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November 28, 1980

Housing:SacredCow?
Some sacred cows wi II have to be slaughtered in the lean years looming ahead, and
housing-industry leaders are beginning to realize that they may provide one of the more
tempting targets in this regard. Business
Week,in a recent editorial, putthe problem in
these terms: "The diversion of capital from
industry to housing-the primary aim of
government policy-is one of the reasons
investment in productive facilities has
been inadequate." And its prescription was
forthright: "Wean the housing industry of
continuing government assistance and make
it stand on its own feet."
The genesis of this viewpoint is a growing
body of evidence that inflation and tax pol icy
have caused an over-allocation of resources
to the housing sector over the last decade. As
the nation enters the 1980's with the goal of
expanding the energy and defense industries
and "reindustrializing" the economy, the
pressure to redirect resourcesto these sectors
will increase. Policies that are designed to
promote housing activity at the expense of
other sectors are thus likely to come under
increasing scrutiny.

The causes
The argument that the housing sector was
overemphasized during the last decade rests
on a number of factors. First, tax policy treats
homeownership relatively favorably. Homeowners can deduct all interest payments from
taxable income. They also benefit from their
ability to sell their homes without paying
capital-gains taxes on the proceeds (provided
another home is purchased), and to take out
$100,000 in capital gains afterthe age of 55
without paying any tax at all. In contrast,
capital-gains proceeds from financial invest. ments (such as stocks and bonds) are taxed,
albeit favorably relative to wage and salary
income.
In addition, homeowners are nottaxed on the
"implicit" income they enjoy from an invest-

ment in a house in the form of the services
that the housing provides them. A $100,000
investment in bonds, for example, provides
benefits to the holder ofthe bonds in the form
of interest payments, which would be taxable
as income. The same $100,000 invested in a
home also provide benefits; but because
these are in "kind" rather than in cash, they
are nottaxed. This, too, is a special tax advantage that housing (and other consumer durabies) enjoy.
The second major factor affecting the housing
equation is inflation. During the late 1960's
and throughoutthe 1970's, inflation has been
steadily on the rise, and households thus have
continuously revised upward their expectations of future inflation. It has been rational,
therefore, for households to expect substantial capital gains to accrue to all real assets,
including housing.
These two factors have combined to make
ownership of housing particularly attractivefor American households. Expectations of
higher rates of inflation bring visions of large'
(and tax-free) capital gains, thereby lowering
the perceived cost of housing. Of course
higher inflation expectations also bring
some higher costs in the form of higher nominal interest rates as lenders-who expect
higher inflation too-build in protection for
themselves in their contract rates. But the
combination of deductible interest payments,
tax-free capital gains and tax-free "implicit"
housing income more than offsets the direct
effect of the higher finance costs.

The housingrush
Given the stimulus that tax policy provides
homeownership in an inflationary era, it is no
surprise, then, that something likea "housing
rush" developed during the 1970's. The
nation produced 17.8 million housing units
during the 1970's, a substantial 24-percent
increase over the previous decade's production. Although a maturing baby boom also

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Opinions expressed in this newsleHet' do not
necessarilv reflect the views of the rnanagement
of the Federal Reserve Bank of San Francisco,
nor of the Board of GovernlJrS of the Federal
Reserve Systertl.

. -. _. -

ifestations, however, of the housing rush
described above.

caused the number of individuals of homebuying age to grow rapidly during this period,
by the end of the decade the number of occupied housing units per capita was at an
all-time high.

Affordability
There is no doubt that the purchase price of
housing has risen relative to other prices in
recent years. Between 1970 and 1980, the
price of a single-family home of a.given quality increased at about a 9.3-percent annual
rate, as compared with a 6.8-percent annual
rise in overall consumer prices (as measured
by the deflator for personal-consumption
expenditures). In addition, this increase in
real housing prices has been accompanied by
a sharp rise in mortgage rates.

In addition, contrary to the relatively minor
role played by "no-frills" housing, the quality-as well as the quantity-of housing was
on the rise during the last decade. The average home in 1 979 had a greater floor area,
more bathrooms and bedrooms, and more
amenities (such as garage space and central
air conditioning) than a new home in 1 970.
All of this is suggestive of a major shift of real
resources to the housing sector, a pattern that
is reflected, too, in credit flows. During the
1970's, $586 billion flowed 'tnto homefi;.;"
nancing. This represents an increase in the
share of mortgages in total flows from an
average of 19 percent in the 1960's to
a 20.5-percent share in the 1970's. Sti II,
government-sponsored institutions played
a major role here, financing almost onefourth of all home mortgages in the 1970's
(see chart).

On the surface, this combination suggests
that the costs of homeownership have risen.
The true cost of housing,'however, 'indudes:
not only interest costs (and maintenance,
taxes, and so on) but also the expected capital
gains accrual, all after taxes. On this basis, it is
not at all clear that the cost of housing has
risen. Indeed, the evidence cited above on
the increased quantity and quality of housing
services being consumed suggeststhat housing costs have probablyJallen overall during
the 1970's, despite the rise in prices and
interest rates.

This picture of an inflation and tax-distorted
boom in the housing sector does not square
with many people's perspective on the housing market. Housing leaders are more apt to
remember the volatility of the industry than
its substantial growth, because many fortunes
have been lost in the increasingly wide fluctuations affecting the industry. In the 1 973-75
downturn, and again in the 1 978-80 downturn, housing starts declined by half or more.
More fundamentally, many policymakers
perceive that a dual crisis is developing in
housing: owner-occupied housing is becoming "unaffordable" and the rental market is
dwindling. These are very likely surface man-

j

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The convention of a fixed-payment mortgage
and a lim it on the ratio of mortgage payments
to current income, of course, cause some
households to experience difficulty qualifying for a loan and taking advantage of these
lower costs. This problem-called the
"affordability" constraint-is undoubtedly
important for many families, particularly
during periods of tight money.
Over the last decade, however, this constraint
apparently was not very binding. Homeownership appears to have continued to rise, and
even first-time buyers (young families) are
homeowners in increasing proportions. In
1 970, only about 39 percent of households
with heads under the age of 30 were owneroccupants; by the middle of the 1970's, that
proportion had increased to over 46 percent.

2.

$ Billions

Home Mortgage

Funds

75

50

25

1965

1970

1979

1975

the proportion of rented single-family homes.
Between 1 970 and 1 976 alone, the proportion of single-family homes occupied by
renters dropped from 19.3 percent to 1 6.6
percent.

The fact that such trends occurred in the face
of mortgage rates and housing prices that
were rising faster than income has several
explanations. First, banks substantially eased
the terms of their loan-qualificationtests
when they broadened the defi n ition of
"income" to include the second income of a
household. Secondly, many households had
some latitude to "lend to themselves" by
contributing more of their savings to housing
than they otherwise would. Finally, new
mortgage instruments, such as the graduated
payment mortgage, may have helped certain
borrowers to partially overcome the constraint imposed by high initial mortgage
payments.

Yet these changes must be viewed as a symptom of the overall rush to housing rather than
a separate trend. The movement away from
rental housing, including the conversion of
rental housing to owner-occupancy status,
represents a natural consequence of the market's adjustment to the combined impact of
inflation and tax regulations.

The future
Any policy moves to channel resources into
"reindustrialization" will have to deal with
the inflation and tax factors that have distorted the economy's natural patterns of
resource allocation duringthe past decade or
so. It will be necessary to bring the tax treatment of housing and other investments into
line if the distortions in investment patterns
are not to persist. In addition, the relative tax
treatment of landlords and owner-occupants
may have to be reconsidered to address the
issue of imbalances within the housing sector.

Rental housing
The performance. of the rental market, paradoxically, has been consistent with the notion
of a housing rush. Inflation and tax factorsin addition to distorting the position of housing relative to the rest of the economy-have
caused distortions within the housing industry. Since some of the tax advantages enjoyed
by homeowners are not available to landlords (tax-free capital gains, for example), the
ability of rental housing to "compete" with
owner-occupancy has been somewhat limited. As inflation expectations have risen and
made the cost of owner-occupied housing
appear low, therefore, the rental market has
declined.

Housing may, ironically, enjoy benefits from
a rationalization of housing and general
investment policy. The industry'S major problem in recent decades has been the volatility
rather than the nominal level of activity. Measures taken to stabilize the relationship between housi ng and the rest of the economy
may thereby reduce the heavy costs of excess
capacity in this feast-or-famine industry.
Housing is likely to remain a sacred cow, but
the beast may actually be healthier with a
leaner yet more consistent diet in the decade
ahead.

This decline has been manifested in several
ways. First, the construction of rental property
has dropped significantly despite large
Federal subsidies. In 1979, total rental-unit
construction dropped 20 percent from the
preceding year-while the number of
unsubsidized starts fell to only half of
peak-year volume, and then dropped almost
by half again in 1980. Second, many existing
multi-unit properties have been converted to
condominiums to satisfy homeownership
demands. In 1979, about 1 95,000 units were
converted in this fashion, up substantially
from earlier years. But a more subtle form of
conversion has also occurred with a drop in

Randall Pozdena and William Burke

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BANKINGDATA-TWELFTHFEDERAL
RESERVE
DISTRICT
(Dollaramounts millions)
in

Loans
(gross,
adjusted) investments*
and
Loans
(gross,
adjusted) total#
Commercial industrial
and
Real
estate
Loans individuals
to
Securities
loans
U.s.Treasury
securities*
Othersecurities*
Demand
deposits total#
Demand
deposits adjusted
Savings
deposits total
Timedeposits total#
Individuals, & corp.
part.
(Large
negotiable
CD's)
WeeklyAverages
of Daily Figures
MemberBankReserve
Position
Excess
Reserves }/Deficiency
(+
(-)
Borrowings
Netfreereserves }/Netborrowed(
(+
-)

mJ"®
CS

C@I

·J!le:>
IO;)SpueJ:I
ueS

Selected
Assets Liabilities
and
large Commercial
Banks

JJ

Amount
Outstanding

Change
from

11/12/80
144,133
122,016
35,736
49,217
23,733
1,202
6,687
15,430
47,193
35,273
29,484
67,103
58,180
26,139

11/5/80
1,052
1,034
58
100
8
20
2
16
-1 ,068
857
- 417
1,226
1,211
520

Change
from
yearago
Dollar
Percent

-

Weekended

Weekended

11/12/80

11/5/80

n.a.

n.a.

95

167

n.a.

n.a.

8,697
9,710
3,818
6,817
154
366
777
236
1,141
2,987
481
9,431
8,897
4,674

6.4
8.6
12.0
16.1
0.6
- 23.3
10.4
1.5
2.5
9.3
1.7
16.4
18.1
21.8

Comparable
year-ago
period
39
277
238

* Excludes
trading
account
securities.
# Includes
items shown
not
separately.
Editorial
comments beaddresseC:I editor(WilliamBurke) to theauthor.... Free
may
to the
or
copies this
of
andotherFederal
Reserve
publications beobtained calling writingthePublic
can
by
or
Information
Section,
Federal
Reserve
Bank SanFrancisco, Box7702,SanFrancisco
of
P.O.
94120.Phone
(415)544·2184.