A Housing Thought Experiment

I've been thinking a bit about the idea of housing as an asset class, and I wondered if it was possible to somehow separate the shelter aspect of housing from the financial-asset aspect in order to work out just how much people are really paying for the asset part.

So consider this: you want to buy a house which at the moment costs $1,000 a month to rent. I'm willing to sell it to you, on the proviso that if you ever sell it, or when you die -- which will be many decades hence -- I get to buy it back for $1. In the meantime, it's yours: you can rent it out immediately, if you like, or you can live in it indefinitely, or you can do some kind of home-exchange with someone else if you ever want to move. How much would you be willing to pay for the house?

The answer, I think, is going to be very close to the present value of future rent payments. Now no one knows how much rents will go up over time, and it's not obvious what the right discount rate to use might be, but fiddling around with a present value calculator and assuming rent inflation of about 3% and a discount rate of 5%, it's easy to get a number of about $200,000 if you assume that you'll keep the house for a couple of decades.

At this point it's worth noting that a $200,000 mortgage at a 5% interest rate costs about $1,000 a month. So it should be a no-brainer to buy a house renting out at $1,000 a month for $200,000: that's how much you'd pay if it had no financial-asset value at all. But in fact you're buying an asset which you'll be able to sell for a six-figure sum if and when you ever need to. That's got to be worth something, right, on top of the pure shelter value of $200,000? But how much?

It strikes me that in practice the answer to that question is often zero: there are many markets where it's actually cheaper, on a monthly basis, to buy than it is to rent. That wasn't the case during the housing bubble, but we're moving back to those kind of house prices now.

So could it be that although houses were perceived to have financial value for a few short bubble years, most of the time they don't really have any financial value at all, over and above their shelter value? That when you're buying a house you really are just buying a place to live, and not a financial asset?