Joel's Jambalaya #4: Housing Cooperatives

Welcome to Joel’s Jambalaya! No major project news this week. Sophie and I are actually on vacation, so this issue will be some thinking out loud on a topic I’ve been fascinated by lately: Housing cooperatives.

We’ll look at what they are and how they work, and how the model might be extended to solve some of the issues we see in real estate today.

What is a Cooperative?

I had a vague idea of how a co-op worked, but it took some reading to get into the details. Note: there are lots of kinds of co-ops, but for today I’m only looking at housing co-ops.

Formally defined, a co-op is an organization which is owned and run jointly by its members, who share the profits or benefits.

In a housing co-op, it usually works like this:

The cooperative (a private, for-profit corporation) purchases a building. Individuals who want to live there do not buy individual units of real estate, they buy shares in the cooperative. Ownership of those shares then entitles them to a perpetual lease (for as long as they own the shares) of a unit of real estate in the building.

Units may be different sizes, and different numbers of shares are required to occupy each one. Purchasing the shares is still expensive, so a loan is usually needed to finance it.

For the individual, there is a monthly payment that is split between 1. the debt service on their share loan and 2. occupancy costs like maintenance, property tax, utilities, etc. Though they have a “lease” on the space, there is no rent in the traditional sense - only a pro rata portion of building operating costs.

What problem do they solve?

On the surface it may seem like this model doesn’t offer anything that can’t be obtained with current methods of real estate occupancy (either fee-simple ownership or renting)

But both owning and renting have some real drawbacks:

Renting

• No wealth or value accrual to the lessee

• Can be “priced out” if rents increase (at mercy of landlord)

• Fundamental mismatch between tenant incentives (reasonably priced, quality housing) and building owner incentive (maximize rent and minimize cost)

Owning

• High upfront cost

• Inflexible & high transaction costs - moving properties is very expensive

• Requires considerable active management depending on property type (maintenance, insurance, utilities, tax payments)

• Long-term mortgages encourage extreme risk-aversion (more on this later)

In many ways, a cooperative gives members the best of both worlds:

• Flexibility in where/what type of housing they have, ability to change unit as their circumstances change without incurring high transaction costs

• Benefits of real estate ownership in a more liquid and flexible way

• Members don’t have to manage the maintenance, upkeep, etc. of the building/unit on their own

• Can’t be priced out if rents go up

• Incentives are aligned between you and other members of the cooperative

• Affordable: Lower down payment, much lower closing costs, economies of scale, and a longer mortgage term all make cooperatives more affordable than other ownership housing

• Tax Deductions. For income tax purposes, the cooperative member is usually considered a homeowner and, as such, can deduct his or her share of the real estate taxes and mortgage interest paid by the cooperative

• Limited Liability. Members have no personal liability on the cooperative mortgage. The cooperative association is responsible for paying off any mortgage loans. This can often make it possible for persons whose income might not qualify them for an individual mortgage to buy a membership in a limited equity cooperative

Tragedy of the Privates

I hope you find this improvised name as funny as I do. This is my attempt to explain at least part of why new housing is so difficult to build, and to use that explanation to form a framework for constructing a solution.

I think of this as the opposite of the “Tragedy of the Commons” problem that has been documented for thousands of years, starting with Aristotle:

What is common to many is taken least care of, for all men have greater regard for what is their own than for what they possess in common with others.

Here’s a more detailed example (Feel free to skip this section if you’re familiar with the idea)

Picture a pasture open to all. It is to be expected that each herdsman will try to keep as many cattle as possible on the commons. Such an arrangement may work reasonably satisfactorily for centuries because tribal wars, poaching, and disease keep the numbers of both man and beast well below the carrying capacity of the land. Finally, however, comes the day of reckoning, that is, the day when the long-desired goal of social stability becomes a reality. At this point, the inherent logic of the commons remorselessly generates tragedy.

As a rational being, each herdsman seeks to maximize his gain. Explicitly or implicitly, more or less consciously, he asks, “What is the utility to me of adding one more animal to my herd?” This utility has one negative and one positive component.

1) The positive component is a function of the increment of one animal. Since the herdsman receives all the proceeds from the sale of the additional animal, the positive utility is nearly +1.

2) The negative component is a function of the additional overgrazing created by one more animal. Since, however, the effects of overgrazing are shared by all the herdsmen, the negative utility for any particular decision-making herdsman is only a fraction of 1.

Adding together the component partial utilities, the rational herdsman concludes that the only sensible course for him to pursue is to add another animal to his herd. And another; and another. . . . But this is the conclusion reached by each and every rational herdsman sharing a commons. Therein is the tragedy. Each man is locked into a system that compels him to increase his herd without limit–in a world that is limited. Ruin is the destination toward which all men rush, each pursuing his own best interest in a society that believes in the freedom of the commons. Freedom in a commons brings ruin to all.

Source: https://ton.sdsu.edu/tragedyofthecommons.html

We can essentially reverse the above example to arrive at what’s happening in our “tragedy of the privates”:

• The positive component (from the homeowner’s perspective) is a function of the negative (perceived) effect that is avoided: common objections include increased crime, stress on utilities, change in neighborhood character. No matter the reason given, it seems most opposition is driven mostly by a fear of change, which is in turn a product of most homeowners having virtually all of their wealth tied in a single asset.

• For each project stopped, this individual gets utility of +1. They have successfully avoided things changing and can be sure that their property value won’t decline. In fact, since they are stopping the creation of new housing, it probably means their property value will increase as supply is further restricted.

• The negative utility to the homeowner for blocking new development is only a fraction of 1. This is because the negative benefit is spread out across the whole city, so it is not very tangible to the homeowner and spread out across all residents in the city.

• This is a classic “privatize the gains and socialize the losses” where the gain is personal to the homeowner or small group of homeowners, and the loss is socialized across the entire city and future generations.

The irony, of course, is that in the long run this behavior makes the homeowner much worse off. Cities with an inability to supply housing consummate with demand for it see all sorts of social issues that extend far beyond housing. See: San Francisco for an extreme example.

To sum up: The Tragedy of the Privates refers to a situation in which individuals with ownership of a monopoly resource (their fee-simple real estate) act in their own interest and, in doing so, ultimately destroy the commons.

The Structure that Produces NIMBYs

This effect often goes by the acronym of NIMBY: “Not in my back yard”. In other words, “I’m all for new housing and growth as long as it isn’t near me.”

These individuals are often blamed for a city’s inability to build more housing, either by directly opposing development projects or enacting legislation that makes it difficult or impossible to build housing.

But here’s a hot take: maybe the NIMBY reaction isn’t because they’re bad people. Maybe it’s because, as Andrew Hitchcock points out, “NIMBYism is primarily driven by a rational economic response to holding most of your wealth in a single physical asset.”

Growth of housing and an influx of new residents is a good thing for the common good of a city. It makes the city more vibrant, culturally diverse, economically competitive, and more. People don’t oppose new housing because they’re bad people. They oppose new housing because the incentives of the system they’re a part of are set up in a way that they can’t really do anything else.

A person with a 30 year mortgage and family to feed can’t afford for anything to change. Change means uncertainty. Uncertainty might mean not being able to pay the mortgage. A big mortgage is like driving with a knife on the steering wheel of the car. You might be a better driver overall, but even a single bump could be fatal, so it’s best not to take any chances at all.

New Incentive Structures

“Show me the incentives and I’ll show you the outcome” - Charlie Munger

How can we align the incentive of individuals with that of the broader community? Residents need a way to more directly see financial upside as their community grows and prospers, rather than just suffering the costs of construction and crowding.

The solution is not to bemoan those darn “NIMBYs”, but instead to create a new system that functions differently, with different incentives, and achieves an overall better result.

Cooperatives seem to me like a very interesting alternative set of incentive structures to do this. It would make the benefits of building additional housing much more tangible, and would make the downsides less threatening.

What I’m talking about is a cooperatively owned city where all residents of the city are owners of the city. Not in name or spirit the way people are today, but true economic interest holders.

People would think differently about where and how they live if they more directly bore the cost of building infrastructure to suburban developments. They would also think differently about the growth and planning of their city if they directly benefitted from the addition of new residents.

This idea comes from a personal belief of mine: that empowering individuals with more autonomy and ownership of the systems that affect them is always a worthy goal. Even if it doesn’t completely solve the tragedy of the privates - where new housing is effectively impossible to build in some places - could it at least turn it into a fair fight?

There are some clear issues that have to be addressed:

1. This obviously couldn’t be done in existing cities. It would need to be implemented from the ground up in a new location.

2. Logistically, it will not be easy. Cooperatives are great at smaller scales, but famously do not often scale beyond a certain level. They work great at the scale of an individual building or farm, but once their members number into the thousands, the social dynamics change dramatically. I think there is a way to address this using new transaction-cost lowering technologies.

Even in light of these challenges to be addressed, I think it’s an interesting enough model to continue exploring. That’s what I plan to do in the next issue. See you then!

Joel