercial real estate in the here and now. This is yet another reason why the economic powers in charge of the housing industry will always act to keep supply in check so long as it’s the market controlling housing, regardless of what their entitlements may be.
Private Equity and Gentrification
It’s not just REITs doing this either. Private equity funds have invested their billions as well. Private equity real estate is broken down into at least four risk strategies — core, core plus, value-added, and opportunistic. Core is just what it sounds like — ”Class A,” fully-leased, non-leveraged, high value, low-risk properties. Value-added and opportunistic strategies, on the other hand, seek out riskier investments. Value-added private equity strategies in particular seek out older, “underperforming” properties and use renovations or other use improvements to add value and make them more profitable.
This is, of course, the very definition of gentrification. Since at least 2014 this strategy has been the “hottest” among private equity funds, according to this eye-opening article from the National Real Estate Investor:
There are still markets in the U.S. where the difference between the monthly rent on class-A and class-B apartments has widened to more than $400 a month. In these places, developers who spend about $10,000 per apartment might hope to increase rents by as much as $150 a month and still be several hundred dollars below the rents of class-A properties, says Donovan. The renovations often focus on the assets’ common areas. “They generally spend a lot on the clubhouse and a new amenity package.”
For anyone who has experienced their rent going up $150 a month after some landscaping changes this is “let them eat cake” kind of talk. An important 2010 study in the Journal for Real Estate Research found that value-added and opportunistic — even riskier, usually unimproved land that has to be fully developed — strategies perform best in conditions of cheap debt. Debt is likely cheaper now than at any point in human history, hence the massive investment in gentrification in recent years.
The idea that neighborhood associations are somehow a more significant factor than Wall Street institutions pouring hundreds of billions into the real estate market at large is ludicrous. Using a land-use plan to try and reverse this is worse than trying to make UT cheaper by tinkering with admissions; it’s like trying to put out a wildfire with a bicycle horn.
Oh, one last tidbit: REITs in particular have seen their stock prices stall out or decline since the fall — essentially at the same time the Federal Reserve announced the end of QE. Rents are also down in New York, Oakland, San Francisco, Austin, Chicago, Honolulu, and many other cities. The press claims supply increases are to thank, but this seems like an absurd, self-serving attempt to avoid global explanations for global effects.
Inequality and Demand
Of course if there aren’t tenants or buyers to pay the higher prices demanded by these investors then the whole thing falls apart. This is where the dramatic increase in wealth inequality over this decade comes in. For folks whose worth is tied up in property ownership — especially securities and real estate — everything we laid out above has made them a ton of money. What was billed as a strategy for economic recovery was more accurately a massive redistribution of wealth towards the ruling class.
This increase trickled down to the upper end of management and professional servants to the ruling class — attorneys, accountants, etc. It has also generated huge sums for venture capital, more than doubling the funds available to startups since 2008. The can’t-lose nature of the investment market and its core in the tech industry — the so-called “FAANGs” of Facebook, Apple, Amazon, Netflix, and Google — has meant that high tech businesses have seen huge income increases in the last several years.
The generalized increase in wealth among the investment class and their professional, technical, and managerial allies has meant that cities across the world have experienced at least some gentrification as their local captains of industry bid up housing prices and invest in real estate. This is how you end up with gentrified corners of otherwise struggling cities such as Detroit or Baltimore or Rochester. The specific concentration of resources in the start-up and tech industries means that tech centers like San Jose, Austin, and Seattle are getting the worst of it.
Once again, the idea that this can be reversed by allowing more granny flats or eliminating parking requirements is ridiculous. There may be other reasons to do those things, and there are benefits and drawbacks to all the land-use choices we can make as a city, but when we try to make these choices roll back $50 trillion or so of economic pressures the process is certain to fail. This is where we’re at in Austin right now.