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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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Given their potential benefits, one wonders why it is that long-term residential leases are not already commonplace in the United States? Although long-term fixed rent leases (or with built in, known escalations) are prevalent in commercial real estate in the United States, they are exceedingly rare in domestic residential leases. Genesove (2003) found that fewer than 2 percent of residential leases in the United States are for 1 year or more, although many renter households Presumably, a tenant would be worried about counterparty risk—the landlord would collect an up-front rent payment and then fail to provide the contracted rental unit.

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live in the same rental unit for longer than 1 year. One possible explanation is that it simply is cheaper to obtain long-term lease benefits by owning. As discussed previously, homeownership is favored by the tax code. Perhaps, absent subsidized ownership, a long-term rental sector would develop. Unfortunately, existing empirical research does not address that issue. In most studies, the own-rent margin is not estimated to be very sensitive to the tax subsidy amount for homeownership. This empirical research cannot truly address any systemic shifts in the housing market that might arise from a large change in the overall tax treatment of homeownership, however, because typically they are estimated from small changes in tax rates.

Another possible explanation for the lack of long-term renting in the United States is that tenants would have to pay a premium for such a lease. One expensive likely feature of a long-term residential lease would be that a tenant could break the lease at will. When would a tenant break a lease? Besides exogenous moves, if market rents dropped below what was agreed on in a long-term lease, a strategic tenant would move out to a cheaper apartment and the landlord would have to re-lease the unit at a lower rent. If rents rose above what was agreed upon in the lease contract, the tenant would not move out. This one-sided benefit in favor of the tenant would be most valuable in housing markets where rents were the most volatile. Commercial leases avoid this asymmetry by enforcing that a tenant pays either the rent for the entire lease term or a penalty that makes the landlord whole if the tenant departs. It seems less likely that individual residential tenants could be forced to do that in a contract and, even if they could, that a landlord could efficiently collect.

Instead, a landlord would have to be compensated for the tenant’s option through higher rent for long-term leases. That rent premium would have to be largest in housing markets where housing costs fluctuated the most and for longer leases, where the odds are higher that market rents could drop below the rates in the long-term lease. Paradoxically, the very households that would value long-term leases—those that intend not to move—face the highest rental premium and the lowest ownership cost. As renters, they would have to pay a high rent premium because the option to break the lease is most likely to be “in the money.” Because households that are unlikely to move amortize the high transaction costs of ownership over a longer horizon, they reduce the per period ownership cost.

A second risk source, detailed previously, is uncertainty about housing costs in future residences, whether those new houses are in the same city as the current ones, or in new housing markets.

Homeowners’ investment positions hedge them against changes in housing costs in future houses in the same city because the value of their investments go up when local housing costs rise. To the extent that changes in housing costs are correlated across cities the household might move to, the same change in sale value hedges an owner against changes in housing costs in other cities.

Renters, because they lack investment positions in housing, are unhedged. Long-term leases could remedy this omission if the leases could be transferred to new tenants. The reason is that long-term leases become more valuable when current rents rise, just as houses become more valuable when rents go up. A household that moves out of a rental unit could sell the right to take over a favorable lease and use the proceeds to defray higher rent in the next rental unit. One possible reason that long-term leases have not gained traction in the United States is that the domestic population is fairly mobile and assumable leases are atypical.

Cityscape 121Sinai

Other potential options for renters to avoid the risk from moving involve taking positions between the extremes of only renting or only owning. These alternatives run into a host of concerns about implementation, however. For example, if a renter knew with certainty where she would move next, just not when, she could become a landlord in that other city. She could buy a housing unit there and rent it to a tenant, meanwhile renting a place herself in her current city. This strategy separates the investment in housing, which provides the hedge against uncertain future housing costs, from the consumption in housing. This approach poses a number of practical problems.

For example, when it is time for her to move, the combination tenant and landlord would have to break the lease both with her landlord and with her tenant. She would have to manage her rental property. And, because being a landlord is homeownership, this approach does not achieve a policy goal of encouraging households to be renters rather than owners.

An alternative to being a landlord would be to invest in a housing index that tracked the destination city. This alternative would provide an investment position in housing without the hassle of managing a property. A renter could even invest in a basket of city housing indexes, weighted by her likelihood of moving to each of the cities. Such indexes, such as the S&P/Case-Shiller Home Price Indices, are tradable and would simply need to be packaged into products that consumers could easily understand (for examples, see Case, Shiller, and Weiss, 1993; DeJong, Driessen, and Van Hemert, 2007; Shiller, 2008; and Voicu, 2007). Adopting this strategy faces several difficulties.

First, where does a household find the money to maintain a long position in possible future cities?

And, if leverage is necessary to buy the position in the housing index, a decline in the index can leave the renter under water just like a decline in home prices can do to an owner. Instead, a renter might prefer an option-based product to reduce their risk. For example, a renter who wished to limit his exposure to home price increases could purchase an option that pays the excess of home prices in a destination city above some threshold if home prices rise enough. Such financial products would be expensive, however, because the option seller would absorb the risk from the renter, and the derivatives markets necessary to create such products have failed to develop.

Because the market has not delivered mechanisms for renters to reduce their housing risk, policymakers could mitigate the adverse effects on risk of subsidizing renting by targeting rental subsidies to those households that do not face much rental risk. Households with a short expected duration of stay in a home face less risk from renting and more risk from owning than do long duration renters, therefore, these households possibly could be subsidized to rent (and definitely should not be subsidized to own). Households living in stable housing markets, with not much rent volatility, face little rental risk no matter their horizon, and thus encouragement to rent would not significantly affect their housing risk. Households in industries with wages that covary positively with rents face relatively low risk as renters. Targeted incentives would thus distort risk-taking the least.

Conclusion It is natural, given the recent volatility in home prices, for the public policy pendulum to shift from favoring homeownership to supporting renting. It is important to keep in mind that the alternative to homeownership, renting, is also risky. It is also hard to claim that one tenure mode is more or less risky than the other in any absolute sense. Rather, the risks are multidimensional and affect various household types to differing degrees.

122 Rental Housing Policy in the United States Understanding and Mitigating Rental Risk This article focused on two aspects of housing risk: First, what is the housing cost uncertainty in the current residence? Second, what is the housing cost uncertainty if a household were to move to a new residence, or a new city? It then discussed ways in which public policy could encourage renting or, alternatively, cease to encourage homeownership, and still minimize the additional risk taken on by renters.

Because housing markets with volatile prices also tend to have volatile rents, neither renting nor owning has an inherent financial risk advantage over the other. Instead, the tenure mode affects how underlying volatility manifests itself. In low-volatility housing markets, choosing renting versus owning exposes a household to little difference in risk. In high-volatility markets, owning locks in the current residence cost but leaves the sale price uncertain whereas renting leaves the annual cost uncertain. Households with long durations of stay reduce their housing cost risk by owning rather than adopting annual leases. Owning also provides an investment that hedges housing costs after a move for households that would move within a housing market or move to a new housing market with correlated home price changes but which adds volatility if those conditions are not met. Renters are exposed to home price risk for future houses.

These risk sources for renters can be mitigated in three broad ways. The first is to help households to be sufficiently conservative financially that they can absorb volatility in housing costs. This article showed that renters tend to spend less cashflow on rent than owners do on housing costs.

Many possible reasons exist for this cost difference, but it is doubtful that renting is an inherently cheaper way to obtain housing. Instead, current renters probably consume less housing than owners do. The lower amount of housing consumption provides a financial buffer against unexpected changes in rents or income. Any rental policy should avoid subsidizing additional spending on rent by renters because that would increase household risk. By contrast, the current tax treatment of owner-occupied housing provides a subsidy that increases in the amount spent on housing, encouraging increased housing consumption.

The second risk mitigation approach would be for renters to adopt positions somewhere in between the current norm of annual leases and a perpetual lease, which is like owning. Long-term leases could provide certainty about housing costs for a shorter horizon household and a possible hedge against housing costs in future markets. Housing derivatives based products could also aid renters; however, neither option has proven to be popular.

A third approach would be to target rental subsidies to those households that have low renting risks. Such targets include highly mobile households, those in low-volatility cities, and those with incomes that tend to covary with rents.

Because nearly all households either rent or own, an alternative to rental policy would be less favoritism towards homeownership. One wonders if the paucity of long-term lease contracts is due in part to crowd out from subsidized homeownership. A reduction in the subsidy to owneroccupied housing could be across the board, or it could be targeted to those households with the highest ownership risk.

Cityscape 123Sinai

Acknowledgments The author thanks the Zell-Lurie Real Estate Center at Wharton for research support, Moises Yi for outstanding research assistance, and Ingrid Gould Ellen and two anonymous referees for helpful suggestions. This article was originally prepared for the “Reconsidering Rental Housing Goals” meeting at the U.S. Department of Housing and Urban Development, May 13, 2010.

Author Todd Sinai is an associate professor of real estate and business and public policy at The Wharton School, the University of Pennsylvania, and a research associate at the National Bureau of Economic Research.

References Blackley, Dixie, and James Follain. 1996. “In Search of Empirical Evidence That Links Rent and User Cost,” Regional Science and Urban Economics 26: 409–431.

Case, Karl, Robert Shiller, and Allan Weiss. 1993. “Index-Based Futures and Options Markets in Real Estate,” Journal of Portfolio Management 19 (2): 83–92.

Chan, Sewin. 2001. “Spatial Lock-In: Do Falling House Prices Constrain Residential Mobility?” Journal of Urban Economics 49 (3): 567–586.

Davidoff, Thomas. 2006. “Labor Income, Housing Prices and Homeownership,” Journal of Urban Economics 59 (2): 209–235.

DeJong, Frank, Joost Driessen, and Otto Van Hemert. 2007. Hedging House Price Risk: Portfolio Choice With Housing Futures. Mimeo New York: New York University.

Ferreira, Fernado, Joseph Gyourko, and Joseph Tracy. 2010. “Housing Busts and Household Mobility,” Journal of Urban Economics 68 (1): 34–45.

Genesove, David. 2003. “The Nominal Rigidity of Apartment Rents,” The Review of Economics and Statistics 85 (4): 844–853.

Glaeser, Edward, and Joseph Gyourko. 2006. “Housing Dynamics.” NBER Working Paper 12787.

Cambridge, MA: National Bureau of Economic Research.

Gyourko, Joseph, and Donald Keim. 1992. “What Does the Stock Market Tell Us About Real Estate Returns?” Journal of the American Real Estate and Urban Economics Association 20 (3): 457–485.

Han, Lu. 2010. “The Effects of House Price Uncertainty on Housing Demand: Empirical Evidence From the U.S. Housing Markets,” Review of Financial Studies 23 (11): 3889–3928.

Hendershott, Patric, and Joel Slemrod. 1983. “Taxes and the User Cost of Capital for OwnerOccupied Housing,” AREUEA Journal Winter 10 (4): 375–393.

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Meese, Richard, and Nancy Wallace. 1994. “Testing the Present Value Relation for Housing Prices:

Should I Leave My House in San Francisco?” Journal of Urban Economics 35: 245–266.

Ortalo-Magné, Francois, and Andrea Prat. 2010. “Spatial Asset Pricing: A First Step.” CEPR Discussion papers 7842. London, United Kingdom: Centre for Economic Policy Research.

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