Sunday, January 11, 2009

The Ownership Premium

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", 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 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, 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 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. If owner-occupiers will 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 next to impossible 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.

Edit: 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 premiums related to speculation of future price gains or expected increased utility by densification. The point is the intangibles of ownership do not in themselves justify higher prices.

17 comments:

Traciatim said...

Of course the only reason that person can rent the $1200 apartment is because someone else purchased it when prices were lower and is living off of this persons inability to plan ahead.

The person that buys the condo today and pays 1600 bucks a month for it, but owns it, in 10 years will be paying less . . . 10 years after that, even less. 5 years after that... very little indeed.

The only people that should rent in the general public are people who haven't figured out what city they want to live in, need to be mobile for job requirements, or people who don't care about their security in retirement. (of course, there are TIMES when you shouldn't buy, like when valuations go crazy and a shanty is 500K . . . but then you should be saving to buy to get a good deal when things get back to more normal levels or you find a place you can stay in a long time and afford).

Think how easy retirement would be if you own your own place instead of your rent increasing every year for the next 20 years.

The only argument against buying is that you can get better returns on other investments. The problem is that most people don't get better returns on other investments and unless you are extremely dedicated you simply will spend any saving on renting an inferior home on stuff you don't need anyway.


Maybe I'm just biased a bit being a home owner in a city that has an average home going for around 2.7 times average family income, right about where it should be. Who knows . . .

patriotz said...

The only argument against buying is that you can get better returns on other investments.

That's the only argument that matters. ROI for housing cannot be lower than ROI for investments of comparable risk (i.e. predictability of earnings) - not to mention fixed income - in the long run. Capital cannot flow indefinitely into an asset with inferior return. The supply of greater fools must run out eventually.

Another point, Mohican, your "ownership premium" in micro terms is nothing other than the "consumer's surplus", the fact that all buyers except the marginal buyer - i.e. the buyers to the left of the suppl/demand interction - derive greater utility and are therefore willing to pay more. But it's the marginal buyer - the investor - who determines the market price for everyone.

mohican said...

great points jesse

the ownership premium essentially boils down to an expectation of future property price gains that cannot be had by renting. In the end, as we are seeing unfold now, the prices will revert to what rents can support and earnings yield will be the only reason why anyone will invest in real estate, as it should be.

Paying any more than rental equivalence to own is plain stupid.

alexcanuck said...

Paying any more than rental equivalence to own is plain stupid.
Not quite so fast, there.
Paying any more than a small ownership premium, perhaps 10% over rental equivalence to own is plain stupid.
There really is such a thing as pride of ownership, and it is worth a MODEST amount. The insane prices in Vancouver, of course, are so far beyond that point that the difference is hardly noticeable from here.
That's all, just a small quibble.

jesse said...

"There really is such a thing as pride of ownership, and it is worth a MODEST amount."

alexcanuck, I completely agree however you don't HAVE to pay this premium, EVEN if you are willing to. That's the point.

patriotz said...

10% over rental equivalence

at purchase time is not necessarily an ownership premium, because the nominal net rental value will rise in the future, while the nominal mortgage payment doesn't. In other words the real return after financing costs is skewed into the future. This is particularly true for a house where the land represents a large amount of the value and does not depreciate like the structure. Remember depreciation is a noncash expense. Also future real rent can increase due to densification.

Also Mohican, I would not call a willingness to buy at low yield on an expectation of future capital gains an ownership premium. That's a speculative premium, and it applies to both owner-occupiers and investors (and to stocks, etc. as well). Rather I think what most people mean by an ownership premium is the willingness to accept an inferior total return on an owner-occupied property due to intangible benefits. Of course an owner-occupier may be motivated by both at the same time.

In economic terms both an ownership premium and speculative premium mean being willing to pay more than the fundamental value, i.e. the present discounted value of net rental income. This is not necessarily the same thing as being over rent equivalence at the time of purchase - although for a condo I would say it more likely is. People buying condos with monthly outlays of 2x rental value are just nuts.

And of course prices will inevitably revert to fundamental value at some point, if not below.

jesse said...

"The person that buys the condo today and pays 1600 bucks a month for it, but owns it, in 10 years will be paying less"

Traciatim, a straight fiscal decision to buy or rent would factor in decreasing interest payments and opportunity costs, i.e. looking at (as I said) "total costs".

Traciatim said...

I'm with Alex, paying more than renting in year 1 is fine, depending on your time frame. Let's keep with the 1200 example and a 10 year time frame. Rent of 1200 will go up by about 3% per year. That makes the monthly rent per year from 1200-1615 or so. Add in to this the intangibles like pride of ownership, customizing, not being able to be kicked out on a whim, not relying on someone else's finances to ensure you still have a place to live (IE, Landlord defaulting on loan) . . . then the average rent for the period would be about 1400 or so, which puts what I would pay for a place I was staying for 10 years at about 1500-1600 that is currently renting for 1200 which puts the premium at about 25%-33% for owning.

Of course this doesn't include that at the end of 10 years I get to sell for the inflation adjusted price of what I purchased it for. Which makes a 250K house now worth about 335K (if we follow the same 3% inflation) . . . and my loan will be slightly less than I started with, so I will walk away with 100K in my pocket while the renter walks with nothing.

All in all I still the the advice for the general population is to find a city you like in your early years, find a nice home you can live in for a long time in an area you like in that city, buy it and stay there as long as possible.

jesse said...

"I would not call a willingness to buy at low yield on an expectation of future capital gains an ownership premium. That's a speculative premium, and it applies to both owner-occupiers and investors (and to stocks, etc. as well). "

Yes. The ownership premium focuses only on preference, part of the reason why it's instructive to look at fully densified housing such as condominiums. Underutilised land and properties without many direct comparisons for rentals can confuse things.

jesse said...

patriotz, I hope readers understand the difference as well. The point I was trying to raise but didn't come out right is that often some investors can confuse a "speculative premium" -- which as you say is justified if that's your game plan -- with a population's desire to own instead of rent. The two are completely separate concepts but often confused.

mohican said...

The differences are comparatively trivial but I am not sure that there is any ownership premium at all that should justify a 'premium' price above rental equivalence.

Obviously, all things being equal, it is better to own than rent for the control reasons cited but ownership comes with high risks that are hidden or ignored by many people. Just ask homeowners in Chilliwack recently or anyone who has had a special assessment on their leaky condo. These risks only come to the homeowner, not the renter, and the owner 'should' be compensated for these substantial risks by paying a lower price - ie. a price at rental equivalence - without a premium.

patriotz said...

Of course this doesn't include that at the end of 10 years I get to sell for the inflation adjusted price of what I purchased it for.

Unless you don't. People buying in 1981 had to wait 25 years, for example, and I don't even want to think about when the real price peak of 2008 will be reached again.

freako said...

Great post.

1. Traciatim misunderstands the point/situation and seems thinks that a true premium really isn't a premium. He/she argues that classic "mortage payments stay the same but rents increase" cliche.

2. If they had to, many people would no doubt pay the "premium".

3. As Jesse states, they don't have to. I have posted this a million times, but here we go again:

The owner's premium is the renters discount (by definition). The renters discount is the landlords low yield. Low yield will cause landlords to exit the business. This marginal pressure will eventually drive prices down to where there is no owners premium.

4. As has been discussed/alluded to, capital gains DO NOT compensate for low yield. Exception must be made for underutilized land, but that is another unrelated story.

jesse said...

Credit where credit is due. freako, patriotz, VHB, mohican, and others have been screaming this for years now and still there are those who choose to believe because they are willing and able to pay a premium for the "intangibles" of ownership, it justifies the requirement to pay a premium over renting. Nope.

This is indeed great news for everyone who wants to own but cannot afford to buy what they can rent. You can indeed have your cake and eat it too, adding on a justifiable premium for densification in certain situations. It is part of the wonder of the economy that being house poor need not be a requirement for survival; if that were the case there would not be much of an economy at all.

freako said...

If we want to get technical, over the long run we'd expect the owner to get a "discount". This would occur for pretty well the same reason it is cheaper to own a car than to rent one. The landlord wants to be compensated for vacancies, wear and tear, risk. The owner also receives two other indirect "discounts".

1. The oft mentioned intangibles.
2. Reduced rental risk (his costs are now mostly fixed, whereas a renter's are not.

Basically, when you own you are a landlord renting to yourself.

The data bears all this out, and OVER THE LONG RUN it is indeed cheaper to rent than to own, so there really is no owner's premium (but there is price risk). The problem is that the usual hucksters/spinmeisters misappropriate this data to justify overpaying TODAY. The oppsite argument should be made. The owner's discount is a long run expectation, which to remain true would require prices to GO DOWN from todays levels.

jesse said...

Yes landlords need to make a spread. Interestingly there has been little in the way of large-scale rental complexes built for many years now precisely because there is no spread to be had. Instead it is all capital gains handled by small time landlords.

Perhaps a sign of the bottom is when large scale rental units run by an REIT or similar profit making enterprise are back investing in the market.

alexcanuck said...

Just for the record, Traciatim may be with me, but I am NOT with him/her. Much closer to Patriotz/ mohican et al.