Housing Profitability During the Bubble

One of the reasons for the housing bubble's inflation was the relative attractiveness of real estate at a time when borrowing costs were very low. Due to all of the government support for residential real estate, the investment's relative profitability was comparable to business investment. A post here last week explained how these policies helped to create overinvestment in housing, based on an Economix post by University of Chicago economist Casey Mulligan. His analysis stopped at the year 2000, however, which left some readers wanting more. He followed up this week with the rest of the data, and it shows what you would think: housing profitability continued to decline as the bubble inflated, while business investment alternatives should have been viewed as even more profitable.

As a quick refresher to last week's post, here's the chart that Mulligan relies on to show the profitability of housing capital:

housing capital mulligan.jpg

In 2000, it was 6.4%, which is right around where it stood since 1990. Meanwhile, the return on a business capital investment over this period was much higher, averaging out to 15.3%, according to Mulligan. That value would barely show up on the chart above unless the bounds of the its vertical axis were twice as great.

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Mulligan explained that the market should prefer a more profitable investment when one becomes oversaturated, as its relative return would decline. So why did people invest so much in housing instead of business? When Mulligan took taxes into account, including both rates and incentives, he determined the profitability gap shrinks from almost 10% to between zero and 5%. This shows that government policy is at least partially responsible for housing's relative attractiveness as an investment and crowds out business investment.

Now we can look at how the picture changes from 2000 onward. Here's a chart he provides this week:

residential business capital after 2000 mulligan.jpg

This chart is constructed to show the inverse relationship between the changing marginal product of capital for residential and business (nonresidential) investment. You can see pretty clearly that they moved in opposite directions. That makes sense, because when investment dollars flow into one of these sources, they leave the other.

But you have to look at this chart carefully to understand it. The values of each curve are found on separate vertical axes. The right vertical axis provides the values for the red, residential investment line. If you were to connect that to the first chart above, you see that it dips all the way down to around 5% in 2006, only to rise again as investors began to flee residential real estate when the bubble popped.

The way this second chart was constructed actually does a disservice to the huge disparity between residential and business capital, since it utilizes two axes. Although it shows the inverse relationship quite clearly, it doesn't accentuate the big variances in the profitability of residential and business capital. If these lines were on a chart with just one vertical axis, you would have a space of about 5% from the lowest point on the business line to the highest point on the residential line. The two curves wouldn't come close to crossing. In other words, it would then demonstrate how much more investors stood to make off business capital compared to housing capital.

As Mulligan's analysis prior to 2000 showed, throughout the last decade, housing capital continued to look like a far more attractive investment than business capital due to tax structure differences. In fact, housing should have appeared a far less attractive investment -- particularly when the boom was at a climax. There appeared to be an incredible 11.5% spread between the profitability of the two investment alternatives in late 2006.

But taxes for business and housing didn't change that much last decade. Their disparity just served as an essential initial condition, along with very cheap borrowing costs, that provided a perfect environment for a housing bubble to grow. In the early 2000s, dollars began leaving business investment and heading for housing. Perhaps this was because the stock market bubble popped, so Americans sought something safer -- and what's safer than real estate? Or so they thought.

As real estate began appreciating at unsustainable rates, people naively believed that there must be a paradigm shift in how housing values rise. They continued to think home prices wouldn't decline. So again, investment kept flowing into the sector. The stars were aligned: its tax advantage made it competitive with business investment's profitability, interest rates were very low, rates of return were skyrocketing as irrational exuberance gripped investors, and risk of loss was seen as impossible.

There's your recipe for disaster. If any of these factors hadn't been present or had changed, the housing bubble would have been much smaller or may not have been existed at all.