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THE ECONOMICS OF HOUSING SUBSIDIES

Denise DiPasquale

National Community Development Initiative Seminar

October 17, 1996
New York, New York

I. Housing Subsidy Programs and Economic Efficiency

Types of Subsidy Programs:
1. Cash Transfers
2. Vouchers
3. Housing Units
Economists Mantra: Cash is more efficient than in-kind transfers.
Efficiency Argument: Maximizing the welfare of subsidy recipients requires that recipients
consume those goods and services that best match their tastes given their
budgets.
Why subsidize housing?
By targeting a specific good, government is attempting to encourage
some minimum level of housing consumption in terms of quantity or
quality. This goal may or may not be consistent with the recipients
view of his welfare.
Why is cash generally viewed as More Efficient?
With cash, households are free to choose any combination of purchases.
The fundamental point is that the individual is the best judge of his own
welfare.
Are housing subsidies efficient?
1. Housing voucher could be equivalent to cash. If the voucher is less
than the amount the household would choose to spend on housing then
the voucher is equivalent to cash. The recipient simply replaces some
portion of his own funds that would have gone to housing with the
voucher.
2. Providing housing units is unlikely to be as efficient as cash since it is
unlikely that the unit provided exactly matches the choice that a
household would have made with cash. The housing units may be better
or worse than that which the recipient would have picked.

Fundamental Question:

Is the goal of the program to maximize recipient welfare

or to maximize the welfare of the donor?

Basic Mechanics:

Household chooses a combination of housing and other goods and services to maximize its
welfare given its budget, BB. Welfare of that household is the same along each curve, I.
Household is better off on I than I. Household would choose H of housing and X of other
goods.

Budget BB is the households original budget line. The extended budget line BB'B' and the
welfare curve I'' are the results of a voucher. In this case, vouchers are equivalent to cash.
Voucher insures that household spends at least H on housing but left alone the household would
spend H' without the voucher and H'' with the voucher.
Providing a housing unit would mean that a household would have to operate at a single point on
the graph. It is unlikely that this single point is the one that the household would choose if it
were free to select the amount of housing and other goods and services to consume.
2

The Impact of Housing Subsidy Programs on the Private Housing Market

Subsidies impact either the demand or supply sides of the market. Specifically, we want to know
the impact of each subsidy program on rent levels, the value of the real estate, housing
construction, and the stock of apartments.
Demand Programs
Tenant-based subsidies such as housing vouchers increase the demand for housing
in the private market.
Impacts:
Rents
Value
Construction
Stock

8
8
8
8

Supply Programs
Public housing units built and owned by the government decrease the demand for
housing in the private market.
Impacts:
Rents
Value
Construction
Stock

9
9
9
9

Tax incentives to investors in rental housing such as the Low Income Housing
Tax Credit decrease the return required by investors.
Impacts:
Value
Construction
Stock
Rent

8
8
8
9

Encouraging more development by relaxing local building regulations or

subsidizing development with HOME funds decreases construction costs.
Impacts:
Construction
Stock
Rent
Value

8
8
9
9
3

II. The Real Estate Market

The real estate market is comprised of two markets:
1. Market for real estate use (property market) where space is rented or purchased for
occupancy.
2. Market for real estate assets (asset market) where buildings are bought and sold as
investments.
Consider the market for rental housing:
CRents are determined in the property market where the supply of apartments is fixed.
Demand for apartments depends on rent and other economic factors such as income levels
and the number of households.
CValue of an apartment building is determined in the asset market. Investors in apartment
buildings are simply purchasing an income stream. The income stream is determined by
rent less expenses.
CConstruction of new apartment buildings is determined in the asset market. The level of
construction depends on the value of new buildings relative to construction costs.
How much is a potential investor willing to pay, P, for a building that will generate
income, R, each year, forever?
P'

R
i

where i is the capitalization rate, the rate at which income is translated into value.1

This simple capitalization formula is a good rule of thumb. Clearly, income streams are
usually not expected to last forever. If the income stream is expected to last n years then:

P'

R1

R2

R3

(1%i) (1%i)2 (1%i)3

%...%

Rn
(1%i) n

What determines the capitalization rate?

CLong-term interest rate in the economy
CExpected growth in rents
CRisks associated with that rental income stream
CTreatment of real estate in the U.S. federal tax code

Important connections between the property market and the asset market:
CRents determined in the property market are central to determining the demand for real
estate assets.
CAn increase in construction increases the supply of apartments in the property market
which should decrease rents.

The Relationship Between the Property and Asset Markets

The relationship between the property and asset markets is illustrated in Figure 1.1. The right
half of Figure 1.1 represents the property market and the left half represents the asset market.
Figure 1.1
REAL ESTATE: The Property and Asset Markets

From DiPasquale and Wheaton. Urban Economics and Real Estate Markets. Prentice-Hall, 1996.

CThe NE quadrant has two axes: rent (per unit of space) on the vertical axis and the stock
of space (also measured in units of space such as square feet) on the horizontal axis. The
curve represents how the demand for space depends on rents, given the state of the
economy. Rent is determined by taking a level of stock of space on the horizontal axis,
drawing a line up to the demand curve, and then over to the vertical axis.
CThe NW quadrant represents the first part of the asset market and has two axes: rent and
price (per unit of space). The ray emanating from the origin represents the capitalization
rate for real estate assets: the ratio of rent-to-price. This is the current yield that investors
demand in order to hold real estate assets. Thus, the purpose of the NW quadrant is to
take the rent level, R, from the NE quadrant and determine a price for real estate assets, P,
using a capitalization rate. The price is determined by moving from the rent level on the
vertical axis in the NE quadrant over to the ray in the NW quadrant, and then down to the
horizontal axis where asset price is given.

CThe SW quadrant is that portion of the asset market where the creation of new assets is
determined. Here, the curve represents the replacement cost of real estate. The cost of
replacement through new construction is assumed to increase with greater building activity (C), and so the curve moves in a southwesterly direction. It intersects the price axis
at that minimum dollar value (per unit of space) required to get some level of new
development underway. Given the price of real estate assets from the NW quadrant, a
line down to the replacement cost curve and then over to the vertical axis determines the
level of new construction where replacement costs equal asset prices.
CThe SE quadrant converts the annual flow of new construction, C, into a long run stock
of real estate space. The change in the stock, S, in a given period is equal to new
construction minus losses from the stock measured by the depreciation (removal) rate, .
The ray emanating from the origin represents that level of stock (on the horizontal axis)
which requires an annual level of construction for replacement just equal to that value on
the vertical axis. To determine the new level of stock needed for equilibrium, take the
level of construction from the vertical axis, move over to the ray in the SE quadrant, and
then up to the horizontal axis where stock is represented.

Review of Figure 1.1: Starting with a level of stock, the property market determines rents in the
NE quadrant which then get translated into property prices by the asset market in the NW
quadrant. These asset prices, in turn, generate new construction in the SW quadrant which back
in the property market eventually yields a new level of stock in the SE quadrant.

The Impact of Housing Policy on the Apartment Market

What is the impact of rental vouchers on the apartment market?

CVouchers increase demand for housing which will result in an outward shift in the
demand curve in the NE quadrant as shown in Figure 1.2. This increase in demand will
increase rents.
CThese higher rents lead to greater asset prices in the NW quadrant.
CHigher asset prices will bring forth more construction in the SW quadrant.
CMore construction increases the stock of apartments in the SE quadrant.

Figure 1.2
The Property and Asset Markets: Property Demand Shifts

From DiPasquale and Wheaton. Urban Economics and Real Estate Markets. Prentice-Hall, 1996.

What is the impact of favorable federal tax treatment of rental housing?

CFavorable tax treatment of rental housing will reduce the return that investors require
from rental housing.
CIn Figure 1.4, favorable tax treatment results in a lowering of the capitalization rate (a
counterclockwise rotation in the curve in the NW quadrant) which increases the value of
an apartment building that produces a given income stream.
CThe increase in asset prices in the NW quadrant increases construction in the SW
quadrant.
CThe increase in construction in the SW quadrant increases the stock in the SE quadrant.
CThe increase in the stock in the SW quadrant decreases rent in the NE quadrant.

Figure 1.4
The Property and Asset Markets: Asset Demand Shifts

From DiPasquale and Wheaton. Urban Economics and Real Estate Markets. Prentice-Hall, 1996.

What is the impact of increases in building regulations by local governments on the rental
housing market?
CBuilding regulations often significantly increase the cost of development, reducing the
profitability of new construction.
CIn Figure 1.7, the increase in regulation impacts construction by shifting out the cost
curve in the SW quadrant. This shift means that a given asset price will now generate
less construction.
CThe decrease in construction will decrease the stock of apartments in the SE quadrant.
CThe decrease in the stock will increase rents in the NE quadrant.
CThe increase in rents in the NE quadrant will increase asset prices in the NW quadrant.

Figure 1.7
The Property and Asset Markets: Asset Cost Shifts

From DiPasquale and Wheaton. Urban Economics and Real Estate Markets. Prentice-Hall, 1996.

10

III. The Importance of Real Estate in the U.S. Economy

Real estate is the national stock of buildings, the land on which they are built, and all vacant
land.
Real estate can be measured both as a flow and as a stock.

The flow of real estate is the value of new buildings put in place each year, less losses from the
stock through depreciation or demolition. In recent years, investment in new buildings has
accounted for roughly 7% of Gross Domestic Product (GDP).
Measuring the Flow: The Census measures the flow of real estate by estimating the value
of new construction put in place. As shown in Table 1.1, private construction represented
$301 billion (5.5% of GDP).
CResidential buildings accounted for 61% of the value of private construction of
buildings.
CIn the public sector, buildings represented only about 42% of the $109 billion in public
construction with residential buildings representing less than 10% of the value of
buildings.

The stock of real estate is the total value of all existing buildings and the value of all land. Since
land is non-reproducible, it is always a stock variable and never a flow variable.
Measuring the Stock: Valuing the total real estate stock at any point in time, however, is
far more difficult than measuring the flow. A 1991 study made a gallant attempt at
estimating the value of all U.S. real estate.
CAs shown in Table 1.2, total real estate in the U.S. for 1990 was estimated to be worth
$8.8 trillion which represents roughly 56% of the nations wealth.
CAlmost 70% of all U.S. real estate was residential, and almost 90% of the value of
residential real estate was in the nation's stock of single family homes.

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T a b le 1 .1
V a lue o f N e w C o ns truc tio n P ut in P la c e , 1 9 9 0
Billions
of $s

Perc ent
of GDP

Pr ivate C o n s tr u ctio n
Bu ild in gs
Res idential Buildings
Non-Res idential Buildings
Indus trial
Of f ic e
Hotels /Motels
Other Commerc ial
A ll Other Non-Res idential
Non -Bu ilding Co ns tr u ctio n
Public Utilities
A ll Other

338
301
183
118
24
29
10
34
21
37
31
6

6.1
5.5
3.3
2.1
0.4
0.5
0.2
0.6
0.4
0.7
0.6
0.1

Pu blic C on s tr uction
Bu ild in gs
Hous ing and Dev elopment
Indus trial
Other
Non -Bu ilding Co ns tr u ctio n
Inf ras truc ture
A ll Other

109
46
4
1
41
63
55
8

2.0
0.8
0.1
0.0
0.7
1.1
1.0
0.1

To tal Ne w C o ns tr u ctio n

446

8.1

5,514

100.0

To tal GDP:

Sourc e: Current Cons truc tion Reports , Series C30.

U.S. Bureau of Cens us . Gros s Domes tic Produc t f rom
Ec onomic Report of the Pres ident 1992.
From DiPas quale and Wheaton, Urban Ec onomic s and Real Es tate Markets . Prentic e-Hall, 1996.

T a b le 1 .2
V a lue o f U .S . R e a l E s ta te , 1 9 9 0

Billions
of $s

Perc ent
of Total

Re s id e n tial
Single Family Homes
Multif amily
Condominiums /Coops
Mobile Homes

6,122
5,419
552
96
55

69.8
61.7
6.3
1.1
0.6

Re tail
Office
M an ufactu r ing
War e h ou s e

1,115
1,009
308
223

12.7
11.5
3.5
2.5

T otal U.S. Re al Es tate

8,777

100.0

Sourc e: IREM Foundation and A rthur A nders on. 1991.

"Managing the Future: Real Es tate in the 1990s ." 28, 31.
From DiPas quale and Wheaton. Urban Ec onomic s and Real Es tate Markets . Prentic e-Hall, 1996.

12

Who owns American real estate?

CAs shown in Table 1.3, 83% of residential real estate was owned by individuals.
CThe 62% of non-residential real estate that was owned by corporations consists of
investment property as well as buildings occupied by their corporate owners.
CPartnerships own almost equal shares of residential and non-residential property.
COwnership of U.S. real estate by foreign entities is virtually nil, despite considerable
concern about this during the last few years.

T a ble 1.3
W ho Owns U .S . R e a l E sta te , 1990
(Billions of 1990 $s)

--ALL REAL ESTATE-Percent

-RESIDENTIAL ONLYPercent

NON-RESIDENTIAL ONLY
Percent

Individuals
Corporations
Partnerships
Not-For-Profits
Government
Institutional Investors
Financial Institutions
Other (includes foreign)

5,088
1,699
1,011
411
234
128
114
92

58.0
19.4
11.5
4.7
2.6
1.5
1.3
1.0

5,071
66
673
104
173
14
13
8

82.8
1.1
11.0
1.7
2.8
0.2
0.2
0.1

17
1,633
338
307
61
114
101
84

0.6
61.5
12.7
11.6
2.3
4.3
3.8
3.2

Total:
Percent of All Real Estate:

8,777

100.0
100.0

6,122

100.0
69.8

2,655

100.0
30.2

Source: IREM Foundation and Arthur Anderson. 1991.

"Managing the Future: Real Estate in the 1990s." 29-33.
From DiPasquale and Wheaton. Urban Economics and Real Estate Markets. Prentice-Hall, 1996.

13