Importance of Housing

1. Importance of Housing • Housing, as shelter, is one of the basic needs of human kind. • Houses are financial investments. • Housing is a significant component of the local, regional and national economy. • Housing is a social priority as declared by the U.S. Congress in 1949. • Housing is a merit good.

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

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

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

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

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

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

8. U.S. Population By Age

9. U.S. Households By Type

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

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

13. Features that Make Housing Different • Housing is heterogeneous • Housing is immobile • Housing is durable • Housing is expensive • Moving costs are relatively high

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

15. Heterogeneity and Immobility • 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

16. Heterogeneity and Immobility • 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

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

18. Heterogeneity and Immobility • Implications for the Housing Markets • 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. • 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.

19. Durability of Housing • 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

20. Durability of Housing: Implications • Deterioration and Maintenance • The landlord can control the rate of physical deterioration • by spending time and money on repair and maintenance. • The question for the landlord is • how much should be spent on maintenance over time. • Whatever amount of maintenance expenditure • that maximizes the landlord profit should be spent. • 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.

21. Durability of Housing: Implications • 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

22. Durability of Housing: Implications • The Filtering Model of the Housing Market • The filtering model captures some of the essential features of the market for used housing. • It describes the interactions between different housing submarkets and the process through which dwelling passes from one use to another. • 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.

23. The High Cost of Housing • When a household buys a home, it typically spends between two and four times its annual income on the house. • 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.

24. The High Cost of Housing • When a household buys a home, it typically spends between two and four times its annual income on the house • 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

25. The High Cost of Housing • Taxes and Housing • 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

26. Large Moving Cost • Housing consumption changes sometimes require a move to a different dwelling • 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. • In other words, a move to a new neighborhood disrupts social and consumption patterns

27. Large Moving Cost: Implications • Housing costs: • a household changes its housing consumption only if benefits of moving exceeds the cost of moving. • 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. • A household moves to a different dwelling only if the change in income and price is large relative to moving cost. • When a household changes houses, it is likely to make a large change in its housing consumption.

28. Large Moving Cost: Implications • 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.

29. Large Moving Cost: Implications • Income Elasticity of Demand for Housing • There is a consensus on three points regarding income elasticity of demand for housing • (1) the overall income elasticity is about .75: • a 10 percent increase in income increases housing consumption by about 7.5 percent. • (2)the income elasticity of renters is less than the income elasticity for owner-occupants. • (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.

30. Large Moving Cost: Implications • Price Elasticity of Demand for Housing • What is the price elasticity of demand for housing? • Most estimates of the price elasticity fall between -0.75 and -1.2. • The consensus is that demand is slightly price-inelastic • (elasticity slightly less than 1.0 in absolute value). • 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.

31. Basic Equation in Housing • Concept of the Price of Housing • Housing Demand • Housing Supply • Home ownership Choice

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

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

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

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

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

37. User Cost: Example • Let i = .1 • k = .75 (ratio of mortgage to price of house) = M/(M+E) • d = .02 • pi = .04 • P = 100,000 • tax = 0 • UCo = (.75*.1 + .25*.1 + .02 - .03)100000 = $9,000

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

39. Housing Demand for Owners • Same except we now have • h = f(uc, Y, px , preferences)

40. Empirical Specification • h = a0 + a1 pr + a2 px + a3 Y + a4 Z • pr = rental price for renters and UCo for owners • usually in natural logarithms • ln q = ln alpha + ln y - ln ph

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

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

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

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

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

46. Why would they differ? • Externalities • Income Tax Preferences for Home ownership

47. To Own or Lease a Car? • Same logic but different parameters