Endless eviction bans, bans on credit checks for new residents, and limits on rent increases are just a few of the government interventions that have proliferated in the last several years, even before Covid-19 and government reactions to it that cost people their jobs and incomes. It would be sensible to guess that the risk of entering the housing market place as an investor, developer, or housing provider would have increased along with all these interventions. However, one of the features of the housing market are some counter intuitive realities about risk and how they impact both producers and consumers.
Investopedia characterizes financial risk this way:
“A fundamental idea in finance is the relationship between risk and return. The greater the amount of risk an investor is willing to take, the greater the potential return.”
That’s easy enough to understand for almost everyone. Bet lots of money on the long shot horse at the race track and you’ll win more money than a small bet on the favorite horse. Risk and return are something that is deeply intuitive and understood among human beings. But how does it play out in the housing market?
On the one hand, when government makes lots and lots of rules that make it more difficult to produce and operate housing, supply doesn’t keep up with demand; when this happens, the resulting scarcity means higher prices. When a real estate asset can command higher rents, its value goes up. So, if you own a property in a highly regulated market, more regulation will make your asset worth even more. And if you’re an investor, investing in production in one of these markets makes sense because even if it takes years to get a permit, once the project is collecting rent, it’s likely to remain valuable.
On the other hand, in place with little demand and not much regulation, rents stay low, so low that often, the potential return doesn’t cover the cost of land, financing, construction, and operations. In places like these, housing doesn’t get built until demand for housing exceeds supply enough that prices rise to create enough income to cover costs and generate a return for investors. This is why many rural communities have lower vacancy rates than urban areas and more housing hardship for families with less money.
I’ve posted about capitalization rates before, and how buildings with higher rents in low-supply, high demand cities tend to hold their value even with more regulation and Covid-19 impacts than buildings with lower rents that meet the needs of people with less money. Properties in highly regulated, high demand cities like Seattle and San Francisco, are safer bets for investors. Perversely, the more unhinged local governments become, the more housing investments gain in value because supply is suppressed, demand continues, and price “skyrockets.” And when prices go up, local governments impose more regulation. That ends up being good for large private real estate investors, owners, and operators. Smaller investors get crushed, sell their more affordable rentals which stokes supply problems.
I spoke with Alex Cohen is the CEO of Liberty SBF, a national commercial real estate financing company about risk, and he agreed that even markets with local governments that impose punitive regulatory regimes on new and existing rental housing are mitigated and absorbed by housing shortages. In his work financing new rental housing and acquisition of existing rental housing, Cohen told me that a project in a place like Seattle or Portland might have to “price in the risk” of those unhinged local governments and volatile and violent street theatre. But if demand is strong enough, the fundamentals would support projects going forward.
I’ve learned through many years of working on housing and land use policy that while people in the real estate business worry about the risk generated by politicians imposing regulations that make housing shortages worse, more often than not, those people decide those risks are mitigated by the scarcity created by those regulations. Prices stay high and thus make for safer investments longer term. It’s the reason why I’ve pointed out that capitalism needs no defense; in the end, individual project feasibility trumps the difficulty of building and managing rental housing. Housing will still get built in spite of efforts to make it more difficult, it will simply be more expensive, driving regulations that push up wages and subsidies for that housing.
This is the inflationary death spiral we are seeing in the housing sector, one that will increasingly lead to calls for making housing “a right.” As I explained to Cohen in our conversation, this presents the greater risk longer term to housing as a commodity. As more radical elements create chaos, risk, and scarcity with overregulation, prices will go up, and so will pain among those with less money. As this happens, the demand to end housing as a commodity and covert it to an entitlement will have a profound impact on how housing is financed. This is exactly what the radical leftists want: a collapse of the housing market, a takeover by government, and rationing of housing.
You’d think that people and companies who finance, build, and operate housing at scale would be alarmed enough to do something about this. But they can’t. They’re far too busy assessing individual projects, most of which “work” because as Cohen points out, demand and low supply – inflation – creates scarcity that can continue to absorb the shocks of more and more regulation. This inflationary hothouse is good for investors, left leaning politicians, activists, academics, and large-scale developers and operators, but devastating for people who live pay check to pay check. Everyone is following their rational self-interest, but people with less money get hurt. This proves the point of agitators and convinces the general public that the private housing market is unfair and a failure.
Is there a housing crisis in the United States? Yes, but it is like a dog chasing its tail; the more rules politicians impose, the worse the crisis gets, and so the more rules have to be imposed. Projects “work” because they deliver returns. People with jobs see their wages rise, pushed up by wage controls at the bottom of the labor market, and those with fewer dollars see their incomes chewed up by higher and higher housing costs. This means more subsidies at the expense of new housing, costs that get passed on in the form of higher rents. As our once and future President might say, “Sad!”
Can the poor dog be saved? Maybe. But housing’s private sector will have to develop some discipline, invest in understanding what might beguile the public from its slide toward seeing housing as “a right,” and then educate the public about how the housing economy works so that the public demands something more from politicians than easy and punitive attacks on housing producers and providers. This would mean people who finance, build, and operate housing at scale would have to give up the hopeless chase even though that chase is, for now, profitable.