Lec-7 Housing Demand and Tenure Choice

1. Lec-7 Housing Demand and Tenure Choice Engr. Dr. Attaullah Shah

2. Take Home Test Answer briefly: Q-1: Define Urban Economics and Explain its subject matter Q.-2: What is meant by Central Place theory and how the rent and transportation cost affect the consumer’s choice of house selection? Q-3: What is meant by Urban Sprawl and how can we control it through policy initiatives?

3. Questions for Discussion • Why some people prefer to live in rented houses, though sometimes they can afford to build their houses? • Why some people prefer to live in owned houses though they can’t afford it? • How some consumer manage to own house where as the other consumers will prefer to live in rented houses, though they have the same levels incomes.

4. Housing Demands • Traditional Approach: • the housing consumption was measured Uni- dimensional • For urban houses, the housing consumption was measured in terms of FAR in a dwelling as q = αpβyθ • q is the housing consumption, p is price per unit and y is income, β and α are the elasticities of price and income, negative and positive respectively • The researchers are interested to measure these elesticities • We multiply the both sides by q, we get • The quantity pq the housing expenditure denoted by E = αpβ+1yθ • Taking natural logarithm, we get log E = log α+(β+1)logp+θlogy • where logp= γ • Here the housing expenditure is the function of price and income • The income and price elastictities can be measured with the help of regression equations from the data of house rent/value and income and price . The elasticities are given as • The house demand is price inelastic and it rises less proportionally with income . Hence housing expenditure makes small portion of income when it increases.

5. Housing Demand- Hedonic Approach • In actual world, the housing demand depends on many attributes rather than FAR. Hence the utility function of u=f(c,q) is written as u = f(c,a1,a2,a3……..) • In real practice the consumer has demand for individual attributes of house rather than the house lot such as rooms, types of construction, finishes etc • The hedonic price is determined from the data available with the real estate people, where the house selling price depends on many attributes of houses • Once such function was first estimated by Grether and Mieszkowski (1974) by developing Hedonic price regression equation for the house in Connecticut during 1962-69

6. The user Cost of Housing • When house is rented the housing value is the rental value with p as the rental price per unit • In case of owned house, the house value becomes more complicated as the owner has to pay cost of land, mortgage cost, maintenance cost and depreciation etc • Lets V denotes the house value, i is interest rate, h is property tax, d: depreciation, g: gains in values and lets supposed that house is owned at 100 mortgage • The consumer annual interest is iV, property tax is hV and depreciation cost is dV, the house value gain is gV… • The annual cost home owner is paying comes to • If v denotes the purchase price then V=vq= • Owner occupier cost per unit is given as:

7. Tax treatment Housing • The tax treatment of Owner occupied house affects the housing cost and for landlord, it affects the rental cost • The tax treatment • Mortgage interest property taxes and depreciation are tax deductible for landlords. Mortgage interest property taxes are deductible for owner occupiers • For owner occupiers, tax subsidies are given by Govt.

8. Use cost of owner occupied house • Due to tax deduction for owner occupied house, the housing cost is adjusted by introducing the term (1-π) and the housing cost becomes • The owner occupied house cost per unit becomes • If the purchase price of house per unit v increases, q will fall and similarly when the mortgage interest rises the q will fall. Hence the cost of mortgage contributes to the cost of owner occupied houses • Higher depreciation would increase the user cost causing q to fall • Increase in the capital gains would lead to increase in house quantity

9. Inflation and Hosing bubbles • If inflation raises by 1 % (0.01) and the mortgage interest raises by 1% as a result • The change in user cost is given as: • The general inflation reduces the users cost and the owner occupiers would demand more houses • A housing bubble arises, when the widespread expectation from house gains are self fulfilling • If users expects higher gains g with no change in inflation then the user cost falls and it will lead to higher demand • The higher demand would in turn lead to increase in house price as well as capital gains. • This further fuels the housing bubble

10. If a landlord buys a house at price q per unit of house on 100% mortgage and rents it at p per unit. The land lord cost per unit after payment of taxes is • Where λ is landlord tax. If the capital gains are also taxes then he retains only (1- λ)gv. The rent is also taxed and the return is (1- λ)p. The landlord net income after tax is: • In case of extensive housing bubble, the competition of houses makes this net income or profit minimum and even zero at the end. • This will give • This is similar to owner occupied cost of house except no income tax term

11. Tenure Choice in basic Model • The choice to own or rent will depend on the choice of tenure • The renter cost of house is more than the owner cost and the later is less • The consumer would prefer to be the owner occupier • About one third of US houses are rented and the remaining are owned. However this may not be correct for other countries of the world as the housing mortgages are very cheaply available every year due to high inflation in most parts of the world. • Furthermore an importnat element of house depreciation has not been included in the house cost

12. The choice of tenure with depreciation • For buildings accelerated depreciation rate has been proposed by the US Govt. Buildings are supposed to wear and tear quickly than actual under the tax code • If the depreciation is “d+e” for houses tax purpose where d is normal depreciation and e is excess depreciation • The profit expression would become: • Hence with accelerated depreciation creates a saving of λev • Where λ is equal to landlord’s tax rate time the dollar amount of excess depreciation per unit of housing (ev). The second profit expression shows that net result is the addition of λev to the previous profit formula. • Setting the last profit expression to zero, we get

13. Housing Tenure Choice • The renting is cheaper than owning for households with low ’s and owning is cheaper with high ’s • Again ’s rises with income it follows that the low income households will be renters and the high income households will be owner-occupiers

14. What are other factors • If renting can be preferable for many low income households, then why they prefer to be the owner occupiers. • Pride of Ownership . What does it mean? • Expected Mobility: Households more frequently shifting and moving may not prefer to own house as they would like to avoid the burden of buying and selling's, commissions, processing charges, documentations etc • Risk: Home ownership is a risky business as in most of the cases the prices of houses are correlated to people income and in case of bad times, both the income and house prices would fall leaving the homeowners to double jeopardy • Dislike of home maintenance tasks: The burden of maintenance costs may not be liked by many

15. Other factors • Down Payment Tenure choice and mortgage default • The consumer who couldn’t afford to pay the down payment would prefer to rent the house • The down payment would need to save from current consumption but the impatient consumer would prefer to spend more rather than to save and hence they would not have any savings for down payments. At the other hand, the patient consumer will save ….. • In case of default of paying back the mortgage loan and installment would make the consumer, debarred for many years to apply for any other loan or mortgage, therefore they would prefer to rent rather than own the house

16. Property abuse and tenure choice • Suppose that an owner occupier buys a house at the beginning of a period at amount V and sells at the end of the period. • An operating cost O is incurred by owner occupier while living in the house. i.e property taxes, incomes taxes. • The cost of caring the house i.e. security, close monitoring etc and is denoted by C • If damage to the house is denoted by D and the market conditions remain unchanged, the re-sale value is V-D • If care is exercised, the cost of owner occupancy during the period is V+O+C-V=O+C, Hence the owner occupier pays an additional cost for the operation and care. If the care is not exercised, then the cost of damage will be incurred and the cost of owner occupancy is V+0 – (V+D)= O+D. The cost of C is avoided but is has led to D • Hence care will be exercised if C<D and it will be avoided if D>C • Now if we consider the renter who also exercises house care will pay P+C. Since the renter doesn't own the property, therefore, he will not care for the damage. The landlord will charge min P=O+D • Should the consumer be an owner or renter for the above cases?

17. The cost of owning: O+C and the cost of renting: P=O+D • Since C<D, the owner occupancy cost is lower and as a result no one chooses to be a renter • The landlord must charge the resultant Damage as part of rent.

18. Summary

19. Housing Tenure Choice in Transitional Urban China: A Multilevel Analysis • Youqin Huang and William A. V. Clark • Urban Studies, Vol. 39, No. 1, 7–32, 2002 • Using a 1996 national survey of housing in China and a multilevel modeling technique, we examine housing tenure choice in transitional urban China where households have been granted limited freedom of choice in the housing market since the housing reforms of 1988. • We find that both market mechanisms and institutional forces affect households’ tenure choice in urban China. While some socioeconomic factors such as age, household size, household income and housing price have similar effects on tenure choice as in the West, others such as the number of workers and marital status have rather different effects. In addition, factors characterizing institutional relationships among the state, work units and households, such as hukou, job rank and work unit rank, still play important roles in tenure choice.

20. A Joint Model of Tenure Choice and Demand for Housing in the City of Karachi Nuzhat AhmadUrban Studies SAGE Journals • The paper estimates a joint model of tenure choice and demand for housing for the city of Karachi, Pakistan, using a two-stage estimation procedure. • Permanent income and demographic variables are included in the analysis. The study uses data collected at the household level in the city in 1987/88. • Results show that ownership rates are high in Karachi. Ownership is more likely with increases in permanent income, age, household size and residence in the Unauthorized Areas. • Permanent income, transitory income, age and education of the head significantly affect the consumption of housing both for renter and owner households. Results of the analysis and the estimated income elasticities of demand are comparable and consistent with those reported for other developing countries.