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Landmark Links May 17th – Not Going Anywhere

 

Last week we took a look at the impact of Prop 13 on new development when home prices stagnate or fall.  Today, I want to take a closer look at in issue in high-priced coastal markets that’s somewhat related to Prop 13: why home owners in high-priced California markets are renovating rather than moving when they outgrow their home.

In a markets like those found along the coast in California that have highly restricted zoning and astronomical land and home prices, Prop 13 provides a huge incentive for home owners to stay put for long periods of time rather than move.  The reason is that they can’t take their tax basis with them after a sale (aside for a provision that allows older homeowners a one time basis transfer).  This leads to the bizarre scenario where a home could have an assessed value of less than $100k and a market value of several million dollars while an identical house next door is worth $2.5MM  or more and has an assessed value of $2.5MM.  The LA Times did a feature article on this phenomenon back in 2003 focusing on  Lido Isle in Newport Beach:

…that’s a long way to come for a place once so undesirable that owners held a “disposal sale” in 1932 to sell lots as cheaply as $550. By 1935, most of the 800-plus lots remained unsold. Agnes Blomquist, who contributed to the book “Newport Beach: The First Century,” wrote that she looked at the acres of salt grass and weeds and said, “Why do you want to come to this God-forsaken spot?”

But over time, Lido evolved — first as a vacation spot for Angelenos and inlanders looking for a weekend escape, and later, in the 1970s, to a residential community where people settled year-round. It is also a place people do not leave: one-third of Lido Isle’s residents have lived there for more than 20 years.

In recent years, compared to the rest of Newport Beach, I think Lido Isle has been undervalued,” said real estate agent Alison McCormick, a third-generation Lido resident.

“But in the last two years, people go, ‘My gosh — beaches, a yacht club, playgrounds. You’ve got docks, tennis courts.’ It’s like a year-round vacation, really. It’s become quite popular.”

The median sale price is about $1 million, according to the 2000 U.S. Census, with an accompanying property-tax bill of about $10,000. Homes on the water sell for significantly more.

I know this sounds absurd to the majority of Americans but the median sales price in that previous quote seems downright cheap by 2016 standards – the least expensive home listed on Lido today is asking $1.8MM and the median sale price on the island over the past two years was just under $2.5MM.  Imagine you live in a home and have a basis of $500,000 that’s worth $2.5MM today but have outgrown it and need a larger place (to be clear, having that type of equity in a home is a good “problem” to have).  If you move anywhere near where you currently live, your taxes are going to go up.  A lot.  So what do you do?  Stay put and renovate so you only get reassessed on the increase in value to the structure. According to the Wall Street Journal, that’s exactly what Californians are doing:

California may be a capital of cosmetic surgery, but it’s not just noses and eyelids falling under the knife. A hot housing market is driving buyers to pay exorbitant sums for old, frumpy houses, knowing they’ll pay plenty more to remake them to modern tastes. Others currently own dowdy houses and choose to renovate rather than relocate.

While the dynamic is playing out in a number of U.S. cities, California’s plight is particularly intense because of Proposition 13, a 1978 amendment to the state constitution. It set property taxes based on 1975 assessments and capped future property-tax increases at 2% a year. The catch: When a home in California is sold, the property is reassessed based on its current sale price, resulting in a large tax increase for the new buyer. To avoid this tax hit, many homeowners simply stay put rather than move, which further suppresses the inventory of home listings and keeps prices high.

“Prop. 13 has a strong tendency to keep people in homes longer than they otherwise would be,” said Paul Habibi, a professor of real estate at the Ziman Center for Real Estate the University of California, Los Angeles. “If the market is rising faster than the assessed values, you have all the economic incentive to stay in place,” Mr. Habibi said.
A study released in 2005 by the National Bureau of Economic Research, a Cambridge, Mass.-based think tank, found that in California, on average, homeowners stay put for 1.4 years longer than in other states due to Proposition 13. In coastal cities, the “lock-in effect,” as the study called it, is even higher. Homeowners in Los Angeles stay put over two years longer, and San Francisco homeowners keep their homes over three years longer than homeowners in other states.

In addition to Prop 13, there is another tax provision that is fueling this as well: the IRS home sale exemption that allows a seller to pay no tax on a gain up to $500k (assuming a married couple filing jointly) so long as they have lived in the house (rentals don’t count) for at least two years.  $500k is a very large amount of money and around double the median national home price. However, in coastal California cities where zoning is highly restrictive, it’s not unusual to see appreciation exceed that amount by a substantial amount over a long enough time, leading to a huge affordability problem when you run out of space to develop and can’t get entitlements to add density.

Let’s take the a hypothetical Lido Isle resident from the example in the beginning of the post.  Assume that a family bought a house on Lido back in 2003 for the median sale price of $1MM in that year, put 20% down got a 30 year mortgage at 4% (I’m trying to keep things simple so I’m using today’s rate).  Now lets assume that they need more space and have a decision to make: move to a larger house in the same neighborhood or renovate and expand their existing house.  Assume that their sales value is today’s median price of $2.5MM and a larger house in a similar neighborhood costs $3.5MM (again, I know the values are obscene but that has been the reality on the coast out here for quite a while).  If they sell the house, their tax basis will increase from just under $1.3MM (it’s been inflating at a capped rate of 2% per year despite the property value increasing much more) to $3.5MM.  On top of that you have a capital gain of $1.5MM, $1MM of which is subject to capital gains subject to a 20% Federal tax and 13.3% state tax (assuming the highest brackets).  That means our hypothetical family is left with a net gain of $1,167,000 after they pay $333,000 in capital gains taxes.  In addition, the loan has amortized down to $545k so they gets an additional $455k back after the sale for a total of $1,622,000.  If they put that entire amount into the new house as a down-payment, they now need to take out a loan of just under $1.9MM.

Now lets look at what happens if that same family on Lido were to decide to renovate and add on to their home instead of moving.  Assume that they re-finance in order to fund a $500k renovation.  Assuming that they didn’t take any cash out, their mortgage balance is now around $545k.  If they do a cash out refinance to get the $500k, the loan balance would increase to to $1,045,000.  The tax basis would increase to around $1.8MM since you only get re-assessed on the new improvements when you renovate in CA.  The exiting improvements and the land do not get re-assessed.

I put together a quick table to illustrate the impact of moving versus renovating.  We’ll assume that the locations are nearly identical and that the structures are similar post-renovation as well meaning that the market values of both properties are the same as are the replacement costs for purposes of insurance.  I also assumed that the $500k renovation budget is enough to cover temporary shelter for the owner while the renovation/addition is taking place:

  Renovate Move Difference
Market Value $3,500,000 $3,500,000 $0
Tax Basis 1,800,000 3,500,000 1,700,000
New Loan Amount 1,045,000 1,900,000 855,000
       
Annual Payment (P+I) 60,000 108,000 48,000
Annual RE Tax @ 1.1% 19,800 38,500 18,700
Annual Insurance 2,100 2,100 0
TOTAL ANNUAL PAYMENT $81,900 $148,600 $66,700

The end result is that the family that renovates rather than moving to a larger home in the same neighborhood saves a whopping $66,700 a year under this scenario.  A quick disclaimer: I am NOT IN ANY WAY advocating a lifting of the $500k exemption cap.  I’m sure someone who sells a home and has a $1.5MM profit will be just fine.  My intent is to point out the reality that there are huge incentives in place to stay put in high-priced closed access California coastal markets unless you have such a large disposable income or net worth that cost is irrelevant, in which case I hope you enjoy your new beachfront home.  I picked Newport Beach as an example because it’s one of the more egregious examples in terms of median home prices.  However, the same thing is happening up and down the state in coastal cities with somewhat lower price tags.

If this seems like a recipe for massive home price inflation in coastal markets, you are correct.  Extremely high barriers to entry through zoning lit the match that started this fire once available land was used up and development restrictions made it impossible to add much density.  Prop 13 then threw fuel on the fire by giving existing owners a massive incentive to stay put.  The final douse of jet fuel came when high priced markets reached a price point where it became commonplace to have gains that exceeded the Federal capital gains exemption.  The result is that fewer people move and fewer houses become available which drives prices up more.

There was a time that coastal cities in California had entry level housing stock.  People bought homes and live in them until they outgrew them.  Then they would buy a larger, often newer home in a nearby neighborhood.  Today, those starter homes are getting knocked down or renovated by their owners since there are huge incentives to stay put.  When an older home does sell, it is often bought up by buyers who rebuild or renovate or developers do the same to sell at a much higher price.  The end result is that the older, entry level housing stock near the coast is long gone and we are now stuck relying on new housing construction in inland locations which are nearly impossible to build at an affordable level because impact fees and direct expenses have gone through the roof relative to home prices.  As I said last week, large sweeping statutes like Prop 13 have consequences that continue to manifest themselves decades after they are passed.  In this case, it’s a dearth of entry level housing in coastal markets.

Economy

Size Matters: New economy businesses from Chipotle to fintech start ups to Uber are fighting the reality that their business models are incredibly difficult to scale.

That Didn’t Take Long: Declining oil production from attacks in Nigeria to fires in Canada have quickly turned an output surplus into a deficit.  But See: Hedging in the oil futures market indicate that drillers think that the 3-month rally in oil is nearing an end.

Commercial

Concentration Issue: 75% of all apartments constructed in 2015 were high end,  luxury construction, a new high.  A lack of supply at the low end doesn’t appear to be getting better anytime soon.

Rent Cafe High-End Rentals Year by Year Chart

Residential

Selfish: Modern-day NIMBYs like to think of themselves as the heroic reincarnation of activists like Jane Jacobs, who organized opposition in the 1950s to the government ruining Greenwhich Village in Manhattan by building an expressway down the middle of it.  Instead, they are typically self-interested busy-bodies doing anything possible to keep their views intact, drive up prices and keep newcomers out at all costs.

Profiles 

Anti-Social: Late last week a story came out about former Facebook employees admitting to suppressing conservative news topics.  In reality, that’s just the tip of the iceberg.  More and more people rely on social media feeds for news.  The problem is that the goal of social media is to generate views as opposed to showing you accurate information.  This means keeping you engaged by showing you topics that are of interest to you, regardless of how realistic they are.  Fast Company published a feature this weekend that outlined the issue well:

First it is important to understand the technology that drives the system. Most algorithms work simply: Web companies try to tailor their content (which includes news and search results) to match the tastes and interests of readers. However as online organizer and author Eli Pariser says in the TED Talk where the idea of the filter bubble became popularized: “There’s a dangerous unintended consequence. We get trapped in a ‘filter bubble’ and don’t get exposed to information that could challenge or broaden our worldview.”

Facebook’s news feed and personalized search delivers results that are tailored just to us because a social network’s business is to keep us interested and happy. Feeling good drives engagement and more time spent on a site, and that keeps a user targetable with advertisements for longer. Pariser argues that this nearly invisible editing of the Internet limits what we see—and that it will “ultimately prove to be bad for us and bad for democracy.”

The article continues:

Once a user joins a single group on Facebook, the social network will suggest dozens of others on that topic, as well as groups focused on tangential topics that people with similar profiles also joined. That is smart business. However, with unchecked content, it means that once people join a single conspiracy-minded group, they are algorithmically routed to a plethora of others. Join an anti-vaccine group, and your suggestions will include anti-GMO, chemtrail watch, flat Earther (yes, really), and “curing cancer naturally” groups. Rather than pulling a user out of the rabbit hole, the recommendation engine pushes them further in. We are long past merely partisan filter bubbles and well into the realm of siloed communities that experience their own reality and operate with their own facts.

So, there you have it.  Facebook’s algorithm is creating a bunch of conspiracy kooks and it’s probably only going to get worse.  Time to build a bunker, stock up on canned food and break out the tinfoil hats.

Chart of the Day

The most hysterical chart you’ll ever see and it’s 100% real.


WTF

Sieg Fail: A Scottish man is facing hate crime charges stemming from a widely circulated video showing his pug doing a Nazi salute.

Unprotected: STDs are on the rise and pretty much everyone is blaming Tinder and it’s imitators.

Going too Far: France recently passed a law that would allow grow-up children to sue their parents for posting embarrassing pictures of them on social media when they were younger, potentially resulting in hefty fines or imprisonment.  In related news, thank God I don’t live in France.

Landmark Links – A candid look at the economy, real estate, and other things sometimes related.

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