Moontower #79

Friends,

You will be working from home more often. Not all of you but many of you. That means browser tabs devoted to Zillow searches in Austin, Nashville, Vegas, Denver, and Miami. Geo-arbitrage won’t be as dramatic as software devs had hoped since the big companies will cut your pay when you leave, but in some of these places you could sustain a 20% pay cut and still be better off (at least if you’re leaving SF).

One of the biggest inputs into cost-of-living comparisons are so-called SALT (state and local) taxes. Since 2018, SALT deductions are limited to $10,000. They were previously uncapped. This has created even larger disparities in cost-of-living between states. CA, IL, NJ, and NY have income taxes that get a bit handsy with their residents.

Beyond state income taxes, one needs to consider property taxes for a more complete picture. Texans enjoy zero state income tax but hefty property taxes. NJ residents are assaulted from both ends — above average state income taxes and punitive property taxes. How about CA? The state income tax, gas tax and the cost of renewing a vehicle registration are nothing short of sunny weather ransoms.

But what about CA property taxes? The answer to this is sneaky and can be used to understand the impact of property taxes in general. But I’d go further and say that if you have not walked through the math the way we are about to, then you may be walking around with some very mistaken impressions about the cost of housing.

Property Taxes: Apples to Apples

The effect of property taxes depends on 2 core variables. The property tax rate and the assessed value. If you are weighing a house in CA to a house in NJ you want to make an apples-to-apples comparison. How do you do that when the rates are different and the methods of assessing value are different?

Let’s isolate each effect.

[Obviously the cost to buy a home has many factors that can mostly be tucked under the headings of supply and demand. Yet the effect of property taxes is significant so it’s worth isolating. It’s also worth noting that since a primary residence is most people’s largest asset, a property tax is a defacto, albeit incomplete, wealth tax. Economically it’s passed-thru to renters so it hits everyone]

Assessed Value Effect

Property taxes are waged on assessed value. In NJ, assessed value resets whenever a home trades. So if you buy a $1,000,000 home and the property tax rate is 1% you owe $10,000 per year in property tax. As the estimated market value of your home changes, your assessed value changes. So if your market value jumps 15% in one year you can expect a big increase in your tax bill. It may lag the full market return but the idea is the assessed value tracks the value of the home. Downturns in prices require homeowners to plead their case that the home’s value has declined if they want relief on their taxes.

Like NJ, CA assessed value resets to the purchase price after a transaction. But then CA diverges from other states. A month before I was born, in June 1978, CA passed Prop 13, a ballot proposition that has created distortions in wealth that few could have foreseen. Prop 13 froze assessed values at 1976 levels for homes which have not since traded. It also limits increases in assessed value to a cap of 2% per year.

Combined with a NIMBY attitude to permitting new construction, CA features a lopsided sight to behold — multi-million dollar homes with single-digit thousand tax bills. Nice for those owners but not socially desirable.

Consider:

• The flipside of having seniors be able to stay in their homes is that it limits worker mobility by poorly allocating big homes to people who don’t need them. It basically keeps rooms off the market. If you are a senior citizen on a fixed income you are not going to sell the home you’ve outgrown to buy a condo with much higher property tax than the big house you leave behind. And that’s after you pay a huge cap gains bill.
• Prop 13 starves the state of tax revenue that needs to come from somewhere. So the state income tax can be seen as a wealth transfer from young, working Californians to older, entrenched Californians.

In a state that has seen generational wealth built on a loop of buying real estate, and cash-out refis it’s easy to see how Prop 13 has contributed to the party. Let’s pretend you buy a home in CA and NJ.

Assume:

• Each home costs $1,000,000
• Each has a property tax of 2.5%. We are isolating the assessed value effect so need to hold the tax rate constant.
• Each home has a real (inflation-adjusted) return of 2% per year.
• The only difference is the CA home is assessed only when you buy it, but the NJ home is assessed each year.

The CA home’s IRR will be .14% after-tax while the NJ home’s IRR is -.52%. The CA home outperformed the NJ home by .66% per year over 30 years. On a $1mm home that’s over $275,000 simply because the NJ home is re-assessed every year.

It gets crazier. The effect actually explodes with higher appreciation rates. If we double the appreciation rate to 4% per year, the CA homes nets you $700,000 more than the NJ home. Remember that the tax rates are the same! We are just isolating the impact of fixing the assessed value at the purchase price.

The main takeaway is Prop 13 is a call option on inflation. Your home is much less of an inflation hedge than you think if its assessed value increases in-step with the market value.

[This year Prop 15 is on the CA ballot. Prop 15 would repeal Prop 13 for commercial properties only. Based on the examples above, it’s obviously something RE investors are highly concerned about.]

Rate Effect

What if you wanted to compare the price of homes in 2 places with different property tax rates? Let’s pretend CA no longer had Prop 13. Like NJ, it’s property taxes were re-assessed annually. This allows us to simply isolate the impact of differing tax rates.

Let’s assume:

• Each home costs $1,000,000
• CA tax rate is 1%
• NJ tax rate is 2.5%.
• The homes do not appreciate over 30 years (just to keep it simple)

Let’s explore 2 methods of comparison:

The Mortgage Method

If the homes do not appreciate then their assessed value remains fixed at $1mm. This makes it easy — the CA home owes $10,000/yr in taxes and the NJ home owes $25,000. On a monthly basis, the NJ come costs an extra $1,250. If mortgage rates are 3% we can find that a $300,000 30-year mortgage corresponds to a $1,250 monthly payment. So we can say that a $1mm house in CA costs the same as a $700,000 house in NJ since the $700,000 plus an additional $300,000 mortgage would equate to the cost of the CA home.

The IRR Method

The IRR on your home’s value will will approximately differ by the spread in the tax rates. In the table below, we see that the CA home returns 1.44% more (close to 1.50%) over 30 years. If we use an inflation rate of 3% to keep consistent with what I chose as a mortgage rate, we find that the NJ home costs you $300,000 more over the 30 year holding period than the CA home, matching the result from the mortgage method.

Combining Effects

To compare the price of a home in CA to a home in NJ you need to account for both the difference in property taxes and how assessed values are treated. Let’s combine the results in one model with more realistic numbers:

• A 4% annual home appreciation in both markets
• A 2% inflation rate
• CA tax rate is 1%
• NJ tax rate is 2.5%
• CA assessed values do not increase, NJ is re-assessed annually

CA, due to Prop 13 and a lower property tax rate, has an almost 2% edge in annual return (3.29% vs 1.34%). Since these are nominal returns and inflation is 2% per year we see that the NJ home end up actually losing value in real terms. The fact that the home is re-assessed every year means that even though the home’s value is growing faster than inflation the taxes are also growing very quickly.

I don’t want to have you miss the point — these CA and NJ homes were assumed to grow at the same rate of 4% per year and yet the CA home earned you an extra $900k in present value vs the NJ home. This is strictly due to lower property taxes and Prop 13.

We know that home appreciation in CA has been faster than NJ (my family considered moving to CA in late 70s, early 80s so we are very sensitive to the comparison). The difference in property tax policies has a staggering delta in terminal wealth when applied to CA real estate boom over the past 50 years.

Wrapping Up

Having grown up in NJ and now lived in CA, I have noticed a massive divide in how people have earned their money and wealth. You cannot live here and not notice the wealth built in real estate and not think about how policy has enabled it. When you start comparing apples-to-apples, the headline prices of CA homes are not as relatively expensive as they appear. Don’t hate on Californians though. Those SALT taxes are still burying all of us who still work for a living.

In sum:

• Prop 13 allows homes to be a call option on home appreciation/inflation
• High property taxes on homes that are re-assessed require rapid appreciation to not render the home ‘dead money’
• Compare homes with different property taxes by amortizing the difference in monthly payments into a mortgage

Sending a thanks to @econompic who I discussed these topics with. As another NJ to East Bay transplant he has given these ideas plenty of thought as well. And on the math side, he gave me the idea to use IRRs instead of CAGRs. CAGRs are simpler because they are compounded returns which require no more than a start value, ending value, and time period. They are commonly used when calculating a return for a stock or fund that you buy and hold.

In this case, IRRs or NPVs are preferable since there are many cashflows.

The Money Angle

A couple posts from Nick Maggiulli worth your time:

• 9 Income Producing Assets (Link)

  There are many ways to win when it comes to investing.  In this game, it’s not about picking the “optimal” assets, but the ones that will work best for you and your situation.

  Nick provides a handy taxonomy of what’s involved, the general riskiness, and return ranges for various investment types.

• How Much Lifestyle Creep Is Ok? (Link)

  I’ve explained before how a dollar saved is worth more than a dollar earned when it comes to retirement planning. One reason for that is when you increase your spending you not only have less savings to invest/compound. But there’s an invisible effect that multiples the problem. Increasing your spending raises the baseline for the standard of living you must provide for in your later non-working years. And if that cost is recurring, it’s an expense that also compounds with inflation.

  This leads to sobering arithmetic. If you get a raise and start spending most of that money you actually delay your retirement age despite the fact that you are still netting more after-tax savings.

Last Call

• A collection of twitter threads by topic from one of my favorite writers (Link)
  Venkatesh Rao

  My favorites were:

  Learning as rental over ownership (Link)

  And these threads that pair well together:

  Bullshit jobs and culture wars (Link)
  On grift (Link)

• The Four Quadrants of Conformism (Link)
  Paul Graham

  The conventional-minded say, as they always do, that they don’t want to shut down the discussion of all ideas, just the bad ones.You’d think it would be obvious just from that sentence what a dangerous game they’re playing. But I’ll spell it out. There are two reasons why we need to be able to discuss even “bad” ideas.

  The first is that any process for deciding which ideas to ban is bound to make mistakes. All the more so because no one intelligent wants to undertake that kind of work, so it ends up being done by the stupid.

  The second reason it’s dangerous to ban the discussion of ideas is that ideas are more closely related than they look…Having ideas in a world where some ideas are banned is like playing soccer on a pitch that has a minefield in one corner. You don’t just play the same game you would have, but on a different shaped pitch. You play a much more subdued game even on the ground that’s safe.

From my actual life