Wednesday, January 26, 2011

Housing-Sector Profitability Returns to Previous Levels

Copyright, The New York Times Company

The housing boom further increased our economy’s bias against business capital, but by 2010 housing profitability was back to normal.

Last week I examined a measure of the profitability of housing capital: the value added by houses in the form of shelter and convenience for their occupants during a year, expressed as a fraction of the total value of homes. Before the housing boom, housing added much less value per dollar than business capital did, largely because business taxes restrict the supply of business capital.

The less business capital there is, the higher the rate of return that remaining business capital earns, because each unit of capital serves more customers, as I noted last week. A low profit rate for housing is a symptom of its abundance.

The profitability gap between nonresidential and residential capital shows that our economy was overinvested in housing, long before the housing boom of the early 2000s. Business taxes cause an underinvestment in business capital, and business capital has been so profitable to the economy because it is more scarce.

Value added to the economy would have been greater if some housing investment had been invested in business instead; each $10 billion of housing investment redirected to business investment could have added almost a billion dollars to G.D.P.

The chart below displays the same marginal product measure of residential capital profitability (red line, from the first quarter of 2000 to the third quarter of last year (Luke Threinen, a University of Chicago student, helped with these calculations).

The chart also displays the marginal product of business capital (blue line). Because of the extraordinary “depreciation” from Hurricane Katrina, values for 2005 have been interpolated.

The marginal product of residential capital is measured on the right axis, while the marginal product of nonresidential capital is measured on the left axis. By looking at the 2000-1 values – 6.6 percent for residential and 15.2 percent for nonresidential – we see the result, noted last week, that nonresidential capital was twice as profitable before taxes than residential capital.

After the 2001 recession, and during the housing bubble, the marginal product of residential capital fell sharply. (This finding is related to previous findings that rent-to-price ratios were low during the mid-2000s, because housing profitability is essentially the rent-to-price ratio minus the expense-to-price ratio.) During this period, housing construction was booming.

Housing was not particularly profitable during the housing construction boom – the market appears to have built so many new homes during those years because of an expectation that houses would be profitable in the future, and in part because home buyers were encouraged by easy credit.

As a result, an ever-growing housing inventory was competing for much the same demand for shelter, which kept rents low and made vacancies high.

While housing sector profitability became so low, business sector profitability was quite high. At the peak of the housing boom, the marginal product of nonresidential capital was more than triple the marginal product of residential capital.

By widening the profitability discrepancy between the two sectors, the housing boom was more damaging than it would have been if the boom hadn’t begun with an abundance of housing.

When the housing bubble burst in 2006-7, and housing construction nearly came to a halt, the marginal product of housing began to rise toward previous levels as the population grew into the extra housing, and some existing housing deteriorated. By the fourth quarter of 2009, the marginal product of residential capital hit 6.2 percent and has remained about there since then.

The good news is that the 6.2 percent housing sector profitability of the past is actually a bit higher than the historical average from 1950 to 2000, which means that housing is adding value at a rate similar to the pre-bubble years.

The strongest economic pressures preventing further increases in our housing inventory have been gone for a year now, which is one reason I do not expect the housing market to get any worse.

Business capital profitability has also returned to previous levels, but the bad news is that housing capital remains much less profitable than business capital. In this sense, housing is still too abundant, an economic waste that shows no signs of repairing itself.

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