Economics of Home Ownership in High Density Areas

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This has been knocking around my head for a while, and I've written on closely related subjects before. But the idea behind this essay really just gelled in my mind within the past couple days.

Here are the facts of the situation, whether you're talking about San Diego or Manhattan, the Bay Area, Los Angeles, or any of the other densely packed, high cost areas where all the employment and career opportunities are.

Fact 1: Land is expensive. The cheapest unimproved little 8000 square foot irregular lots in the area I work most - no tests done, no utilities on the lot, even though they may be close, no permits whatsoever and zoning R1 at best - run just under $200,000. Matter of fact, I consider that one basically unsuitable for housing due to the freeway that runs through where the back yard would be. Here's the worse news: Prices are going to get higher. They're not making any more land. Demand is increasing. More people want to live in those high density areas every year. More businesses want to open. Not far from my office, there's a 9500 square foot R1 lot someone is buying for about $250,000 with a condemned residence on it. He's going to have to scrape it himself, and assume all risk of the city issuing the permits for new construction, and he was glad to get it, even though he knows the soil needs to be repacked also. (Manhattanites may jeer at the low price if they'd like - for now). Land is a scarce good in high density areas - the very places where everyone wants to live, needs to live, because they have to live within commuting distance of their career. Lots like this are where we're going to get buildable lots in the future, and usually, those purchasing them are going to pay for the single family residence that happens to sit on it now. There. Is. No. More. Dirt.

Land with residential structures, specifically, 8000 square foot lots that happen to have one residential structure are equally costly, in and of themselves, as the 8000 square foot lot next door which happens to have six residential structures, Or a commercial warehouse, manufacturing facility, office building, etcetera. They use the same amount of area on the earth's surface. With the exception of location and the soil that happens to be there, everything else that's been done to that land is completely artificial. This starts with the utilities that may or may not be there, extends through zoning and conditional use permits, and arrives at specific structures that may be in existence. All artificial. Absolutely nothing to do with any natural virtue of one parcel over another.

The first statistic I find says that cost of construction per square foot is roughly $150, while commercial buildings sell for roughly $300 per square foot locally. So, you can pay $200,000 for that lot, build one fifteen hundred square foot building, and sell for roughly $450,000, having made $25,000 net (450-225-200), and that's providing there's no existing structure. Or you can build six twelve hundred square foot two story buildings (or six one story units, three upstairs and three down), still have space for some kind of communal outdoor area, sell for $360,000 each, and make $2,160,000, leaving $880,000 net, still maybe $600,000 if you had to pay for the single family residence that used to be on it as well. I'm intentionally neglecting transaction costs, by the way, which swing the figures even more decisively in favor of the high density alternative. Question: Under which of these two scenarios is it more likely that they'll cut the price? Under which is it more likely they'll raise it? Question: Even if the price isn't cut, which of these two alternatives can more people afford? Which is a more efficient use of the land? Which ends up giving the better return on investment, indicating that more of them will be built? There's hardly an infinite supply of either, but which is likely to remain more affordable, as builders build more and more of them in relation to the alternative? Shared lots, particularly when paired with communal outdoor areas, make a whole lot more economic sense than single family residences, they will always be more plentifully available, and the more demand is placed upon a given amount of land, in the form of people wanting to live, work, and play there, the more strongly the economics will favor shared lots. New Yorkers have been used to this for decades. Now, some other areas of the country are becoming just as solidly built upon, if not yet nearly to the depth Manhattan has seen. In fact, by the standards of most cities worldwide, Manhattan isn't particularly dense. Many affluent old world cities have it beat like an dirty old rug when it comes to density per square mile. It's just that it seems dense by comparison with the rest of the US, where we have long been accustomed to lebensraum.

Corollary: The closer to commercial and recreational opportunities a particular parcel is, the more desirable it is. For those skimming this in their sleep, this means the price of that land is raised by people competing more strongly for it. This is one of those things everybody knows (ask people whether the lot by the beach is more expensive than the one twenty miles inland), but few people stop to think about all of the implications. The closer you want to live to the commercial zones, the closer you need to live to all the commercial zones, the more valuable the underlying land is and the more likely it will have some sort of communal lot arrangement. It doesn't matter if you don't drive, can't afford a car, or what, any more than nature cares how badly you want to fly in applying the force of gravity to you. It's nothing personal, any more than the saber tooth picking out one of our ancestors for dinner was after payback, movies or no. It's just a fact of the universe, and the fact that it's economics, measured in dollars, does not make it any more mutable than if we were talking about the thrust of the rocket, measured in Newtons.

For those reading this whose response to the above is governmental in nature, you cannot mandate the building of more affordable detached single family residences. The economics is not there to support it. Developers will build what can make them a profit. They won't build what won't make them a profit. Putting up regulatory hurdles only makes the affordability threshold rise further. You can have the city, the state, the federal government subsidize people into them, but that amounts to giving a band-aid to a decapitated body, economically, because the number of people who can be thusly accommodated is microscopic as compared to the number of people there are who can't afford where prices are now, let alone where they are going if you try this route. Furthermore, limitations on the benefits when these people sell such units short-circuits all of the economic reasons why people should get into home-ownership. It amounts to creating, not a class of homeowners, but a class of privileged renters! It's not even permanently privileged renters. Those of these I've been involved in have clauses where if the bureaucratic or political masters can manufacture a reason, you can be dispossessed. If there are no such restrictions on the sale of the unit, then the lucky recipients get a windfall at the expense of taxpayers and/or everyone else who buys within the development! Kind of like forcing taxpayers to buy hundreds or thousands of dollars worth of lottery tickets per year at the point of a gun, with the suckers getting about their current fifty cents per dollar back, only in the form of real estate rather than cash to those few lucky winners. Except, such winners won't be random. It's like if the bureaucrats and politicians could pick the lottery winners. But I digress.

My point is this: in high density areas, single family detached homes are going to get less and less affordable from this point on. So, for that matter, is everything else. Go back to supply and demand. Demand, which is to say, population of people who want to live there, is increasing. Supply is constant. If I have three apples to sell, and there's only two people who want one, the price is very low. If I have three apples to sell, and there's three hundred people who want one, I set up an auction and the three people willing and able to pay the highest prices get apples, while I get a lot more money than the first case. Same principle with real estate. It doesn't matter that the other 297 people can't afford it. It matters only at which point that 297th person drops out of bidding, leaving the remaining three winners.

(Some people are going to note that we have to put those 297 people somewhere, which is true, but that's not the concern I'm addressing here, although I will state we can plan to do so in a way that's economically logical, or it will happen anyway, no matter what the law and the planning commissions may say. The first way will be a lot more pleasant for everybody.)

If you're in a high density area, you can leave or stay. If you are able to leave, as for instance, retirees can, you're not who I'm planning for here. If you're one of those few who are sufficiently affluent to be able to afford whatever the economic costs are, you don't really care. Real Estate is still going to be every bit as fantastic an investment as it has always been. In fact, the higher the demand goes, the better the investment it's going to be. Real Estate does not increase, over the long term, at the same rate as wages. It increases at that rate plus an additional factor to reflect increasing demand in a constant supply market.

Suppose in my previous example, that I have some magical way to convert one apple into ten oranges? Persons 288 through 297 get together and outbid number 298. They can't have an apple. They decide, however, that it they can't have an apple, they do want an orange and are willing to pay for it. Between them, they outbid person number 298 for that third apple, and have me convert it into ten oranges so that they each can have one. I make more money, and persons 288 through 297 are happy, also. The only person who's unhappy is person 298, who then decides that if he can't have that apple, either, he at least wants an orange, and so he goes and trades some of his money to person number 288, who, if he doesn't have an orange after he makes the deal, does have more money than he started with, assuming it's a willing sale. So now I'm not the only person who has made a profit. Person 288 has also made one. Similarly, person 299, who observed person 298's experience, and still has his apple, voluntarily decides he wants to convert his apple into ten oranges, and offers me something I want in exchange for doing so (remember, I'm the one with the magic trick, aka the construction industry). Person 299 now has ten oranges, and proceeds to sell them to persons 279 to 288. This nets him enough to buy the remaining apple from person 300, who goes and buys person 279's orange with some of the proceeds, while person 299 decides that at this point he's happy and wants to keep this apple for themselves. Look at all of the people who made a profit and came out ahead because I could convert one apple (detached single family residence) into ten oranges (condominiums). Every single choice of every participant here was purely voluntary, and would not have been made if the recipient had not been made happier thereby. Note also, that there's eighteen people who have a place to live, where they would have been homeless if I (the construction industry) couldn't convert apples into oranges. These are all cold hard facts.

Like it or not, Manhattan and the surrounding area represent the way that other high density areas in this country are going to go. Let's leave all the non-essential stuff out of this, and consider only the economics. When the cost of land is high because there's a fixed amount, the only way you can create more space is along the vertical axis. You can go down, or you can go up. You can put multiple units on the same space where there was one. You can stack them fifty high or more. In any of these cases, it's no longer single family detached housing. The better you plan for your city's density, the more of your citizens have a home and the fewer that go homeless or have to relocate. My transform apples into oranges ability in the example above raised the number of people who are able to afford housing by a factor of 7, but that's hardly the maximum possible.

If you don't have the money for an apple - single family residence - now, it's going to take some kind of major change in your circumstances to enable you to afford one. Get your law license, your medical license, win the lottery, make several million dollars in business, get a professional sports contract, something. Your circumstances are not going to change by magic. If you're a shoe salesman, even if you're making $20 per hour, and you're not doing something to change that, it's not likely to happen on its own. Matter of fact, it's going to keep getting more difficult. Right now there's 300 people who want to live in your area. What happens to the price when there's 500? A thousand? Ten thousand? This is an easy answer, straight from the pages of your first economics lesson. The price goes up, and not just in relative but in absolute terms.

If you don't have the money for an apple - single family residence - now, you can choose one of two options. You can decide not to play. Stay a renter forever, or at least until you realize what a mistake it is. Rents go up, and landlords have to pay mortgages and property taxes also. They can also decide to stop playing the landlord game and sell for what they can get at any time. I've heard from a lot of bitter renters who were displaced when their former landlords decided to take the money and run when the market was hot. Furthermore, the rental market is going to keep getting more expensive as the population, and therefore demand, increases also. Right at this moment, there's even more upwards pressure on the rental market as people who lost their properties through foreclosure need a place to stay. The vacancy rate locally was 2.6% in the middle of last month. There is no way around one cold hard truth: Renting leaves decisions about your future in the hands of others, and of random fate.

Your second alternative is that you can decide to buy an orange - a condominium. Condominiums are going to see every bit of the long term gain single family detached housing will, at least proportionally. So you've only made $300,000 when your $300,000 condo doubles in price, as opposed to your $500,000 house doubling in price. Actually, I'll bet you that from this point on, in areas like San Diego, they see just a little bit more appreciation than single family detached homes. Right now, there's still a very large proportion of renters telling themselves they're going to own a house someday, but they're not interested in a condo. As that becomes more and more out of reach for them the majority of them - all of the rational ones - are going to switch their goal to the closest practical equivalent. Condos are never going to be as expensive as single family detached homes, but more people can afford them, and they're going to be more expensive per square foot of living space. Why? Because of the implicit cost of all that land that the single family detached home is not using for living space, which isn't taken into account. Because so many more people can afford a tenth of the lot than can afford the entire thing. When you've got the last single family residence on its own quarter acre lot on Manhattan, someone who sees the profit to be made in higher density construction is going to make you an offer you won't want to refuse, and eventually, you will sell voluntarily. Maybe that person will even be the owner, themselves.

This doesn't happen all at once. It happens piecemeal, over time, but it does happen. Already, I can take you back to the neighborhood I grew up in and the surrounding area. I can show you all of the buildings that weren't there thirty or thirty five years ago, and San Diego hasn't been completely built up anywhere near that length of time. Some of them were vacant land then. Most, however, have been converted from lower density to higher density. I cannot point to a single place that's gone from higher density to lower. People who are middle aged now or older have watched it happen in slow motion, so slow that all of the implications haven't sunk in to most of us, yet. Indeed, the slowness has allowed a lot of people to keep pretending it isn't happening. This doesn't change the fact that it is happening.

Some people don't like oranges (condos). For that matter, some people don't like apples (single unit detached housing). The ones who can afford single unit detached housing but prefer condos don't have a problem. The ones who can afford condos but prefer single unit detached housing do. I've gone over the most obvious solution to this problem before, in Part 2 of Save For A Down Payment or Buy Now?. There are others, but they all involve similar principles of solution.

The bubble everyone (including me) was talking about two years ago is gone. In fact, it's more than gone. San Diego is experiencing a strictly temporary depression in prices, caused by psychological factors, just like 9/11 hurt the stock market for a while, and for precisely equivalent reasons. Mass media always paints things as being better than they are when they're good, and worse than it is when they're bad, causing people who believe mass media to over-react. This means opportunity, while it lasts, until a critical mass of people figure out that things aren't so catastrophic as they have been painted. Some people will see this article, and instantly decide to try to time the market. Don't. You'll mis-time it, with results worse than if you just acted. There are any number of studies that confirm this. I've debated, in person and via email, three bubble advocates in the last week. Every single one of them has tried to start moving the goalposts on me, citing prices of college for the kids, prices of cars and this and that. These extraneous factors have been there for decades. They've never been absent. They're been living in the equation so long that people forget they've already been taken into account, even thouth they've been there all along. But that's the only way these folks with so much emotional investment in the bubble can pretend that prices are going to keep going down.

The condominium market, in particular, has been hit hard for several years. Stuff that was legitimately worth $300,000 several years ago declined in price to where $225,000 was a good offer, and that was before this year's shock to the financial system. There are condo owners who wanted to sell four and five years ago who still have their units, but no one's been making offers. Part of this was "too much, too fast" - converting apartments to condominiums and building new condominiums, in the hope of cashing in on the rush, but the rate got above the current market requirements to a certain extent.

The larger part, however, at least in my estimation, has been "elephant hunting." This is a well known phenomenon in just about any sales occupation, but real estate has been rewarding turning squirrels into elephants these last few years. The hardest part of making money as a loan officer or as an agent is getting clients to work with you, and it takes about the same amount of effort. When you've got a set of buyers (or borrowers) in front of you, the temptation is there to sell them the a larger home with a larger loan than they can really afford, so you get a larger commission. The sort of warm body loans that were available the last few years facilitated this practice. The people want to buy, but can't afford what they want? Instead of trying to talk them into limiting their budget to what they can afford, which risks them leaving your office and going to your competitor, sell them what they really want, with a stated income loan. If you need to lower the payment, make it a 2/28, spread it out over forty or fifty years, add an interest only period at the beginning, or just scrap all that and put them in a negative amortization loan from the get-go, further inflating your loan commission. I've seen estimates that over eighty percent of the sales locally in the last two years used one or more of these tricks in support of it. Like I said, turning squirrels into elephants so you can hunt elephants. These people should almost certainly have been buying condos, but weren't. Given the state and shape of the socio economic pyramid locally, there should have been more condominiums bought and sold than single family detached housing, by a factor of about 3 to 2. That was not the case. The ratio was over 2 to 1 the other way. And if that's not quite a sufficient indictment of the ineffective regulation of the real estate profession to measure up to Emile Zola's "J'accuse!", it'll nonetheless have to do.

In case you haven't been paying attention to the financial news lately, the loans that enabled these tricks are now gone. History, and they're not coming back for years at least, until the lenders develop collective amnesia again. Meanwhile, agents and loan officers who are used to hunting elephants are complaining that they're all gone. Well, they weren't really elephants in the first place, but the lax loan standards made it possible to get an elephant's worth of meat off them, at least for the agents, the loan officer, and the seller. The buyer and the lender, of course, ended up holding the sack. My sympathy for the lenders is non-existent. They knew better. My sympathy for these buyers, on the other hand, is great.

So the condo market has been dead due to the loans situation, while agents and loan officers hunted elephants who were really squirrels. Now that it's rectified, agents won't have a choice. If folks can only afford the price of a condo, It's condo or nothing. Every single one of my A paper sources still has 100% financing for full documentation loans. If any of you don't understand what that means, it means you still don't need a down payment if you can document enough income to afford the loan. For that matter, most of my sub-prime lenders are still offering 100% financing through bank statement qualification. Lack of down payment is not an issue. Ability to afford the payments on the loan is.

Let's hypothetically consider a $225,000 loan on a $225,000 condominium with homeowner's association dues of $250 per month. As I sit here and type this, for one point total retail, I've got a thirty year fixed rate loan at 6.125%, with PMI of just under 1%, which I'll round to 1%. I would prefer to split the loan into two in order to save money for my clients, but as I said here, that simply is not on the list of alternatives right now. Payment on the loan is $1367.12, of which $1148 is tax deductible. PMI is $187.50, and will go away as soon as the buyer has 20% equity, which will likely be sooner than you think. Property taxes, at 1.25% (mine are lower), add $234.38 per month and are also deductible. Total: $2039.00 per month, and most buyers are going to get a significant amount of that back from lowered income taxes (married: roughly $150 per month, single, roughly $250 because the standard deduction is lower). Income needed, $4078 to $4531 gross salary per month, or from just under $49,000 to just over $54,000 gross per year, at most. This is well below area median income for 2006 of $64,900, and it's done with a sustainable loan, without any stated income tricks, without any government programs for first time buyers, or anyone else, no MCC, nothing. These buyers are doing it completely on their own, without a down payment. If they have a down payment, it gets a lot more affordable than this, fast.

Tell me you don't want a condominium, and I'll tell you that's fine. Come up with 10% down, and I can get you that stated income loan you need in order to buy the single family detached property that's all you're willing to buy - but I'm not going to let you pretend I didn't warn you about the consequences. Don't have the down payment? The fastest way to get it is to buy that condo, and I can prove it!

I've been aware for some time that I'm probably going to sell more condominiums than single family detached houses for the rest of my career. No, I don't have any objection to hunting elephants and in fact, yes, I would rather do so. It's just that there's more people who are going to be buying and selling condos out there than there are single family detached from now on, and I'd rather have the money from helping them than not have it, so I might as well hunt squirrels along with elephants. Not only will I make more money, those of my clients who do what is necessary to become elephants will likely come back with more business. And the fact that they listened to me about how to do it (and that this advice worked!) will be the obvious primary reason behind their ability to buy something bigger and more expensive later, making it even more likely they'll come back to me. Not that a 3% commission on that $225,000 condo is squirrel feed, but when it leads to 2.5% of $600,000 to sell it in a few years as well as 3% of $1,000,000 when they can afford to buy that property they can't afford right now, my clients won't be the only ones smiling from ear to ear.

Caveat Emptor

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This page contains a single entry by Dan Melson published on October 15, 2007 7:00 AM.

Games Lenders Play, Part V was the previous entry in this blog.

Retroactive Loan Qualification Problems After Recording is the next entry in this blog.

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