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I don't want to come off as glib - oh Heaven, forfend! - but I seriously wish that journalists and others would stop talking about the current global mortgage-driven crisis in a sloppy fashion. Even commentators who produce good work (for example, Gretchen Morgenson at the New York Times) refer to people facing foreclosure as 'owning' houses, or losing houses that they 'own'. Peter Schiff from Euro-Pacific Capital - again, a fellow whose material is very good - also says "a record number of Americans now own homes".
Enough, already.
I own the underpants I am sitting in at the moment. Do you want to know how I know I own them? Because nobody can take them off me, regardless of what I do to them. Likewise my keyboard here, the fly spray next to the PC, the coffee, and yesterday's baguette. All owned. I do not have to fulfil any contract in order to retain use of them, and should I decide to destroy them completely, I don't have to settle the matter with a noteholder.
Contrast that with the overwhelming bulk of new 'homeowners'; if they fail to hold to their side of their mortgage contract, the bank can take their house off them. Likewise about 70% of people who show off a new car that they 'bought' - but which is security against the loan used to pay for it.
Do not misinterpret what I am saying - I am not arguing against credit per se. Credit markets exist to match consumption time preferences at the margin - compensating those who are willing to forego current consumption (savers) by obtaining a fee from those who want to consume NOW now now now now now NOW. NOW.
So I am not an opponent of lending at interest - the Bastiat-Proudhon debates of the mid-1800s were an exercise in ignorant windbaggery by Bastiat (an otherwise very gifted man, whose Parable of the Broken Window is a perfect explanation of why war is not economically productive). Then again, I would side with Proudhon, wouldn't I...
All I ask, is some small acknowledgement of the fact that those who acquire use of an asset by means of a loan for which the asset is the security, are not owners of the asset in any meaningful sense. They bear the capital gains or losses pertaining thereto, but their ends their proprietorship in any meaningful sense. This could be achieved by putting the word own in quotation marks (or adding [sic] after it, for example, when referring to mortgaged property.I have seen also reportage that in the UK, landlords are starting to try and increase rents in order to try and save themselves from upside-down BTL investments. {Leave aside the lack of logic this embodies - an increase in the cost of the services that are produced by an asset that is declining in value...}
This brings me to my second point - why rents ought always to be lower than mortgage repayments (on a 100% mortgage), and the extent to which deviations from this rule represent evidence of malinvestment. It seems counter-intuitive - after all, why would anybody become a landlord if the rental yield was lower than the mortgage interest rate?
Now to begin, ignore the fact that most let properties are not subject to 100% mortgages - that is not relevant. The best guess as to the required rate of return on a property is the mortgage interest rate (plus apportioned maintenance costs and property taxes).
When an investor buys a property - with or without a mortgage - they have a different relationship to the property than they would have if they were renting (and no, I am not asserting that homeowners mow the lawns more often). They acquire the rights to capital gains on the value of the property, and renters do not. They acquire long-term security of tenure (leave aside issues like compulsory acquisition, which impact both renter and landlord equally).
In theory, the rental on a property represents the market price of the 'pure' stream of services produced by the house - i.e., the market price of the quality of shelter it provides.
So a mortgage payment (on a like-for-like basis - i.e., at 100% of property value) should certainly incorporate the value of the flow of services from the house qua house. But now there is the additional thing which has been purchased - effectively, a call option over future capital gains. The renter does not acquire such a right when he rents the house - that right rests with the landlord. Since it is not a right ceded by the landlord to the tenant, the landlord ought not be compensated for it (by contrast, the landlord certainly gives up the flow of shelter that the house provides, and still pays property taxes and maintenance - which rightfully are incorporated into rents).
That seems straightforward - a mortgage payment should equal the market rent plus the price of a call option over future capital gains.
Now it gets interesting.
If mortgage payments are lower than rents, the call option has a negative value. Not only does that imply a likely absence of capital gains and a risk of capital losses - it implies that the probability of capital losses dwarfs the probability of capital gains; if a call option has a negative value, a put option is deeply in the money.
I've already mentioned that the mortgage payment has to be calculated as if the property is 100% mortgaged, but it is a very straightforward conversion for houses in which the landlord has existing equity.
In any event, consider the situation if the relationship did not hold - if rents were higher than mortgage payments (i.e., if rental yields were higher than mortgage interest rates).
What would happen if landlords were unaware of the embedded option that they were purchasing?
It should be acknowledged that most landlords are aware of the idea that they 'own' the capital gains. That said, they do not think that they pay for them... somehow they are viewed as a gift from a benevolent universe. Madame Market usually has something to say to folks who believe in benevolent universes that dole out money.
So; we are thinking about a world where rents > equivalent mortgage payments, and landlords unaware of option pricing theory.
Such a situation would encourage landlords to convert equity to debt and to put their existing equity somewhere else (usually, another property), since their existing equity could be replaced by debt at a profit. The eventual outcome would be a large number of landlords who had a very large number of properties, but a very thin sliver of equity. A classical malinvestment, and one that we see in abundance nowadays.
This is why so many young 'property magnates' wind up bankrupt - they have no idea that if an investment is showing a rental yield which is greater than the cost of borrowing, then the implied expected value of capital gains is negative. Small changes in interest rates might only have minor effects on the values of their portfolios, but catastrophic effects on their equity, which may be entirely wiped outwit ha smal lmove in property values.
This same logic applies to people who think that a sustainable business can be had by buying properties which are perfectly serviceable as is, sticking in new kitchens and bathrooms and a coat of paint, and somehow get paid for more than just their labour.
Property Porn would have it that you can buy something for X, spend 0.2X 'doing it up', and sell it for 1.5-1.6X. Thus the rate of return on the development expenditure is 150-200% - how is that, again?
That sort of thing can happen in isolated situations - even in non-benevolent universes there will exist property buyers who are so amazingly lazy that they will pay a small integer multiple of the redevelopment cost, just to avoid having to organise it themselves. But there won't be many of them - and they ought to be people with very high hourly wage rates.
The whole premise of Property Porn is that there exist a slew of potential buyers who can't be arsed making a trip to B&Q and Ikea. In other words, they are prepared to pay some multiple of their own hourly wage rate, to have the 'property developer' organise the re-plastering.
Don't misunderstand me here - I am not saying that anybody can do their own plastering. But if you're one of the developers on a Property Porn show, and you're not a plasterer, odds are you're paying for a plasterer. Ditto the carpentry, the cabinetry (even the installation of store-bought kitchen units), the plumbing, the electricals... often even an architect. As the developer, you're providing some design input, plus (often) some unskilled or semi-skilled labour (and those who try their hand at project management usually regret the decision).
So what is the value proposition? Why would it make sense for a property buyer to wait for YOU to redevelop a maisonette (and pay you a 100% premium on your input costs) rather than redeveloping the silly thing themselves at 'cost'?
(Note - here 'cost' is not actually 'cost'... the plasterer, the carpenter, the plumber all charge back the cost of their materials... including a profit).
The answer lies partly in an aberrant psychotype - there are some people who think that borrowed money is theirs as they spend it (it is this behaviour that makes people think that the US is 'rich', simply because its inhabitants are prepared to sell their futures in exchange for higher levels of current consumption).
Knowing that they are able to borrow the amount necessary to pay for the 100% margin on your input into the development, they begin to behave as if their time is much more valuable than it actually is. After all, if they are shelling out £400k for a house, they must have better things to do on weekends than stripping wallpaper or organising plumbers.
It is the same mentality as people who feel the need to speed in order to get home a minute or two quicker than would other wise be the case (do the sums - a 10 mile journey at 35 mph versus the same journey at 40 mph... assuming no speeding-induced bottlenecks). What's so good about evening TV?
Credit markets were such that money was cheap until recently; people borrowed a great deal of money, and then began to behave as if their time was worth that of people who earned in salary what these people had taken on in debt.
That said, it is often the case that when the 'profit' is converted into an hourly rate for the developer, it turns out not to be much different to the hourly rate for semi-skilled labour; in other words, these people are in fact being paid to project manage, but at a rate somewhat lower than the market rate for a decent project manager, and they are carrying the capital risk on the development to boot. Deduct an item marked 'wages to self' from the gross surplus that these projects generate, and you're usually left with something which - if positive - is not strongly so (and certainly doesn't compensate for the carrying of capital risk).
