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IP1 Jk(lJ) § t\\ L iYY 1J. c.. _1 ,_, f __ (C:(j' 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 LED lk If cc cc n (CD 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 ---------- 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 3 1.SI:II:I U018U!4SPM. 4Pln • u08aJO• ppPAaN··04P PI !!PMPH • P!UJoJ!IP:)• puozpV • P>jsPIV CC)) (,;SL· ON OIVd l!)VlSOd llVW SSV1:>lSMI:I ·s·n 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.
