Post 51: Homeownership Myths

During my years as a professional city planner, I helped create and implement a variety of zoning ordinances and reviewed dozens of others.  One feature that was almost universal was a clear bias toward housing – particularly single-family housing – over other forms of land use.  Throughout most zoning regulations there are exemptions and special provisions that favor single-family homes in ways that are not available for office buildings, shopping centers, schools or anything else.  I came to think of the single-family residence as the “sacred cow” of traditional zoning.  It was never clear why this was the case, but it seemed to be accepted by everyone that it was normal and necessary.

The sacred cow status of homeownership starts at the Federal level where generous subsidies are given to homeowners that are not given to renters.  For starters, interest paid on a home mortgage is deductible on federal tax returns.  In practice, this deduction is most useful to wealthy households with big mortgages, of little use to low- or middle-income homeowners, and of absolutely no use to renters.  Thus, it is a subsidy for the people who need subsidizing the least.  Secondly, there is the exemption (up to $500,000 for married couples) for capital gains that can occur when a homeowner sells their primary residence.  To my knowledge, no other investment gets this same type of treatment.  Together, these subsidies cost the taxpayers billions each year and do little to solve the housing problems that the country faces.

I live in a single-family home that I have owned for more than 35 years.  It provided a place for my family to grow and prosper, and it is full of memories that I will cherish for the rest of my life.  So I am definitely not against single-family homes.  But as I think of the problems this country faces with respect to housing affordability and supply, I wonder whether the single-family home deserves the sacred cow status it has been given.  In fact, there are a variety of beliefs about housing that are so ingrained in our American psyche that many people accept them – and act on them – without really thinking about whether they are always true.

These beliefs are so widely held that they have attained almost mythical status, and we have shaped a significant part of our economy and a significant number of our governmental institutions around the assumption that these beliefs are part of the foundation of our society.  I try not to get wrapped up in crazy conspiracy theories, but the more I have looked into the housing industry and the beliefs and policies that support that industry, the more I see a dark side that needs to be brought into the light.  There is a business constituency that benefits mightily from the current subsidies and housing mythology, and they are loath to give up that advantage regardless of how inefficient or misguided those housing policies might be. 

 My goal with this post is to question the “myths” that have grown up around housing and homeownership, and suggest changes to housing policies at both the local and national levels in order to better address the affordability and supply challenges that we currently face.  Here is my list of the top “myths” that need to be reexamined:

Homeownership is a Great Investment

How many young adults or newly married couples have been advised to buy a house as soon as possible because it is a great investment?  Probably millions.  This myth is actually the foundation of several other myths so it is the one I will tackle in the greatest detail.  The problem with debunking this myth is that buying a home can be a great investment – provided you buy at the beginning of a long period of price appreciation, hold onto the home for a long period of time, and avoid plowing a lot of additional money into the house for repairs or remodeling.  For the vast majority of people, buying a home is a mediocre investment decision, and for some an investment debacle.  Buying a home should be seen as a lifestyle decision that hopefully brings you joy and utility.  If it turns into a good investment, then that is icing on the cake.

Here is what can go wrong:

Not all housing appreciates in value.  Yes, housing in general has risen in value faster than the rate of inflation over a long period of time.  The problem is that the average hides times and locations where housing has fallen in value or remained stagnant.  After the housing bubble burst in 2008, hundreds of thousands of people suddenly owed more for their home than the home was worth – and that remained true for most of a decade in the areas that were hardest hit.  In addition, price appreciation often bypasses people who buy homes in undesirable neighborhoods or in small towns that are losing population.  Buying at the wrong time or place can be an investment disaster.

Transaction costs are huge.  When I buy or sell stocks or bonds there is a transaction cost but it is very small compared with the value of my investment.  When you buy or sell a house, however, the transaction costs can easily be 5 to 10 percent of the cost of the home.  These costs are sometimes hidden from the buyer because they are rolled into the monthly mortgage payment, but they reduce the return on investment.  In fact, a new homeowner typically needs 4 to 8 years of solid price appreciation to recover the transaction costs and return to a break-even position.  Need to move sooner than that?  Sorry, you lose.

Homeownership is illiquid and indivisible.  If I own 500 shares of Apple or Microsoft and experience a short-term cash crunch, I can easily sell some of my holdings to raise money.  The asset value of a home, however, is harder to tap in times of need.  Yes, it may be possible to do a cash-out refinancing of the mortgage or take out a Home Equity Line of Credit, but those options are not always available, and they take time and have additional transaction costs.  In fact, a home is often hardest to sell (or refinance) when the need for money is greatest (e.g. during an economic downturn).  

Housing often requires unplanned injections of cash.  If I own Apple stock, no one calls me from Cupertino to ask for $1,000 to replace the water heater.  The truth is that owning a home – particularly an older home – frequently entails spending a substantial amount of money on the structure of the home itself or on one of the key systems that make the home liveable. These expenses are typically unexpected and thus difficult to budget for.  This is particularly problematic for low- or moderate-income households who often have fewer financial resources.  A recent survey by the Federal Reserve, for example, revealed that nearly 40 percent of US households could not cover an unexpected $400 expense without borrowing money or selling an asset. [1]  Yet failure to come up with the money for an essential repair can undermine both the ability of the home to provide safe shelter and the long-term value of the home as a supposed investment.

Tracking the investment performance of homeownership is difficult.  To make wise investment decisions, you need to be able to easily track the performance of each investment.  For most traditional investments (e.g. mutual funds, stocks, CDs, etc.), the return on investment can be calculated at just about any point in time with great precision.  That is not the case for homeownership.  People often buy a house at a certain price, live in the home for 20 or 30 years, sell it at a much higher price and assume that it has been a great investment.  

My house, for example, has gone up in value by roughly 425% and has provided my family with a safe and comfortable place to live (which has a value on top of the price appreciation).  That seems awesome until you consider that I have owned the house for 37 years, have spent hundreds of thousands of dollars remodeling, repairing and redecorating, and have donated a couple of thousand hours of my labor mowing the grass, repainting the trim, shoveling the driveway, doing miscellaneous repairs, and more.  So now what is my real return on investment?  It is almost impossible to calculate and the same is true for the vast majority of homeowners.  The myth makes us think we are getting a good return on our investment but the reality is completely unknown.

The bottom line is that wealthy people who can buy nicer homes in nicer neighborhoods probably have benefited from housing appreciation, but the results are almost assuredly more mixed for moderate- and low-income populations.  Yet the strength of this myth endures and households of all types and income levels continue to make homeownership a key component of their investment portfolio.  A recent study found that the 2021 median net worth of all U.S. households – counting all asset types – was $166,900.  If home equity is excluded, however, that number falls to $57,900 despite the fact that roughly a third of households don’t even own their home.  For people who do own their home, that equity tends to be a disproportionately large share of their total wealth particularly for minority households.  For a majority of black and hispanic homeowners, the equity in their home represented two-thirds or more of their total wealth. [2] Touting homeownership as a universally good investment is a serious disservice to those who are most in need of good investment advice.

The Value of Single-Family Homes Needs to be Protected by Government Intervention

One of the side effects of people thinking of their home primarily as an investment and having that home represent a disproportionately large chunk of their wealth is that they become paranoid about protecting that investment.  This largely plays out in decisions at the local government level.  Despite the fact that throughout history cities have contained a mix of uses in relatively close proximity, we have now convinced millions of homeowners that the value of their home will be undermined by just about any new development type other than more single-family homes.  Particularly in suburbia, this has resulted in acre upon acre of single family subdivisions isolated from shops, offices, apartments, retirement facilities and sometimes even churches and schools.

This behavior is so wide-spread that it has earned its own acronym:  NIMBY (Not In My Back Yard).  Although in this case, “backyard” can be a development site that is a mile away or more.  Many a development request that would have been good for the city or region overall has been turned down because nearby homeowners thought that it would destroy their property values.  Very little actual evidence is ever presented to support the alleged destruction of value, but local decision-makers are generally reluctant to challenge a room full of angry constituents.

This is partly where the “sacred cow” status of single-family housing has come from.  People recognize the fragility of their house as an investment vehicle and so discussions get skewed toward property values of nearby homeowners and away from discussions of what would provide the most utility to the maximum number of people.

Buying a Home Is a Good Investment for Just About Everyone

As I pointed out early on, buying a home can be a good investment under the right circumstances.  The problem is that this “sometimes” circumstance gets extrapolated to be general advice applicable to the general population under all circumstances.  Here are two examples of groups that should not buy a house:

People living paycheck to paycheck.  Recent research by Bank of America showed that about a quarter of all U.S. households spend basically all of their income each month and have little accumulated savings.  This makes it difficult to come up with the traditional down payment required for a mortgage, of course, but even if this obstacle can be overcome it would still be a bad idea for this type of household to buy a home.  As I pointed out earlier, homeownership entails unexpected expenses that keep the house liveable and maintain its value as an investment asset.  Households that can’t come up with the necessary funds whenever those minor emergencies happen are likely to see the value of their home slip quickly away.

People with job instability.  A sudden loss of income can force a homeowner to sell when they don’t want to or even lead to foreclosure.  Both options are likely to create financial difficulties that could have been avoided.  And while anyone can lose their job unexpectedly, there are some households where either voluntary quitting or involuntary layoffs are reasonably predictable.  Recent graduates, for example, are the most likely segment of the population to move across the country to a new city.  Other people work in industries that are notoriously cyclical and tend to go through periods of both hiring and layoffs.  Still others are unsure of their career goals and tend to switch jobs frequently – either voluntarily or involuntarily.  Buying a home and then failing to make mortgage payments because of a job disruption is likely to be much worse than missing a rent payment and having to change apartments.  In addition, people with job instability are probably best served by being as mobile as possible so that they can take advantage of better job opportunities wherever they might be located.

 A Low Down Payment is Fine Because Housing Appreciates in Value Rapidly

Many areas of the country have seen a relatively rapid escalation in housing prices as supply has failed to keep up with demand.  This has made it more difficult to come up with the traditional 20 percent down payment on a mortgage.  The Federal government has a variety of programs that address this issue by allowing mortgages to be issued with as little as 3 percent down.  This makes the loan riskier from the lender’s perspective so typically the borrower is required to pay for private mortgage insurance (PMI) which protects the lender in case of default.

PMI can add hundreds of dollars to your monthly mortgage payment which is a significant penalty, but it can often be removed once the home reaches a loan-to-value ratio of 80 percent.  Of course, each mortgage payment adds to the homeowner’s equity, but early in a mortgage the vast majority of each payment goes toward interest rather than principal reduction.  Five years of mortgage payments might reduce the loan principal by only 10 percent.  

Frequent stories in the press of double-digit increases in housing values, however, make some people assume that they can reach the 80 percent LTV in just a couple of years.  That may be true in some isolated markets that are extremely hot, but it is not true generally and particularly not true throughout the midwest.  To begin with, the average sales price of U.S. homes falls from the previous quarter about a third of the time, and can fall several quarters in a row.  In addition, the press tends to cover exceptional cases rather than the more typical situations.  Here are the actual rates of price appreciation over the long term for a variety of markets – some hot, and some not so much: [3]

Average Annual Rates of Housing Price Change

20-year average     40-year average

Tampa FL     4.32%          4.94%

Austin TX     6.35%         4.73%

San Jose CA     4.63%         6.01%

Cleveland OH     2.46%         3.50%

Indianapolis IN     3.74%         3.91%

Kansas City MO     3.89%         3.90%

The reality is that no one sees double digit increases for very long, and the midwest in particular has relatively pedestrian rates of housing price increases.  This means that borrowers can be stuck paying the PMI penalty for longer than they planned.

The Federal Government Is Doing All It Can to Reduce the Cost of Home Construction

Since the primary housing problems our country is facing are high housing costs and inadequate supply, you would think that the Federal government would have all sorts of programs to encourage innovative ways to reduce construction costs and to encourage local governments to resist the NIMBYs and expand housing opportunities.  Although it has tried such programs in the past (with mixed success), there are virtually no major initiatives in this regard currently.  In fact, I would argue that it is in the Federal government's best interest for housing construction costs to keep rising despite all the official moaning and weeping about housing affordability.

Two of the Federal government’s primary housing tools – Fannie Mae (FNMA) and Freddie Mac (FHLMC) – would be in a much more precarious position if the cost of new housing fell because that would cause the value of existing housing to fall as well.  Fannie and Freddie are in the business of buying mortgages from the originating banks, bundling them into Mortgage Backed Securities (MBS), and selling those securities to investors, all of which allows local banks to keep making loans.  If housing values fall, then the all important loan-to-value ratio gets worse for all of the mortgages they have packaged which makes the probability of default go up (especially those 3% down mortgages).  This was the essential problem during the 2008 housing default crisis – housing values which everyone assumed would keep rising suddenly started to fall.  People who held risky mortgages couldn’t refinance and couldn’t sell at a price that would pay off their mortgage, so they defaulted.

The current situation is not nearly as dire as it was in 2008, but no one at the Federal level really wants housing prices to fall.  Arguably, Federal priorities seem more focused on keeping Fannie and Freddie profitable – not to mention the investment bankers making billions off of various forms of housing securities – rather than on finding affordable housing for those in need.  Instead, Fannie and Freddie claim to be addressing affordability by lowering down payment requirements so that it is easier for people to get a mortgage.  It doesn’t really make anything more affordable, it just expands access to the overpriced home buying market.

The Bottom Line

There are a lot of good reasons to own your own home.  Perhaps you are starting a family, or need room for multiple pets, or want a large garden, or like to customize your living environment in unusual ways  – these reasons (and more) are a perfectly logical basis for homeownership.  They are not, however, sufficient reasons for treating homeownership as some type of sacred cow that is deserving of special protections or subsidies.

Yet the storyline persists that homeownership is worthy of special treatment because it is somehow essential to the American way of life.  Homeownership, it is said, makes for more stable communities, higher levels of community commitment, and a more productive economy.  But is that really true or have we simply accepted the myth without much critical thought?  This might be a situation where we see homeowners being active in the community and reinvesting in their neighborhood, and simply confuse correlation with causation.

It turns out that homeownership rates vary widely among western democracies.  Here is a partial list of countries with rates above ours, about the same as ours, and less than ours:

Poland (87%), Norway (79%), Italy (75%), Greece (70%)

USA (66%), UK (65%), Sweden (65%), France (63%)

Denmark (60%), Austria (54%), Germany (48%), Switzerland (42%)

If there is a connection between homeownership, societal stability, or economic productivity I certainly don’t see it. [4]

In 1917, John Harvey Kellogg popularized the phrase “breakfast is the most important meal of the day.”  Mr. Kellogg, a prominent member of the cereal industry, didn’t have any real evidence that breakfast was any more important than any other meal and yet this phrase has been repeated so often that it was accepted as common wisdom for decades.  Similarly, we have allowed the housing industry to repeat the mantra that owning your own single-family home is an essential part of the American dream so often that it is accepted as true by many people.  The result is a system of developers, contractors, realtors, bankers and financiers who are focused on a very narrow segment of the housing market, and a large pool of households who have been convinced that buying into that narrow segment is the key to their happiness.  That narrow focus has been extremely profitable for the developers, contractors, realtors, bankers and financiers, but it has, in my opinion, been detrimental to many households and our society in general.

There are two things this country needs to focus on:  first, we need to incentivize households to save money in ways that build generational wealth; and second, we need to incentivize the expanded production of safe, energy-efficient housing in more diverse forms and locations than has been produced in recent years.  Housing mythology has unnecessarily bundled these two things together, with a particular emphasis on single-family homeownership to the detriment of other forms of housing and other arrangements for paying housing costs.

In many cities, the monthly cost of homeownership is hundreds of dollars more than the cost of renting an equivalent house or apartment.  In that situation, renting instead of owning and putting the savings into an IRA or 401(k) account (especially one that is matched by your employer) might be a much smarter financial strategy.  This would be particularly true if Federal subsidies for homeownership were dismantled and replaced with incentives for wealth building in any form.  For years, the educational establishment has boosted literacy as a key to a better life.  Perhaps boosting financial literacy should be a close second.

Notes:

1. Board of Governors of the Federal Reserve System; “Report on the Economic Well-Being of U.S. Households in 2022 - May 2023”;  https://www.federalreserve.gov/publications/2023-economic-well-being-of-us-households-in-2022-expenses.htm

2. Rakesh Kochhar and Mohamad Moslimani; “The assets households own and the debts they carry”; The Pew Research Center; December 2023; https://www.pewresearch.org/2023/12/04/the-assets-households-own-and-the-debts-they-carry/

3. Federal Reserve Bank of St Louis; “Economic Data:  All Transactions House Price Index for Cleveland-Elyria Ohio (MSA)”; August 2024; https://fred.stlouisfed.org/series/ATNHPIUS17460Q

4. Morris Davis; “Questioning Homeownership As A Public Policy Goal”; Cato Institute; May 2012; https://www.cato.org/policy-analysis/questioning-homeownership-public-policy-goal

Post 50: Slouching Toward Insolvency

 Ernest Hemingway’s 1926 novel The Sun Also Rises contains the following bit of dialog:

“How did you go bankrupt?” Bill asked.  “Two ways,” Mike said, “Gradually and then suddenly.”

This quote is the source of the title of the documentary on the 2013 Detroit bankruptcy, perhaps the most notorious municipal bankruptcy in American history.  At the time, Detroit had over $18 Billion in debt – an amount estimated to be more than 30 times its readily available assets.  That financial condition was not reached quickly as a result of some cataclysmic event, it was something that built slowly over decades as a result of bad luck mixed with bad decision after bad decision. 

At one time, Detroit was an American success story.  The city grew rapidly in the first half of the twentieth century reaching a population of 1.8 million in 1950.  Detroit was the fourth largest city in the country and had one of the highest per capita incomes.  But economically, Detroit was a one-horse town whose fate was tied to the auto industry.  The struggles of the American auto companies in the 70’s and 80’s popped the Detroit bubble.  That bad luck was reinforced by race riots, white flight, and urban renewal failures.  Efforts to restore its glory led the city to promise too much, spend too much and borrow too much.  The subprime mortgage disaster and the subsequent Great Recession were the final straws.

Fortunately, local government bankruptcies are relatively rare.  Only 31 general purpose local governments (out of nearly 39,000 such entities) have filed for bankruptcy since 2001. [1]  Many states, in fact, do not allow municipalities to file for bankruptcy or place severe limitations on the process.  However, the conditions that lead to bankruptcy – the inability to pay one's bills – are more of a threat than many people realize.  Many cities across the country are borderline insolvent and yet their citizens probably don’t know the full scope of the problems that exist or the ramifications that an unexpected economic blow could have for their day to day lives.

The issues are generally obscured by the gradual nature of the problem.  Insolvency is almost always a slow, meandering journey to the edge of a financial cliff, and bankruptcy is the abrupt shove that pushes you over the edge.  No one intentionally races into insolvency, we get there almost accidentally by not paying attention and by not looking ahead.  We get there by slouching step by step down a path we didn’t even know we were on.

A Local Example

My interest in this topic was piqued recently by two different articles that touched on different aspects of this problem.  The first was an article in my local paper on the difficulties that Kansas City, Kansas was having with bridge closures.  For those not versed in midwestern geography, Kansas City, Kansas (KCK) is the smaller and poorer sibling to the better known Kansas City, Missouri (KCMO).  KCK has a population which is about 70 percent smaller and a per capita income which is about a third lower.  It is also a city that is bordered by the Missouri River on the north and bisected by the Kansas River and broad rail yards.  Thus, bridges are an essential part of KCK’s connectivity to the rest of the metro area and from one part of the city to another.

The article in the Kansas City Star details six bridges that are currently closed for repairs, including the east-bound lanes of I-70 which connect downtown KCK with downtown KCMO and which abruptly closed just a couple of weeks ago for emergency repairs. [2]  What is particularly troubling is that two of the bridges over the Kansas River – the Central Avenue bridge and the Kansas Avenue bridge – have been closed to traffic for several years with no clear timeline for repairs and no funding in place.  Even if federal grants could be obtained for repairs, local leaders are not confident they could come up with the estimated 10 percent local matching funds.

If the repairs are critical, why not sell bonds to raise the necessary money?  The answer is that the city is already awash with debt, over $800 Million according to the recently adopted budget.  According to the County Administrator, nearly 44 percent of the property taxes collected by the city are used to finance debt, more than double what he considers to be healthy. [2]

The core issue is that Kansas City, Kansas has more infrastructure than its tax base can sustainably maintain.  Virtually all midwestern cities have suffered from low-density sprawl in recent decades, but Kansas City, Kansas is worse than most.  The value of its tax base per square mile is 40 percent lower than comparable cities such as Topeka or Wichita – and neither of those cities are in great financial shape themselves.  This is particularly problematic for a city reliant on high-dollar infrastructure such as bridges.  A cash strapped city can allow a roadway to crumble and it is annoying but not likely to be life threatening.  Allowing a bridge to crumble, on the other hand, can be catastrophic. 

Houston, We Have a Problem

During a budget meeting several months ago, Houston Mayor John Whitmire made the following statement in an effort to sum up their financial status:

“I think we can all agree on that, we are broke.”  [3]

This is likely as much political theater as it is a realistic assessment of Houston’s financial condition, but it is true that Houston has a serious budget gap that needs to be plugged (as with many large cities).  In Houston’s case, the shortfall is approximately $160 Million, or nearly 6 percent of the Houston budget.  Unfortunately, efforts to solve the problem are likely to be just bandages that cover up the problem temporarily only to have it resurface in a few years.  

The immediate problem is a recent agreement with the city’s firefighters that compensates them for being underpaid for the past seven years in which they worked without a contract.  The settlement is going to cost Houstonians $650 Million for back pay and an additional $180 Million for wage hikes over the next five years.  But the real mistake, in my opinion, is that Houston is proposing to pay these costs by selling a roughly $1 Billion bond that will take 25 to 30 years to pay off.  Paying a short-term operating cost with long-term general obligation bonds is almost always a bad idea.  As Strong Towns leader Charles Marohn points out,  “A child born today in Houston will make final payments on firefighter back pay from 2018 when they turn 30 years old.” [4]  And yes, if you do the math, that means that today’s operating cost problem isn’t likely to be paid off until roughly 2054.

Some observers have criticized the city for having too many employees (including firefighters) and paying them too well.  I’m going to stay out of the pay issue, but it is valid to ask why the city needs so many employees.  The answer is the same reason Houston has too many streets, too many water lines, too many fire hydrants, and on and on.  Houston is a prime example of uncontrolled, low-density sprawl.  The infrastructure and city personnel to support that development pattern is why Houston (and many other cities) are slouching toward insolvency.  

Marohn refers to this as the “growth Ponzi scheme.”  It appears to make financial sense in the short run – new growth delivers new tax revenue with relatively low initial maintenance cost (after all, everything is new).  But with each new subdivision, shopping center, and suburban office building comes a commitment made by the city to maintain that infrastructure forever.  In the long run, the tax revenue from the low density development cannot sustain the cost of infrastructure maintenance (and firefighters, police officers, maintenance workers, etc.).  To remedy the problem, cities chase more growth to gain more revenue which again seems to be helpful in the short term but simply makes long term problems worse because that growth comes with more infrastructure obligations – hence the Ponzi scheme analogy.

The Allure of Low Density Growth

The term “suburban sprawl” is almost always used in a derogatory manner, but there are a few  advantages to that form of development.  To begin with, Americans are used to living in a big country with lots of land relative to the population, and our nation has deep, agrarian roots that make us think of owning our own chunk of land as an essential part of the American dream.  For many of us, there is something psychologically fulfilling about owning a single-family home on a tract of land that is ours and ours alone.

Beyond that, however, low-density development is relatively inexpensive to build – assuming, of course, that transportation costs are low.  Hundreds of years ago when the structure of many European cities were being formed, transportation costs were high and most people never traveled more than a few miles from where they were born.  Consequently, the development pattern was relatively dense since most people walked from place to place making distance a major “cost.”  In the U.S., transportation  costs started high, but innovation after innovation has gradually changed the equation.  Particularly after World War II, personal transportation via the automobile made distance almost irrelevant.  

There are costs, of course – someone has to build the roads, install utility lines, buy the cars, etc. – but those up-front costs seem manageable to most people.  The problem is that there are a number of “hidden” costs that people don’t realize exist or have chosen to ignore.  The most substantial of these costs is long-term maintenance of physical assets such as roads, bridges and utility lines, and the ever expanding personnel costs associated with operating cities that are expanding geographically.  Calling these “hidden” costs is misleading, of course, because all of them can be estimated with relative precision if you are willing to do the work.  Unfortunately, these long-term costs can easily be dismissed as someone else’s problem which won’t need to be solved for decades.  From the point of view of a politician, is it better to set aside funds for future maintenance and personnel costs or to build something new and shiny for the voters to enjoy?  The answer is obvious and so are the eventual ramifications.

The other hidden cost is that if everyone is driving, then the initial street capacity built by the developer is never enough. New development inevitably attracts traffic demand from outside the immediate area.  After all, everything is new – new roads, new shops, new restaurants, etc. – who wouldn’t want to break away from the old parts of town to experience the latest and greatest?  At the same time, the focus on driving makes alternative transportation modes (walking, biking or transit) so inconvenient that there are no options left other than street expansion.  So money that could have been used to maintain infrastructure gets diverted to street widening projects which deliver only temporary relief because they just reinforce the belief that driving is the only way to move from place to place.  It becomes a feedback loop that is almost impossible to exit.

A Different Kind of Asset

If cities were run like private corporations, they would account for every asset (every road, bridge, fire hydrant, etc.) with maintenance schedules, depreciation tables, and replacement costs using what is known as the accrual method of accounting.  Cities, on the other hand, use what is known as modified accrual accounting which combines aspects of traditional accrual accounting with the simpler cash-basis accounting.  In general, the modified accrual method allows short term events (e.g. account receivables and account payables) to follow cash-basis rules while long term events (e.g. fixed assets and long-term debt) follow the accrual accounting rules.

The two approaches reflect fundamental differences between private business entities and governmental entities.  Private corporations are required to use accrual accounting because it allows stakeholders to see an accurate reflection of the company’s financial health.  Local governments, on the other hand, are more focused on whether current year revenues are enough to cover current year expenditures, and whether such expenditures are following the budget plan that they have adopted.  The modified accrual method accomplishes this task reasonably well. [5]

There are, however, a couple of important differences that apply to the accounting of long-term debt and infrastructure assets.  First, in full accrual accounting, long-term debt is recognized in the financial period in which it is incurred.  The modified accrual method recognizes the current portion of long-term debt as it matures, which means the impact is spread out over time.  Second, most public infrastructure is allowed to be treated as an “inexhaustible capital asset,” thereby eliminating the need for depreciation accounting. [6]  To take advantage of this modified approach, governments must demonstrate that they are maintaining the infrastructure to a selected condition level.  The problem is that defining the appropriate level of maintenance and assessing the degree to which that maintenance is being accomplished is largely left to the government itself which means there is a lot of room for fudging the true state of maintenance efforts and appropriate expenditure levels.

Many cities attempt to track all of their infrastructure assets and maintenance costs but the process is extremely labor intensive.  There is the potential payoff of better allocation of municipal resources but that goal is often undermined by political expediency which shifts money away from maintenance in order to solve a short term budget issue or build something with more political appeal.

Part of the problem is that an infrastructure asset is different from a normal business asset (like a factory) or personal asset (like jewelry).  To begin with, infrastructure assets are almost always acquired by the city for free.  The developer “gifts” the streets, water lines and storm sewers to the city as part of the development process.  The only “cost” is the implied promise to maintain those assets forever.  Second, the value of the infrastructure asset is very difficult to pin down.  No one wants to buy the sidewalk in front of my house so exactly what “value” does that asset have?  It does have some value to kids walking to school or people walking their dogs, but pinning that value down – and deciding how much money should be spent to maintain it – is very difficult.

Perhaps the best approach to the concept of value is to think of public infrastructure as an asset that enables the abutting private property owners to create value with their property.  After all, a shopping center wouldn’t have much value if it weren’t for the streets and bridges that allow goods to be sent to the shopping center and customers to reach the shopping center to make purchases.  The catch, however, is that two virtually identical assets (e.g. streets) can produce wildly different pools of value depending upon the success of the partnership between the city and the private property owners.  In some locations, the street may produce a great deal of value that lasts for a long time.  But in other locations, private development might not produce much lasting value at all due perhaps to poor planning, shoddy construction, or just bad luck. 

This approach refocuses the issue to be “how can cities encourage private property owners to create as much value as possible with the city’s infrastructure assets?”  There is no easy answer to that question because cities have other goals (such as maintaining a certain community character) that can conflict with the goal of maximizing property value.  Finding the right balance is never easy but to me it suggests a development approach which emphasizes design, durability and adaptability rather than simple development volume.

The Bottom Line

It probably shouldn’t be a surprise that few cities actually follow a detailed maintenance plan for their infrastructure.  Cities have a detailed plan, of course, they just find excuse after excuse for not following it.  For most cities, the infrastructure maintenance budget is a relatively random number that grows or shrinks depending upon other budget priorities.  Municipal decision-makers know they should spend more on maintenance but the allure of growth and the political appeal of something new and improved overwhelm their better judgment.  

What is really unfortunate is that every level of government, from the federal bureaucracy to the smallest village board, is structured to focus on building new infrastructure to support new growth despite the fact that the vast majority of cities and counties are actually static or shrinking.  It is almost always easier to get a grant to build something new than to get a grant to fix something that is old.  

Houston provides an interesting example of this phenomenon.  The City of Houston has approximately 16,000 lane-miles of streets that it is responsible to maintain.  Given the average life of a street, it means that they should be resurfacing roughly 400 lane-miles of street each year.  According to data from the City (via the Bill King Blog), the last time the city resurfaced that many lane-miles was 2004.  The average for the past five years has been 146 lane-miles.  Clearly, Houston needs help with street maintenance.  You might think the State of Texas would assist, but instead the State is pushing the North Houston Highway Improvement Project – estimated to cost between $7 Billion and $10 Billion – to improve Interstate I-45N from downtown Houston to Beltway 8.  Repairing stuff is boring, building something new and “improved” is always better!

Our country is growing and community needs change over time so new development is a necessity.  There is, however, a right and a wrong way to grow and more often than not American cities are opting for what is familiar and easy instead of doing the harder, more innovative work of building cities that are focused on the needs of the next 50 years rather than the past 50.  The Ponzi scheme is going to break down eventually, as all Ponzi schemes do.  The question is how much damage is going to be done to your city before you have slouched your way to insolvency?

Notes:

1 Jeff Chapman, Adrienne Lu and Logan Timmerhoff; “By the Numbers:  A Look at Municipal Bankruptcies Over the Past 20 Years;” The Pew Charitable Trusts; July 2020; https://www.pewtrusts.org/en/research-and-analysis/articles/2020/07/07/by-the-numbers-a-look-at-municipal-bankruptcies-over-the-past-20-years

2 Bill Lukitsch; “Leaders, residents alarmed by number of bridges on repair list;” The Kansas City Star; September 12, 2024.

3 Greg Groogan; “Mayor John Whitmire says the City of Houston is ‘Broke’ ”; March 2024; Fox 26 Houston; https://www.fox26houston.com/news/mayor-john-whitmire-says-the-city-of-houston-is-broke

4 Charles Marohn; “Here’s the Real Reason Houston Is Going Broke”; April 2024; Strong Towns; https://www.strongtowns.org/journal/2024/4/1/heres-the-real-reason-houston-is-going-broke

5 The Corporate Finance Institute; “Modified Accrual Accounting;” https://corporatefinanceinstitute.com/resources/accounting/modified-accrual-accounting/

6 Government Finance Officers Association; “Modified Approach for Infrastructure Reporting;” January 2019; https://www.gfoa.org/materials/modified-approach-for-infrastructure-reporting

Special thanks to Eileen Johnson and Gina Bauman for their advice on explaining accounting principles.