2. More on Housing © Allen C. Goodman, 2006

3. The cost of housing We talked about the relation of an asset to the rents that it could earn. If a house generates $R/year in rents, by the simple model the value of the house would be V = R/i where i is the interest rate. BUT …

4. The cost of housing There are other factors capital gains property taxes If you own a property, you have costs other than the cost of capital. You have to pay property taxes, which are usually a factor of the value of the property. So: R = (i + t) V

5. The cost of housing R = (i + t) V, or sometimes R =  V, where  is called the “user cost” of housing. Now, consider two identical houses, but in separate neighborhoods. Same property taxes, same interest rates. BUT People expect the values of houses in N 1 to rise by 5% per year. They don’t expect the houses in N 2 to rise at all.

6. The cost of housing Which house will have a higher value? R 1 = (i + t - g 1 ) V 1 … why negative R 2 = (i + t - g 2 ) V 2 g 1 =.05. Why? g 2 = 0. So: (i + t - 0.05) V 1 = R 1 = R 2 = (i + t) V 2 (Why are rents the same?) V 1 /V 2 = (i + t)/(i + t - 0.05)  V 1 > V 2.

7. The cost of housing High expected capital gains lead to higher housing prices. So: R = (i + t - g) V, a lower “user cost” or: V = R / (i + t - g), a higher value.

8. The cost of housing. What does the tax system do with all of this? We are able to deduct property tax and interest payments, so rather than paying (i + t), we’re paying (i + t) (1 - T), where T = fed. rate. Example. If we pay $5000 in interest and $2000 in property taxes, and we itemize, we reduce our taxable income by $7000. Taxes  by T * 7000. So the tax rate IS: (i + t) (1 - T).

9. Capital Gains Taxes We basically don’t pay capital gains taxes on housing, so: R = [(i + t )(1 - T) - g] V If interest rates and expected capital gains both rise by 1%, what happens? First term rises by (1-T). Second term falls by 1. User cost falls.

10. The cost of housing The reductions of the costs of housing due to inflation and high interest rates in the 1970s led to increased housing demand and increased housing prices.

11. Favorable tax treatment We saw above that if you pay interest and property taxes, that you get favorable treatment. Even if you don’t pay interest, you get favorable treatment of imputed rental income EXCEL. EXCEL Both of these provide a bias toward ownership.

12. Is ownership “good”? Renter externality Renter doesn’t have a long term stake in property. So he doesn’t report problems. May lead to higher maintenance costs. How big is it? If we have an ownership subsidy, why are we giving high income households the largest subsidies?

13. Filtering Where does used housing come from? A> Newer housing. We saw how older housing becomes more costly to maintain. It also leads landlords to provide less housing. How do we model it?

14. Filtering Assume –Three income groups: wealthy, middle, poor –Rising income –Costly upgrading –Deterioration @ 5% per year.

15. Filtering Start in 2000. We have households in houses that were built in 1970, 1980, and 1990. Rich, middle, poor. Size Quality 1970 1980 1990

16. Filtering In 2006, we build new housing. Who moves into it? What do the others do? Size Quality What happens to this housing?

17. Filtering and the World It’s very difficult (in U.S.) to provide new, low quality housing. We generally end up subsidizing high quality housing. How does this benefit those at lower housing levels? –By building more high quality housing, you lower the price. This allows people at lower levels to move up. –Induces some owners to let their housing filter down to lower quality submarket.

18. Next time Housing Policy -- Chapter 15