Asymmetrical Information - Megan McArdle

10.23.12

Is DC Real Estate Headed Up or Down?

The local housing bubble may be a lobbying bubble.

This topic may not seem so fascinating to those of you who live out in the wilds beyond the beltway, where men are real men, women are real women, and families go entire weeks without discussing federal regulatory policy.  But it shoud fascinate you.  DC real estate prices tell you a little about broader urban trends, and a whole lot about what's happening with your federal government.  Given that said government is now spending almost a quarter of our annual income, it behooves us to keep an eye on it.  

I am perhaps unusually fascinated by the market because my mother is getting ready to close on a house, and a couple of friends have just started dipping their toes into the market.  But I am also fascinated because it's fascinating.  DC's housing market is very strange.  While the rest of the country falls, we're in a veritable boom. Where others zig, we zag.  What the heck is going on?

To be sure, DC didn't escape the bubble entirely.  If you're interested in reliving the local housing market's rise and fall, I highly recommend this discussion forum.  But be sure to set aside a couple of hours, because I guarantee that you will not be able to stop once you start.  It's like watching an entire herd of lemmings plunge off a cliff in slow-motion, with instant replay and a hell of a post-game wrapup.  

For those who don't have a couple of hours right now, I'll sum up: the outer suburbs and newly gentrifying neighborhoods like mine saw a big price drop.  But then the city experienced a spectacular rebound.  Home prices on some blocks are up 20-30% from a couple of years ago.

I've lived through waves of gentrification in New York, but I've never seen anything like the pace of this; a corner that had no bars or restaurants when we moved in two years ago now features three sit down places, with two more under construction.  The neighborhood due south of us has multiple cranes working.  Homes that are not wildly overpriced tend to sell within a few days of going on the market.  

A real estate agent writing on a local blog recently described what's happening to neighborhoods like the one where I live, and where my Mom is (fingers crossed!) buying an (unrenovated) home:  

As I’ve mentioned in other Good Deal or Not Revisited (GDoN-R) posts, the extremely low interest rates are pushing the monthly affordability of mortgages down while allowing a larger pool of buyers to qualify at higher price points. Buyers are paying increased prices in DC than they were a year ago, and a large part of the demand is focused upon properties that have been renovated with all new systems, fixtures, floors, walls, etc. Although raw product (i.e. un-renovated houses) is scarce, business is good again for area developers.

There are renovated properties to be found all over the city. It’s worth noting, however, that areas that did not previously see a lot of this type of sales activity during the early and mid 2000’s boom market are experiencing a current revival. There tends to be a larger availability of houses that are good candidates for rehab at prices that make sense for investors.

When buyers begin paying hearty prices for the finished product, they start to comp each other out, and voila…the market prices and demand in that area can change quite dramatically in what seems like a short period of time. One of the comments on the original GDoN post was “That will never sell for that price. Maybe in 5 years”. The mentality of buyers (and appraisers, and real estate agents, and tax assessors) is more like “if the houses down the street were of similar size and condition and sold for x, then that’s current market value for the location, size, and condition.”

This immediate area (within 1/5th of a mile of the subject property) saw no sold prices for houses over $700,000. in 2011. There have been three sales in addition to the subject over $700,000. so far in 2012.

Those of you who live in more normal housing markets may feel a bit faint at the thought of paying $700,000 for a 2,000 square foot townhome, however recently renovated with the finest that Home Depot has to offer.  You are strongly encouraged to sit down, and perhaps take a small restorative brandy.

Feeling better?  All right, back to the main question: is it a bubble?  Or are we headed for, erm, a permanently high plateau?  Prospective homebuyers want to know.

Good question!  There are roughly three theories about why this is happening.  To know whether prices are due for a crash, you need to know which of these three theories is true:  

1) Democrats like to live in cities.  An Obama administration has meant lots of Democrats, who have moved here and bought houses.  

2) Government spending is rocketing away, boosting salaries in the area.  There are actually two flavors of this theory: one which credits the Bush-induced defense spending, and one which credits the Obama-era domestic spending.  

3) DC is now in a virtuous cycle: falling crime and a decades-long trend towards moving back into city centers have boosted property values, which in turn boosts city resources and causes crime to fall and more amenities to be provided that attract more affluent residents.

 If "more Democrats" is the answer, then home values depend on the outcome of the election. If "more spending" is the answer, then home values probably depend on whether we go over the fiscal cliff, which would mean cutting a lot of spending.  And if "nationwide urbanization trend" is the answer, then the price appreciation will probably continue for a while no matter what.

Of the three, I find the first the least convincing.  In theory it's compelling, but in practice, DC was gentrifying at a pretty rapid clip when Bush was in office.  So breathe easy, DC homeowners: Mitt Romney may do all sorts of terrible things if elected, but he will probably not destroy your home values.  

The third theory is, I think, inarguably true:  central cities are becoming desireable real estate once again, a process that Alan Ehrenhalt has dubbed "The Great Inversion". But that doesn't necessarily explain why DC housing prices are booming, while all the other cities that are, er, greatly inverting, are not experiencing the same phenomenon.

Which leaves us with theory two.  Oh, you can complicate it by describing DC's somewhat archaic land-use restrictions, or its public transit infrastructure, but those things do not do a lot of explanatory work all by themselves.  DC has had these constraints, and more, for a very long time.  The reason prices are rising is that, unlike twenty years ago, those constraints are now bumping up against rapidly increasing demand.

So, theory two.  It has a lot going for it.  Government spending has gone up pretty fast over the last ten years, and hey, we're where all the government happens!  

On the other hand, there are some problems.  Most domestic spending does not create a lot of jobs in Washington; it creates jobs in national forests, or maybe building more check writing machines.  And while it's superficially appealling to credit the military run-up, there are two big problems: first, that military families do not make a lot of money with which to bid up the cost of housing, and second, that military families do not tend to live in the District, where the craziest appreciation has taken place.  

So where is all this money coming from?  

Contractors and lobbyists, says my mother's real estate agent.  He's seeing an enormous number of young two-income couples who are making $200,000-400,000 a year.  Usually there's a law degree involved, but sometimes it's a PhD or an MBA.  Those couples are priced out of Georgetown, or maybe they want something a little less stodgy.  So they buy on the edge of U Street, Logan, or Capitol Hill/H Street--and in the process push the singles or couples making $120,000-$150,000 (of which DC has a lot) out into the fringes of the gentrified areas.  Things rapidly gentrify around those couples, and then the next round begins in a new neighborhood a couple of years later.  

This is despite the fact that DC is now adding housing stock pretty rapidly.  A couple of years ago, I wrote that the neighborhood to the south of me, where the train is, was still too dangerous for me to walk at night--but that I expected it to get safer as more people moved in.  A number of emailers chided me.  "People lived there before, privileged white person!"  

Actually, no.  NoMA, as the area is called, was an industrial area; the census tract directly to our south registered a few dozen people in the 2000 census.  It's now got well over a thousand, most of them paying outrageous rents for condos directly above the metro stop.  And the number is growing rapidly, thanks to the aforementioned cranes.  The same thing is happening over much of the city: mid-rises being built, unoccupied houses renovated, row-houses split into two or three units. And yet it's not enough to prevent the bidding wars. 

There's also a fair amount of empirical support for the theory that lobbying dollars are driving up home prices in the District.  And so anecdote and data both suggest that as long as government spending continues apace, the boom will also keep roaring along.  

A more interesting question is what happens when the spending stops.  You might think it's obvious that no money means no lobbying.  But with the peculiar logic of lobbying, that ain't necessarily so.  

If the money had never flowed in the first place, we'd probably have fewer lobbyists.  But these things are what social scientists call "path dependent", which is a fancy way of saying that stopping something is not the same as never having started it.  Anyone who has been through a bad breakup can attest to this truth.

After all, the lobbyists are here now.  They've bought houses and established a social circle.  They have a lifestyle they enjoy. What do they do if a Romney or Obama administration starts closing the taps?  Just sell the houses at a loss and look into social work?  

Rather than selling the house, there's strong reason to believe that they start selling their services even harder--an argument you can read at greater length in Government's End, Jonathan Rauch's brilliant book on lobbying.  There are a lot of interest groups currently dipping into the river of money flowing out of Washington.  If the river starts drying up, those groups will need lobbyists more than ever, to defend their position on the riverbank.  Every trade association, consumer group, and union in America will descend on Washington to try to deflect the spending cuts and taxes increases onto someone--anyone!--else.  

The upshot is that it seems as likely as not that DC home prices will stay high for a while, no matter what happens to government spending.  That's great news for my mother and me.  But it's terrible news for America.