…a homeowner who moves has a cross-location hedging opportunity against sale price risk if he buys a new home at another location. Instead, a homeowner who moves to a rental house may only have been intertemporally hedged against price changes. This paper investigates the quality of both hedging opportunities.
That is from a new paper on the sales price risk of homeownership, and the value of homeownership as a hedging strategy against future price rises. The idea is that if you buy a home today and plan on selling it in the future and buying another home, you are facing two sources of risk: the risk in the uncertainty of the future sale price of the house you’re buying today, and the risk in the uncertainty of the future buying price of your next house. However, if you stay in the same neighborhood, or move into a neighborhood with correlated prices, then these risks may cancel out such that you are are hedged against this uncertainty. The authors use home sales data from the Netherlands to confirm the existence of this hedging opportunity.
This does suggest that if you are planning on buying a house in the future you are exposed to house price risk even if you don’t buy a home today. Heding against future price rises is a benefit of buying a home today.
However, the authors offer two words of caution for those who would seek to capitalize on this in today’s market. First, they note that
…the risk position of households may be aggravated, because income shocks and house price shocks are usually positively correlated.
And second, their empirical evidence shows that the ratio of risk to return is higher during periods of economic decline:
Hence, especially during an economic downturn the risk per unit of return is relatively high. In particular, one euro of return in 2000 was associated with between 0.6 and 1.6 euros spread in returns across types of houses. In 2003, this range was between 1.5 and 3.7 per euro return, and it was even higher in 2008 with the coefficient of variation ranging from 2.8 to 4.3. Hence, risk per unit of return may be between two or three times higher during an economic bust than during an economic boom.
Nevertheless, if you are certain you are going to buy a house in the future, than you are exposed to house price risk. Buying a house today can allow you to hedge against that risk.
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Friday ~ May 7th, 2010 at 11:58 am
Nick Rowe
Interesting find. But look at one of their assumptions!!!:
“We abstract from rent risk. This assumption allows us to focus on house price variation only (i.e. sale price risk). Moreover, such an assumption may be justified, since rents are highly regulated in the Netherlands.9 Since renting a future home is not assumed to be risky…”
1. They don’t seem to fully recognise that we are born with a short position in housing (something you and I were blogging about a year or so ago). They assume it away, anyway.
2. They assume that rent controls will reduce the risk of renting! They don’t recognise that rent controls will *increase* the risk of renting, if you have to move, and can’t find a place to rent, because there’s an excess demand!
Friday ~ May 7th, 2010 at 6:08 pm
Adam Ozimek
Nick,
While they don’t really discuss the it, unless I am misunderstanding their model (which is totally possible) I don’t think their model ignores the fact that we are born short in housing in any meaningful way. Now if their model included a scenario where you buy a house in period t and sell it in t+s without replacing, then I think they would be ignoring that fact and in an important way. Is there some part of their theoretical or empirical models that suggest to you they are ignoring this fact?
That’s a very interesting point, and I’ve never really thought about housing you want to buy or rent not being available as a risk, but I think that’s definitely true, and I think you’re right that they don’t recognize it either. But could you quantify that risk or model it? I would be very interested to see a model like that for housing. Has anyone modeled that for any goods?
Friday ~ May 7th, 2010 at 7:02 pm
Nick Rowe
Adam: I have had another brief read through their paper, but I cannot figure out what the person’s choice is in the model. You can only meaningfully talk about risk when you compare the risk of doing A vs the risk of doing B. I can’t figure out what B is. It must be renting. What else could it be? You have to live somewhere.
I don’t know of anyone who has modelled the risk created by rent controls. Not my area at all. Here’s how I would start:
Draw the standard supply and demand diagram, Draw a binding rent control at Pbar. Qs(Pbar) is now the quantity supplied. The effective supply curve now becomes perfectly inelastic at that quantity. Where that vertical effective supply curve cuts the demand curve tells us the demand price. Assume that the gap between the demand price and Pbar is dissipated by queuing costs. So movers actually pay the demand price, not Pbar.
Generally, for given shocks in the demand curve, the less elastic the supply curve, the greater the variance in price. Therefore, rent controls increase rental risk. (I can’t quite get my head around shocks to supply).
Friday ~ May 7th, 2010 at 11:36 pm
Adam Ozimek
The sales price risk for the person who goes from owning to renting is equation 1) on page 6, which really just has a risk of zero from renting. So I’m guessing -and the paper isn’t clearly written, so I’m not really sure- that they are ignoring the risk for people who rent in period t and t+s because it’s equal to zero under their assumption of no risk for renters. So you’re right you need a base case, and I think theirs is zero. I agree that that’s not really very appealing, and even if it is for the Netherlands, it’s less applicable to the U.S.
Your model sounds like a good start. Keep in mind though that the supply curve is for housing is pretty close to perfectly inelastic in the short run even without rent, so the short run risk will be lower under rent control since nominal prices probably adjust faster than queuing costs to demand shifts… but then again I don’t have a good idea of what those queuing costs are… bribes, gifts?
In the long-run though I suspect the issue depends on how slow or fast those queuing costs can increase. Again, I’m not exactly sure what all the queuing costs are, but I have to guess that informal price markets change slower than normal prices do, which would decrease risk.
Friday ~ May 7th, 2010 at 7:11 pm
Nick Rowe
Decades ago, David Laidler did some research on this, I think. He always complained that UK rent controls increased the natural rate of unemployment, by making it harder for unemployed workers to move to where the jobs were. In the 1960′s and 1970′s, UK rent controls really were binding. Sitting tenants did not move. It was almost impossible to find rental accommodation in places with jobs.
A sitting tenant with binding rent controls effectively owns a share of equity in the house. But has to give that share back to the landlord (or next tenant) if he moves. It’s an asset that is not transferable.
It’s not a *risk* it will be wroth less if you move; it’s a *certainty* that you will throw away that asset if you move. If rents are controlled at (say) 75% of market value, anyone who moves from a rent controlled house has essentially faced a 25% transactions cost on moving.
Saturday ~ May 8th, 2010 at 11:22 am
Nick Rowe
Queuing costs: probably in part the cost of extra search. But mostly having to rent a place that is not at all like the place you would want to rent if it were available. Too small and crowded in particular (the same number of people have to live somewhere, so ultimately rent control must force them to double up and all squeeze in.). Landlords skimp on maintenance. But also in the wrong location, etc. So the price per unit of subjective quality rises to equal the demand price.
Saturday ~ May 8th, 2010 at 11:30 am
Adam Ozimek
That makes a lot of sense. The authors of the paper want to ignore risk because it has been “regulated away”. But you’re saying it’s just regulated into another area: quality adjusted price risk. Which in fact may be greater. The only saving graces the authors may have is that homebuyers don’t perceive quality adjusted price risk as much as the perceive nominal price risk. But I do think your point stands that they’ve assumed away the risk of the renting scenario probably too much, and a better model would incorporate it.
I think there’s a better paper waiting to be written on this issue that uses rental and house price data, and has a fuller model of housing risk.
Monday ~ May 10th, 2010 at 9:35 am
Nick Rowe
Thanks. The authors get it half right, as far as I can see. The relevance of the covariance between the price of your current house and your next house is an important measure of risk of owning. They just ignore the other half: the risk of renting.
If you knew you would live forever, and would never want to move (and had good fire insurance etc.) then buying a house would be risk-free. You have bought the whole matrix of Arrow-Debreu securities you will consume (a place to live at all times in all states of the world) at a known price.