Wednesday, January 19, 2011

Housing Sector Profitability

Copyright, The New York Times Company

Long before the housing boom, overbuilding effects of government policy were evident.

A house is a piece of capital, meaning that it produces value over a number of years. In the case of housing capital, the value is in the form of shelter and the convenience of a home.

As with any piece of capital, a home’s profitability (its marginal product, as economists call it) can be calculated as the dollar value it creates during a year – after subtracting depreciation, costs of labor, maintenance, and intermediate goods – per dollar invested.

Owners of capital prefer their capital to be more profitable, rather than less. It’s the profitability of capital (after taxes and subsidies – more on those below) that makes an owner willing to purchase capital in the first place.

For a home that is rented or vacant, the home profitability calculation is straightforward: take the landlord’s rental income for the year, subtract depreciation, costs of maintenance and labor expenses (if any) for the same year and divide by the amount the home is worth.

A home occupied by its owner does not have rental income per se – the homeowner does not pay himself rent – but a hypothetical rental income can be imputed to owner-occupied homes by looking at the rental incomes earned by comparable homes that are on the rental market.

The Bureau of Economic Analysis makes rent imputations part of its preparation of gross domestic product and other items in the national economic accounts and reports a total value created during the year by all homes. It also estimates an aggregate home value (more precisely, it estimates what it would cost to replace each home with one just like it). The table below shows its results for the year 2000.

The first row of the table reports that the homes, condos and mobile homes in the United States in the year 2000 provided $1.01 trillion of housing services — that is, the value of the housing in rent or imputed rent — in the year 2000 (next week I’ll examine the years 2000 to 2010 more closely). A total of $160 billion of intermediate goods and services — mainly closing costs and brokers’ fees — were used, and the normal rate of depreciation of homes amounted to a cost of $162 billion.

The housing sector employed some people, such as apartment managers, with a payroll that amounted to $11 billion. But the Bureau of Economic Analysis does not try to measure the value of time of people who maintain their own homes, and for this reason the housing sector’s labor costs are significantly understated. With this caveat, the operating surplus of the housing sector was $677 billion.

The housing stock in the year 2000 was worth $10.63 trillion, so the housing sector’s operating surplus amounted to 6.4 percent of the value of its housing capital. (This surplus was divided among owners and mortgage lenders, but today I focus on the overall profitability of capital without regard to how it is shared).

Luke Threinen, a University of Chicago student, and I used these ingredients, and some minor adjustments for inflation during the year, to calculate housing profitability rates for 80 years. The chart below displays our results for the years 1950 to 2000.

The profitability of housing fluctuated between 4 and 7 percent, averaging 5.7 percent over the decades shown in the chart. The 5.7 percent may seem large, because few of us earn that much on our savings accounts.

Part of the explanation is that most homes owe property tax, and the chart shows pretax profitability (another part of the explanation is that savings accounts are generally low-return investments).

More notable is the comparison of housing’s 5.7 percent profitability to the profitability of business capital. Mr. Threinen and I made analogous calculations for the nonresidential sector – annual business revenue minus variable (nontax) costs expressed as a percentage of the amount of business capital – and found business capital to have a profit rate of 15.3 percent.

We concluded that 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 capital has been so profitable to the economy because it is more scarce. It’s the law of demand: 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. A low profit rate for housing is a symptom of its abundance.

With each dollar of business capital adding 15.3 cents of value per year and each dollar of housing capital adding only 5.7 cents, total value added in the economy would have been greater if some of the housing investment had been business investment instead, even before the housing boom. Each $10 billion of housing investment that could have been redirected to business investment have added almost a billion dollars to G.D.P.

Business capital has been more scarce largely because of business taxes and housing subsidies. Houses are not tax-free — I mentioned the property tax — but, in addition to property taxes, investors in businesses also owe sales taxes, corporate income taxes and personal income taxes.

The business-residential profitability gap is almost 10 percent, but our attempts to adjust both profit rates for applicable taxes show that the after-tax profitability gap is zero to five percentage points.

I mentioned last week how, in the short run, capital income taxes result in lower after-tax returns for the owners of the capital being taxed. In the long run, the opposite occurs: investors have choices about where and how to invest, so the after-tax profitability of housing has to be pretty close to the after-tax profitability of business.

Business taxes cause an underinvestment in business capital – scarcity is the only way business capital can earn an after-tax return that compares with the return on lesser-taxed housing – and overinvestment in housing.


Steve Roth said...

Figure in the housing sector's uncounted labor costs, and the gap is even bigger than 10%. (Home-work really doesn't pay).

Here's what I find odd, though:

You mention taxes and subsidies, but only discuss business taxes as causing the gap.

Without going to look it up, I have to assume that housing subsidies -- the mortgage-interest deduction, implicit and explicit subsidies to lenders, and lender-favorable monetary policy (all minus property taxes) -- utterly dwarf business tax revenues. Am I right? What were your findings?

If I am right, I would think that those housing subsidies would also utterly dwarf business taxes as the presumed cause of the gap. I find it quite odd that you don't discuss that.

Steve Roth said...

And while I'm thinking about it: how do you explain the fact that Norway has more entrepreneurs per capita than the U.S., given their onerous, crushing tax burdens -- business and personal?

Maybe the effect of business taxes is not as profound as you assume?