This is a slightly edited re-post of a piece I wrote on housing-analysis about two years ago. It is a culmination of much of the comments and logic advanced by regular wiley veterans of the local blogosphere — VHB, freako, patriotz, mohican, to name a few. True to form, it is still as true today, two years subsequent to the original post date.
No analysis blog would be complete without a paradox and I believe there is none more relevant now than the so-called “ownership premium” that owner-occupiers place on property values. I would like to offer an alternate view of the so-called “ownership premium” that has been discussed on this blog and others in the past years.
The “ownership premium,” sometimes called the “control premium” or “consumer surplus,” is a premium that a potential buyer will pay for the right of owning (and “controlling”) a property compared to renting. Here is an example thought process of how the ownership premium concept works, from a buyer’s perspective:
jesse is renting a condominium for $1200 per month but is on a month-to-month lease. With a wife and young child, jesse does not want the uncertainty of renting month-to-month and his wife wants to customize the suite, something not always possible when renting. jesse looks at the condo for sale next door. If he were to buy it at market rate, the total costs of doing so far exceed that of continuing to rent. After factoring in all expected costs and trade-offs of his specific situation, jesse decides he is willing and able to pay a monetary premium to buy. But — and here’s the thing — he doesn’t have to.
(The “ownership premium”, as described here, is in its essence describing one’s personal preference to own or rent a property — the “intangibles” of ownership. It is not to do with more tangible and fungible premiums related to speculation of future price gains or expected increased utility by densification.)
The alternate view of the ownership premium looks not at individual circumstances but at the overall market comprised of owner-occupiers and investors competing over the same product. Here, for simplicity, we can look at condominiums that have a healthy mix of both owner-occupiers and investors and have relatively meager prospects of increasing land utility. If owner-occupiers are willing and able pay a market premium to own, the investor must compete by also paying the same premium. This has the effect of reducing the investor’s yield and instead must rely on capital gains to compensate for the poor yield.
In speculative bubbles, low rental yields go virtually unnoticed because everybody is “making money” on capital appreciation. Investors can compete head-to-head with owner-occupiers because rental yield is dwarfed by capital appreciation. The “ownership premium” train of thought becomes justified, even amongst many investors who justify it as a premium for scarcity and control of how the property is used. During bubbles, the premium continually increases.
However, when a bubble deflates, total return is not about capital appreciation but net income from rents. At this point the investor will require higher rents or lower prices to make the investment worthwhile. Housing markets around the world are starting to revert to where cash flows make sense again and this means lower prices. Rising rents are muted when there is an oversupply of dwellings and wages are flat to falling with rising unemployment. The ownership premium, for investors, is once again meaningless.
This does not mean that the ownership premium for owner-occupiers is a fallacy. It exists and is real. In addition, for many others, the mobility and lower responsibility offered by renting means their personal premiums are negative. The point is that it doesn’t matter. When a significant portion of a market is focused on monetary returns ex intangible benefits -– i.e. investors –- they will eventually and invariably set the price. It also doesn’t mean anyone is necessarily wrong for paying a premium but ones doing so should not use it to justify high prices and instead realize they made an investment with a lower monetary return.