What can housing markets teach us about economics?

AuthorStroebel, Johannes
PositionResearch Summaries

Housing is a unique asset. Both an investment and a consumption good, it is traded in markets that are subject to significant search frictions and information asymmetries. In addition, housing accounts for a large share of wealth in the economy. As a result, changes in house prices can have large effects on aggregate economic activity. In combination with the availability of excellent microdata on housing transactions, this makes housing an ideal asset for the study of a range of questions of broader economic interest. In this piece, I summarize a number of findings that have emerged from my empirical research on housing markets.

Housing and Long-Run Discount Rates

Long-run discount rates play a central role in economics and public policy. For example, decisions about how much to invest in climate change abatement depend crucially on the trade-off between the immediate costs and the very long-term benefits of efforts to reduce global warming. Yet, despite their importance, there are few, if any, reliable estimates of the discount rates households attach to payoffs that accrue over horizons exceeding 30 years. This is, in large parts, due to the absence of finite, long-maturity assets necessary to estimate these discount rates.

In a set of papers with Stefano Giglio and Matteo Maggiori, I take advantage of a unique feature of housing markets in the U.K. and Singapore to provide direct estimates of long-run discount rates for housing cash flows that materialize hundreds of years in the future. (1) In both countries, property ownership takes the form of either a leasehold or a freehold. Leaseholds are temporary, pre-paid, and tradable ownership contracts with initial maturities ranging from 99 to 999 years, while freeholds are perpetual ownership contracts. This contract structure allows us to infer households' maturity-specific valuation of cash flows over horizons spanning hundreds of years. In particular, the price difference between leaseholds and freeholds for otherwise identical properties captures the present value of perpetual rental income starting at leasehold expiry, and is thus informative about households' discount rates over extremely long and previously unexplored horizons.

We estimate the price difference between leaseholds and freeholds of different maturities with hedonic regressions, using data on the universe of housing transactions and associated property characteristics since 1994. Our findings show that, in both the U.K. and Singapore, 100-year leaseholds are valued at 10 to 15 percent less than otherwise identical freeholds; the price difference is smaller for leaseholds with higher maturities, and goes to zero for leaseholds with remaining maturities of 700 years or more. Figure 1 shows the term-structure of leasehold discounts for the United Kingdom.

We show that these price discounts of leaseholds are not driven by institutional features of the contracts. We also introduce a large dataset on rental listings to show that, conditional on observable control variables, leaseholds of different maturities and freeholds rent for similar amounts. This suggests that differences in unobservable property characteristics across leaseholds and freeholds do not confound our findings. A natural interpretation of our results is that households attach a relatively high value to housing cash flows arising far in the future. This implies that their corresponding discount rates have to be low--according to our calculations, below 2.6 percent for housing cash flows more than 100 years in the future.

In related work together with Andreas Weber, we explore the implications of these findings for the appropriate discount rates to value investments in climate change abatement. (2) We begin by providing new empirical evidence on the shape of the entire term structure of housing discount rates. In particular, we find the average return to real estate to be above 6 percent. In combination with the low long-run discount rates estimated above, this implies that the term structure of housing discount rates is steeply downward-sloping: the further out the cashflow, the lower the annual discount rate attached to it. This suggests that average rates of return to assets, which generally average over discount rates at many different horizons, are likely to be uninformative about the appropriate discount rates for valuing very long-run costs or benefits. In addition, we emphasize that the appropriate discount rate for valuing an investment depends on its riskiness, this is, whether that investment is more likely to pay off in good or in bad states of the world. We also show that house prices are generally positively correlated with the state of the economy, which makes housing a risky asset. Similarly, to the extent that climate change abatement investments are designed to avoid climate disasters, those investments are hedge assets. This implies that the declining term structure of...

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