Streetwise Professor

June 10, 2021

Bad Day At BlackRock?

Filed under: Economics,Financial crisis,Politics,Regulation — cpirrong @ 6:16 pm

There has been something of a kerfuffle recently over the large scale purchases of single family homes by the likes of BlackRock and other institutional investors like pension funds. The criticism is somewhat redolent of the Occupy days, because it unites many on the left with some on the populist right, like J.D. Vance:

Understanding should come before judgment. So let’s try to figure out what is going on here. I don’t have a definitive answer, but my strong sense is that this phenomenon is ultimately a consequence of the 2008-2009 Financial Crisis, and the various policy responses to it.

One thing is clear is that the initial foray of institutional investors was a response to the Crisis. And no wonder. Massive amounts of single family homes were in foreclosure, and the biggest fire sale in American real estate history was underway. And in fire sales, those with “dry powder”–cash rich investors relatively undamaged by the crisis that sparks the sales–go bargain hunting. In 2009-2010, the bargains were in residential real estate, especially single family houses. And the “real money” investors like BlackRock and pension funds were best positioned to grab those bargains.

Here it is almost certain that the activities of BlackRock et al did elevate real estate prices. And a good thing, too, for the problem at the time was not that housing prices were too high, but too low. Without bargain hunters (or vultures, if you wish) housing prices would have been even lower, more homeowners would have been underwater, more of them would have been foreclosed, etc. Of course BlackRock et al were not doing this out of charity, but to make a buck. But they were responding to price signals and their actions almost certainly mitigated a horrible situation.

But as the WSJ article linked above notes, institutional investment in the housing sector has persisted after the fire sales ended–especially in places like Houston, Atlanta, and Nashville. This is characterized as a reach for yield strategy on the part of the institutional investors. The yield on rental property is apparently attractive relative to alternative investments. And no surprise: have you looked at bond yields recently? Like in the last 12 years? Is it any wonder that investors like pension funds (especially government funds that are hugely under water) are desperate for assets that generate a stream of cash flows at attractive rates?

But high yield suggests that prices are low in some sense, rather than high. (Price is in the denominator of the return calculation.) “Bubble” real estate markets are characterized by extremely low rental yields, not high ones.

Look at this another way. People are choosing to pay rent, rather than buy and make mortgage payments and forego income on the investment of a down payment amount. Why? Why are they paying rents that generate a high return for the housing owner, rather than buying homes and capturing that return themselves?

My answers will be somewhat speculative, but now the question is the important thing. Many individuals are choosing not to buy, and to pay rent instead. The rents that they are willing to pay are driven by the stream of benefits that they get from living in a single family home. Why don’t they outbid BlackRock or some state pension fund and pay a price that capitalizes that stream of benefits?

Note that there are clear advantages to occupiers owning. The Atlantic article linked earlier discusses the frictions associated with renting. Well, renter-landlord relations have been fraught always and everywhere. Rental contracts are not “complete”–they leave a lot of grey areas that give rise to conflict between owner and renter, and to opportunism by both. Those wasteful activities can be eliminated by having those who live in a home own it. That in and of itself should give individuals a bidding advantage over institutions when buying homes. Cut out the middleman and you cut out the transaction costs inherent in the landlord-tenant relationship.

So then what gives? Now for the speculation, which again revolves around the fallout from the Financial Crisis.

First, the leading diagnosis of the cause of the Financial Crisis was that it was too easy to get a mortgage. In response to this, post-Crisis legislation and regulation tightened up the home financing market. A lot. You can argue that the tightening was justified. You can argue that it went too far. But regardless, restrictions on the ability of individuals to finance a home purchase, or regulations that made it more expensive to do this, shifted the balance away from purchasing towards renting.

Indeed, if the likes of Elizabeth Warren were intellectually consistent (yeah I’m a comedian, I know), they should see the increased presence of Wall Street on Elm Street as a good thing, because it means that their endeavors to prevent another housing “bubble” have worked.

Second, the Financial Crisis took a severe toll on the balance sheets and creditworthiness of many individuals. Although these problems have dissipated, they haven’t disappeared. Combined with the more restrictive access to credit, these creditworthiness/balance sheet effects impede the ability of individuals to capture the high returns of home ownership, and they cannot compete on price with institutional investors who do not face such impediments.

Third–and this is perhaps the most speculative point of all–the Financial Crisis and the follow on Foreclosure Crisis arguably had an impact on the preferences of individuals, especially Millennials and Gen-Zs. Post-Crisis home ownership seemed less like a dream–it had a potential dark side. So many in those cohorts prefer to pay rent and give a high return to institutional investors and deal with the hassles of a landlord rather than buy and face the risk of financial ruin.

Fed policy may also play a role. It clearly has depressed returns on conventional fixed income investments–and has done so by design. That has made institutional investors look at non-traditional investments. But Fed policy alone can’t explain why yields on housing investments apparently haven’t fallen to the level of the low yields on bonds. There must be some other factor impeding the rise of housing prices to reduce the yields that the institutional investors are apparently capturing by buying and renting out single family homes. That brings us back to a search for factors (like those just discussed) that prevent individuals from outbidding institutional investors to capture the stream of returns from housing ownership (and to eliminate the costs that arise when the home occupier is not the owner).

In turn, this means that inquiry into this issue should focus on whether post-Crisis, there are excessive restrictions and costs imposed on individuals looking to finance home purchases. That is, are the post-2008 laws and regulations designed to prevent a recurrence of the housing boom too restrictive?

I don’t have an answer to that question, but again, posing the right question is where you have to start.

My provisional conclusion now is that institutional investors are doing what they do: responding to price signals in order to maximize risk adjusted returns. They are responding to incentives. To evaluate what is going on, it is necessary to evaluate whether those incentives have been distorted by ill-conceived policies.

Of course, these policies were not created in a vacuum. They are the result of a political process that includes lobbying and rent seeking by institutional investors, among others. They have an incentive to harm potential competitors in the housing market. So any inquiry should also focus on whether these institutional investors have helped rig the game against individuals by pressing for the imposition of unwarranted restrictions on home financing. If so, censorious judgment would be warranted.

So is burgeoning institutional ownership of single family housing a 2020s version of Bad Day at Black Rock? A 2020s film noir? I don’t know. But I have the questions and some provisional answers.

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  1. Aren’t markets made at the margins? Also “funds” aren’t likely to “move up” as their family needs or wants change. So, where family price signals and incentives were likely change “funds incentives are different. Especially if they see a capital increase on top of rental income, although I’m sure, that capital increase was part of the initial strategy.
    So, this is an interesting problem where a market is realigned with a new, large participant that has much different parameters moving it’s decisions. Housing markets before were driven by demographics, and all the things we understand from previous study.
    I think the “funds” have bought up enough houses to be a real factor in price.
    Ah hell! I’m lost! you’re the economist Prof. You figure it out or get a grad student(s) and let me know the conclusions when you do.

    Comment by Donald Wolfe — June 11, 2021 @ 10:32 am

  2. Buying and owning a house also has frictional costs – mortgage terms are only part of it. There is also the real estate commission and closing costs when trading up, downsizing, or relocating for greener pastures. It also ties up investment capital and time for management and maintenance So if we had a free market some people would still choose to rent based on individual circumstances.

    I think pre-2008 the banks and US govt were subsidizing home ownership intentionally or not. Even now, developments near Conroe (mentioned in the WSJ article) are built outside city limits so as to be eligible for USDA financing. That’s zero down financing made possible by the US Govt. Get the seller to cover closing costs and you’ve got “owners” with no skin in the game. Also, the credit qualification for a new build is based on the previous year’s tax – before the house was built. Property taxes are around 2.5% of value depending on the exact jurisdiction in that area, so that escrow payment can really jump the second year.

    So, I hardly see an unduly tight mortgage finance system for owner-occupants. I am inclined to think that home ownership was higher than optimum in 2007 and has slowly been rebalancing. Since the federal government is still subsidizing it, we’re probably not at a free market equilibrium yet. There could also be longer term cultural trends at play shifting the equilibrium point – such as the tendency to cohabit instead of marrying, etc.

    Another interesting question to me is: Why are large institutions displacing the small landlords who collectively used to dominate the single-family rental market? Some of it has to be the institution’s ability defer taxes by offshoring profits to a finance subsidiary in the Virgin Islands, but that also comes with institutional overhead. Are the financing terms for landlords with small portfolios more onerous (compared to institutions) now than in the past? Or is this the next step in financialization where instead of owning a rental house, upper middle class people own pension entitlements or index funds and the money finds it’s way to the rental housing market indirectly?

    Comment by Jack — June 11, 2021 @ 9:21 pm

  3. For many years, a pattern of home occupation in continental Europe was to rent in the city and buy a house in the country. Theoretically this would produce a highly mobile bourgeois work force, being unencumbered by frictional costs of moving home for a new job.
    Theory did not reflect practice. In reality the European work force was highly immobile.
    Can you explain this, prof? Anyone?

    Comment by philip — June 13, 2021 @ 2:47 am

  4. Never mind the Economics, how about a share tip. Should I invest in Blackrock?

    Comment by dearieme — June 13, 2021 @ 11:03 am

  5. “In reality the European work force was highly immobile.
    Can you explain this, prof? Anyone”

    My guess: Very high levels of job security and unemployment insurance, no tradition of the kind of mobility that’s common in the US and finally language barriers.

    Comment by HibernoFrog — June 16, 2021 @ 2:34 am

  6. Having just participated in acquiring a new outpost in Southern California, it was definitely the case that renting looked more expensive than buying. Otherwise I would never have bought into such a frothy market. But for the same square footage and location, it looked like owning was pretty much a no-brainer for anyone who could pony up enough cash for a downpayment at the low rates being quoted.

    That’s the opposite of what it looked like decades ago, when we first arrived in Los Angeles and renting was much cheaper than owning, leading me to delay buying anything for several years until things got closer to balance.

    Comment by SRP — June 16, 2021 @ 4:56 pm

  7. Perhaps the return on rentals versus buying a house is a delicate balance, sometimes upset by government actions. It may swing each side of balance, but it will return to balance over time. Look at SRP above. While more or less 50% have an IQ of less than 100, this does not mean they are unable to see what is best for them. This is why while all say it is best to buy American, Oz, Canadian, etc, most go into the likes of Walmart and buy cheapest at their preferred quality. This applies to all goods including houses. Arbitrage in markets is difficult. buying and selling needs to be done before rather than after major price shifts. Markets climb a ramp and fall of a cliff. One day turns you from hero to goat. Borrowed money turns you into sacrificial goat. It is my view that banks are good predictors of a recovery. Recovery comes one day after the banks finish tidying up their debt list and forcing payment of debts they have been carrying.

    Comment by Peewhit — June 21, 2021 @ 5:34 am

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