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«reNtal HousiNg Policy iN tHe uNited states Volume 13, Number 2 • 2011 U.S. Department of Housing and Urban Development | Office of Policy ...»

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Owners, on the other hand, know exactly how much their house will cost them: It’s in the purchase and sale agreement. Of course, that assumes that owners never move out and thus never have to sell their houses. But for a homeowner who stays put for a long time, that sale price is relatively inconsequential. It occurs so far in the future that, unless average house price growth is substantial, the sale price is small in present value terms. It’s almost as if the household never had to sell its house.

When a household move does arise, homeowners face the need to sell their house, which potentially has a volatile asset value. By contrast, renters presumably invested their wealth in a more diversified asset portfolio, and therefore, have less wealth volatility upon moving. Whether volatility in wealth at the time of a move is detrimental to the household is analyzed later in this article.

Despite the certainty of the purchase price, owners face uncertainty about the total homeownership cost. Property taxes and maintenance costs, for example, are paid by homeowners, are not guaranteed in advance, and are not insurable. These two cost components can be quite sizeable—property taxes average just above 1 percent of house value and maintenance costs are widely believed to be about

2.5 percent of house value—and, given today’s low interest rates, are collectively about one-half of the annual property rental value. The volatility of these particular homeownership costs are not known; it is difficult to collect data on changes in local property taxes and, because maintenance can be deferred, it is hard to distinguish the true arrival rate of underlying problems that should be fixed or updated from when the homeowner fixed them. In this paper, the comparison between the risks of renting and owning implicitly nets out any volatility in property tax or maintenance costs.

Rent volatility is presumably caused by localized shocks to housing demand or supply. Housing demand shocks are usually attributed to changes in the local economy or migration. New housing construction typically follows demand shocks, but is limited in some areas due to regulation or topographical constraints. Saiz (2010) and Sinai (2009) presented some rough evidence that rent volatility is most pronounced in areas with more volatile underlying demand and relatively inelastic supply. Using a cross section of metropolitan statistical areas (MSAs), Sinai (2009) showed that MSAs with less elastic supply and more volatile employment experience more variable apartment rents. These volatility sources would affect annual rents and current house prices, but not the annual costs of already purchased homes. Those latter costs are locked in at the time of the home purchase, with the exception of the sale price of the house, which responds to the demand and supply conditions in the market.

108 Rental Housing Policy in the United States Understanding and Mitigating Rental Risk Another potential source of volatility for owners is financing costs. Empirically, it is rare for households to buy their houses with cash. In the 2007 Survey of Consumer Finances, 33 percent of homeowners had no mortgage debt. Homeowners who had mortgage debt averaged a 53-percent loan-to-value ratio. Fixed-rate mortgages are common in the United States, however, and allow any household to avoid interest rate volatility if it prefers to do so.

The risk in housing costs for renters and owners can come in two forms. First, the total cost of obtaining housing services during some period, such as the duration of stay in a residence, or during one’s lifetime, is volatile. This total cost volatility is a pretty fundamental source of risk;

simply put, one does not know in advance how much a given amount of housing will cost. Renters and owners can experience very different total cost volatilities. Renters who are going to remain in their houses for a long time face considerable risk because their total rent depends on market forces. By contrast, owners who are going to remain in their houses a long time face little risk because the purchase price of a house is known and the sale price is so far in the future as to be inconsequential (or the household will have died by then).

Economists tend to focus on total housing cost volatility because they assume that households can borrow easily (and inexpensively). That is, a year of high rent followed by a year of low rent doesn’t matter to a household if it can borrow to cover rent in expensive years and pay the loan back when rent is cheap, or has sufficient liquid assets to tap to smooth the volatility. Such a household worries only about total housing costs. If, by contrast, households face liquidity constraints, the year-to-year volatility in rent generates additional risk for renter households. Owner households are less exposed to this additional risk because their nondiscretionary cash outflow for the house has less volatility. Although liquidity constrained owners must find a way to borrow money to purchase a home in the first place, after they have made the purchase the year-to-year volatility in housing costs is significantly reduced.

Households are not equally exposed to housing cost risk. Volatility can vary considerably across housing markets; therefore, renters in a volatile market have less certainty about their total housing costs than do renters in a less volatile market. Likewise, owners in a volatile market are less sure about their sale prices than owners elsewhere. The differences in volatility can be seen in exhibit 1.

On the x-axis, the standard deviation in annualized growth in real rents during a 5-year period is plotted. Each dot corresponds to an MSA. Rents come from a survey by REIS, Inc., of high-quality apartment buildings in 38 major markets during the 1980 through 2009 period. The standard deviation in rent growth ranges from 0.005 to 0.040. At the bottom end of the range, an apartment that rented for $12,000 per year that experienced a one standard deviation excess real growth in rent would rent for $12,550 5 years later.1 At the top end of the rent volatility range, if that same apartment experienced a one standard deviation higher rent growth rate, it would rent for $14,883 after 5 years. In the former case, renters are not exposed to much uncertainty. In the latter case, rent uncertainty is considerably higher. Thus, exhibit 1 shows that the amount of rent uncertainty varies by housing market. Sinai (2009) reported rent volatility for each MSA individually.

The average growth rate in rents is approximately 0.4 percent annualized during a 5-year period: (1 + 0.005 + 0.004)5 × 12,000 = 12,550.

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Relationship of House Price Growth Volatility to Rent Growth Volatility, 5-Year Growth, 1980–2009 Correlation coefficient =.394 (38 observations)

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0.06 0.04 0.02 0.00

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A similar range can be seen in the standard deviation of real house price growth (again, annualized over 5 years), which is plotted on the y-axis. It ranges from about 1 to 7 percent and is constructed using the FHFA repeat sales index, adjusted for inflation. An MSA at the bottom of the house price volatility range that saw real house price growth of one standard deviation above the average would experience real price growth from $120,000 to $126,120 after 5 years. At the top of the range, a one standard deviation higher house price growth would cause a $120,000 house to appreciate to $168,306. Although homeowners might be sanguine about house price increases, a parallel decline in house prices would yield a $114,175 real sale price in the low volatility MSA after 5 years and $85,558 in the high-volatility MSA. Once again, some housing markets are relatively stable and others are much more uncertain. (See Sinai, 2009, for a breakdown by MSA.) Although renters and owners both face volatility in any given housing market, little evidence exists to show whether either group is exposed to more or less inherent housing market uncertainty than the other. In any given city, house prices and rents generally track each other. This empirical fact is consistent with theory which, with varying degrees of complication, notes that asset market equilibrium requires that house prices be equal to the present value of expected future rents plus an adjustment for differences in risk (for examples, see Meese and Wallace, 1994; Ortalo-Magné and Prat, 2010; and Sinai and Souleles, 2005). Sinai (2009) showed that, during the 1990 to 2002 period, the correlation in the standard deviations of detrended real rents and detrended real house prices was 0.87. In exhibit 1, the correlation in the real 5-year (annualized) standard deviations 110 Rental Housing Policy in the United States Understanding and Mitigating Rental Risk for these 38 MSAs is 0.39. The reason for the lower correlation is twofold. First, exhibit 1 encompasses the housing boom-bust period of the late 2000s, which was a low-correlation period, whereas the sample period in Sinai (2009) ended in 2002. Second, the growth rates used in exhibit 1, being a short difference, tend to have lower correlations than do deviations from a trend, used in Sinai (2009), which are a long difference. Exhibit 2 restricts the time period to end in 2002, which leaves out the recent boom-bust period for housing. The correlation in rent and price growth standard deviation is 0.73 during the 1980 to 2002 period. The MSA points in exhibit 2 also lie closer to the bivariate regression line than they do in exhibit 1, suggesting that the 2002-to-2009 period added noise to the historical relationship between rent volatility and house price volatility.

The usual high correlation in rent and house price volatility shown in exhibits 1 and 2 suggest that differences in risk between owners and renters within a given housing market are largely due to how housing services are funded, not any difference in the inherent volatility of the two housing sectors within a given MSA.

It is worth noting that although the fact that house prices and rents are correlated within a market is consistent with the asset pricing notion that a shock to either the rental or owner-occupied market should be reflected in the other sector, it is not proof. Instead, a shock that is common to both the rental and owner-occupied sectors, such as a demand shock, could be generating correlated price responses. In fact, Blackley and Follain (1996) found little evidence that a shock to the demand for owner-occupied housing because of changes in the tax code is reflected in the rental sector.

Exhibit 2 Relationship of House Price Growth Volatility to Rent Growth Volatility, 5-Year Growth, 1980–2002 Correlation coefficient =.729 (38 observations)

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0.06 0.04 0.02

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Many households do not have the luxury of staying in one house virtually forever, even leaving aside the nasty complication of death. They might need to move for a job, for a different school system, or for a larger house or apartment. Such forced moving creates another financial uncertainty source and another distinction between renters and owners. Renters are uncertain whether future rental costs will be higher or lower than expected. Owners are uncertain about the future sales price of their current house. In addition, like renters, they are uncertain about how much they will have to pay for their next house. Once again, the degree of uncertainty depends on the current household location and the location to which it might move. In the previous example, if a renter in the lowest volatility MSA moved to the highest volatility MSA after 5 years, and both MSAs experienced a one standard deviation positive shock, the renter would be moving from a $12,550 per year rental unit to one that cost $14,883 per year. A similarly situated owner would be moving from a market where his house cost $120,000 to a location where an equivalent house would cost $168,306. And that is assuming that initial rents or purchase prices were the same in both housing markets.2 Getting From Volatility to Risk It is important to recognize that volatility is not necessarily the same as risk. If housing service cost volatility leads to housing and nonhousing consumption volatility, one would expect households to dislike it. But volatility in housing costs can reduce volatility in housing and nonhousing consumption if changes in housing costs undo volatility in other dimensions, for example, income or the cost of consumption. Such helpful volatility is labeled a hedge, and the volatility that households dislike, a risk.

In a simple sense, just owning a house provides a hedge for housing market risk. Recall that the difference between owners and renters is just the realization of their portfolio returns, because owners own houses and renters invest in other assets. The returns on houses are highly correlated with rental costs; therefore, houses generate a higher return when rental costs are more expensive.

By contrast, renters’ assets have a lower correlation with rental costs because it is extremely difficult to obtain a set of financial assets that vary along with housing costs as much as a house does. In a housing market where rents are volatile, renters would face risk in their total or annual housing costs because their investment returns may be low when housing costs end up being high, or vice versa. A homeowner, by contrast, owns an asset that implicitly pays an annual dividend exactly equal to the rent needed in each year. For homeowners, that implicit rental income offsets the implicit rental expense and leaves them with less risk on net. Because the housing unit is the same whether or not the rental cost increases, a household can actually reduce the volatility of its overall consumption—housing and nonhousing—by investing in an asset with a return that offsets the preexisting rent liability.3 Although this article focuses on the differences in financial risk between renting and owning, nonfinancial differences are also important. For example, homeowners have control of their houses—when to move, whether to renovate, and so forth—in a way that renters do not.

It is not necessarily the case that a household should want to undo all of their housing cost risk by buying a house. A partial hedge could be preferable. Renting plus holding an asset that pays a dividend that is correlated with rental costs could obtain that position. Likewise, owning and taking the opposite position on the hedge would generate the same position.

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