Housing – Part 1: A Unique Asset
Housing, housing supply and housing prices are complex issues facing many societies. Part of it is driven by the unique nature of housing.
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Housing is one of the most discussed policy issues around the world, as there is a housing undersupply. Housing is also a complex asset and understanding how housing supply and prices react to policies is generally misunderstood (for example, we have written about upzoning and housing supply). In Part 1, we will discuss why housing is somewhat of a unique asset and discuss what can impact house prices. In Part 2, next week, we will discuss house price dynamics and how government policies impact house pricing.
Housing – Two Functions
The uniqueness of housing comes from the fact that it provides two different functions:
Housing Services – a house provides people living in it with a flow of services. Some of the services housing provides are quite clear – for example, houses provide shelter and amenities, such as a swimming pool. Additionally, housing provides less obvious services such as access to particular jobs.
A store of value/investment – housing has typically been seen as a good store of value, as housing has historically appreciated in value. Many use this feature of housing for the purpose of diversifying their investment portfolio (i.e. purchase a house with the aim of selling it at a gain in the future).
The key difference between the two functions is that the first function is a ‘flow’ – something that is continuously provided to the owner or user; while the second function is more akin to a ‘stock’ – the value of the house at a specific point in time.
Most other items apart from housing usually provide only one of the flow and stock functions. For example, consumer goods such as food or clothes, typically provide only a flow benefit (service) to the buyer – nutrition and clothing, respectively. On the other hand, items such as gold, cash or company stocks are predominantly a stock (store of value or investment) as they do not provide any particular service to the holder. We do not gain any personal satisfaction from holding these assets beyond their change in market value.
It is worth adding that some goods, such as ‘durable’ goods, theoretically do provide both functions. For example, a car also provides services – transport services – and is a store of value if one was to sell the car. The issue is that typically the sale price of a car is well below its purchase price, making it a very poor store of value.
House Value and Pricing
In determining the price of a house, it is necessary to first focus on the housing services it provides, as the value of the house predominantly depends on the value of these housing services.
Value of Housing Services
Certain housing services are quite tangible and clear to see the value of – the amount of space, type of finishes or amenities a house has. We can even argue that the personal value of having an additional room is more or less universal. Houses, however, also provide other, less tangible services. One of the biggest services is its location and the surrounding area. There is value to having access to a specific location (“location based services”) – for example, access to particular jobs, schools and other services, such as entertainment. A physically identical house in a location that provides significantly more location based services (such as an urban area) will generate more value to the person living in it than that house in a location with few location based services (such as a rural area).
A lot of the benefit from the location predominantly comes from the access to job opportunities. Since these jobs can only be accessed by being in that location, location inherently generates value for the people in that location. Holding all else constant, people prefer locations with better job opportunities, meaning these locations generate more value for them.
Pricing Housing Services
How do we estimate a numerical value of housing services provided by a house? Typically, we look at market rental rates as a good proxy for the value of housing services, since the person renting does not own the property, but pays an amount for living in the house. Since rents are observed market prices, this implies that people that are paying the rents should be getting at least as much value from the housing services as the amount of rent paid. Otherwise, the renter would not be paying this amount of rent. Similarly, on the other side of the transaction, the landlord, (for simplicity let’s assume a one-property landlord), is willing to accept this rent instead of living in the house, because the rent is at least as high as the value the landlord would get from the housing services generated by this house.
Thus, if we look at rent value as proxies for the value of housing services, any changes in rent prices are reflections of the changing value of housing services. If a location gets new job opportunities or a new benefit such as a subway line, house rents in that location, holding all else constant, should go up.
It is worth looking at the lockdowns that occurred during the pandemic as a case confirming some of this intuition. When lockdowns were instituted and, therefore, job opportunities were de-linked from location, rents in many cities fell significantly – over 20-30%. Below is a chart for New York City median rents from RentHop between 2014 and 2023.
The onset of the pandemic dramatically reduced median rents in New York, implying that people perceived the value of housing services as lower. Although one could argue that some of this price drop was due to the reduction in amenity quality (closure of restaurants and entertainment venues), many places remained open. Thus, to me, it appears this fall was driven by no longer having to be in New York to work at New York-based jobs.
Supply, Demand and Rent Negotiations
The market rent data we observe publicly is the outcome of negotiations between the renter and the landlord. Thus, to understand what determines these rents, it’s helpful to discuss the bargaining process. From the renter’s perspective, there is a maximum amount of rent they are willing to pay. This will depend on the value of the housing services the house provides, which in turn depends on the income and wages the renter can expect to get from living in that location. Note that the income is an uncertain data point – that is, the renter may not find a job and is uncertain of the exact income they will have. Thus, from the renter’s perspective, their income is a random distribution rather than a specific amount. It is worth noting that the wages offered by employers impacts renters’ willingness to pay. Wages and rents, therefore, mutually influence each other.
The landlord (assume a one property landlord for simplicity), on other hand, has a minimum amount they’d be willing to accept, which is basically equivalent to the value they’d get from living in the house. These two numbers – the renter’s maximum and the landlord’s minimum – are unlikely to coincide since the numbers themselves are uncertain (as mentioned above, income uncertainty creates this issue). Where the final rent falls between these two numbers will depend then on broader market forces – the supply of housing in the area and the demand for housing (the number of renters).
Generally, in most urban markets, it can be safe to assume that demand is very high (if not infinite) since high paying jobs entice urban immigration (and potentially global immigration). On the other hand, supply can often be limited in urban areas due to natural restrictions (land restrictions) or administrative restrictions (land use regulations, zoning laws). The supply of housing also takes time to grow, given housing construction is a lengthy process. This implies that in urban areas, the landlord will have a stronger position in the bargaining process than the renters, and thus the rents will be closer to the maximum the renter is willing to pay.
As an aside, in instances where landlords push for legislation that restricts supply (or artificially increases demand) that strengthens the landlords bargaining position, we have a situation of ‘rent-seeking behavior’. Rent-seeking behavior occurs when one party increases their personal wealth without increasing total value (or wealth) in the market. In simpler terms, it is profiting at the expense of others.
Demonstrating how housing prices are exactly determined remains elusive in economic research, but discussion by Gyourko, Mayer and Sinai (2010) suggests there is some evidence that prices are influenced primarily by the flows, or services, provided by a house. Recent research by Van Nieuwerburgh and Weil (2010) has shown that there is evidence that “housing costs are the price one has to pay to access the productivity of a given labor market area” (this is known as the Rosen-Roback result). Moreover, Moretti (2004) has shown that human capital agglomeration results in positive spill-overs on incomes – that is, a person’s income will be higher if they live in an area with more highly skilled people. Urban wage premiums can be up to 20-35% higher in large cities (Glaeser and Mare, 2001). As pointed out by Gyourko, Mayer and Sinai (2010), it is therefore reasonable that some of these gains in productivity caused by agglomeration should be capitalized into higher land values. Lastly, Gyourko, Mayer and Sinai (2010) argue that a large driver of the development in house price dispersion (i.e. some areas have much higher house prices than others) we observe in the US is increasing inequality. Individuals with much higher incomes prefer specific urban areas and since these urban areas have limited housing, the price of housing gets bid up. As income inequality has grown larger in the US, there are more high income individuals that want to live in select urban areas, resulting in large house price increases in these areas.
Housing is unique in that it both provides a service (a flow) and acts as an asset (a stock). No other item acts in such a way and we personally may not even perceive the value of all the services we receive from a house. These housing services, however, are important in discussing housing price dynamics and affordability, which we will discuss next week. Additionally, these housing services, even feed into inflation – if you have been following Nominal News, we have highlighted the concept of “Owner’s Equivalent Rent”, which is an estimate of the value of the flows provided by the house and used as part of the reported inflation figure. These estimates have been especially consequential recently (Q4 2023), as they have had an outsized impact on the inflation data.
Interesting Reads from the Week
Video/Presentation: Ivan Werning (whose work we cite a lot) presented to the American Economic Association on the topic of “Inflation: Old and New Perspectives”.
Data: Consumer expectations of inflation have dropped to standard levels, consistent with 2% inflation.
- discusses how, unfortunately, homelessness in the US has climbed to record highs.
Photo by 4FLY RJ.
If you enjoyed this article, you may also enjoy the following ones from Nominal News:
Repeat After Me: Build Houses, But Use Good Economics (October 13, 2023) – how a Financial Times opinion piece incorrectly interprets certain data and graphs regarding the impact of changes in upzoning policies.
Discrimination in Real Estate (September 17, 2023) – unlike explicit discrimination, statistical discrimination is less talked about. However, it has significant impacts on outcomes for people impacted by it. Real estate agents, often unaware of their own statistical discrimination, end up perpetuating outcomes for minorities.
Unions, Strike Action and the Economy (November 14, 2023) – with significant union organizing and strike action occurring in the US, economic research suggests that unions do impact all workers, not just unionized ones. Moreover, unionization threats also have an impact.