Economists Do It With Models

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When Economists Who Do It With Models Do It With Real Estate…

January 12th, 2011 · 13 Comments
Buyer Beware · Fun With Math

Fact: NYU professor Nouriel Roubini correctly predicted the housing crisis. From Wikipedia:

In 2008, Fortune magazine wrote, “In 2005 Roubini said home prices were riding a speculative wave that would soon sink the economy. Back then the professor was called a Cassandra. Now he’s a sage”.[1] The New York Times notes that he foresaw “homeowners defaulting on mortgages, trillions of dollars of mortgage-backed securities unraveling worldwide and the global financial system shuddering to a halt”.[2] In September 2006, he warned a skeptical IMF that “the United States was likely to face a once-in-a-lifetime housing bust, an oil shock, sharply declining consumer confidence, and, ultimately, a deep recession”. Nobel laureate Paul Krugman adds that his once “seemingly outlandish” predictions have been matched “or even exceeded by reality.”[3]

(Rumored) Fact: Nouriel Roubini does it with models. Some photographic evidence, via Gawker:

Fact: Nouriel Roubini was trying to sell his NYC apartment and is now trying to rent it. The details:

He put it on the market in October for $1.89 million, according to The Real Deal, only to quickly drop the price to $1.79 million before taking it off the market altogether (he bought it in 2002 for $860,000). Now he’s just trying to rent it out for $7,600.

(I strategically left out the part of the article about the vulvas on the walls. You’re welcome.) Here’s the thing: Roubini made a career out of warning that the housing market was in bubble territory and would eventually burst. A speculative bubble, by definition, is a situation where asset prices get out of line with intrinsic values. In the housing market, people were overpaying for houses because they were convinced not that the houses were awesome and actually wanted to live in them but instead that they would be worth more tomorrow. How can we tell that people were overpaying? One way is to compare sale prices with rents. Unless you are banking on property value appreciation (which we now know is risky), one shouldn’t be willing to pay more in interest on a mortgage (counting tax deductions) than they would in rent for the same property. (Yes yes, there are advantages to home ownership such as being able to paint the walls and have pets and whatnot, but there are also risks of repair costs and the like, so let’s just say for now that those two are roughly a wash.)

The situation gets interesting when we consider that the same principle holds for someone who owns a property and is considering whether to sell. Even if the owner doesn’t have a mortgage and the place is paid off in full, there is an opportunity cost in having money that could be earning interest elsewhere tied up in the property. The rent that the owner gets on the place should, if one is not counting on property value appreciation, be enough to cover that opportunity cost, property taxes, depreciation due to use, etc. In this case, Roubini is asking for $7,600 a month in rent, or $91,200 per year. (Good lord.) This page tells me that the relevant property tax rate is 12.596% on 45% of the market value of the property, whatever that means. (In case you’re curious, this is the building that the apartment is in, which appears to confirm to the Class 2 real estate definition.) It’s unclear exactly how market value is determined, but there are maximum increase rules in place similar to rent control laws, so it stands to reason that the “market value” for tax purposes is much less than the actual market value. This calculator gives me an amount of about $6,000 per year if I plug in the 2002 sale price of $860,000. That’s a very conservative figure (i.e. the actual amount is likely much higher), but let’s go with that for now. After he pays the property tax, Roubini has about $85,200 left over in rental income.

Now this is a condo building we’re talking about here, so there is a monthly maintenance fee that Roubini has to pay on behalf of his tenants. I don’t live in New York City, and my place will not sell anytime in the foreseeable future for anywhere near $1.79 million, and my condo fee is somewhere in the neighborhood of $400 per month, so that seems like a reasonable starting point for a lower bound. (Before you get all outraged, consider that heat is included in the condo fee and I live in New England.) Also, if you go here and click on “Floorplans & Availability,” you will see some condo fees for a reasonably comparable building. Based on this, $1000 per month seems like a pretty conservative condo fee estimate for this property. This would leave Roubini with $73,200 per year minus whatever he has to pay in order to get repairs done for his tenants in income.

Historically speaking, stock market returns are somewhere in the neighborhood of 10% per year. Therefore, on average, Roubini could theoretically sell his place for $732,000, put the money in the stock market, and get the same $73,200 per year out of it without the hassle of being a landlord. Now, you may want to argue that the stock market is risky and no one is guaranteed to see that 10 percent- you might see 0 percent, and you might even lose money. This is certainly true, but it’s also possible that Roubini has trouble finding tenants, that things in the apartment that are expensive to fix break more often than he had anticipated, that, oh I don’t know, the value of the property could decline (isn’t that, like, sort of his thing?), etc. I’m not entirely sure how to compare these risks, but I am sure that neither the stock market nor the real estate market is anything even approaching a risk-free investment.

If Roubini is announcing that his property is worth $1.79 million (and isn’t willing to sell for significantly less) but is willing to rent it for $7,600 per month, he is effectively saying that he is only requiring a 4 percent income stream from his asset, based on the estimates above. Things aren’t quite that simple once taxes are taken into account- Roubini will have to pay a 15% capital gains tax on all but the first $250,000 of profit from the sale, which would make the $1.79 million price tag turn into $1.688 million in his pocket. (Poor thing.) Even then, however, a 10 percent a year return on an investment of $1.688 million is still well over what he is asking for in rental income. There are other tax considerations that could be taken into account, but it’s very unlikely that renting out the property for $7,600 per month is going to show anything near the 10 percent average return that the stock market gets.

This only leaves one question- is Roubini optimistic about the housing market or pessimistic about the stock market? 🙂

Tags: Buyer Beware · Fun With Math

13 responses so far ↓

  • 1 Andrew // Jan 12, 2011 at 6:43 pm

    I’m thinking he’s pessimistic on the stock market.

    Another aspect to consider… If he paid cash for the property, he has foregone the ‘opportunity cost’ of investing that money in some other way for 9 years. If he put 10% down, that isn’t a lot, but it has been 9 years. Perhaps $70K?

    If he has a mortgage, assuming he still owes about $500,000 from the original purchase, he would only be able to invest about $1.2M after selling, which makes the rental income look better than in your example — though he would still have a mortgage payment to make and receiving a tax deduction (where are the accountants when we need them!)

    Another terrific post, econgirl.

    Andrew

  • 2 Tristan T. // Jan 12, 2011 at 8:00 pm

    I agree. He’s probably more pessimistic about the stock market.

    Yowza! That some serious cash. Now I don’t feel so bad buying his book used. 😉

  • 3 Dan L // Jan 13, 2011 at 10:41 am

    The analysis is necessarily shaky since you have to estimate a lot of figures, but I’m with Andrew regarding the mortgage. Presumably he has a fat mortgage on that property, which changes the analysis quite a bit.

    And, are prostitutes the same thing as models?

  • 4 Twitter Trackbacks for When Economists Who Do It With Models Do It With Real Estate… [economistsdoitwithmodels.com] on Topsy.com // Jan 13, 2011 at 9:27 pm

    […] When Economists Who Do It With Models Do It With Real Estate…  economistsdoitwithmodels.com – view page – cached + I got an email from Steve Landsburg with the subject line “krugman, me and you.” I can’t decide whether that counts as the sort of threesome I’ve always dreamt about… […]

  • 5 Sixth Street Bars // Jan 14, 2011 at 10:48 am

    I guess I’ll be the only one to comment on the “models”… I like the brunette on the left. 🙂

  • 6 BradyDale // Jan 14, 2011 at 12:24 pm

    Things I like about this post:

    1) the photo

    2) that you are coldly dismissing the idea that owning a home is anything but a financial decision. Yes, yes, yes.

    I have a house. Super cheap house in Philadelphia. Still stresses me out. I may some lose some money when I sell because I bought in the bubble, but the thing was so cheap I can’t lose a lot.

    Anyway… it still stresses me out. It’s still an obligation.

    Painting the freaking walls is not worth it. God.

    I’ve been listening to CRISIS ECONOMICS lately on my iPod. It’s interesting to see this true life story of Roubini in these markets.

  • 7 BradyDale // Jan 14, 2011 at 12:25 pm

    P.S. One nice thing about rent, tho, is you get it in cash. You can spend it right there without the hassle of selling off some stalk and stressing about selling off the stalk. And getting fees for selling.

    On $7600/month in cash, you could move down to Philadelphia and write books all day living the life in a sweet Center City apartment and just chillax.

  • 8 econgirl // Jan 14, 2011 at 1:10 pm

    @ Tristan: That’s not even taking into account the fact that his new place set him back over $5 million.

    @ Dan: I was very careful to estimate in a way that the rental income would favorable compared to the sale income, and it still doesn’t match up. Also, whether or not he has a mortgage on the property is (perhaps counterintuitively) mainly irrelevant, since all it does is turn an implicit opportunity cost (foregone investment income) into an explicit cost (interest paid). This is especially true since he is no longer living in the property and thus not getting the mortgage interest deduction on this place. By my calculations, the $7600 per month would almost exactly cover a mortgage for the original purchase price and expenses, so he’s likely not paying anything out of pocket to keep the place, but that doesn’t mean that the true cost is zero.

    @ BradyDale: Yes yes, home ownership is the American Dream. Gag me. On that note, I will point out that Mark Zuckerberg rents:
    http://perezhilton.com/2011-01-14-mark-zuckerberg-rents-a-new-home

    I will acknowledge that you have a point in your second comment- the fixed income nature of the rent means that a bond is potentially more comparable than a stock. That said, historical bond rates, even for AAA rated companies (which I would argue even given recent events are safer than real estate) are higher than the 4 or so percent Roubini is getting on the property:
    http://www.freeby50.com/2008/08/historical-rates-for-corporate-aaa.html

  • 9 Dan L // Jan 15, 2011 at 12:10 am

    I did understand that you were using very figures for favoring renting it out. I might have read this post kind of fast, but I thought you were assuming that he could make 10% interest on the cash from sale. But if the cash is being used to pay down a mortgage, the interest rate is going to be whatever the mortgage rate is, say 5% or so. (In any case, it doesn’t seem right to use 10% interest rate anyway because of risk premium.)

  • 10 steve // Jan 19, 2011 at 1:03 am

    you don’t need to consider a mortgage if you are considering opportunity cost. If you do consider a mortgage, then the risk premium on the deposit goes way up well above 10%, such that it actually doesn’t make any difference. the original article is quite on to it and makes a good simple description of how ridiculous property prices have been and still are.

  • 11 Paul // Feb 2, 2011 at 4:55 pm

    “I’m not entirely sure how to compare these risks, but I am sure that neither the stock market nor the real estate market is anything even approaching a risk-free investment.”

    This was the kind of comment I was waiting for while reading this post. You made a lot of calculations that I don’t want to try and argue with. Yet, to make a comparison of these two investments on an opportunity cost basis they would need to be of equal risk (I think). Just because they are both not risk-free shouldn’t mean you can compare them in this way. If they are not of comparable risk it seems very ambiguous which is the better investment and what his thoughts are on the housing market vs. the stock market.

  • 12 Kyle Pate // Feb 16, 2011 at 11:16 pm

    Wow! I find it interesting how you collected all this information… like how did you decide on a Nouriel Roubini expose? BTW, you have earned yourself a link on my site.

  • 13 econgirl // Feb 16, 2011 at 11:35 pm

    I don’t have a good answer for you on that one- I read a lot, and eventually I come upon several things that I can put together. How I decide what to write about mainly depends on my mood, and a lot of times I will start writing and get bored/frustrated and leave something as a draft.

    Thanks for the link. 🙂

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