Chapter 1

Real estate, Stock ow models

1.1 Introduction
Real estate, Stock ow models chapter focuses on price movements according to change on
stock in housing market. It also briey analysis lack of models and its biases.
1.2 Model
The paper House Price Dynamics: The Role of Tax Policy and Demography focuses on price
movements in U.S. between early 70s and late 80s. Author tries to base reasons of price
uctuations on two factors which are changes in tax code and demography of households in
US.
Figures belong to housing market indicates how it is important for overall economy. In
1990s households (abbreviated as HH from now on) net worth is $17.1 trillion where $4.6
trillion in gross values of it belongs to owner occupied homes. The fact that corporate equity
owned by HH, which is around $2.4 trillion, is far less than owned house.
Three dierent data has been used for regressions. A data from Census Bureau Data
has been used for aggregated information according to Census Regional criteria.
1
More
disaggregated data is available from the National Association of Realtors (NAR) and reports
quarterly median house prices for 115 Standard Metropolitan Statistical Areas (SMSA).
While Census Bureau constant quality prices index for valuing only structure, NAR median
house prices captures combines cost of land and structure. Third and last data set belongs
to Urban Land Institute (ULI) which provides semi decadal data based on survey of land
cost and available since 1975. The survey asks experts to price a standard improved 10.000
sq. foot in 30 dierent cities.
In order to explain house price movements, we need to indicate that Housing market
consist of two sub-markets: Stock for existing house and ow of new construction. Price
of house determined by existing stock house whereas level of new investment is determined
by ow of new constructions. Thus, any shock to those sub-markets will eect house price.
Equilibrium of owner occupied house market requires house owner should get some return
1
See Appendix 1
1
2 CHAPTER 1. REAL ESTATE, STOCK FLOW MODELS
from investing to houses as they could get some return when they invest on any other asset.
Furthermore, this requires equation 1 which is user cost equation.
where R
H
denotes the marginal value of the rental services per period on owner-occupied
homes, P
H
the price of existing houses, the investors marginal tax rate, i the nominal
interest rate,
p
the property tax rate as a share of house value, the depreciation rate
on housing capital, the risk premium required on assets with the risk characteristics of
housing, m the maintenance cost per unit value, and
e
the investors expected rate of
nominal house price appreciation.
2
The fact that the issue with this equation is that it assumes all house has same quality,
location and other characteristic. Nevertheless it help us determine what investor will do
after looking at cost of investing via this equation. Housing stock is determined at beginning
of every period by past investment and housing stock then determines RH. In the equation
1, everything except e are endogenous. So, expected housing ination shapes rational expec-
tations on housing investors. Then, it becomes a connection between housing price today
and housing investment in future. This relation is demonstrated on equation 2.
Under the assumption of expectation which is formed with future prediction,
e
t
=
(P
H,t+1
P
Ht
)/P
Ht
, equation 1 and 2 becomes pair and initial house price should be deter-
mined in order to solve forward. In this framework, real price can increase by supply shock
which can cause an increase on price of current or future construction cost or by current and
anticipated demand shocks which can cause an increase on value of rental services of owner
occupied house stock. On the other hand we can shape framework with extrapolative ex-
pectations rather than rational. This allow systematic overbuilding of houses in the housing
market and also allow to predict what excess return will be on houses. House price move-
ment during 70s and 80s showed that investor in housing have extrapolative expectations
therefore there are not rational on investment decision making process.
There are three popular way of explanation of price raise on 70s. First one is shock to
construction cost which caused systematic change. Afterwards, it resulted with an increase
in housing price relative to GNP deator. Second one is favorable and unexpected demand
shock. As it is demonstrated on equation 1, U.S. tax code allows households to deduct
nominal interest rate from taxable income. If nominal interest rates increase 1 by 1 according
to ination rates, then [(1-)i-
e
] which is after tax of borrowing declines as ination rate
increases. The tax reform during 80s reduced marginal tax rates, and this increased marginal
2
taken from Poterba, J.M., Weil, D.N., and Shiller, R. (1991). House Price Dynamics: The Role of Tax
Policy and Demography.
1.2. MODEL 3
cost of housing and it stressed the price of homes, especially hold by higher income of
house owners. Third one is based on demography. The forecast is that people between
25-35 years old will demand a house more than other part of community due to fact that
marriage, becoming independent etc. So, Mankiw and Weil(1989) argue that entry of large
cohort into 24-35 age period should be forecasted earlier than they start demanding new
houses. However, they found that price increase in during 70s mainly caused by baby-boom
generation. They fall into 24-35 age bracket during 70s and high demand increased house
prices. In addition to that, next generation was not populated as much as baby-boom
generation and this could be one of the reasons of price fall during 90s.
In order to estimate price change on relative appreciation of dierent sized houses, re-
gression has run based on hedonic approach. Big-size houses that can be bought by high
income household and small size houses can be bought by low income households are dened
as a trade-up houses and starter houses respectively by author. Findings shows that broad
patter of price change on dierent sized houses has a same patter with a change on real
user cost as it can be seen on table 2. But, hedonic approach has a shortcomings. A better
housing index should include analyzing repeat sales of houses. Because repeat sales method
4 CHAPTER 1. REAL ESTATE, STOCK FLOW MODELS
has advantage of capability of controlling for the heterogeneity in housing characteristic and
the less data requirement in the estimation. For that, Karl E. Case and Robert J. Schiller
discuss about repeat sales in their article, The Eciency of the Market for Single-Family
Home, which is published on The American Economic Review on March, 1989. Their paper
tries to nd an answer to eciency in housing market for years from 1970 to 1986 for four
dierent cities; Atlanta, Chicago, Dallas and Oakland/San Francisco. They use repeat sale
data on individual homes which havent have apparent characteristic change. On their paper,
they modied a model based on Martin J. Bailey, Richard Muth and Hugh Nourse (Initials
BMN) and called it as Weighted Repeated Sales. It is three-step weighted procedure. For
rst step, BMN model followed, which produces estimation and standard errors for housing
price index by using ordinary least square regression method on change in log price of each
house. In second step, squared residuals from rst regression has regressed again on a con-
stant and the time distance between sales. Constant term is estimate of variance of noise
in price and slope term is estimate of variance of individual housing value through time.
In the last step, they rst divide each observation in the regression in step-one by square
root of tted value in second step regression, then they run regression again. They found
out that citywide real hosing prices in given certain year tends to anticipate a change on
same direction for the following year. Also, forecasted change in real interest rates does not
seem to be incorporated in prices. Additionally, taxes and rental rates reveal that city wise
after-tax return excess are predictable.
However, Man Cho also indicates that there is various potential biases on repeat sales
which comes from the structural changes between sales or by some time-varying structural
qualications. There are 5 dierent type of bias in repeat sales indices: renovation bias where
is caused by structural changes between two sales; hedonic bias which is a bias comes from
values of some structural and locational characters changes over time; trading- frequency
1.2. MODEL 5
bias where trading frequency causes some bias on measured rate of appreciation; sample-
selection bias where occurs when there is a bias on estimates of the changes in the value of
the stock of housing and aggregation bias where time interval causes bias. In order to solve
these issues, 3 dierent methods are suggested: Hedonic Repeat Sales Model which models
the eects of the age of structure, a vector of time dummies in the hedonic model, and a
set of time dummies in the Repeat Sales Model on the covariance between repeat sales and
hedonic residuals; Intercept Repeat Sales Model which adds a xed eect item to Repeat
Sales Model and estimate mean and variance of xed and temporal items of repeat sales
by using maximum likelihood method , and Distance Weighted Repeat Sales Model that
decompose the price appreciation as per-period expected return, jurisdiction-specic return,
and random changes private property to a house, then assumed distributional characteristics
of error terms designate covariance between housing returns of those two jurisdictions.
It is also important to analyze price change in city level over time according to change
in demography, construction cost, incomes and tax rates. Equation 3, reduced form cross
section model gives us the relation in empirically.
where p
it
is the logarithm of the real median house price in city i at period t, c
it
denotes
the logarithm of real construction costs, d
it
is the logarithm of a demand measure based on
population structure, y
it
is the logarithm of real per capita income, u
it
is an indicator of
real user costs of home-ownership, and v
it
are residuals.
3
The demand pattern is result of
holding a house, household formation decisions and decision about how much to purchase
based on holding conditions. All of those are eected by price level. Migration decisions are
also aected by price level. Thus, in order to prevent endogeneity , d
it
is calculated by using
national index of aged specied housing demand. Another variable is a measure of user cost
of housing in dierent cities. Including nominal interest rates and expected ination, most
of components of user cost doesnt change among cities. However, federal marginal tax rates
vary among cities where households can deduct mortgage interest and property taxes.
What about the question of forecast of price movements. Recent studies convey that
prices can be anticipated. Equation 4 demonstrates this arguments empirically.
where r
t
in a return on 90-day Treasury Bills and dependent variable is excess on housing
investment.
3
taken from Poterba, J.M., Weil, D.N., and Shiller, R. (1991). House Price Dynamics: The Role of Tax
Policy and Demography.
6 CHAPTER 1. REAL ESTATE, STOCK FLOW MODELS
1.3 Conclusion
As a conclusion, demographical changes might be a possible explanation for price decline
during 80s. There is a strong relation between level of real house price and housing demand
related with age prole of population for United States. Caution is needed in extrapolating
historical trend of hosing prices and demography far into future. Because, even if there
is relation, on SMSAs level demography-house price link doesnt always hold. Investors in
owner occupied house market does not have a rational expectations but extrapolating for
estimating future capital gains on housing. This could be a reason of price movement during
80s due to fact that investors hadnt realized yet that user cost is higher than 70s. Same
intuition can be make price decline late 80s. Investors had extrapolated price deductions
starter mid-80s and shaped their decisions according to recent price decline.
References
Poterba, J.M., Weil, D.N., and Shiller, R. (1991). House Price Dynamics: The Role of Tax
Policy and Demography. Brookings Papers on Economic Activity, Vol. 1991, No. 2, pp.
143-203.
Case, K.E. and Shiller, R.J. (1989). The Eciency of the Market for Single-Family Homes.
The American Economic Review, Vol. 79, No. 1, pp. 125-137.
Cho, M. (1996). House Price Dynamics: A Survey of Theoretical and Empirical Issues.
Journal of Housing Research, Volume 7, Issue 2, pp. 145-172.
1.3. CONCLUSION 7
Appendix 1