Importance of Housing u Housing, as shelter, is one of the basic needs of human kind. u Houses are financial investments. u Housing is a significant component of the local, regional and national economy. u Housing is a social priority as declared by the U.S. Congress in u Housing is a merit good.

K.O.R.E Enterprises, LLC The Definition of Housing 9/4/08

Functions of Housing u Protection from elements, wild beasts and human predators. u Storehouse for personal possessions. u Workplace. u Assembling workforce. u Privacy. u Forced savings/store of wealth. u Social status.

Housing: What We Care About u Quality: size, amenities, habitability and livability. u Quantity: size of GDP, countercyclical measures, and stabilizing the economy. u Cost: efficiency, affordability and appropriate incentives. u Transactions and outcomes: fairness, equality and equity.

Nature of Housing u Durability: lasts a long-time, difficult and costly to modify, today’s choices set future conditions. u Fixed in place and produces neighborhood effects. u Limited knowledge by the consumer produces severe information failures.

U.S. Fixed Tangible Wealth Source: Dasso, Shilling and Ring; Hartzell et al.

Land Finance Infrastructure Labor Materials Developers Builders Landlords Homeowners Renters Homeowners (Income and Population) Inputs ProductionDemand P R I C E S P R I C E S How Housing Markets Work

U.S. Population By Age

U.S. Households By Type

Homeownership Rates, By Income and Race/Ethnicity Source: 1993 AHS

Goals of Housing Discussion u Why is Housing Different? u What are the Implications? u Understand Basic Equations in a Housing Market Model

Features that Make Housing Different u Housing is heterogeneous u Housing is immobile u Housing is durable u Housing is expensive u Moving costs are relatively high

Heterogeneity and Immobility u Housing is –a bundle of housing services –a set of features or –a list of attributes u The bundle of services is produced from –a combination of two set of characteristics –Dwelling characteristics –Site characteristics

Heterogeneity and Immobility u Dwelling Characteristics: –Size: square footage of living space –Layout: the arrangement of rooms within the dwelling –Kitchen: the quality and efficiency of kitchen equipments –Utilities and utilities systems: heating, air conditioning, plumbing and electrical –Interior design: type of flooring, windows, cabinets –Structural integrity: durability of foundation and the roof

Heterogeneity and Immobility u Site Characteristics –Accessibility: sites differ in access to jobs, shopping, and entertainment –Provision of local public services: schools, fire protection and police services –Environmental quality: sites differ in air quality and noise levels (from cars, trucks, airplanes and factories –Appearance of the neighborhood: exterior features of neighboring houses and lots, curb appeal

Heterogeneity and Immobility u Implications for the Housing Markets u Housing is priced as a composite good. –The market price of a dwelling is the sum of the prices of the individual components. u The quality of housing or the quantity of housing services depends – not only on dwelling characteristics, but also on the characteristics of its neighborhood. u Benefits of amenities and costs of disamenities are capitalized into house prices

Heterogeneity and Immobility u Implications for the Housing Markets u Implicit and Explicit markets: – Households shop for characteristics in the implicit housing markets where they determine their tradeoffs among the different characteristics, but make their home purchases in explicit markets for housing as a bundle. u Segmented but related markets: –The heterogeneity of the housing stock means that a city’s housing market is composed of a number of submarkets. The housing market is segmented with respect to size, location and quality.

Durability of Housing u Housing is more durable than most goods –If a dwelling is maintained properly, it can last 100 years or more –The durability of housing has three implications for the housing market »the landlord can control the rate of physical deterioration »there is large supply of used housing »the supply of housing is relatively inelastic

Durability of Housing: Implications u Deterioration and Maintenance u The landlord can control the rate of physical deterioration –by spending time and money on repair and maintenance. u The question for the landlord is –how much should be spent on maintenance over time. u Whatever amount of maintenance expenditure – that maximizes the landlord profit should be spent. u However, the optimum quality of housing services changes overtime –as a result of »changes in variable costs due to the aging of dwelling »and also a decrease in demand for housing in the area.

Durability of Housing: Implications u Durability and Supply Elasticity –There is large supply of used housing on the market every year –The supply of housing is relatively inelastic. »The market is dominated by the stock of used housing, so changes in price cause relatively small changes in the quality supplied. –There are three types of supply responses to an increase in price: »building new dwellings, slow deterioration of used buildings, and remodeling used dwellings

Durability of Housing: Implications u The Filtering Model of the Housing Market u The filtering model captures some of the essential features of the market for used housing. u It describes the interactions between different housing submarkets and the process through which dwelling passes from one use to another. u The filtering process has two basic features: –Decrease in housing services. The quality of housing services produced by particular dwelling decreases overtime. »The decrease in quality results from physical deterioration, technological obsolescence, and changes in housing fashion. –Decreases in occupant income: the dwelling is occupied by households with progressively lower incomes.

The High Cost of Housing u When a household buys a home, it typically spends between two and four times its annual income on the house. u The large cost of housing has four implications for the housing market. –First, given the large investment required for homeownership, a large fraction of households rent instead of owning. In the United States, about one-third of households are renters. –Second, most middle-income households use homeownership to accumulate wealth. In other words, a large fraction of the savings of middle-income households is tied up in dwellings.

The High Cost of Housing u When a household buys a home, it typically spends between two and four times its annual income on the house u The large cost of housing has four implications for the housing market –Third, most households need a loan to be able to purchase their homes, hence the existence of the elaborate mortgage finance infrastructure supporting the housing market –Fourth, the government assists the housing markets with a substantial and wide range of subsidies especially through the tax code

The High Cost of Housing u Taxes and Housing u The federal government provides a number of tax breaks for both rental and owner-occupied property. –The tax breaks for rental property decrease the landlord’s costs, and these savings are passed on to consumers in the form of lower rent. –The tax break for homeowners are more explicit: Homeowners deduct interest costs from their gross income, so they pay lower taxes

Large Moving Cost u Housing consumption changes sometimes require a move to a different dwelling u Moving cost is substantial: –in addition to the large cost of moving furniture, clothes, and kitchen equipment, –there is also a large personal cost associated with leaving behind the old neighborhood »with its people, schools, and stores. u In other words, a move to a new neighborhood disrupts social and consumption patterns

Large Moving Cost: Implications u Housing costs: –a household changes its housing consumption only if benefits of moving exceeds the cost of moving. u Small changes in income or price are unlikely to change housing consumption. –Most households tolerate some dissatisfaction with their housing circumstances because moving is costly. u A household moves to a different dwelling only if the change in income and price is large relative to moving cost. u When a household changes houses, it is likely to make a large change in its housing consumption.

Large Moving Cost: Implications u Economic Elasticities –Because of large cost of moving, households base their consumption choices on permanent, or long run, income. –Given the cost of moving, the household makes a long-term commitment to living in a particular dwelling.

Large Moving Cost: Implications u Income Elasticity of Demand for Housing u There is a consensus on three points regarding income elasticity of demand for housing u (1) the overall income elasticity is about.75: –a 10 percent increase in income increases housing consumption by about 7.5 percent. u (2)the income elasticity of renters is less than the income elasticity for owner-occupants. u (3) the income elasticity increases with income, –the elasticity for low-income households is between 0.14 and 0.62 and for high-income households is between.72 and 1.10.

Large Moving Cost: Implications u Price Elasticity of Demand for Housing u What is the price elasticity of demand for housing? –Most estimates of the price elasticity fall between and u The consensus is that demand is slightly price-inelastic –(elasticity slightly less than 1.0 in absolute value). u This means that an increase in price decreases the quality demanded by slightly smaller percentage amount, so total expenditures (price times quality) increase by a small amount.

Basic Equation in Housing u Concept of the Price of Housing u Housing Demand u Housing Supply u Home ownership Choice

What is the price of rental housing? u Rental price (pr): cost per period for a constant quality of housing u Rent = pr h u h is the quantity of rental housing services per period

What is the price of owner- occupied housing? u User cost: analog to rental price u Value = P H u H is the quantity of the housing owned at one point in time

User Cost: Definition u The cost of using one unit of capital for one period. u Equals the sum of the opportunity cost of capital invested in housing, mortgage payments, depreciation in the housing unit less tax benefits and appreciation

Components of User Cost u cost of equity = ie E u cost of mortgage debt = im M u property taxes = pt P u depreciation = d P u expected appreciation = pi P u tax benefits = tax P

Equation for User Cost u uc = (ie E + im M + pt + d - pi - tax) P

User Cost: Example u Let i =.1 u k =.75 (ratio of mortgage to price of house) = M/(M+E) u d =.02 u pi =.04 u P = 100,000 u tax = 0 u UCo = (.75* * ) = $9,000

Housing Demand for Renters u Standard Utility Maximization Problem u Max U(x,h) u subject to: pr h +p x x = Y u Result: h = f(pr, Y, p x, preferences)

Housing Demand for Owners u Same except we now have u h = f(uc, Y, p x, preferences)

Empirical Specification u h = a 0 + a 1 p r + a 2 p x + a 3 Y + a 4 Z u p r = rental price for renters and UCo for owners u usually in natural logarithms u ln q = ln alpha + ln y - ln p h

Measuring P h u Problem: how do we measure the price of a standard housing unit u Method #1: Repeat Sales u Measure change in same housing unit over time to determine change in P u Method #2: Hedonic Index u Estimate causes of variation in Value among housing units in one market

Measuring Income (Y) u Problem: Housing is a decision that lasts for many years; therefore, current income is not the sole or even primary determinant u Permanent or average income is key u Method #1: Proxy: average consumption u Method #2: Predicted Income u ln y = b0 + b1 Education + b2 Age + b3 occupation, etc

Housing Supply u Standard Specification u Profit Maximization u Max PQ u subject to: C(Q) u where C = C(Q, production function, w, i, pm)

Empirical Specification u Q = c0 + c1P + c2 w + c3 i + c4 pm u Q is the value of the entire stock –number of units –average value per unit

To Own or Rent? u What is the cost of owning (UCo) u What is the cost of renting (rental payments = pq)

Why would they differ? –Externalities –Income Tax Preferences for Home ownership

To Own or Lease a Car? u Same logic but different parameters