Single-family home prices are up nearly 50 percent since the start of the pandemic, a massive increase in just four years. Even though institutional investors own less than 2 percent of the rented single-family homes, many Americans blame private equity firms for skyrocketing prices, prompting bills designed to ban Wall Street from owning single-family homes. It’s an unfortunate reaction based in an erroneous understanding of this dysfunctional market.
The recent surge in private equity’s interest in housing is a symptom of a market broken by Byzantine zoning, lot size, and parking laws. Housing is expensive because cities force developers to waste land. Housing is expensive because building affordable housing is illegal, and Wall Street investment is the natural result of these higher prices. Private equity firms not only wouldn’t be involved if land-use restrictions weren’t ratcheting up prices, they wouldn’t be needed.
Middlemen Are Valuable
Private equity firms are middlemen — middlepeople if you prefer. They do not buy homes to leave them vacant as part of some mass conspiracy to drive up home prices. They are landlords, expanding the rental market with every home purchase. Blaming high housing prices on private equity because they “bought up all the available homes” is like blaming high food prices on grocery stores because they bought up all the available food.
Landlords, like all middlemen, are sellers as well as buyers. They provide valuable services in the form of lower transaction costs, or costs associated with search, coordination, and risk attached to a transaction.
As grocery stores connect farmers with customers, and banks connect savers with borrowers, landlords connect home sellers with people looking for a place to live. Yes, they are renting instead of buying, but some people prefer to rent because it gives them flexibility — selling a home comes with massive transaction costs. Others cannot marshal the down payment or the loan to purchase an increasingly expensive home, a long-standing problem that has been exacerbated by higher interest rates. Because of landlords, these individuals can live in places that would otherwise be beyond their reach.
Landlords see lower transaction costs with maintenance as well. Ten different homeowners with the same problem have to search ten different times for the right contractor and run the risk of a bad job in ten different instances. (My own home is peppered with small projects I haven’t handled yet — or rather haven’t found someone to handle yet — because the transaction costs are so high.) But one landlord owning ten properties needs to find a good contractor only once, and with the chance of nine more jobs, that contractor’s going to work hard to avoid problems and delays.
Private equity firms, and other institutional investors, are just bigger landlords. Scarier-sounding, but with more potential to assuage the distortive effects of government meddling.
Private Equity Firms Amplify These Efficiency Gains
As home prices have skyrocketed, private equity firms and other institutional investors have stepped in to fill the growing gap. Not only are they investing in an asset that government regulation guarantees will appreciate, their resources enable them to bring transaction costs down even more.
When my wife and I were looking for a house nine years ago, our real estate agent made it clear that we were at a disadvantage. Other buyers had cash, she said (over and over again), and we, lacking a wealthy relative or the sale of a previous home, did not.
Sellers prefer cash buyers because mortgage buyers are risky. Banks must approve the buyer’s loan, and that means appraisals and time. Interest rates could rise, or the buyer might have a change in fortune. The deal might fail for any number of reasons, forcing the buyer to relist the property, likely at a lower price. For an eager seller, the wait can be nerve-racking.
My real estate agent would’ve loved all these private equity firms — cash buyers suffer none of those risks. Avoiding those risks yields a significant discount: cash buyers pay about 10 percent less than mortgage buyers. Far from driving home prices up, private equity’s all-cash transactions drive prices down.
Private equity firms save on transaction costs in another way: they tend to purchase fixer-uppers. While a landlord knows a good plumber, electrician, and handyman, private equity employs teams of appraisers and construction professionals, enabling them to repeatedly buy dilapidated houses that most consumers shun. These workers are more reliable and available as employees. In-house workers have much lower transaction costs.
Buying properties across the country enables private equity firms to diversify risk in a way conventional landlords can only dream of, further lowering transaction costs. Different areas have differing and dynamic housing markets, resulting in varying returns on investment for any one region. Overly strong tenants’ rights laws (which make it hard to evict nonpayers) and squatters’ right laws (which can result in people legally seizing property) further reward the risk-reducing effects of diversification.
Affordability Improves
It’s hard to tell what private equity’s net effect on the list price of housing is, but it is clear that these middlemen improve the market’s efficiency — a critical service in a market with such a constrained supply. When you remember to include transaction costs in the price, the downward effect on affordability is unambiguous. As grocery stores are far more efficient than farmers markets — on hours, on selection, and even on some list prices — private equity firms improve the housing market.
Private equity investment in single-family homes is a symptom of sky-high prices, not a cause. Governments have made the housing market so dysfunctional, that Wall Street can’t lower the cost of living nearly as much as needed. If policymakers were serious about making housing more affordable, they’d focus on getting out of the way, instead of demonizing middlemen responding to the problem.
