Cost of home ownership in the '70s may look like a song in the '80s
A new measure of total housing costs which was worked out by a North Carolina professor indicates that the net cost of home ownership actually declined during the 1970s.
In fact, the cost was almost certainly negative for some families.
The same analysis also suggests, however, that housing costs and rents will increase sharply in the 1980s, setting off the most serious housing crisis since the Korean war.
In constructing his comprehensive measure of housing costs, Prof. Douglas Diamond of North Carolina State University brings together all the relevant costs facing the homeowner or landlord: mortgage rates, property taxes and insurance, energy and other operating costs, depreciation, and capital gains.
It is the capital-gains component that caused the cost of owning a home to decline in the 1970s, since capitala gains more than offset the increases in all the other cost components.
Consider, for example, a family that bought a typical $35,000 house in mid- 1973, at a time when mortgage interest rates were running around 8 percent. Depending on the length of the loan, let's says that mortgage payments would have been $225 a month, and total housing costs, including all of the above components, would have been $400 or less in most areas of the United States.
Based on national numbers, the same median-priced house would have been worth about $75,000 by mid-1980.
This family would have paid out $4,800 a year for seven years, or $33,600, for interest, taxes, insurance, utilities, maintenance, and the like. The capital gain, however, would have been $40,000.
Professor Diamond's estimate is that housing cost declined about 30 percent in the 1970s, largely because of capital gains. In effect, housing became cheap because it was getting more expensive!
Based on the premise that "there is no such thing as a free lunch," Professor Diamond argues that it is extremely unlikely that net cost will behave this way in the 1980s. Indeed, the recent sharp increases in mortgage rates themselves would suggest he is right.
In other words, an 8 or 9 percent mortgage rate was a good deal in the 1970s when home prices were rising at 11 or 12 percent a year. But what about an interest rate of 18 percent or higher, as at present? Clearly, the free lunch is over.
The sharp rise in mortgage interest rates will have the effect of reducing the demand for housing and future capital gains. As homeowners receive lower capital gains, the cost of owning a house will rise. While interest rates themselves may fall, they are not likely to fall as much as overall inflation, so that in the 1980s housing will never be the relative bargain it once was.
Many homeowners who bought at relatively low prices in the early '70s are now gloating: "If you rented a house like this, you'd pay twice what we pay."
However, what they forget is something economists call "opportunity cost." This is the amount they could now earn on their equity if it were not invested in the house. A family that put down $10,000 on a house and has amassed a $40, 000 paper profit could sell the house and put the $50,000 into a savings-and-loan certificate or other investment vehicle and earn, at present, about 15 percent.
The fact that they don't do this nonetheless means that this foregone income must be included in their "true" cost of homeownership.
The earnings on $50,000 at 15 percent is $7,500 a year, or $625 a month. Again, the prospects for this component of housing cost are ominous, because opportunity costs will be higher in the 1980s and interest rates will almost certainly remain higher than they were in the '70s.
Renters are involved as well as buyers.
Rents did not increase nearly as fast as the overall inflation rate in the 1970s. While some economists are puzzled by the fact, it is no surprise to Diamond. In fact, it fits right into his framework. As landlords took a major portion of their return in the form of capital gains, "the old rule of thumb that monthly rents should equal 1 percent of a dwelling unit's value went the way of the 6 percent mortgage."
However, with higher interest rates, the higher opportunity cost of investing equity in rental housing, and the prospect of lower relative capital gains, rents could explode in the 1980s.
President Reagan's across-the-board tax cuts will also reduce the tax advantages of owning a house.
Because of the chronic savings shortage, low productivity growth, and excessive borrowings by all sectors of the economy, there could be some moves to directly reduce the tax benefits from owning a house.Some economists and politicians have suggested that deductions for mortgage interest be scaled down to prevent "overinvestment" in housing.
At the very least, there will almost certainly be no additional aid to home ownership.
With the ownership rate now about 65 percent, policymakers may see no need for additional incentives to encourage people to own their own homes. Instead, the priority could be in other areas, such as business spending for plant and equipment.
Putting all the numbers together, Diamond concludes that the prospects for housing costs in the decade ahead are bleak in deed. Costs are expected to rise 75 percent faster than the overall inflation rate, an estimate that he now suggests is conservative. This is primarily because of the prospect that mortgage rates will remain high relative to the rate of appreciation in housing.
Lower tax savings and the higher initial cost of home purchase also play a significant role in this outlook.
The estimate isd conservative because it ignores the effect of the recent deregulation of energy prices as well as the higher "opportunity cost" of the equity tied up in existing homes. This suggests that the actual result might be housing costs increasing twice as fast as overall inflation.
Of course, the homeowner might not actually see all of these cost increases directly. Some, like the opportunity cost, will remain hidden. Homeowners will still be enjoying some capital gains on their homes, for example, and they may continue to perceive housing as a good investment.They may even see slightly lower mortgage rates than at present.
The renter, on the other hand, will face a real squeeze as rents follow the trend of total homeowner costs.
Landlords will be faced with the same set of cost increases as homeowners and will simply be passing these costs on to consumers. The sharp declines in vacancy rates in most local markets will permit them to do this.
Those who are not able to pass on the increases will be tempted to convert their units to condominiums.
In fact, while the comprehensive housing-cost framework developed by Diamond suggests that the housing crunch of the 1970s was a phony crisis, it also suggests that the housing crisis of the '80s will be real.