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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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The first column of exhibit 3 uses the hedonic to impute rents to homeowners. It shows renters, on average, spend about 17 percent less per year on rent (or equivalent) than owners, holding a number of household characteristics, including income, constant. In the second column, a scaling factor, estimated from the user cost model, is applied to self-reported home values to obtain the rental equivalent for an owned house. Under these conditions renters are estimated to spend 17 percent more per year on housing than owners. The explanation for the discrepancy between columns 1 and 2 is evident in column 3, which modifies the user cost scaling factor to exclude the capital gains component and thus deliver a number closer to a cashflow measure of housing spending (without the capital gains offset since it is just a paper gain). In that case, renters are estimated to spend 63 percent less on housing than similarly situated owners. Basically, owners are spending more cash on their residences than renters, but they (on average) more than get that difference back on paper in the form of capital gains.

The last two columns repeat the exercise using the Survey of Consumer Finances (SCF) and the user cost imputation. The same gap between the standard user cost and the user cost that excludes the benefit of capital gains can be seen in this data set. Renters spend an estimated 53 percent less on housing (on a more or less cashflow basis) than owners (the last column). When owners are credited with the benefit of the expected capital appreciation, renters are estimated to spend 21 percent less than them on their housing service flow. In results not reported in this article, the same pattern can be found when net worth (excluding housing) is controlled for in the SCF regressions.

Renters spend less on housing, ceteris paribus, for many possible reasons. One reason might be that renters are savvy enough to recognize that they are accepting more housing cost volatility and intentionally buffer themselves against that volatility by consuming less housing relative to income or net worth. Another is that renters choose to rent in part because they are the types of people, even holding observable characteristics constant, who do not like to consume much housing and the rental stock is typically cheaper than the owned stock. A third possible reason is renters are saving for a down payment to buy a house. A fourth possible reason is that the tax price elasticity of demand for housing might be greater than one, and thus the tax subsidy to homeowners leads to higher spending even net of tax. Glaeser and Gyourko (2006) summarized that elasticities found by the literature range from 0 to 2.

In any case, the lower spend rate on housing suggests that renters can more easily absorb higher than expected rent growth. In addition, they can better handle declines in their incomes because they have not committed to spending as high of a fraction of their incomes. Sinai and Souleles (2005) provided some evidence that households realize that spending less on housing provides a buffer against housing market volatility: households that live in housing markets that are costly relative to their incomes are more apt to take housing market volatility into account when making their housing decisions than households with housing costs that are a smaller portion of their spending.

Cityscape 117Sinai

The tendency of owners to spend a larger fraction of their incomes on housing than renters could be one of the main reasons that the conventional wisdom views homeownership as riskier. If renters spent as much of their incomes on housing as owners implicitly do, they would be more likely to be evicted for nonpayment of rent in a downturn than they currently are. Still, even if renters and owners exhibited comparable housing spending, it is less expensive to be forced to move out of a rental apartment than to move out of a house, merely because the transaction cost of selling a home is higher than the transaction cost of moving out of an apartment.

A possible virtue of renting, however, comes in how the time path of rental payments in a market where rents are expected to increase differs from the cash outflow an owner must pay. A renter pays a low initial rent because a landlord expects some capital gain because of the anticipated growth in rental income and thus does not need as high of a cash yield in the form of rent. But because rents typically go up over time, the expected rent trajectory for renters starts low and rises.

Homeownership cash costs are essentially level. In addition, they are higher than rents would be because the owner expects to get money back on paper on average via capital gains, but does not actually monetize that gain until he sells. For liquidity-constrained households with rising expected incomes, renting matches cashflows better than owning.

Another important reason the conventional wisdom might view renting as less risky than owning is that the use of leverage by homeowners magnifies the consequences of a bad shock. Namely, owners can be under water on their mortgages, whereas renters, who have no mortgages, cannot.

Negative equity can lead to many problems ranging from impaired mobility (Chan, 2001; Ferreira, Gyourko, and Tracy, 2010) to foreclosures and risks to the financial system. These risks, however, result from using high levels of debt finance to purchase housing, not from merely owning housing in isolation. If households were able to pay cash for their houses, none of the problems listed above would exist. Indeed, many of the major complications created by the housing bust of 2007 are because of defaults and foreclosures, which are a feature of mortgage finance, not homeownership per se.

It would be disingenuous to dismiss the risk of mortgage finance, however, because most homeowners in the United States use mortgages to purchase their houses. According to Sinai and Souleles (2008), 90 percent of homeowners under the age of 45, but less than 20 percent of homeowners above the age of 75, have mortgages. Low-income and younger homeowners simply do not have the assets to obtain their preferred home without a mortgage. Using data from the 2004 Survey of Consumer Finances, Poterba and Sinai (2011) showed that less than 30 percent of aggregate mortgage debt could be replaced with equity from financial assets on households’ balance sheets.

Young, low-income households in particular could reduce their mortgage debt by no more than 15 percent. Like it or not, using leverage appears to be bundled with homeownership.

A full treatment of the risks of home mortgages is beyond the scope of this article. In addition, it is already well understood that financing a volatile asset with high leverage—whether in commercial real estate, houses, or even airlines—is risky. Instead, to enjoy the risk management aspects of homeownership, homeowners need to mitigate the risks of leverage. The steps are simple in theory, although more difficult to execute in practice. Use conservative amounts of debt: households that use less leverage are less likely to find themselves owing more than the home is worth. Do not purchase more home than you can afford: households that purchase conservative amounts of housing are less likely to find themselves unable to pay for it. And beware of the risks of mandatory debt 118 Rental Housing Policy in the United States Understanding and Mitigating Rental Risk refinancing, whether explicitly (through a new mortgage) or implicitly (through an adjustment in an option adjustable rate mortgage). With typical fully amortizing mortgages, refinancing is an issue only when a household moves. At that point, a household runs the risk that mortgage rates have risen—and it then becomes an expensive proposition to give up a low-rate mortgage to switch houses—or that financing criteria have become more conservative and they cannot borrow enough to afford a new house. This difficult dilemma can be eased either by households saving to accumulate enough assets to reduce the total leverage on their balance sheets or by the creation of portable mortgages that could be transferred (with reasonable restrictions) to a new house.

Implications for Rental Policy Currently, the housing playing field is tilted toward homeownership, especially at the high end of the income distribution, due to its favorable tax treatment and the government subsidy for mortgage finance (first through the implicit guarantee of GSE debt and subsequently through the Fed’s active role as a purchaser of mortgage backed securities). For less well-off households, the playing field is more neutral. The subsidy to homeownership is smaller for low-income households that, despite financing their houses largely with debt, typically do not receive much benefit from the mortgage interest deduction because they do not have enough potential deductions to merit itemizing on their tax returns (Poterba and Sinai, 2011). Renting is subsidized largely through place-based public housing and voucher programs. Because of the large amount of crowd out of private housing consumption by public subsidies, however, low-income housing subsidies can be more like targeted income transfers than subsidies to renting (Sinai and Waldfogel, 2005).

The playing field between renting and owning can be leveled in two ways. One is to reduce the subsidy to homeownership. The other is to increase the subsidy to renters to compensate for the existing subsidy to homeownership. These two approaches are neither equivalent in terms of risk nor incentives. It is important to recognize that housing or rental policies typically influence not only whether households own or rent, or how much housing they consume, but also how much and what kinds of risk they take on. Assessments of housing policies should account for whether households are induced to take more appropriate risks, not just whether household consumption is affected.

To assess differences in risk, it is helpful to recall that homeownership can be thought of as housing consumption plus an investment in housing in the local market. Both components have independent effects on risk. The housing consumption part has the same risks for both renters and owners—the cost of housing services can fluctuate. Because everyone needs a home, both renters and owners need to obtain housing services and face this source of risk. The difference between them, in fact, comes in how they handle it.

Owners deal with the uncertainty about future housing costs by making investments in their local housing markets: They buy houses. (It is an extremely local market, because they buy their own houses.) Renters just accept the volatility of housing cost fluctuations and invest in a more diversified portfolio. This decomposition of owning into renting plus an offsetting investment makes some sources of risk apparent. First, risk rises with spending on housing services (holding income constant). Thus, the most obvious way for any household—renter or owner—to control risk is

Cityscape 119Sinai

to avoid spending too much on housing relative to its income or wealth. For renters, spending less on rent relative to income reduces the effect of rent fluctuations on nonhousing consumption or income fluctuations on the ability to continue to pay rent. Therefore, policymakers should be careful to make sure that any incentive for renting is not also an incentive to spend more on rent.

Likewise, current tax policy subsidizes the consumption of additional housing for homeowners.

Reducing this subsidy would mitigate the risk that follows from homeowners being incentivized to devote more of their resources to housing.

The second way a renter can manage the risk of rent fluctuations is by taking on an offsetting investment in local housing. Although it seems ironic to encourage households to make a volatile investment, the investment simply negates the household’s preexisting risk. For example, one can think of owning a home as owning a financial asset that for each period in perpetuity pays the current rental cost of a home combined with renting the house. When rents are higher, the financial asset pays just enough more to cover the increment. When rents are expected to be higher in the future, the financial asset is worth more, just offsetting the extra cost.

Currently, the only viable way to invest in local housing markets is to own the home you live in.

That is a polar case investment of 100 percent of the approximate expected rental cost (in present value, adjusted for risk) if a household were to live in the home in perpetuity. Renting is another polar case, but of zero investment. For many households, owning can be too much investment in housing because they do not expect to stay in the home for a long enough time. In that case, the residual home value at the time of its sale is uncertain, potentially leading to risk.

An investment in housing, however, need not be limited to 100 percent (owning) or zero (renting).

For example, long-term leases eliminate the primary risk renters face, not being able to lock in their total cost of obtaining housing, for a set time period. That is because a long-term lease is like a financial asset that for each period during the lease term pays the current home rental cost.

The economic difference between a lease and ownership is merely the fixed rent term length (a lease is finite but ownership is perpetual). Indeed, an infinitely long, transferable lease is just like owning. Other differences between leasing and owning are merely institutional. For example, lease payments typically are paid each year whereas a purchase price is paid upfront. The timing and amount of lease payments are set by contract; however, the only reason they are not frontloaded like a purchase is that the landlord and tenant choose not to.4 Another typical institutional difference between renting and owning is that residential tenants typically do not have discretion about making renovations to a property like an owner does. But they would, if the lease contract were not written to disallow it.

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