International Housing Finance Program Wharton Real Estate Center International Housing Finance Program Wharton Real Estate Center Subsidizing Housing Why, When and How Marja C. Hoek-Smit The Wharton School University of Pennsylvania World Bank Seminar on Housing Finance March 10-13, 2003 Copyright 2003 Trustees of the University of Pennsylvania/ International housing Finance Program

International Housing Finance Program Wharton Real Estate Center International Housing Finance Program Wharton Real Estate Center Presentation Outline Subsidizing Housing Marja Hoek-Smit Why Subsidize Housing? Types of Housing Subsidies Who Should be Subsidized? Criteria for the Design and Evaluation of Subsidies Housing Finance Subsidies Douglas Diamond A Roadmap to Subsidy Marja Hoek-Smit Reform and Design

International Housing Finance Program Wharton Real Estate Center Subsidizing Housing

International Housing Finance Program Wharton Real Estate Center Why Subsidize Housing? Rationales Improving public health Improving fairness and justice Influencing economic and political stability Overcoming market inefficiencies that yield monopoly profits or poor housing quality or insufficient volume of new and/or low-income construction, and that cannot be solved through regulations Stimulating economic growth

International Housing Finance Program Wharton Real Estate Center Why Subsidize Housing? The Political Reality The political system influences subsidy design Subsidies are initiated in response to specific macro-economic or social situations But remain long after conditions have changed Existing subsidies are seldom evaluated New subsidies are added to address new frontiers The subsidy scene in each country is a tapestry

International Housing Finance Program Wharton Real Estate Center

International Housing Finance Program Wharton Real Estate Center Subsidy Defined “A subsidy is an incentive provided by government to enable and persuade a certain class of producers or consumers to do something they would not otherwise do, by lowering their opportunity cost or otherwise increase the potential benefit of doing so” (adapted from US Congress, 1969).

International Housing Finance Program Wharton Real Estate Center Subsidies and Opportunity Cost  Opportunity Cost for Consumers or Producers of Housing: Current costs, net present value of future costs, uncertainty of future profits or costs because of lack of information e.g. for lender going down-market; cost reduction on servicing, compensation for lower yield (funding support) or insurance against risks (default risk)  Opportunity Costs for Government to Provide a Subsidy: Need to be taken into account in the same comprehensive way

International Housing Finance Program Wharton Real Estate Center Demand or Supply-Oriented Subsidies? Supply side: subsidize housing directly  needed when input markets do not work well  the downside is that they often distort markets Demand side: subsidize consumer  considered more efficient (consumer choice)  can only be applied in segments of the housing market that work reasonably well (i.e., when markets respond to an increase in demand by producing more housing in the desired category)  if supply markets are non-responsive, demand-side subsidies benefit lenders or developers --  turn into supply-side subsidies

International Housing Finance Program Wharton Real Estate Center Location-based or Scatter-site Subsidies? Location specific subsidies tend to be capitalized into real estate values and taxes and will in the longer term be less efficient from an equity perspective, but are often critical in the short term Location-based subsidies can positively impact collateral value and encourage investment/lending in a particular area Location-based subsidies can leverage community inputs which individual subsidies can not do

International Housing Finance Program Wharton Real Estate Center Entitlements or Rationed/Allocated Subsidies? Who Should Be Subsidized? (1) Should every household falling below a defined income/wealth threshold receive housing assistance? What should be that threshold? Should assistance ever be given to households above the threshold?

International Housing Finance Program Wharton Real Estate Center Who Should Be Subsidized? (2) If not every qualified household is to receive a housing subsidy, who is to be preferred? the neediest? those who will be helped the most by the assistance? those for whom assistance will do the most for the housing system as a whole? the most deserving (e.g. the working poor)? groups with special problems (e.g. the handicapped)? no one? Distribute housing assistance through a lottery How should this question be approached? better housing, somehow defined, is an intermediate goal who is to be favored with a subsidy depends on the higher level objective; that is, why, precisely is a housing subsidy being considered?

International Housing Finance Program Wharton Real Estate Center Entitlements or Rationed/Allocated Subsidies? (3) Budgetary constraints limit entitlement subsidies (provided to all qualifying households) If objective is public health or redistributive or focused on facilitating first-time home-ownership, entitlement subsidies are most effective If objective is facilitating down-market expansion, rationed / allocated subsidies are often more efficient

International Housing Finance Program Wharton Real Estate Center Types of Housing Subsidies (1) Production/Rehabilitation land grant or “write down” infrastructure / services assistance labor, materials, management below cost capital grant to purchaser/owner cross subsidy Finance subsidized construction loan subsidized permanent loan –at or below govt. borrowing rate –buy-down –foreclosure relief/mortgage insurance subsidized investor instruments –System default insurance/cashflow insurance

International Housing Finance Program Wharton Real Estate Center Types of Subsidies (2)  Operating expenses public housing or employee housing housing allowance heat and utilities provided free or at reduced price  Real estate tax deductions tax abatement tax cap for the elderly, the poor, etc. income tax credits/deductions for homeowners and certain investors  Rent control

International Housing Finance Program Wharton Real Estate Center Finance is critical to extend supply of housing Finance extends affordability and hence demand for housing Finance subsidies are relatively easy to design/ implement Finance subsidies can often be hidden from the budget (irresistible for politicians) But many disastrous examples of finance-linked subsidies Why are Housing Finance-linked Subsidies Amongst the Most Prevalent Housing Subsidies ?

International Housing Finance Program Wharton Real Estate Center : Limitations of Most Finance-linked Subsidies (1) Focus on formal mortgage finance excludes large section of population, i.e., households with low-income, income/employment instability, or collateral problems (negative impact on income distribution if mortgage-linked subsidy is main national subsidy) Often regressive when tied to size of loan Inefficiencies in the real sector not addressed, e.g., land markets, infrastructure provision, community services, building standards (subsidy capture by lenders or developers)

International Housing Finance Program Wharton Real Estate Center : Limitations of Most Finance-linked Subsidies (2) The way in which subsidies are mixed with finance has negative impact on the efficient development of national housing finance systems:  Prevents private finance sector from developing systems to address lending risks in middle and lower-middle income market  Subsidies offered exclusively by public housing banks or trusts which are typically less efficient than private institutions High, often uncertain and “hidden” cost to government

International Housing Finance Program Wharton Real Estate Center Linking Housing Subsidies to Finance or Not? Many countries drew lessons from poorly designed finance-linked subsidy systems and have, or are considering to move to more transparent and less distorting subsidies, e.g.,  Upfront grant subsidy system linked to savings or credit (but allocated through private lenders). Several Latin American countries; examples Costa Rica, Suriname, Mexico  On-budget interest rate subsidy / buy-down; Indonesia  Support to private, non-profit mortgage insurance, for short term and limited exposure; South Africa

International Housing Finance Program Wharton Real Estate Center Criteria for Designing and Evaluating Housing Subsidies (1) Efficiency (with respect to a specific purpose) productive (lowest cost per subsidy/cost of provision by government versus private sector) allocative (does expenditures reflect opportunity costs) transfer  welfare loss to individual (market value of assistance minus recipient’s valuation)  “buying out the base”/fungability of funds/ (recipient’s reduction of own spending on housing because of assistance)  % of recipients on the “margin” Equity horizontal vertical / “cliff-effect” Transparency (fiscal costs and allocation)

International Housing Finance Program Wharton Real Estate Center Criteria for Designing and Evaluating Housing Subsidies (2) Effects on Public Investment Portfolio (present and future) Effect on housing market as a whole production (housing allowance vs. production subsidies) prices quality Political Feasibility or Imperative Effect on Class Structure Effects on Labor Mobility (an oft problem with subsidized rental housing) Administrative simplicity

International Housing Finance Program Wharton Real Estate Center Given these Criteria, Is It Possible to Design an Optimal Subsidy? Multiple conflicting goals and values make achievement of optimality impossible Subsidies that seem appropriate in one country may not be appropriate in another, because of differing values, institutions, conditions and already existing subsidy arrangements throughout the economy Nevertheless, some subsidy arrangements are better than others in any particular situation

International Housing Finance Program Wharton Real Estate Center Road Map to Subsidy Reform and Design

International Housing Finance Program Wharton Real Estate Center International Housing Finance Program Wharton Real Estate Center 1. Determine the Housing Issues or Goals to be Addressed Why is housing consumption below desired levels?  Are house prices too high  Are finance cost too high  Are incomes of some are too low and redistribution through housing is desired What are the specific constraints to improve the housing sector? Refine the objectives for subsidies

International Housing Finance Program Wharton Real Estate Center International Housing Finance Program Wharton Real Estate Center 2. Which constraints can be corrected without a subsidy? What policy, regulatory, institutional measures other than subsidies are required to achieve the policy goals? Which constraints can only be corrected at the macro-economic level? i.e., high and volatile inflation, institutional distortions of special housing tax funds/banks

International Housing Finance Program Wharton Real Estate Center International Housing Finance Program Wharton Real Estate Center 3. What specific household or societal problems, or market constraints, should be addressed by subsidy programs? And what type of subsidy instrument or approach is best suited to address each specific objective?

International Housing Finance Program Wharton Real Estate Center International Housing Finance Program Wharton Real Estate Center Option 1. Concern about low-income housing conditions? Response: Promote housing consumption at low income level Pay a portion of the cost of renting or owning to household through allowances or buy-down interest subsidies (when finance and real markets works); US, Northern European countries Supply rental housing (US), serviced sites or core houses, improve slums; most developing nations

International Housing Finance Program Wharton Real Estate Center International Housing Finance Program Wharton Real Estate Center Option 2. A general housing subsidy to address general high cost of housing ? Response: General VAT exemption for housing Non-distorting subsidy on interest rates or housing loans (rentals, owner-occupied, resale and new) Tax credit (not deduction on income tax)

International Housing Finance Program Wharton Real Estate Center International Housing Finance Program Wharton Real Estate Center Option 3. Housing Finance System Improvement? Beyond regulatory and policy reforms. What specific lender/borrower constraints need to be addressed through the subsidy program? Which risks and costs? State involvement in default insurance for primary markets (short term/limited liability) (plus measures to decrease neighborhood risk) State involvement in cash-flow insurance for funder market Short-term support to alleviate servicing cost for down-market lending

International Housing Finance Program Wharton Real Estate Center International Housing Finance Program Wharton Real Estate Center Option 4. Support first time home- ownership? When home-ownership is policy priority and life-cycle cross-over from from rental to owning is difficult: Lump-sum cash grant (preferably not eliminating down-payment if applied to loan) Transparent interest subsidy for initial period of the loan Mortgage default insurance

International Housing Finance Program Wharton Real Estate Center International Housing Finance Program Wharton Real Estate Center 4.Costing and Detailed Design Macro-economic conditions  inflation rate  expected economic growth and its distribution Expectations concerning house value movements Expected real growth in household income Requirements for capital market transactions Potential to stimulate beneficiary/community contributions (incl.self-help) to increase equity Budgetary requirements  On- or off-budget subsidies (transparency)  Financial accountability (option to budget full cost in the year the subsidy is provided; multi year allocations)

International Housing Finance Program Wharton Real Estate Center 5. Implementation, Monitoring and Evaluation Use private sector entities that are “best in class” for each activity and that will respond to program incentives Minimize administrative requirements for implementing institutions (govt. and non-govt.)  Minimize need for rationing (no windfalls)  Do not unduly complicate financial management  Minimize need for ex post monitoring Regularly monitor, adjust size and conditions, and evaluate outcomes against goals

International Housing Finance Program Wharton Real Estate Center International Housing Finance Program Wharton Real Estate Center So….. It Takes “Three” to Tango Subsidy package/instrument for different groups of under-served households Incentives and institutional innovations to induce lenders, investors, NGOs to make market-rate loans to targeted middle/lower- middle income households/investors in rental housing Real sector reforms to facilitate participation by private developers/builders.