Wednesday, July 23, 2008

What is normalcy?

gaius marius writes:

fwiw -- and i realize this is but anecdotal, but it is illustrative of the general condition -- i live in suburban chicago, renting a house. i pay $2000/mo, property taxes are $550/mo. my rental payment then would support (ignoring upkeep/insurance/etc) a $1450/mo today's 30-year fixed rate (~6.5%), that would support a $230,000 loan. with 20% down, call the purchase price $290,000 -- and generously, as we are excluding all expenses but taxes.this house sold in 2005 for $460,000. houses in the neighborhood still list for $410,000.

Actually, this suggests to me that houses in your area are priced at something like fundamentals. Let us say the marginal tax rate of the typical buyer is 25 percent, that property taxes (which are deductible for most people) are at 1.5 percent, that maintenance costs about 2 percent, and that expect rent growth is 2.5 percent (i.e., a little less than recent CPI growth). Then the user cost of owning would be
410,000*(.065*.75 + .015*.75+ .02 -.025) = 22,550, or a little less than the $24,000 you are paying in rent right now.
Two financial advantages of owning that you are not considering are the tax benefit and the immunization from future rent increases. Of course, should interest rates rise to 8 percent, or tax policy change, these calculations change.


TStockmann said...

By giving full .25 weight to the mortgage and property tax deductions, you're assuming that all other itemized deductions are at least equal to the standard deduction. Since 2/3's of taxpayers (which even includes current homeowners along with would-be homeowners) take the standard deduction would argue for a much morre modest treatment of the net tax advantage.

gaius marius said...

thank you, dr green -- you're teaching me.

correct me if i'm wrong please -- but are we not essentially theorizing with user cost of housing that which is empirically observable in price-to-rent ratios? for the chicago msa, that ratio today stands around 250 -- a figure that, prior to the securitization boom in the late 1990s/early 2000s, stood nearer 190. this again would imply a 25% fall to return to normalcy.

i also worked the formula

R = C = [(1- θ) (r + t) + d + m + α – g – θ πe] * P = μ (residential) * P

found in the linked presentation slide 8 with some input assumptions taken from this new york fed paper (page 8) and got a somewhat different result.


θ = 25% (marginal tax rate)
r = 5% (foregone risk-free rate of return, taken from 30-yr yield)
t = 1.5% (property tax rate)
d = 2.5% (depreciation rate)
m = 2% (maintenance cost rate)
α = 2% (risk premium)
g = 3% (capital gain rate)
πe = 3% (rate of inflation)
μ (residential) = 1

i end up with a P of $314k-- which is near the empirical mean reversion expectations and my own cost-of-carry analysis which you kindly addressed in this post.

one could also wonder about expectations surrounding g, could one not? as the bust deepens and expectations grow more dire, one could posit that trough expectations for g will near zero or even perhaps go negative.

can you attack my method or assumptions? any criticism is veyr much appreciated.

gaius marius said...

μ (residential) = 1

sorry -- missed that edit.

Anonymous said...