29 August 2010

Why Are Russian Houses So Expensive?

Recently my family and I were in Sestroretsk, a city near St. Petersburg. This lovely town is situated on the seashore and embedded in a northern forest decorated with birch trees.

Sestroretsk also happens to be a former favorite resort city for the who’s who of Russia's Communist Party. Because of this city's status during Soviet times, dachas* - typically modest houses and small plots of land - are transmogrified to enormous stately mansions on two or more acres of land.
Main Street on Sestroretsk:  Giant Communist Era Dachas

These mansions are beautiful; more accurately, these mansions were beautiful and some still are. Some older structures have been maintained and still have the glory they had some fifty years ago. Some have been razed and replaced by modern, very expensive buildings. Some are relics of yore and have been abandoned and, even in some cases, have fire damage.
New and Old in Sestroretsk:  Pricing Shock and Awe

The location of these mansions is idyllic. The maintained or new properties prove that there are a sufficient number of wealthy builders that are keeping Sestroretsk beautiful. The surprise is the high number of abandoned buildings. The question is why they are there; more precisely, the question is why are not more of them sold to would-be-buyers who could and would invest in them to maintain their soundness and beauty.

Clearly, one answer is that the price is too high, thereby limiting the pool of buyers to the ultra-wealthy. The "high-priced real estate" phenomenon, however, is not unique to Sestroretsk. Per my experience, all of Russia has surprisingly high real estate prices as measured by American standards. In the US (before the housing bubble where sanity prevailed), the rule of thumb was that houses should cost somewhere between three to four times the annual household income. As such, a family making $100,000 per year would be expected to live in a house that cost $300,000 - $400,000. My casual observation indicates that the house price to annual income ratio is far higher in Russia, and in some cases close to infinity (because income is nearly zero).

The question thus becomes "why are houses so expensive in Russia?"

While the complete answer is, like most things in life, complex, most of the answer, like most things in life, is simple. Basically, it comes down to property taxes, or the lack there of.

In the US, one pays the government for the privilege of owning a house. This property tax is different in different regions of the US, but tends to be 1% to 1.5% in most places. The family making $100,000 and living in the $300,000 house above would have to pay some at least $3,000 of annual taxes for living in the house. That is at least a 3% income loss, and a significant loss if there is the family has a small discretionary budget. Accordingly, the family living in the house has to generate enough cash annually to pay for all expenses and property taxes. Therefore, if rich Uncle Oswald bequeaths a mansion to poor Nephew Norman, and Norman does not have the income to support the property tax, you can be sure that Oswald's estate would be on the market and sold to the highest bidder that would show up within a reasonable amount of time.

Because there are effectively no property taxes in Russia**, there is no need to have the wherewithal to sustain a property after it has been acquired***. This makes housing prices at least inelastic in Russia (or it may even increase prices) as owners with no immediate need to sell and can hold on to the property indefinitely until the buyer with the "right" price - as defined by them - comes along. The more patient the owner is, the higher the price he can command.

Unfortunately for the average Russian, there are too many patient owners and too many ultra-wealthy Russians. Owners are patient because there is no property tax to motivate them to dump their properties on the market, thereby drive prices down. And because of the very uneven income distribution in Russia, there are those elite few who can buy what they want at very high prices. These factors conspire to pump up prices of new home purchases beyond the reach of the average Russian.

Patient owners, immune from foreclosure fears, are waiting for one of those rich Russians to come along and pay the "right" price. Thus, you have a checkerboard of beautifully-maintained or newly-constructed mansions next to dilapidated former estates in Sestroretsk.

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* Dachas are summer residences that are nearly universally owned by every Russian family. They are located out of the city in a nearby forest.

** There are some minimum property taxes but, compared to the US, those taxes are effectively zero.

*** Acquisition may come through a purchase, an inheritance, or otherwise. The point is that it does not matter how the house is acquired because property taxes should apply uniformly, regardless of the method of acquisition, to the owner.

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Addendum

Just for the fun of it, I have tried to model the interaction described above. The model is raw and needs more work; currently, it looks like this:

t is the time the owner is willing to wait to sell his property. The more patient the owner, the larger t is.
I is the owner's income in real terms.
T is the tax burden (not the tax rate) in real terms.
P is the owner's property value.

t is a function of T and I. In other words, t = F(TI).

If I is much larger than Tt approaches infinity (the owner is very patient if his income dwarfs his tax burden, as I have witnessed for many owners in Russia). However, the closer in size I and T get, the smaller t gets. And if I is smaller than T - as was the case for nephew Norman above - the owner is operating on short time and we can expect a fire sale. So,

t = F(IT) = (I / Tn where n > 0 and is descriptive of endogenous factors that may increase (n > 1), decrease (1 > n > 0), or have no impact (n = 1) on the owner's patience.

Now things get raw.

P is a function of t and x. In other words P = Q(tx), where x is a catch-all for the time being that describes several exogenous market factors that determine market prices such as economic or political stability, expected inflation rate, foreign exchange rates, and so forth.

It is clear that the size of P (house price) and the size of t (owner's patience) are correlated. Hence, the larger t, the larger P tends to be and vice versa. It is still not clear whether the relationship of t and x with P is in terms of price elasticity or whether t and x actually determine the value of P. The answer largely depends on how x and Q are defined.

I have to noodle on this some more.  Comments welcome.

2 comments:

  1. Eleven posts in August. Zero posts in September. Not only are the posts enjoyable and entertaining, but also the above suggests an equation:

    N=f(doesnt-care-for-his-readers-anymore, month)
    where month is an integer 1-12 inclusive, and caring seems to decline seriously for month=9.

    I actually understood the estate-pricing equation for about 10 minutes, but it's been so long I can hardly even remember it. At the time I thought there was a missing variable somewhere. Now I think there's just a missing author.

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  2. WoW!! We don't pay tax like the Americans and Russians do...
    In England we pay a one off fee of a very little percent to the government when we first buy the property and that's it.
    We pay a annual fee to the local council for rubbish clearence and street cleaning etc..
    I think you guys are getting ripped off.

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