Mar7 JDN 2459281

A few years back I asked the question: “What is gentrification?”

The term evokes the notion of a gentry—a landed upper class who hoards wealth and keeps the rest of the population in penury and de facto servitude. Yet the usual meaning of the term really just seems to mean “rich people buying houses in poor areas”. Where did we get the idea that rich people buying houses in poor areas constitutes the formation of a landed gentry?

In that previous post I argued that the concept of “gentrification” as usually applied is not a useful one, and we should instead be focusing directly on the issues of poverty and housing affordability. I still think that’s right.

But it occurs to me that there is something “gentrification” could be used to mean, that would actually capture some of the original intended meaning. It doesn’t seem to be used this way often, but unlike the usual meaning, this one actually has some genuine connection with the original concept of a gentry.

Here goes: Gentrification is the purchasing of housing for the purpose of renting it out.

Why this definition in particular? Well, it actually does have an effect similar in direction (though hardly in magnitude) to the formation of a landed gentry: It concentrates land ownership and makes people into tenants instead of homeowners. It converts what should have been a one-time transfer of wealth from one owner to another into a permanent passive income stream that typically involves the poor indefinitely paying to the rich.

Because houses aren’t very fungible, the housing market is one of monopolistic competition: Each house is its own unique commodity, only partially substitutable with others, and this gives market power to the owners of houses. When it’s a permanent sale, that market power will be reflected in the price, but it will also effectively transfer to the new owner. When it’s a rental, that market power remains firmly in the hands of the landlord. The more a landlord owns, the more market power they can amass: A large landholding corporation like the Irvine Company can amass an enormous amount of market power, effectively monopolizing an entire city. (Now that feels like a landed gentry! Bend the knee before the great and noble House Irvine.)

Compare this to two other activities that are often called “gentrification”: Rich people buying houses in poor areas for the purpose of living in them, and developers building apartment buildings and renting them out.

When rich people buy houses for the purpose of living in them, they are not concentrating land ownership. They aren’t generating a passive income stream. They are simply doing the same thing that other people do—buying houses to live in them—but they have more money with which to do so. This is utterly unproblematic, and I think people need to stop complaining about it. There is absolutely nothing wrong with buying a house because you want to live in it, and if it’s a really expensive house—like Jeff Bezos’ $165 million mansion—then the problem isn’t rich people buying houses, it’s the massive concentration of wealth that made anyone that rich in the first place. No one should be made to feel guilty for spending their own money on their own house. Every time “gentrification” is used to describe this process, it just makes it seem like “gentrification” is nothing to worry about—or maybe even something to celebrate.

What about developers who build apartments to rent them out? Aren’t they setting up a passive income stream from the poor to the rich? Don’t they have monopolistic market power? Yes, that’s all true. But they’re also doing something else that buying houses in order to rent them doesn’t: They are increasing the supply of housing.

What are the two most important factors determining the price of housing? The same two factors as anything else: Supply and demand. If prices are too high, the best way to fix that is to increase supply. Developers do that.

Conversely, buying up a house in order to rent it is actually reducing the supply of housing—or at least the supply of permanent owner-occupied housing. Whereas developers buy land that has less housing and build more housing on it, gentrifiers (as I’m defining them) buy housing that already exists and rent it out to others.

Indeed, it’s really not clear to me that rent is a thing that needs to exist. Obviously people need housing. And it certainly makes sense to have things like hotels for very short-term stays and dorms for students who are living in an area for a fixed number of years.

But it’s not clear to me that we really needed to have a system where people would own other people’s houses and charge them for the privilege of living in them. I think the best argument for it is a libertarian one: If people want to do that, why not let them?

Yet I think the downsides of renting are clear enough: People get evicted and displaced, and in many cases landlords consistently fail to provide the additional services that they are supposed to provide. (I wasn’t able to quickly find good statistics on how common it is for landlords to evade their responsibilities like this, but anecdotal evidence would suggest that it’s not uncommon.)

The clearest upside is that security deposits are generally cheaper than down payments, so it’s generally easier to rent a home than to buy one. But why does this have to be the case? Indeed, why do banks insist on such large down payments in the first place? It seems to be only social norms that set the rate of down payments; I’m not aware of any actual economic arguments for why a particular percentage of the home’s value needs to be paid in cash up front. It’s commonly thought that large down payments somehow reduce the risk of defaulting on a mortgage; but I’m not aware of much actual evidence of this. Here’s a theoretical model saying that down payments should matter, but it’s purely theoretical. Here’s an empirical paper showing that lower down payments are associated with higher interest rates—but it may be the higher interest rates that account for the higher defaults, not the lower down payments. There is also a selection bias, where buyers with worse credit get worse loan terms (which can be a self-fulfilling prophecy).

The best empirical work I could find on the subject was a HUD study suggesting that yes, lower down payments are associated with higher default risk—but their effect is much smaller than lots of other things. In particular, one percentage point of down payment was equivalent to about 5 points of credit score. So someone with a credit score of 750 and a down payment of 0% is no more likely to default than someone with a credit score of 650 and a down payment of 20%. Or, to use an example they specifically state in the paper: “For example, to have the same probability of default as a prime loan, a B or C [subprime] loan needs to have a CLTV [combined loan-to-value ratio] that is 11.9 percentage points lower than the CLTV of an otherwise identical prime loan.” A combined loan-to-value ratio 12 percentage points lower is essentially the same thing as a down payment that is 12 percentage points larger—and 12% of the median US home price of $300,000 is $36,000, not an amount of money most middle-class families can easily come up with.

I also found a quasi-experimental study showing that support from nonprofit housing organizations was much more effective at reducing default rates than higher down payments. So even if larger down payments do reduce defaults, there are better ways of doing so.

The biggest determinant of whether you will default on your mortgage is the obvious one: whether you have steady income large enough to afford the mortgage payment. Typically when people default it’s because their adjustable interest rate surged or they lost their job. When housing prices decline and you end up “underwater” (owing more than the house’s current price), strategic default can theoretically increase your wealth; but in fact it’s relatively rare to take advantage of this, because it’s devastating to your credit rating. Only about 20% of all mortgage defaults in the crisis were strategic—the other 80% were people who actually couldn’t afford to pay.

Another potential upside is that it may be easier to move from one place to another if you rent your home, since selling a home can take a considerable amount of time. But I think this benefit is overstated: Most home leases are 12 months long, while selling a house generally takes 60-90 days. So unless you are already near the end of your lease term when you decide to move, you may actually find that you could move faster if you sold your home than if you waited for your lease to end—and if you end your lease early, the penalties are often substantial. Your best-case scenario is a flat early termination fee; your worst-case scenario is being on the hook for all the remaining rent (at which point, why bother?). Some landlords instead require you to cover rent until a new tenant is found—which you may recognize as almost exactly equivalent to selling your own home.

I think the main reason that people rent instead of buying is simply that they can’t come up with a down payment. If it seems too heavy-handed or risky to simply cap down payments, how about we offer government-subsidized loans (or even grants!) to first-time home buyers to cover their down payments? This would be expensive, but no more so than the mortgage interest deduction—and far less regressive.

For now, we can continue to let people rent out homes. When developers do this, I think the benefits generally outweigh the harms: Above all, they are increasing the supply of housing. A case could be made for policies that incentivize the construction of condos rather than rentals, but above all, policy should be focusing on incentivizing construction.

However, when someone buys an existing house and then rents it out, they are doing something harmful. It probably shouldn’t be illegal, and in some cases there may be no good alternatives to simply letting people do it. But it’s a harmful activity nonetheless, and where legal enforcement is too strict, social stigma can be useful. And for that reason, I think it might actually be fair to call them gentrifiers.