REAL ESTATE MARKETS SINCE 1980: WHAT ROLE HAVE TAXCHANGES PLAYED?

JAMES R. FOLLAIN*, PATRIC H. HENDERSHOTT**, AND DAVID C. LING***

SHORTLY after passage of the 1986 Tax bances will the impact of tax changes beAct, we wrote a two-part paper on tax clearly revealed .2

reform (Follain, Hendershott, and Ling, Real estate markets in the early 1990s1987). In the first part, we developed a differ markedly from the 1980 market in"theory" of tax law changes that inter- at least two important respects. First, al-preted the lengthened tax depreciation though 1990 real interest rates are aboutschedules and increased capital gains tax equal to 1980 values, the combination ofrate as a rational response to a decrease cuts in regular income tax rates and equalin the inflation rate. In the second part, reductions in both nominal interest rateswe forecast the long-run impact of the 1986 and expected inflation has doubled realtax act on real estate, assuming no future after-tax interest rates. As a result, 1990tax changes. In an exercise in account- investment hurdles rates or user costs forability, we now evaluate the accuracy of all real estate (and non-real estate) in-our theory and forecasts. vestments are substantially higher. Sec-

The theory and its implied forecast can ond, a "lending frenzy" has produced a glutbe summarized briefly. Under U.S. tax law, of commercial real estate in most regionstax depreciation allowances are based on of the country, and a substantial excess ofhistoric cost and nominal capital gains are multifamily residential units in some re-taxed. Arguably, allowances and gains gions. Moreover, this glut (excess) wasshould be indexed for inflation (deprecia- produced during the 1983-86 period andfion should be based on replacement cost thus has already existed for over five years.and only real gains should be taxed). In Two of our 1987 forecasts appear off thethe absence of formal indexation, depre- mark, one by a wide margin. We pre-ciation allowances should be shortened and dicted small increases in real rents andcapital gains tax rates cut when inflation decreases in real values for income-pro-rises, and historically this has been the ducing real estate. For apartments, realcase. Thus we forecast that a significant rents have been flat and real values havecut in the capital gains tax rate and declined, although the evidence is mixedshortening of tax depreciation schedules and varies by region. For commercialwould come only if inflation accelerated.' properties, both real rents and real valuesInflation has not accelerated, and the cut have plunged. The poorer-than-expectedand shortening have not occurred. value performances are obviously caused

Forecasting is a dangerous business as by the lower-than-expected rental incomethe cardinal rule for forecasters suggests: streams.3 Below expected rental income isgive them a number or give them a date, attributable, we contend, to the over-but never give them both. While we gave building in the middle 1980s, not to aseveral numerical long-run forecasts five misunderstanding of the 1986 tax provi-years ago, we contend that five years isn't sions or their ceteris paribus impacts.the long-run and for some real estate While one might think that ample timenwkets we should not yet expect to see has passed for us to be seeing the long-any of the forecasted impacts. Tax law run economic impacts of the 1986 tax act,changes are just one of many possible dis- and that may be true for impacts in sometwi)ances to real estate markets, and only markets, it is decidedly not true for in-in the absence of other major distur-

come-producing real estate. Overbuildingin the middle 1980s has simply swamped

'Syracuse University, Syracuse, NY 13244-1090. the long-run effects of the 1986 tax act.

*wMeOhio State University, Columbus, OH 43210. Regarding owner-occupied housing, the'$*University of Florida, Gainesville, FL 32611. forecasted economic impacts of the 1986

253

254 NATIONAL TAX JOURNAL [Vol. XLV

tax act might be expected to be seen by percent; the 1986 act halved the tax sav.now because widespread overbuilding has ings and doubled the capital gains tax ratp.not occurred. Because after-tax real in- Thus, the 1981 tax act should have in.terest rates increased sharply and real creased investment, lowered rents, andrents moved little, we would expect sub- raised asset values, and the 1986 actstantial declines in homeownership and a should have done the reverse. The in.slowdown in the rate of increase, if not an crease in real after-tax interest rates wouldabsolute decline, in real house prices act to dampen the impact of the 1981 Adthroughout the decade. These have, in fact, and to reinforce that of the 1986 Act.been observed. Further, the 1986 tax act The last, and almost certainly greateskprovides some predictions about the use disturbance to commercial real estateof mortgage debt, which seem to be oc- markets in the 1980s is a phenomenoncurring. Hendershott and Kane (1992a) term a

Our paper is divided into three sections "lending frenzy." By this they refer to theand a conclusion. We begin with a further financing of income-producing real estateelaboration of the major disturbances to construction to the point of extraordinaryincome-producing real estate markets in excess supply in the middle of the decadethe 1980s and then describe a simple model and the continuing financing of it tothat can be used to illustrate the effects maintain this excess supply throughoutof such disturbances. Section two inter- the remainder of the decade. Apartmentprets developments in the multifamily and (over 4 unit buildings) vacancy rates,office markets, and section three consid- which varied between 6 and 8 percenters the owner-occupied housing market. during the 1970-84 period, exceeded 9

percent in late 1986 and averaged 9.5

Shocks to Commercial Real Estate percent throughout the rest of the decadc

Markets in the 1980s Between 1968 and 1983, downtown officemarket vacancy rates were above 11 per.

The 1980s and 1990s both began with cent only in 1975 and 1976; since 1985,substantial economic weakness. The 1980- they have exceeded 16 percent continu-82 period had two relatively short reces- ously and averaged 17.5 (suburban va-sions, the second being quite deep; the cancy rates have averaged 22 percent).1990-92 period has been marked by a Substantial excess supply also existedsingle long, double-dip recession. The early in the second half of the 19808 for most ofrecessions were caused by the first seri- the rest of the commercial real estateous period of monetary restraint in half a market. Overall, Hendershott and Kanecentury. The restraint was successful in estimate that $80 to $100 billion in ex-reducing the expected inflation rate from cess commercial real estate was con-nearly ten percent to four percent. Nom- structed. Using a much different method,inal interest rates fell much less rapidly Giliberto (1991) derives a lower $50 to $70during the first half of the 1980s, and thus billion estimate of excess construction.real interest rates averaged over 3 per- Many lending institutions have con.centage points above the 1978-80 levels tributed to this frenzy. Probably the first,(nearly 5 percentage points above the and certainly the easiest to document, were1975-78 levels) during the 1981-84 pe- the savings and loans (S&Ls). Between theriod (Hendershott and Peek, 1992). Real end of 1981 and the end of 1985, the pro.after-tax interest rates increased even portion of S&L assets in home mortgages,further because tax rates were lowered. which had varied within the tight 0.72 to

The 1981 and 1986 tax acts changed the 0.74 range throughout the 1965-81 pe-provisions affecting income-producing real riod, plunged to 0.57. These institutionsestate in opposite directions (Follain, had been encouraged/required to borrowHendershott, and Ling, 1987). The 1981 short and lend long (federally-charteredact increased the tax saving from tax de- institutions were not allowed to originatepreciation deductions by 40 percent and adjustable-rate mortgages until 1981).lowered the capital gains tax rate by 30 When interest rates rose sharply in the

No.31 JAMESFOLLAIN,PATRICHENDERSHOTT,DAVID LING 255

late 1970s and early 1980s, the enter- Tax law changes alter the user cost, butprise-contributed equity (as opposed to so do changes in real after-tax interestdeposit-insurance-generated equity) of the rates. This user cost (relative to marketinstitutions became negative. rents) affects the price/replacement-cost

Mistakenly left operating with govern- ratio, the force driving construction. Con-ment deposit guarantees and given new struction, in turn, attects the vacancy ratepowers to fund construction loans and to and thus real rents. The long-run equilib-wt as real estate equity investors through rium in an income-producing propertytheir real estate service corporations, as market is characterized by P = RC, userwell as a 150 percent increase in deposit cost equal to rents, and a vacancy rateinsurance coverage, S&Ls increased their equal to the natural rate. In such a mar-investments in nonhome mortgage loans ket, an unfavorable tax law change (e.g.,at a 30 percent annual rate throughout the 1986 Tax Act) increases the user costthe 1982-84 period. After that the growth above rents and lowers prices below re-in these loans returned, until the 1989 placement cost. This, in turn, should haltFIRREA legislation, to the normal 10 construction and, with normal discards andpercent per annum rate, but was applied absorption, drive vacancy rates below theto a base that had doubled in the 1982- natural level. Only then will the t'ax84 period. change be reflected in higher real rents.'

Supervision of commercial bank risk- A lending frenzy acts as an ad hoc add-taking and capital adequacy was only on to the construction relationship. ThatOightly better. Banks pursued risky con- is, the frenzy can stimulate constructioncentrations of lending both to less-devel- (and thus depress rents) even when re-oped countries and in local real estate placement cost seems to exceed marketmarkets. Developers were no longer re- value (and user cost to exceed net rents).quired to secure "take-out" financing as a In fact, the frenzy pushed an "effective"

site to obtaining a construction user cost well below the "efficient mar-oranr7FUiinally,foreign (especially Japa- ket" user cost we have computed. Whenam) investors, pension funds, and life lenders become equity participants and doinsurance companies poured money into not require a fair risk premium or whencommercial real estate after 1986, even developers do not have to put up any eq-though vacancy rates were at extraordi- uity or obtain permanent financing prioruq levels. to getting a construction loan, efficient

Our framework for thinking about how market user costs become irrelevant to thethese shocks should have affected income- determination of construction and thusproducing real estate markets consists of real rents.five relationships describing: (1) the ad-jutment of real rents to differences be- Income-Producing Real Estatetween the natural and actual vacancyrates, (2) an identity relating the current The tax acts of 1981 (ERTA) and 1986vacancy rate to last periods rate, the net (TRA) were predicted to have different(of discards) construction rate, and the economic effects. ERTA was expected to6wrption rate, (3) a Tobin-q like rela- encourage construction and thereby re-Wn between the construction rate and the duce rents (Hendershott and Ling, 1984),price-replacement cost ratio (P/RC) less while TRA was anticipated to do the re-unity, (4) an identity relating the differ- verse (Hendershott, Follain, and Ling,ow between P/RC and unity to the pres- 1987). The primary sources of these pre-ent value of all future differences be- dictions were changes in the tax savingtween the expected and equilibrium (user from tax depreciation writeoffs, althoughcost) rental rates, and (5) the dependency capital gains changes reinforced the im-of the user cost on the real after-tax in- pact of the tax depreciation changes. Fig-Wmt rate, the economic depreciation rate, ure 1 (right axis) illustrates both the in-oW the tax saving on the present value crease in this tax saving in 1982 and theof tax depreciation. plunge in 1987.5

256 NATIONAL TAX JOURNAL [Vol. XLY

FIGURE 1USER COST AND ITS COMPONENTS

0.15 a3O

0.10 - a25

ao5 OL20

0.00 0.15

-0.050.10

1975197619771978197919801981198219831984198519861987198819891990

Rental User Cost 6 Real After-Tax Discount Rate

Tax Savings of Depreciation Allowance

Figure 1 also reveals that the impact of rate is on the right axis, and indices, waledthe favorable tax changes in 1981 on the to unity in 1980, for the other two seriesuser cost was overwhelmed by the in- are on the left axis. As can be seen, realcrease in real after-tax interest rates, part rents rose by 12 percent between 1981 amof which has been attributed to the in- 1986. The rent increase was more directlyvestment incentives provided by ERTA in response to a surge in the number of(Hendershott and Peek, 1992). The user renting households (during the 1982-85cost (left axis) was clearly higher after period, renter households increased at1981 than before, and especially higher twice the 1978-81 rate) combined with arelative to the 1975-79 period .6 As a re- low initial vacancy rate (see figure) thansult, we should find real rent increases, to a higher user cost.not decreases, during the first half of the While the surge in starts in the 1983-decade. During the second half of the de- 86 period is consistent with a naive a&cade, the user cost is roughly constant. sessment of the 1981 tax act (tax advan.

In the remainder of this section, we dis- tages increased), it is not consistent withcuss developments in the rental

7housing the observed jump in user cost owing to

and office markets in the 1980s. We use higher real after-tax interest rates. It @the office market as illustrative of com- certainly consistent, though, with a lend-mercial real estate generally. ing frenzy, especially when combined with

an initially low vacancy rate and a bulp

Rental Housingin the number of renter households. Thissurge in starts led to a glut of rental

Figure 2 plots three series from the housing by 1987.multifamily market: real rents, vacancy Returning to Figure 1, the negative turates, and housing starts.3 The vacancy 'changes in TRA translated into a higher

No. 31 JAMES FOLLAIN, PATRIC HENDERSH07r, DAVID LING 257

FIGURE 2RENT, MULTI-FAMILY STARTS, AND VACANCIES

L6 0.095

LS -- 0.08

L4 -

L3 -- 0.075

Ll - - 0. 07

Li- 0.065

a9 -- 0.06

ag - 0.055

a7- 0.05

a6

as 0.045197519761977 1978 1979 1980 19811982 1983 1984 1985 1986 1987 1988 1989 1990

-.0- Real Rent Index -.*- MF Starts Index --*- Vacancy Rate

wr cost and thus might reasonably be struction during the late 1980s and earlyexpected to reduce multifamily construe- 1990s.don and increase real rents.9 Starts didfall substantially in 1987, but real rents

Office Marketshave remained largely unchanged. Thefailure of rents to rise seems to be a direct Indices of office market vacancies, realresult of the high vacancy rate, which has effective rents, and the real value of con-continued, in spite of reduced starts, be- struction for the 1972-90 time period areesta the rate of increase in renter house- presented in Figure 3.'o Hendershott andholds has returned to its low 1978-81 Kane (1992a) describe the 1970s as a pro-level. totypical real estate cycle: overbuilding

While the passage of TRA in late 1986 late in the 1971-73 boom, leading to areduced the incentive to construct new cutback in production, decreases in va-rental housing, TRA should not be viewed cancy rates, and eventually another boom.n the sole cause of the construction col- In fact, office vacancies had fallen belowkpw. As a consequence of the excess sup- 4 percent by the beginning of the 1980s,Oy and slowed absorption of rental units, production had already rebounded to itsrental housing construction was destined 1971-73 levels, and the offilee market wasfor several years of low production with ready for another "normal" spurt of over-orwithout TRA. Further, the final end to building.the lending frenzy caused by the passage Post-1981 increases in construction andofFIMA and comparable tightening of declines in real rents are not consistentcapital requirements on commercial banks with the increase in the user cost. Theyhas certainly played a major role in the are, however, consistent with a lendingcontinued decline of rental housing con- frenzy. The surge in construction peaked

258 NATIONAL TAX JOURNAL [Vol. XLV

FIGURE 3OFFICE MARKET: 1972-1990 c

REAL CONSTRUCTION VALUE, RENTS, AND VACANCIES1

2.60- 19%

2.40- -17%2.20-

2.00- w

1.80 -13%

0 11.60: -11%z - z

1.40- 9%1.20-

1.00--5%0.80-

0,60-7

.2 7

.4 7

.6 i8 iO 8

.2 8

.4 i6 8'8 9'0'

3%

73 75 77 79 81 83 85 87 89

REAL VALUE CONS REAL RENTS )K VACANCY

in 1985 at a level two-and-a-half times that Owner-Occupied Housingachieved in the late 1970s. Downtown va-

The average cost or annual "price" ofcancy rates exceeded 17 percent by 1986,owner-occupied housing influences the

and real rents had fallen 25 percent fromtenure (or buy-versus-rent) decision of

their 1982 high."households, and the marginal cost affects

While TRA increased user costs mar-the quantity demanded by households that

ginally, the massive excess office capacitychoose to own. Both costs likely affect thethat existed just prior to TRA would havereal asset price of owner-occupied hou&

been sufficient to keep real rents from ris- .ing for an extended period of time, even

ing. These costs depend upon the required

if new construction had plunged in re- returns on owner equity and debt, prop

sponse to TRA. Because construction dur- erty taxes, economic depreciation, ex-

ing the remainder of the 1980s never fell pected appreciation in house values and

below twice the average of the 1970s, va- rents, and homeowner tax benefits. The

cancy rates remained at 18 (downtown) to benefits relevant to the two costs can

22 (suburban) percent and, faced with this change differentially, as we shall show.

persistent oversupply, real office rents The tax benefits to homeowners are the

continued to decline, being only half their nontaxation of imputed rental income and

1982 level in 1992. the "light" taxation of capital gains owing

Owing to the unprecedented overbuild- to deferral and the $125,000 one-time ex.

ing, the expected increase in real rents is clusion. Deductibility of home mortgage

unlikely to develop for the better part of interest ensures that itemizing house-a decade. In fact, given the numerous tax holds with mortgages also benefit from thechanges of the last decade, a more gen- nontaxation of owner-occupied housing.erous tax act could be enacted before any The higher the tax rate of the individual,increase in real rents is evidenced, ne- the larger the tax benefit and the lowergating any impetus for the increase. the after-tax cost of owner-occupied hous-

No.31 JAMESFOLLAIN,PATRICHENDERSHOTT,DAVID LING 259

ing, TRA lowered the tax benefits of prisingly, both of these followed substan-owner-occupied housing by reducing the tial increases in excess nonhousingmarginal tax rates at which higher in- expenses, the first caused by the tax re-come households deduct housing Co$tS.12 form act of 1976, which raised the stan-Allelse equal, these reductions increased dard deductions of married couples fromthe after4ax cost of owner-occupied hous- $1000 to $3200 and of singles from $500mg and would be consistent with a de- to $2200. The 1986 Act raised the deduccline in ownership, reduced quantity de- tion for married couples from $3964 inmanded, and a softening of house prices 1986 to $5000 in 1988 and for householdat the higher end of the market. heads from $2578 to $4000, and lowered

A more subtle but potentially more im- nonhousing expenses (see note 13).pdrtant effect of TRA follows from its sub- The remainder of this section is dividedstantial increase in standard deductions into two parts. First, the effect of TRA onand decrease in the amount of nonhous- the amount of wasted housing deductionsing expenses that can be claimed as item- (excess of standard deduction over non-ited (Schedule A) deductions. 13 These pro- housing deductions) is computed and evi-visions have had a combined effect dence on changes in the relative use of debtcomparable to elimination of the mort- financing among owners is presented.pge interest deduction for many house- Second, trends in ownership rates ofholds, which sharply raises the costs rel- younger, more mobile households sinceevant to their tenure and quantity 1973 are compared with estimates of thedecisions. For other households that con- cost of owning housing relative to the costfinue to itemize under TRA, the cost rel- of renting, and the real asset price ofevant to the quantity-demanded decision owner-occupied housing during the 1970sis not affected (beyond the direct cut in and 1980s is compared with marginal usermarginal tax rates), but the average value costs and real income per household.of mortgage interest deductions is re-duced if their total nonhousing dedue-

Changes in Wasted Housing Deductionsfions are less than the standard deduc-and the Use of Mortgage Debtfion. Thus, the average after-tax cost of

debt for these households is greater than Because itemization requires giving upthe average risk-adjusted after-tax cost of the standard deduction, housing deduc-equity, even if the two costs are equated tions equal to the standard deduction (SD)at the margin. less deductible nonhousing expenses

Ling (1992) calculates marginal and (NHE) are "wasted" in that this amounttenure-choice owner income tax rates (in- does not reduce taxable income below whatcluding state taxes) for nineteen income it would be if the household retained itsgroups and for each of three household renter status. In the language of user cost,types on a quarterly basis from 1973 the average after-tax cost of housing un-through 1989. Overall weighted average der TRA for households with nonhousingtax rates in each quarter are based on the deductions below their standard deduc-actual distribution of households among tion depends on the loan-to-value ratio.de three household types and across the This TRA-induced anti-debt bias would benineteen income classes. Annual aver- consistent with a subsequent decline inMo of these weighted-averages are shown ownership rates among younger, lessin Figure 4. 14 If there were no excess non- wealthy households because such house-housing deductions, the tenure choice tax holds are less able to substitute equity forrate would always exceed the marginal debt financing. Those households that didrate in a progressive tax system because choose to own would be expected to makedw tenure choice rate would simply be an relatively less use of mortgage debt (Fol-average of the marginal and higher tax lain and Ling, 1991).rates. , On the other hand, TRA also elimi-

This is the general pattern with two ex- iiated the deduction for consumer inter-ceptions, 1977-79 and 1987-89. Not sur- est.'5 For households without wasted

260 NATIONAL TAX JOURNAL (Vol. XLV

FIGURE 4MARGINAL AND TENURE CHOICE TAX RATES

WEIGHTED AVERAGES ACROSS INCOME AND HOUSEHOLD TYPES

0.22-

0.21-

0.20-

0.19-cow 0.18-

0.17-

0.16-

0.15-

0,14-

0.13-

0.12-i3 75 77 i9 @l @3 i-5 i7 69

74 76 78 80 82 84 86 88

MARGINAL TAX RATES TENURE TAX RATES

housing deductions, we would expect in- estimates can be inferred.16creases in the use of mortgage debt be- The left-hand portion of Table 1 showscause its deductibility (along with its fa- that wasted housing deductions averagedvorable collateral value) makes it the $1,042 in 1985 and were not a seriouscheapest source of consumer debt financ- problem for households with more thaning. about $25,000 in adjusted gross income.

Evidence regarding changes in house- However, average wasted housing deduc-hold financing decisions after TRA have tions jumped more than 150 percent tobeen obtained from the 1985 and 1989- $2,699 in 1989. In fact, typical householdsAmerican Housing Surveys (AHS) con- with adjusted gross income (AGI) be-ducted by the U.S. Department of Com- tween $30,000 and $35,000 (approxi-merce. The AHS contains detailed micro mately the 1989 median) received no taxdata on households, including geographic benefit in 1989 from their first $2,638 inlocation, number, age, and marital status mortgage interest and property tax ex.of occupants, income type and level, ten- penses.ure status, original and current home Reductions in the use of mortgage debtavalues, and property tax payments. De- by lower income households would btailed mortgage information also is col- consistent with this surge in wastedlected, including the number and amount housing deductions. The middle portion ofof mortgages (including home equity Table 1 shows that the percent of houwloans), mortgage interest rates and pay- holds with no mortgage debt increased,ments, and original and remaining terms between 1985 and 1989, by 3 percentageand balances. Each survey observation points for those with AGI between $10,000(household) is weighted so that national and $30,000. Similarly, the percent of

TABLE IWASTED HOUSING DEDUCTIONS AND HOUSEHOLD MORTGAGE DEBT: 1985

ALL HOUSEHOLDS FROM SUPPLEMENTED AHS DATA

198S 19as 19a9 1985 t of 1989 t ofAdjusted Wasted Wasted HHs With HHs With 19

Gross Housin Housing No mtg. No Mtg. HHIncomes ExpL-nseit Expense Difference Debt Debt Difference Sec

0-10 2,116 4,504 2,388 73.8 75.4 1.610-20 1,878 4,369 2,491 52.4 55.5 3.120-30 861 3,226 2,365 32.5 35.4 2.930-40 16 2,020 2,004 2S.3 26.0 0.740-50 0 877 877 21.8 20.8 050-75 0 28 28 18.8 20.7 1.975-100 0 0 0 22.2 18.6 -3.6

100+ 0 0 0 20.0 20.3 0.3

Total 1,042 2,699 1,657 42.7 42.4 -0.3

a. Number of households is based on the AHS survey sample projected back to the popu1989 income brackets are adjusted to reflect the amount of inflation between 1

b. Wasted housing expense represents the difference between the household*B standitemized deductions, i. e., the amount of housing deductions that will be absobeyond simply using the standard deduction.

262 NATIONAL TAX JOURNAL [Vol. XLV

households with second mortgages de- dropped from 82.8 percent to 79.7 per.clined by a point for those in this income cent . 18

range. In contrast, higher income house- Homeownership rates for married cou.holds, presumably those that can make full ples over the longer 1960-90 period clearlyuse of their mortgage interest deductions, show that the surge to homeownership inincreased their use of mortgages in re- the 1970s has been completely reversedsponse to the elimination of the consumer for married couples under age 35 and Willinterest deduction. For those in the probably shortly be reversed for those un-$75,000 to $100,000 range, the percent- der age 44. The surge and its reversal anage with no mortgage debt decreased by consistent with movements in tenure um3.6 percentage points (16 percent), and an costs, which were extraordinarily low inadditional 3 to 4 percent of those in the the 1970s as well as high in the 1980%$50,000 to $100,000 range took on second but they may also reflect other phenom.mortgages (a 40 to 50 percent increase). 17 ena. For example, recent distribution@This type of financial adjustment, which data suggest that higher income (likelydampened the potential negative impact older) households had substantially greaterof the tax act on homeownership and con. real income gains in the 1980s than lowersumer durable demand, illustrates how income (likely younger) households. Thefinancial behavior adjustments can make observed reduced propensity to save couldreal responses to "prices" seem lower than also have played a role, as could the in.they actually are (Slemrod, 1992). crease in labor force participation rates.

Because ownership requires saving priorto purchase and saving to repay the mor@

Effects on Ownership Rates and Asset gage, a lower saving propensity could mPrices duce ownership. Because two-earner fam.

ilies have less aggregate nonwork time,Homeownership depends on, among their cost of home maintenance is greater

other things, the ratio of the average cost than that of a one-eamer married couple.of owning (the tenure-choice user cost) to Research on the impact of the recent sharpthe cost of renting (the market rent series decline in homeownership should be a highreferred to earlier). The tenure-choice user priority. If the observed decline is largelycost is a weighted-average for median in- due to reduced desires to save or to spendcome owners of the three household types time on home maintenance, we may not(Ling, 1992). Figure 5 plots the ratio of be concerned. But if the decline largelythese costs. Because rents moved so little, reflects higher housing costs caused by taxthe ratio is dominated by the sharp in- law changes or by real income declines,crease in after-tax interest rates from the we might be concerned about the possiblelate 1970s to the early 1980s. implications of a "forced" renter society.

The high ratio of owner to renter costs Changes in weighted-average marginalin the 1980s should have caused declines user costs are dominated by changes in thein homeownership, particularly of younger level of nominal interest rates and ex-households whose greater mobility causes pected appreciation in house prices andthem to be more sensitive to changes in implicit rents. Figure 6 shows that mar-costs. Declines have, in fact, occurred in ginal user costs were high throughout thethe ownership rates for married house- 1980s. Figure 6 also includes real incomeholds. The rate for households headed by per household and real house prices, bothan individual less than 25 years of age fell indexed to one in 1973. Nominal housefrom 37.5 percent in 1979 to 27.3 percent prices are measured by the Census Bu-in 1990. The corresponding declines for the reau's constant quality house price index25-29 and 30-34 age groups, which are and are

9deflated using the CPI net of

plotted in Figure 6, over the same years shelter.'are from 58.1 percent down to 50.7 per- Relatively low user costs in the middlecent and from 74.5 down to 67.0. Even for and late 1970s appear to have stimulatedthe 35-44 group (not graphed) the rate real house prices, and high real user costs

No. 31 JAMES FOLLAIN, PATRIC HENDERSHOTT, DAVID LING 263

FIGURE 5OWNERSHIP RATES OF YOUNG MARRIED HOUSEHOLDS

VERSUS COST OF OWNING TO RENTING

750/o- 16% 0)-15%

70%- -14% a:-13% 46

412% (9650/o-

0

Q6 -11%0

.2-10%

60%--9% c

550/0- -7% 0

-6% 0

600/0i4 i6 i8 @O i2 @6 @8 9'0

5%

75 77 79 81 83 85 87 89

1 25-29 Yrs )K 30-34 yrs E3 Own/Rent Costs

inthe 1980s to have lowered real house So what can we say about taxes? Re-,n'N s ightly in spite of rising real in- garding the commercial market, probablycome@'We say appears because all three not much. Because high construction lev-seriesare subject to substantial measure- els continued long after passage of thement error. User cost depends on an ex- 1986 tax act, it is hard to attribute thepected appreciation series; alternative pre-1986 high levels to the earlier 1981measures of constant-quality house prices tax act. Moreover, the vacancy rate wasdiffer;and the relevant real income per so high for so much of the decade, tryingbdunhold series should be for owners only to discern a direct link from user costs to(theplotted series likely understates real rents seems pretty hopeless. For apart-imomegrowth of owners). ments, the tax link seems clearer. Mul-

tifamily starts surged shortly after the1981 tax act and plunged after the 1986

Conclusion tax act.Discerning the impact of tax changes Is a stronger multifamily response to the

on real estate in the 1980s is not as sim- 1986 tax act plausible? While tax depre-plea matter as one might think. Two ma- ciation for commercial properties is slightlyOr disturbances occurred in the decade in less generous than for residential underaddition to the two major tax changes. post-TRA law, depreciation for the formerFirst, inflation plummeted early in the was even less generous than for the latterdecade and real after-tax interest rates under pre-TRA law. More specifically, thesurged. By the end of the decade the lat- recapture provisions for commercial prop-ter were still high, although real pretax erties were such that if trading was ex-mteshad finally returned to more normal pected before the tax life, straight-linelevels.Second, a lending frenzy funded an depreciation was preferred to acceler-enormousglut of commercial real estate, ated .21 Thus tax-oriented limited partner-n well as a few extra apartments. ships worked better with residential than

264 NATIONAL TAX JOURNAL [Vol. XLV

FIGURE 6HOUSE PRICES, USER COSTS, AND HOUSEHOLD INCOME

1.20- 16%

1.16--14%

1.10-

- 1 20/cx

,a 1.05-C

-io%

1.00-

0.95--8%

0.90--7---r- 6%73 75 77 i9 di @3 65 67 69

74 76 78 80 82 84 86 88

-0- REAL HOUSE PRICE -+- MARGINALUSERCOST -)K- REALlNcz7m@

with commercial properties, and when the tax act is the sharp reduction in the ef.tax law was changed to curtail limited fective home mortgage interest deductionpartnership deals, residential invest- for low and moderate income households.ments were more adversely affected. The combination of large increases in the

The impact of relative prices, and thus standard deduction and decreases in non-of the taxes that affect these prices, on housing deductions effectively eliminatesowner-occupied housing decisions seems or almost eliminates the home mortgageclear. Real house prices rose sharply in the interest deduction. This makes debt fi-late 1970s, when the cost of owning was nancing relatively more expensive thanrelatively low, and then fell in the 1980s equity financing and leads to lower debtwhen the cost was high. Similarly, home- usage by such households.ownership grew sharply in the 1970s,when the relative cost of owning was low, ENDNOTESand reversed itself in the 1980s, when therelative cost of owning was high. The sharp 'Note the adjective "significant." In the earlier pa-decline (10 percentage points for married per we stated that the 1986 act had "overshoe'the

couples under age 25 and 7.5 percentage theory-tax depreciation had been lengthened moreand the tax rate raised higher than the cut in the

points for married couples age 26 to 35) inflation rate warranted. Thus, a small reduction inmay be a major social concern, and iden- the capital gains tax rate would not be inconsistenttifying the cause of the decline is cer- with the theory.

tainly an important topic for future re- 'This is in the spirit of Hendershott (1987), who, inhis attempt to assess whether or not events between

search. 1981 and 1985 were consistent with the 1981 Tax ActA possibly unintended effect of the 1986 simulated both the tax change and a three pereentap

No. 31 JAMES FOLLAIN, PATRIC HENDERSHOTT, DAVID LING 265

pointdecline in the inflation rate, recognizing that a 2 percent floor, and the floor for medical deductionstWlatter was potentially as important a disturbance has been increased to 7.5 percent of AGI from 5.0 per-n the tax law change. cent. Thus for many households, charitable contri-

'rhe appreciation components of the Russell- butions and state income tax liabilities are the onlyNCREIF indexes suggest substantial declines in real personal nonhousing deductions that remain.mutant-quality prices in recent years. For office 14The constancy of the marginal rate in the figurebuildings, the decline is 30 percent since the end of (compare 1979-80 with 1988-89) in the face of sharp10, a third of this coming in 1991, and for apart- cuts in marginal income tax rates reflects the sub-ments16 percent since the end of 1987, with half the stantial decline in homeownership of younger, lower&din coming in 1991. Hendershott and Kane (1992b) income households. This decline is discussed below.&W that office building market-value prices should l5Skinner and Feenberg (1990) emphasize the im-have risen far less than appraisal prices did prior to pact of this change on the composition of household1986and should not have fallen so drastically since. debt.

'As we stressed in Follain, Hendershott, and Ling, 16Calculation of 1985 and 1989 federal income tax1987,the timing of the increase in real rents caused liabilities is accomplished for each household by ap-bythe 1986 tax act would depend on local market plying the applicable federal income tax structure toconditions.local markets that were overbuilt prior to an enhanced AHS database. Although the AHS datapmge of the act would not experience real rent in- do not contain income tax liability information, mostaeam until discards and absorption depleted the ex- of the raw data required for estimating income taxem supply. Absorption, of course, would depend on liabilities are present. Ling and McGill (1992) pro-the rate of economic growth in the local market. vide a detailed discussion of the calculations and the

'The tax saving depends on the tax depreciation enhancement of the AHS data base with supplemen-"ule, the after-tax discount rate, and the tax rate tal information from the Internal Revenue Service'sat which the deductions are taxed. The decrease in individual tax return data.the tax saving in 1980-81 is due to a sharp increase 17Most notable, though, was the 17 percentage pointin the discount rate. increase (32 percent to 49 percent) in the total mort-

'Me derivation of the user cost of capital is based gage-debt-to-value ratio of households with AGIupon the concepts and methods discussed in Follain, greater than $120,000. (The aggregate mortgage-loan-16ndershott, and Ling (1987). The series relies upon to-market-value ratio increased slightly from 31.2an expected inflation series generated by a distrib- percent in 1985 to 32.8 percent in 1989.)uted lag of past inflation rates. The series also as- "We thank David Crowe for supplying us with theseP=s a tax rate for investors equal to 50 percent for numbers.the period prior to ERTA, 45 percent for the period 19Numerous alternatives to the Census Bureau'sIN2 to 1986, and a 36 percent rate since the passage constant quality house price index have been put for-d TRA.The specific rental user cost series plotted here ward. The differences in these house price seriesmbeing used in ongoing work by Dixie Blackley and highlight the difficulty associated with the construc-Jow Follain. tion of house price indexes. A recent special issue of

'These discussions draw on Follain, Leavens, and the Journal of the American Real Estate & UrbanVolt (1992) and Hendershott and Kane (1992a) who, Economics Association (Fall, 1991) contains numer-roqwtively, discuss developments in the rental hous- ous papers that address this topic.14 and office markets in the 1980s. '-'OFora general analysis of many factors affecting

,me real rent series is the residential rent com- real house prices, see Peek and Wilcox (1992)pment of the CPI with two modifications. First, the 21 If accelerated depreciation were taken, all depre-rut component is adjusted upward beginning in 1964 ciation would be recaptured at ordinary income taxby0.5 percent annually to correct what many believe rates; if straight-line depreciation were taken, it wouldto be a downward bias in the residential rent com- be effectively recaptured at the capital gains tax rate.ponent.Second, the series is converted into real terms (For residential, the excess of accelerated over straight-bydividing by the CPI-Iess-shelter series. line was recaptured at ordinary rates, and the straight-

'Poterba (1990) attributes the decrease in starts to line was recaptured at the capital gains tax rate.)the 1986 tax act.

"rhe series are described more fully in Hender-shott and Kane (1992a). REFERENCES"While office markets represent the best measured&Wprobably the most dramatic example of over- Follain, James R., Patric H. Hendershott, and Davidbuilding in the 1980s, they are hardly the only.one. C. Ling, "Understanding the Real Estate Provi-To industrial vacancy rate moved similarly, rising sions of Tax Reform: Motivation and Impact," Na-hom 3.5 percent in 1980 to over 5.5 percent in 1986 tional Tax Journal, 1987, pp. 363-72.ad staying above that level for the rest of the de- F,Ilain, James R. and David C. Ling, "The FederaleWo.While harder to document, the hotel/motel and Tax Subsidy to Housing and the Reduced Value ofshopping-center markets showed major weakness as the Mortgage Interest Deduction," National Taxoil]. Journal, June 1991, pp, 147-68.

'4U also limited the deductibility of mortgage in- Follain, James R, Donald Leavens, and Orawin Velz,tsrnt expense to that on mortgages of $1 million plus "Identifying the l@,ffectsof Tax Reform on Multi-6100,000 of home equity debt. family Rental Housing," March 1992, National As-

'More specifically, consumer (non-inortgage) inter- sociation of REALTORS Research Paper (revisionad has been phased out, sales taxes are no longer de- forthcoming in Journal of Urban Economics)."ble, miscellaneous deductions are now subject to Giliberto, S. Michael, "The Real Estate Bubble," Sal-

266 NATIONAL TAX JOURNAL

omon Brothers, October 8, 1991. search in Real Es&zte.- Volume IV, forthcoming 1991Hendershott, Patric H., "Tax Changes and Capital Ling, David C. and Gary A. Mc(;ill, "Measuring the

Allocation in the 1980s," in Feldstein (ed.), The Ef- Size and Distributional Effects of Home Owner Tafects of Taxation on Capital Formation, University Preferences," Journal of Housing Research, for&of Chicago Press, 1987, pp- 259-290. coming 1992.

Hendershott, Patric H., James R. Follain, and David Peek, Joe, and Wilcox, "The Measurement and De.C, Ling, "Effects on Real Fstate," in Pechman (ed.), terminants of Single-Family House Prices," Jour.Tax Reform and the U S Economy, The Brookings nal of the American Real Estate & Urban Econom.Institution, 1987, pp. 71-102. ics Association, Fall 1991, pp. 353-82.

Hendershott, Patric H. and Edward J. Kane, "Causes Poterba, James M., "Taxation and Housing Markaand Consequences of the 1980s Commercial Con- Preliminary Evidence on the Effects of Recent Tustruction Boom," Journal of Applied Corporate Fi- Reforms," in Slemrod (ed.), Do Taxes Matter? Tknance, May 1992a, pp. 61-70. Impact of the Tax Reform Act of 1986, Cambridgr.

-, "Office Market Values During the Past De- The MIT Press, 1990, pp. 141-160.cade: How Distorted Have Appraisals Been?," May Skinner, Jonathan and Daniel Feenberg, "The I*1992b. pact of the 1986 Tax Reform on Personal Saving,*

Hendershott, Patric H. and Joe Peek, "Treasury Bill in Slemrod, (ed.), Do Taxes Matter? The Impact 4Rates in the 1970s and 1980s," Journal of Money, the Tax Reform Act of 1986, Cambridge: The MITCredit and Banking, May 1992, pp 195 - 214. Press, 1990, pp. 50-79.

Ling, David C., "The Price of Owner-Occupied Hous- Slemrod, Joel, "Do Taxes Matter? Lessons from theing Services: 1973-1989," in Sa-Aadu (ed.), Re- 1980s,- NBER Working Paper No. 4008, March 1991