How Rental Income Gets Lost
in United States National Income Accounts
Michael Hudson, Ph.D.
[1995]
Real estate held by the nonprofit sector
The Fed's treatment of the land values for non-profit organizations
undervalues land by a steeper discount than occurs anywhere else in
the accounts published so far -- only 10 percent of the estimated real
estate value. This is because the replacement cost of buildings in
this sector absorbs about 90 percent of the overall value.
This figure looks suspicious for a number of reasons. For one thing,
tax assessments on real estate held by non-profits tend to be
notoriously low. Secondly, their buildings tend to be specially
designed in ways that make it particularly difficult to shift them to
normal household residential use or to commercial use.
For this reason, land should represent a higher proportion of the
true market value of structures held by non-profits than is found for
corporately held real estate (60 percent, using a historical cost
basis to estimate building values). Estimating land at 60 percent of
the value of nonprofit real estate would indicate a value of $0.5
trillion for 1996. Estimating land at 75 percent would raise this
figure to $0.6 trillion.
These two adjustments -- for corporate and non-profit real estate --
shift some $2.5 trillion in value from structures to the land.
The household sector's residential real estate
The largest category of land and real estate value, of course,
consists of residential housing held by the household sector (that is,
owner-occupants). Unfortunately -- and unlike the case with corporate
real estate -- the FRB does not estimate homes at their historical
cost, but only on a replacement cost basis. Using this "land
residual" technique leaves today's household sector with a land
value of just under $2 trillion, virtually unchanged from 1987 (that
is, for nearly a decade). This means that land has fallen from 30
percent to just 20 percent of overall household real estate value.
Is this reasonable? During these years the overall value of household
real estate has grown from under $5.5 trillion to over $8.1 trillion,
a gain of $2.6 trillion. Even if we were to accept the "land
residual" method as being valid during the many decades of
soaring land and site values, holding the land value total steady at
30 percent would increase land values by $0.5 trillion, to a total
$2.4 trillion.
One of the two really big "sense of proportion" questions
to be asked, of course, is whether household residences should be
valued at their replacement cost or at their historical cost. The
problem with valuing them at their steadily rising replacement cost is
that this absorbs all the appreciation in property values -- an
appreciation that seems more realistically the result of rising
land-site values, to the extent that it is "environmental"
(referring in this case to the business environment and its
asset-price inflation). In the late 1980s, household and corporate
replacement costs of buildings left land with only about 28 percent of
total property values. If we made the same adjustment for residential
housing that the Fed made for corporate buildings in valuing them at
their historical cost, this would raise residential land values to 60
percent of the total (the 1990 figure) or at least 45 percent (the
1996 figure).
Taking as a rough order of magnitude a 50/50 split between
residential land and buildings would produce a land value of over $4
trillion, double the Fed's estimate.
This addition of some $2 trillion of residential land value seems
justified on pragmatic grounds by the notorious undervaluation of land
appraisals by local tax assessors. As these assessments are the basis
on which Census statistics are compiled, one must accordingly use
common sense in making the above adjustments.
The other "sense of proportion" question is whether one
should use a "building residual" rather than a "land
residual" appraisal method. This method likewise would add about
$2 trillion to the rise in land values over the past decade,
confirming the above estimate.
So far, these adjustments have added $4.5 trillion to the nation's
land values. And this does not include the noncorporate real estate
sector, that is, the sector to which most commercial real estate
belongs.
As matters turn out, there also is another reason to suspect that the
Fed may be undervaluing household real estate. The Bureau of Labor
Statistics (BLS) conducts its own surveys of what homeowners believe
the market value of their residences to be.
The FRB's estimates of residential real estate and land values in
light of BLS statistics
An alternative government source of statistics on residential home
values is published by the Bureau of Labor Statistics (BLS). The BLS
asks its statistical sample of homeowners to estimate the market value
of their homes. Expanding this sample to a nationwide scale,
owner-occupants reported a value of $7.4 trillion for their homes in
1995.
In evaluating the quality and reasonableness of the BLS statistics, a
number of caveats apply. Ego may indeed play a role in the
respondants' estimates of the market value of their homes. On the
other hand, this probably does not distort their reporting as much as
do the under-appraisals that appear in tax assessment records. The
political sway of homeowners when it comes to contesting appraisals of
their property for tax purposes may be stronger than the egos
reflected in what they tell the BLS.
The BLS estimate for homeowners' real estate value is closely in line
with the FRB estimate of $7.6 trillion. Indeed, over the past decade
the BLS and Fed figures closely reflect each other. Yet one would have
expected that the Fed's statistics would be somewhat higher, for its
estimates for the value of residential real estate owned by households
cover more categories than are surveyed by the BLS. For instance, it
is well known that the wealthiest 5 or 10 percent of the population
own a disproportional value of its real estate and other assets.
Recognizing this fact, the Fed oversamples these categories. It also
includes household ownership of vacation housing, whereas the BLS asks
homeowners only to estimate the market value of their primary
residences.
The relative absence of the very richest families from the BLS
numbers suggests that its estimates miss an important element of the
economy's total household real estate value. Yet the FRB statistics do
not provide a higher estimate. This suggests that homeowners probably
estimate the market value of their residences at a higher level than
local assessors (on whose reports the Fed relies), but that this
probably more realistic estimate may be more than offset by the more
narrow scope of BLS surveys.
A comparison of the year-to-year changes in BLS and Fed series on
household residential real estate holdings suggests that the BLS
reporters have a good idea of the market shifts occurring. In 1984,
the year when the BLS series began, housing prices were just beginning
to take off. The BLS nationwide estimate of $4.265 trillion was
slightly higher than the Fed's $4.018 trillion estimate. But in 1985
the Fed's estimate pulled ahead, and has remained higher ever since.
In 1994, owner- occupants surveyed by both the BLS and Fed estimated
that the value of their homes rose by about $0.3 trillion, and by the
same amount again in 1995. These estimates seem reasonable.
It is notorious that in times of rapidly raising prices, local real
estate appraisals fail to keep up with the exploding market. The
reason is largely political: homeowners would protest against the
sharply rising taxes that would accompany realistic annual property
reappraisals.
In sum, the estimates made by respondents to the BLS Consumer
Expenditure survey regarding the market value of homes to their owners
seem to be based on realistic calculations by the homeowners making
them. At least their estimates stand closely in line with those made
by the Federal Reserve System in its compilation of nationwide balance
sheets. But one would have expected the FRB statistics in Table B.100
to have been substantially higher. If the 5 percent wealthiest
American families own 20 percent of the real estate, this would have
added about $1.5 trillion to BLS statistics that exclude these
families. This suggests that the Fed's real estate estimates for the
household sector should be higher than those of the BLS -- unless the
homeowners surveyed by the BLS tend chronically to overvalue their
homes.
This higher value in turn would be deemed to generate a proportional
flow of rent.
In sum, a comparison of the year-to-year changes in BLS and Fed
series on household residential real estate holdings suggests that the
BLS reporters have a good idea of the market shifts occurring. In
1984, the year when the BLS series began, housing prices were just
beginning to take off. The BLS nationwide estimate of $4.265 trillion
was slightly higher than the Fed's $5.6 trillion estimate. But in 1985
the Fed's estimate pulled ahead, and has remained higher ever since.
It is notorious that in times of rapidly raising prices, local real
estate appraisals fail to keep up with the exploding market. The
reason is largely political: homeowners would protest against the
sharply rising taxes that would accompany realistic annual property
reappraisals. Yet in 1994, the BLS and Fed both estimated that the
value of their homes rose by about $0.3 trillion, and by the same
amount again in 1995. These estimates seem reasonable.
The question that inevitably arises is, how much should the rise in
home values be attributed to rising land appreciation, and how much to
building costs. The BLS does not ask its respondents to answer this
question. The Fed answers it in an arbitrary way. After estimating the
value of residential real estate (and other real estate) held by
households, non-profit institutions, corporate and non-corporate
business, farms and other categories of holders, it then estimates the
replacement cost of real estate structures. This leaves a residual,
which formerly was called "land" and which now is not even
listed separately, evidently because the Fed recognizes that its
methodology produces nonsense results.
The noncorporate real estate sector
The most recent statistics published for noncorporate real estate
remain those for 1994. In that year, land ($551 billion) accounted for
less than 25 percent of the sector's overall assessed real estate
value -- down from 42 percent as recently as 1989. Here we see the FRB
once again charging land with the entire price decline that is derived
by subtracting the replacement costs of buildings from their market
values (which are scarcely recognized to have budged in any year since
1989!).
Using the land residual technique of appraisal, in 1989 the Fed
derived a land value of over $1,024 trillion. But by 1994 this
derivative had been cut nearly in half, to $551 billion. Yet
inexorably, the replacement cost of buildings was calculated as
rising.
Certainly this derived figure did not represent market values. As the
economy shrunk, demand for office space contracted. This suggests that
a building residual technique would have been more relevant to use.
Simply holding land values steady would have added some $0.5 trillion
to the FRB's land estimates. This is virtually what we would get by
holding land constant at its 1989 proportion to overal real estate
value. And taking a ratio of 60 percent -- the proportion indicated by
valuing corporate real estate at its historical cost basis -- produces
a land value of $1.3 trillion, some $0.8 trillion over the reported
1994 land figure.
Adding similar adjustments for farmland and for financial corporation
increases the land value by some $1.0 trillion. This figure, taken in
conjunction with the $4.5 trillion added for residential, non-profit
and corporate real estate more than doubles the estimated land value,
from $4.4 trillion in 1994 to nearly $9 trillion.
Taken together, these adjustments suggest that in imputing the
proportion of real estate rental income as between land and buildings,
land should be credited with 60 percent of the total.
Should structures be valued at their historical cost or their
replacement cost?
While the cost of construction always is rising (by about 3 percent
annually), these buildings also are depreciating in value. Private
firms within the real estate industry make estimates both of cost
increases and depreciation rates. And in summer of 1997, the NIPA
statisticians made their own critique of the depreciation numbers that
had been based on IRS filings.
To some extent (but not entirely), depreciation and obsolescence
offsets rising replacement costs of buildings. But building values in
reality rarely decline by more than 25 percent from physical wear and
tear, unless the building's purpose becomes obsolescent (as in the
case of many industrial structures, primarily those in the corporate
nonfinancial sector).
Of course, real estate values rise and fall in keeping with overall
property prices. But these shifts are not properly attributed to the
buildings themselves. Being "environmental" (in this case,
the financial environment as well as the physical and economic
environment), they fall into the category of land value.
If the purpose of statistics is to depict the economy in terms of the
motivations of its actors (investors and consumers, as well as bankers
and other intermediaries), it is necessary to have better calculations
of land values for the household, non- corporate and corporate
sectors, and to juxtapose these land values to overall real estate
prices and building values. In such an analysis, it is the building
values that would be the residual item, not land values.
Conclusion: What is needed for a satisfactory estimate of land
and building values
The above discussion has explained that the Fed's appraisal
methodology is not the only way in which this estimate could have been
made. In fact, it is not the most reasonable way. Structures could
have been taken at their historical cost, for instance. A comparison
with corporately owned real estate shows that there are good reasons
for using this means of evaluation. Furthermore, it is more plausible
to use a "building residual" method of appraisal than to use
a "land residual." This is because the real estate landscape
is continually changing, and few builders would choose to replicate
existing buildings.
In addition to the problem of overall household real estate
assessments, the Fed statisticians face the further problem of
estimating the value of residential structures at their replacement
cost rather than on a historical cost basis.The results produced for
the corporate nonfinancial sector suggest that it would be more
logical to subtract the historical cost of structures from the
property's current market value.
But an even preferable method exists -- the building residual method
of valuation. This would begin with an independent appraisal of land
values, and then credit (or in some cases, debit) the structures with
the residual value.
Most desirable of all would be to create a land-map of the U.S.
economy, and attribute the rise and fall of real estate values to the
land, using the buildings as the residual item rather than the land.
Such a land-value map would cost money to initiate. But it is the best
way to track what turns out to be the economy's most valuable asset:
the land.
Such a calculation would go beyond the FRB's resources, to be sure.
The Fed is dependent primarily on Census data for its real estate
values, and the task of creating a land map of the United States
(presumably by states) is properly the task of the Bureau of the
Census.
The job certainly is possible. The government can incorporate this
into the Census routine. It might use this data for federal grants.
My estimates suggest that such a study would revalue land relative to
structures by $1.5 trillion for corporate real estate, another $2
trillion for owner-occupied residential real estate, and $1 trillion
more for noncorporate real estate partnerships. This would double the
value of land from the amount estimated by the FRB.
The final question to be asked is thus why this is not being done.
Political factors supporting an underestimation of the land
In the physical sciences, quantitative measurement is sacrosanct.
From objective quantification emerge the patterns that provide the
clues to how nature's physical and chemical relationships are
organized. Emulating the natural sciences, economists express their
theories in mathematical garb, but not many professors venturefrom
their classrooms to deal in concrete statistics. Indeed, some
important theoretical categories appear muddy when tested empirically.
Specifically, the disappearance of land from the economy's balance
sheet statistics cast doubt on how empirical modern economics can
reasonably claim to be.
Nonsensical results indicate that the methodology being used is
seriously flawed. The acronym GIGO ("garbage in, garbage out")
is appropriate. But it is axiomatic that when a wrongheaded
methodology is maintained despite its evident defects, it is wise to
suspect special interests of being at work. Almost invariably there is
a political motive behind what appears to be innocent statistical
madness. In the case of land valuation, the FIRE sector has a
self-interest in not tracking land gains more closely, and government
agencies have acquiesced in this industry bias. This undervaluation
reflects modern economic theory's general disregard for land's role,
despite the fact that more wealth is generated in land appreciation
than anywhere else in the economy remains the best-kept secret of
statistical portrayals of the American economy.
The FRB's emphasis on rising building replacement costs attributes
the rise in property values to something other than land. It also
tends to justify over-depreciation, as owners can claim that they
would have to pay more to replace their structures.
An understandable fear exists that any statistics that estimate a
higher value for rental or land services will lead the government to
tax these assessments at some point. (I understand that this is the
reason why national income statisticians have stopped trying to
estimate the economic value of housewives.) There is no political
constituency that derives a more realistic assessment of the economy's
real estate rent (except perhaps for manufacturing), nor even to track
land values, whose increase has provided the basis for countless
family fortunes and corporate balance sheets as seen by prospective
stock buyers but not by the IRS and local fiscal authorities.
The neglect of land values seems all the more remarkable in view of
the fact that most of the annual appreciation in real estate stems
from rising land values. Yet such capital gains are virtually
neglected in the statistics, although they are a primary objective of
commercial real estate investment.
It will be noted that the value of a site's location, its zoning ,
municipal improvements and the economic development occurring in its
vicinity (including transport accessibility) are not the direct result
of capital expenditures by owners, yet the Fed's statistics depict the
remarkable growth in U.S. real estate values (and, in times of
economic downturn, their shrinkage) as being the result exclusively of
the inexorably rising cost of replacing buildings.
|