Post #217: When will the tear-down boom end?

Posted on March 30, 2019

As I start the process of filing my Federal taxes this year, I have been thinking about the conditions that led to the boom in tear-downs here in Vienna.  And wondering whether or not those conditions have changed enough, yet, to bring the tear-down boom to an end.

Highly valued, and yet, depreciating?

A tear-down is a house that is bought solely for the purpose of tearing it down in order to build another house in its place.  Tear-downs have always been with us, but in the distant past, tear-downs tended to be run-down or uninhabitable properties.  By contrast, the hallmark of the “Vienna tear-down boom” is the practice of tearing down houses not because they are run down or uninhabitable, but merely because they are small. 

While that may seem absolutely obvious to everyone who lives here, there’s a point here:  The only way that works, financially, is if two things happen.  1) You build a very large house in place of what you tore down.  There is no economically-viable was to replace the older house with a similarly-sized newer one.  2) Buyers value that large house highly enough that the builder can profit, after factoring in the destruction of value that occurred when the prior house was torn down.

In short, the buyer ends up paying for two houses: The one he or she lives in, and the perfectly-liveable smaller one that was destroyed in the process.  And the only way that works, as an economic proposition, is if the new house is quite a bit larger than what was torn down.

I know we are all used to this, but if you step back from it a bit — that first part of this — paying for two houses, to live in one — seems a bit odd.  Fully realizing that they aren’t making any more land, it seems like a fairly drastic step to take a habitable house and throw it away.  Then mark up the replacement to cover that cost.

I need something to call that destruction of value, so let me give an analogy using two icons of suburban existence:  the SUV and the Prius.  Suppose you wanted to buy an SUV that cost about $80K to build.  But, in order to comply with new federal fuel diseconomy standards, the SUV manufacture is obliged to buy and destroy a brand new $20K Prius for every SUV sold.  (Note, this is sarcasm.  This is not (yet) a real government policy.)   The SUV purchaser pays $100K:  $80K for the SUV you use, and $20K for the “Prius premium”, i.e., the value of the smaller (but still functional) vehicle that  had to be destroyed in order build the larger one.

Suppose that’s the bargain that was offered.  And people snapped up that bargain left and right.  Wouldn’t that seem a bit odd?

Let me now look at the history of the two tear-downs nearest me.  This is courtesy of the Fairfax County property search website. In the table below, the $236K and $207K are the “Prius premiums”.  That’s the value that was thrown in the dumpster in order to be able to build the much larger house.

Here’s what I find hard to reconcile about these numbers.  Simultaneously, two things are happening.  First, people are perfectly willing to pay the “Prius premium”, i.e., to buy these houses at a price that covers the cost of throwing away the pre-existing house. Second, these are in no sense “hot properties”. At least, not according to Fairfax County.  Price appreciation isn’t even keeping up with the rate of inflation. The real (i.e., inflation-adjusted) value of these properties has fallen steadily since they were built.  (And, in my experience, Fairfax has never been shy about upping the estimated value of my house, for tax purposes).

In short, these new houses appear to be highly valued, and yet, depreciating in real (inflation-adjusted) terms.  I have a hard time getting my mind around that.

A leveraged tax-free investment.

One explanation is that the owners are actually making a pretty good rate of return, ignoring the carrying costs.  First, for a married couple, the first $500K of capital gains on their primary residence is tax-free.  Next, the investment is financially leveraged because the buyer only covers the down payment.  Currently, the median down payment on new homes is shown here as 13%.  So that’s meager price growth, but the investment basis for the homeowner is the (average) 13% down payment.

So, ignoring carry costs (taxes and mortgage interest), let me see what sort of a gross rate of return these depreciating houses are yielding.

In today’s investment environment, that’s pretty good.  Particularly for an investment that is perceived to have little or no risk.

Carrying costs and the 2018 changes in the tax laws.

Now we get to the heavy lifting.  The point here is that recent changes in the tax laws made anything beyond the first $850K in house value much more expensive to new home buyers. All owners of these properties face higher costs due to the tax law changes.  But new buyers of these properties — people buying in 2018 and later — face much higher marginal costs for the portion of the property value in excess of about $850K in purchase price.

Let me keep this simple.  Let me define the carrying cost of the house as:

Mortgage Interest + property taxes – income tax writeoffs.

There are other, more comprehensive ways to look at this.  Jumbo loans with modest down payments probably require private mortgage insurance.  Houses require maintenance, and so on.  But I can make my point without adding those details.

For purposes of modeling this, I’ll assume:

  • $1.4M house.
  • 13% down payment.
  • Mortgage interest rate of 4% (roughly what Wells Fargo is quoting today).
  • Combined marginal tax rate of about 41%, consisting of:
    • 35% federal
    • 5.75% state

I am ignoring FICA and the 2.35% marginal Medicare tax for high-income earners because that is assessed on income before itemized deductions (I think).  I’m also assuming that the bulk of income is wage income, taxes at the above rates, and not capital gains, taxed at a much lower rate.   I am also ignoring a significant nuance of the law, in that at sufficiently high incomes in 2017 tax law, deductions are limited.  So, in effect, I am assuming the home owners earn good money in some sort of job, but not spectacularly good money.

And now I’m going to work out how the changes in the tax laws affect the carrying cost of that house.  Bottom line, the changes in the tax law in 2018 increased the annual cost of owning one of these large homes by about 24%.

The first tax change is in the deductibility of mortgage interest.  Any loan prior to 2018 allows interest on the first $1M to be deducted.  Any loan 2018 and later allows deductibility on the interest on the first $750K of the loan.  Virginia’s stated its intention to conform with those changes, so presumably that limits deductibility for both federal and state taxes.

The second tax change is the deductibility of state and local taxes.  Starting 2018, only the first $10K in state and local taxes will be deductible for Federal income tax purposes.  That includes both your Virginia income tax, and any property taxes.  In all likelihood, a married couple who can afford a $1.4M home would have enough income so that state income taxes alone would exceed that.  And so, under 2018 law, there is no federal tax sheltering for the property taxes for that couple, because income taxes alone exceed the cap.  But as I understand the 2018 tax year forms, state tax sheltering continues to occur, up to the $10K cap, because state income taxes are not deductible on the state tax form.

The combined effect of that is shown above:  Roughly at 24% increase in the annual after-tax cost of home ownership.

But that doesn’t really tell the full story, because most of the change is concentrated on the amount of the house value in excess of about $850,000. So, below, I work out the after-tax annual cost of home ownership for $50K increments of house purchase price.  (All done under the same assumptions as above).

The results are shown below.  Let me define a “tax efficient” house as one that allows the highest percentage tax sheltering possible.  In other words, it’s one where you don’t lose any of your tax advantages by purchasing a house that exceeds some cap written into the law.  The change in the tax law did two things.  It reduced the size of the largest “tax efficient” house from $1,150,000 down to $850,000.    And it made it much more expensive to buy additional housing in excess of $850,000.

In a nutshell, the annual cost of your 5th and 6th bathrooms just went up quite a bit.

Here’s the upshot of all of this:  The tax law has made these large houses more expensive to own.  It shifted the size of the largest “tax efficient” house from about $1,150,000 down to $850,000.  And it has imposed a more-than-60-percent increase on the annual cost of incremental housing above $850,000.

Markets can be unpredictable.  So it’s not clear what effect this will have.  But in one year, the cost of buying these large houses has risen disproportionately, due to the change in the tax code.  And that cost increase is concentrated in the house price in excess of $850,000.

This doesn’t even address potential changes in mortgage rates.  The 2012 – 2016 period saw the lowest mortgage rates in … two generations?  (I literally could not find mortgage data old enough to show sub-four-percent average mortgage rates.)  A return to the interest rates of the 2000s (six-ish percent) would increase the annual after-tax cost of these houses by a little over 40 percent.

Demographics, demand, and the puzzling persistence of the Vienna tear-down boom

What got me thinking about this, lately, was a Wall Street Journal (paywalled) article.  They report that large houses are becoming harder to sell in some retiree destinations.  And the reason given is that the coming generations don’t want large “trophy” houses.  I have no idea whether that’s real, or just newspaper reporting making a mountain out of a molehill.  But if you Google “millenial McMansion”, you’ll find a host of seemingly reputable sources (e.g., that appear to echo the concerns expressed in the Wall Street Journal.

Let me me clear, that is not what I observe in my neighborhood.  The new neighbors tend to be families with kids, not baby boomers.  So, plausibly, Vienna really is not what the Wall Street Journal article is talking about.  These are large houses, but they are not “trophy houses” for retirees.  If anything, they are “trophy houses” for up-and-comers.

But the Wall Street Journal’s argument is also one of the Town’s arguments for MAC zoning.  They don’t think that the oncoming generation will want to own the houses that make up the bulk of Vienna.  And that the aging generation will not want to age place.  (Both of which, in my limited experience, seem to be mostly wrong, here in Vienna.)  Hence, the Town wants to add to the stock of apartments and condos in Vienna.  So, in some odd sense, they Town appears to be betting on the same demographics highlighted in that Wall Street Journal article.

That said, markets eventually clear.  If demand for very large houses really does fall, then so will their prices.  So I’m not worried about (e.g.) abandoned houses.  At some price, they will sell.

The real puzzler, to me, is why the Vienna tear-down boom continues apace.  You’d think that between the change in the tax law, and the demographic shift, and the slight rise in mortgage rates, builders would be a little hesitant to build the next $1.5M house here in Vienna.  But if there is any slowdown, it is not apparent to me.  Perhaps there are enough young high-earners who want to live here that the market for $1.5M homes — and hence the tear-down boom — will remain robust indefinitely.

In any case, the 2018 tax law created a significant shift in incentives for new home owners.  It increased the costs of home ownership substantially, and it particularly concentrated cost increases on the value of the newly-purchased home in excess of $850,000.  Whether or not that will have any impact on what’s being built and sold in Vienna, only time will tell.  Possibly, the tear-down boom will end when the last small house in Vienna gets torn down.