Wednesday, November 11, 2009

Financial complexity

Felix Salmon promotes rent-to-buy residential real estate transactions concluding:

... Right now, when a lot of motivated sellers are looking to any possible way to move their properties, might be a very good time for these ideas to gain traction.

In my view this is seriously misguided. The more complex and idiosyncratic a commercial transaction is the greater the likelihood that one party is being taken advantage of. The simplest and easiest way to move your property is to reduce the cash price. Complicated schemes like rent-to-buy or even just taking back a mortgage in order to sell property generally amount to price cuts in disguise. A naive seller is likely to underestimate the size and risks of this implicit price cut and end up being worse off than if they had just straightforwardly reduced the price.

A naive renter can also be taken advantage of by overpaying via a rent surcharge for an option to buy. Correctly pricing these deals is a complicated problem which the average person is apt to get seriously wrong.

And this isn't even a zero-sum proposition. Transaction costs will increase because such deals are non-standard. And they are more likely to end up in court if something goes wrong. This is to the disadvantage of both parties.

The average person is better off sticking to transactions on traditional terms. These are easier to understand and less likely to encounter unforeseen pitfalls. A policy that even the supposedly sophisticated buyers of complex mortgage backed securities would have been wise to follow.

No comments:

Post a Comment