It hasn’t been possible to buy a small house in Vienna, VA for at least a decade now. Every small house that goes up for sale is purchased by developers, who then proceed to tear it down and build the largest house that will fit onto that lot.
This sustained destruction of middle-class housing, replacing it with lot-filling McMansions, is what I have termed “the tear-down boom”.
I have written about the various implications of the tear-down boom. Among other things, this continual replacement of small houses with gigantic houses means that:
- Post #519. Town revenues from residential real estate have been pushed materially higher by the resulting increase in the price of the houses.
- Post #308. There’s a tremendous mis-match between the stock of houses in the Town of Vienna, and the houses available for sale. Middle-class people can live here — if they already own a house — but they can’t move here, because all the middle-class houses are replaced with McMansions before being re-sold. As a result, increasingly, Vienna is a town for the wealthy, not the middle class, something I termed the “Mcleanification” of Vienna.
And yet, some of the economics of the tear-down boom just didn’t seem to make a lot of sense, simply as way to generate housing stock. People really don’t need 10,000 square foot houses, and everything I read about the next Gen X and later is that they have no interest in buying such gigantic pieces of real estate. Seemed like a classic case of “sell it to whom?”.
The best explanation I could give for the tear-down boom is that it was the result of two toxic Federal economic policies. These were the huge tax advantages to home ownership, including both tax sheltering of current income and tax-exemption of any capital gains, and near-zero real (inflation-adjusted) interest rates. In 1997, the Federal government eliminated capital gains on housing. (With some limits.) That was on top of the tax sheltering that housing provides via income-tax deductibility of mortgage interest and property taxes. Then, in 2008, the Fed dropped inflation-adjusted interest rates to zero or below, following the near-collapse of the U.S. financial system.
Between those two policies — the tax advantages and the free money — it became ludicrously cheap to finance the purchase of a mega-home. And that mega-home was a highly-leveraged investment that was, ultimately, better than tax-free.
But trees don’t grow to the sky. Back in 2019, I asked “When will the tear-down boom end?” That was Post #217.
Even then, the market was showing some oddities. Oddity #1 is that these mega-homes were appreciating less rapidly than adjacent lower-priced homes. Oddity #2 is that the changes in tax law in 2018 made it much more expensive to own homes costing over about $850,000. Here’s the analysis of just how much more expensive it became to carry the cost of a $1.4M house after the 2018 changes in Federal tax law:
Not only did it suddenly cost a lot more to carry that $1.4M house, almost all of the additional cost came from the housing value just in excess of $850,000. Basically, the law reduced the size of what I would term the “tax efficient” house, that is, the house that earns you the maximum tax breaks as a percent of cost.
As a result, in 2019, I looked at that and said, isn’t this going to put the brakes on the tear-down boom?
And so far, the answer is no. Just casually driving around town, these still seems to be a tear-down on pretty much every block.
So far.
Today’s mortgage interest rates.
In this last section, all I want to do is assess the impact of the rise in mortgage interest rates. Literally, dig up the spreadsheet above, and replace the then-current 4% mortgage interest rate with the current 7% (or so) rate.
Source: Federal Reserve Bank of St. Louis (FRED) system.
Redoing the analysis, I find that the carrying cost of a $1.4M (small) McMansion in Vienna is now about 50% higher then it was back in 2018. And 86% higher than it was in 2017, before they changed Federal tax law to reduce the tax advantages of owning an expensive home.
So, to be clear: Those houses are still big money-makers for the owners, as housing prices have risen steeply in the past year. That said, if home prices merely stabilize, new McMansions will have after-tax carrying costs in today’s environment that are 86% higher than they were in 2017.
My belief is that this plausibly is going to put a damper on tear-downs in Vienna.
I’ve been wrong about that before.
But I believe it strongly enough that I spent last week painting the front of my house. That’s a real change for me, because I had simply stopped doing any maintenance on my house that didn’t directly affect occupant health and safety. I figured, why bother to keep the place up, when they’re just going to tear it down when I eventually move?
I was letting the house deteriorate, peeling paint and all. But now I have about a decade’s worth of deferred basic maintenance to do. Because in today’s environment, it’s no longer a given, I think, that this house will be torn down when I leave it.
Sometimes there is value in being an outsider.
This post is prompted by