Housing – Part 2: Price Dynamics

Rising house prices hurt affordability. What drives house price appreciation and how current government home buyer policies are not the fix.

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In Part 1, we discussed why housing is a unique asset, in that it provides both a flow (housing services such as shelter, amenities and location benefits) and a stock (a store of value). In Part 2, we will discuss how the price of housing behaves because of these unique features and the impact of government subsidies. In Part 3 next week, we will turn attention to supply side policies and why housing affordability is difficult to attain.

House Price Appreciation

When discussing house prices, we are typically accustomed to seeing them increase. The 2008 Financial Crisis was in part caused by this belief, as banks began offering mortgages to people with low credit-worthiness.¹ So what can cause house price increases?

One driver of house price appreciation can be the value of housing services (flows) a house provides. If the value of these housing services increases, the price of the house will increase. For example, house improvements are a common way to increase the price. Also, if the house location becomes more desirable (more amenities in the area, better job opportunities), house prices will also go up. 

At the same time, however, a house (the physical structure) can lose some of its value due to depreciation and outdated technologies. Depreciation price loss due to regular wear and tear is usually reversed with regular maintenance spending – every year, house owners have to invest in their house to maintain the quality of the house. On the other hand, dealing with a house becoming outdated is a bit more complex. As technologies develop, new houses should incorporate better materials and technologies in the build process. For example, this can be things like houses with built-in air conditioning or smart technologies. Retrofitting older houses can be very expensive if not impossible. Thus, ‘time’ and technological progress should put downward pressure on housing prices.

House prices can also move due to changes in supply and demand. As we discussed in Part 1, the upper and lower bound on the price of a house, especially in cities, is more or less kept in check by the wages in the location near the house. Moreover, the key limiting factor for housing development is land availability. Since land cannot be created (with a few exceptions), the price of land will directly reflect location value.

Homeowner and Investor Expectations

Many homeowners and real estate investors assume that their house price should appreciate in value. As mentioned, the issue is that the physical structure itself should really only fall in value, whether it is due to wear and tear or obsolescence. Thus, any house should typically become cheaper (in real terms to be precise) without any major investment. On the other hand, the value of the land the house sits on can go up or down. If land values go up, it means that the value of the location went up. Thus, if we expect a house price to appreciate in real terms, it means that the value of living in that location is growing significantly, as it has to outpace the depreciation loss. Interestingly, homeowners who live in their homes benefit two fold from potential housing appreciation. One is the increase in the asset value of the home (the stock value), but they also receive more valuable location services (the flow value).

Affordability – Government Assistance

30 Year Mortgage

Housing affordability is an issue that concerns nearly every country. Moreover, many governments actually subsidize home ownership in various ways. One common way is tax breaks and deductions on mortgage interest. But another way, which is less discussed, is policies such as the 30 year fixed rate mortgage.

In the US (and in a few other countries), people can buy houses financed with fixed rate loans that can be repaid in 30 years. The reason that this type of loan is a government subsidy, is that without government intervention, banks would rarely offer such a loan at any reasonable interest rate to most home buyers. This is why, for example, we rarely observe mortgages longer than 30 years. 

The main cost of loans for banks is the cost of capital. The cost of capital changes in relation to the interest rates central banks set. A loan should, therefore, have a variable interest rate since the cost of capital changes throughout the duration of the loan. A ‘fixed’ interest rate simply means the bank is taking on the risk of changes in the cost of capital, rather than the person taking out the loan (typically a ‘fixed’ interest rate will be higher than the variable interest rate at the time of issuance of the loan to compensate for this risk).

Government Support

However, banks would not typically take on the ‘fixed’ interest rate risk for 30 years (or not at a reasonable price). So why do they do it? That's because the banks know that they can sell these loans to the government, specifically Government Sponsored Entities (GSEs). The most well known GSEs in the US are the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). These two institutions own around 70-80% of all issued mortgages. They are both ‘implicitly’ backed by the government – that is everyone believes that if either of these two institutions struggle financially, the government would bail them out (this assumption was successfully demonstrated during the 2008 Financial Crisis). 

Fannie Mae and Freddie Mac will buy any mortgage that adheres to its underwriting standards. Since the original aim of creating Fannie Mae and Freddie Mac was to improve home affordability, the underwriting standards are not too strict, and allow for 30 year mortgages. Due to the implicit government support, Fannie Mae and Freddie Mac are comfortable with buying mortgages with what is typically considered below market interest rates. This is because once they own these mortgages, they can re-sell them to investors as government backed securities. Since these securities will not be allowed to default, they have the highest quality credit rating and lowest risk, meaning they can offer low interest payments to the investors.

But the government, which provides the implicit support, does not receive any compensation in return for this insurance it provides. Occasionally, as was the case in 2008, it actually had to make large payouts (approximately $190bln). This means that taxpayers are explicitly subsidizing the mortgages of homeowners. 

Subsidy

This mortgage subsidy, which manifests itself as a reduction in the mortgage interest rate, is accessible to nearly all potential home buyers. But this universality of the subsidy creates an issue. Since every home seller knows that the potential buyer can access this lower interest rate, the home seller can effectively increase the price of their house, since the buyer would be able to afford the higher price. 

As an example, suppose a buyer is willing to pay $100,000 for a home with a 10% interest.² Based on a 30 year fixed rate mortgage, this would result in a monthly payment of $878, meaning the value of housing services this house generates to the buyer is at least as high as $878. With a mortgage subsidy, if the interest rate would fall to 8%, the buyer could pay up to $120,000 and have an identical monthly payment. Since the value of the housing services this house provides still remains greater than $878, the buyer is willing to pay this 20% higher price. Thus, in reality, the subsidy directly benefits current homeowners, as they are able to receive higher prices for their homes, with potentially no benefit to home buyers, if the increased price entirely offsets the lower interest rate.  

Hedging Benefit (and Cost)

The 30 year fixed rate mortgage also acts as a type of hedge for homeowners. The value of the housing services a home provides (typically proxied by rent prices) can change over time. In many urban areas, the value of housing services increases. In contrast, the homeowner only has to pay a fixed amount for the duration of the loan, meaning the homeowner basically guarantees themselves a fixed price for the housing services for the duration of the loan. Moreover, even though homeowners receive large and increasing benefits from the housing services, which can be thought of as income, they do not pay any tax on these benefits. This is unlike other earnings, whether income or capital gains. 

However, this can create a lock-in effect for the homeowner, whereby the homeowner will not find it financially sensible to sell the home. If the value of housing services go up (i.e. local rents increase) and if the homeowner were to sell their home, then they would still need a place to stay and therefore would have pay the market rental rate. But under a 30 year fixed mortgage, the homeowners payment was locked for the duration of the loan, and over time, is probably below the market rental rate. Over the course of 30 years, this difference can grow very large, thus resulting in people potentially living in locations and houses that they may no longer actually want to be in.³

In this way, the 30 year fixed rate mortgages end up distorting market efficiency, as people end up staying longer in a particular house than they would actually prefer. The financially driven lock-in effect results in housing misallocation.

Summary

Housing prices appreciation is driven significantly by the value of the flows stemming from the housing services a home provides. Without this growth, house prices should be falling. Paraphrasing a quote I saw attributed to Robert Shiller:

A house is a box that definitely depreciates sitting on a piece of land that may or may not appreciate.

Government support on the buyer side, due to its universality, most likely does not impact affordability issues, as most of the benefits from these government subsidies are appropriated by homeowners who can receive higher sale prices. Fundamentally, solutions on the supply of housing are needed to address the underlying issues of housing affordability, which we will discuss in Part 3 next week.

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Interesting Reads from the Week

1. Tweet/X: With the December Personal Consumption Expenditure (PCE) index being reported this Friday, Nick Timiraos dives into what the numbers may be:

   

2. Tweet/X: Arin Dube discusses how the shelter component of inflation has stagnated now and may keep inflation measures elevated for a while.

3. Tweet/X: An example of how land value (and thus location) can significantly impact prices – a 6,000 sq.ft. house in St. Joseph, Missouri sells for $600,000, while a 2,700 sq.ft. house in Berkeley, California sells for $2.5mln.

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Photo by Pavel Danilyuk.

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1. Banks were willing to offer mortgages to individuals that had lower credit scores, because these banks were not afraid of mortgage default, since they assumed the house used as collateral for the mortgage would be worth more than the outstanding debt over time. 

2. For simplicity, we’re assuming a 0% down payment. With a 20% down payment, the results would be similar.

3. A similar issue has been occurring with the housing market during the recent increase in interest rates. Since many mortgage payers had locked in very low interest rates, at 3-4% per year in 2018-2020, while current rates, as of January 2024, are well in the 7-8% range, most homeowners cannot sell, because they will not be able to afford buying a new home under these elevated interest rates.