Commentary from a Real Estate Contrarian

A New Year has begun which offers the opportunity for new adventures. One of my adventures for 2024 is to start this blog commenting on various aspects of real estate. After over 40 years of studying, researching, and being an active participant in the industry, I have concluded that there is a disconnect and disparity between those who proclaim to be “experts” relating to the state of real estate and what may actually be occurring on the ground. I have reached this conclusion as I compare what I gather through publications (books, newspapers, articles, news feeds, etc.) with what I have experienced throughout my career which includes a multitude of loan underwriting and site inspection assignments.

This disparity/disconnect seems to result in either proposed or actual public policy that may actually have the opposite effect on real estate markets than that is intended. Many organizations try to influence public policy that have an agenda, which may be well-meaning but does not consider the functionality of real estate markets. For example, a policy advocating price controls on residential rental markets may actually decrease the supply of housing which in turn makes the cost of housing even more expensive.

As of the end of 2023, according to the US Bureau of Economic Analysis, the Gross Domestic Product of the United States stood at $27.4 trillion of which 15% to 20% is directly related to real estate depending on how one counts. In addition to direct spending, there are other quantitative and qualitative factors that influence the real estate supply/demand/pricing matrix. Actually, there is very little within the US economy that does not directly or indirectly impact commercial and/or residential real estate. 

To begin with, real estate, whether it is related to commercial or residential properties, is a commodity and subject to a multitude of factors within the supply/demand/pricing matrix. The influence of any given factor within the matrix may change over time. So, a factor that might have a great influence today, say labor costs, may have less influence on pricing in the future. Thus, the ever-evolving relationship between these numerous factors makes the market very dynamic. In addition, real estate is influenced not only by quantitative but also qualitative factors that cannot be specifically measured and put into a database.

Admittedly I am not an economist but have identified over 20 factors that have an impact on either the Supply or Demand side of the supply/demand matrix. In future blogs, I will comment further on these different factors.

But today I would like to comment on one of the biggest misconceptions that permeates the discussion relating to “affordable” housing; the cost of housing for any given household should not exceed 30% of gross income. This standard is used in analyzing and commenting on housing market “affordability” and is quoted by numerous university real estate related research institutes as well as non-profit housing advocacy organizations. However, one has to wonder if those who write articles about housing within these research institutions or organizations lobbying governmental officials and politicians relating to housing, know where this “standard” comes from and under what conditions it is to be applied. I use “standard” since there is clearly a disconnect between these discussions and the marketplace.

A little history is in order. Let us go back to the late 1960s; a time of grassroots community action around many issues including housing. In 1969, as part of the Housing and Urban Development Act of 1969, Senator Edward Brooke (R-Massachusetts) was able to get Congress to approve an amendment to this legislation that established limitations on the percentage of income a public housing tenant can pay in rent. This amendment, simply now referred to as the Brooke Amendment, established the limitation that tenants living in public housing should not pay more than 25% of their gross income on housing. This legislation established, for the first time, a public policy regarding the relationship between rent and income. 

It is important to note that revenue, up until the Brooke Amendment became effective, generated from tenant rent covered approximately 95% of public housing operating expenses. Due to a combination of decreased revenue relating to the Brooke Amendment and increased operating expenses, rental income covered only 72% of public housing operating expenses. This significant increase in the need for Federal government subsidies led to the Nixon Administration to impose a moratorium on the production of new public housing in January 1973. As a result of this moratorium, alternatives were created in the form of the Section 8 housing program (part of the Housing and Community Development Act of 1974) and the Low-Income Tax Credit program which is part of the Tax Reform Act of 1986. But I digress.

The Housing and Community Development Amendments of 1981 reset the rent-to-income formula that was established in the Brooke Amendment to 30% of adjusted income plus an allowance for utilities for those receiving Federal rent assistance. This adjustment covered tenants in public housing or receiving Section 8 housing vouchers. Adjusted income includes a multitude of exemptions, as defined by HUD, with a primary emphasis on medical expenses, personal expenses based on family size, and the cost of childcare.

The reason behind adding a utility allowance as part of the housing cost formula was that the nature of property management was changing. In the late 1970s, multifamily buildings started to submeter apartment units and charge tenants for utility costs above and beyond what was being charged for rent.

This was the beginning of what is generically referred to as RUBS (Ratio Utility Billing System) in which tenants have a base rent and additional tenant reimbursements to the landlord. Over the past 50 years, property management software has been developed as to separate various line-item expenses and add these expenses as additional charges to be paid by a tenant to the landlord on top of a base rent. Expenses such as pro rata water/sewer costs, trash, pest control, etc. simply have become additional lease fees that a tenant is to pay above and beyond the base rent. But again, I have digressed.

Ever since 1981, the world of public discourse has not only shortened the threshold to simply 30% of gross income but now applies this number to the private sector which makes up 87% of the rental market (households not receiving Section 8 housing vouchers, living in public housing or tax credit apartments).

The problem with this shorthanded version is that this rent-to-income ratio does not match the reality of how private-sector rental housing actually functions. The reality is that when applying for an apartment in a multifamily community, the general rule is to qualify a prospective tenant based on a gross income to base rent ratio starting at 33% and, in some circumstances, as high as 40%. Add the cost of utilities and other tenant reimbursements, the ratio can easily reach a minimum of 35% of gross income. If one used the 30% threshold, then any tenant in today’s market signing a lease would be classified as financially stressed. On the assumption that property managers do not approve applicants in which there is not a reasonable belief that the tenant will make their rent payments, there appears to be a disconnect/disparity between academia/housing advocates who insist on the 30% ratio and what is actually occurring in the marketplace. I therefore wonder how to reconcile published reports that as high as 40% of renting households cannot afford their rent and at the same time read published reports stating the national occupancy rate for multifamily properties stands at 95%.

The whole question of why lease rates are what they are, especially relating to new construction, is a topic for future discussion.