Essays on Local Housing Risk and Return

Abstract

Local returns to housing investment across the U.S. cities are estimated and applied to explain the stockholding puzzle, i.e. the tendency for US homeowners to hold only housing and risk free assets in their portfolios. Several empirical problems exist in the previous studies: first, rental returns are always ignored or just assumed to be constant across cities; second, the CAP rates at the city level are often based on the problematic BLS Rent Index (the BLS CAP rate) which is questioned by Ambrose et al (2014).

Using micro data from American Housing Survey (AHS), CAP rates for 38 of the largest MSAs in the U.S. (the AHS CAP rate) are estimated. Pooled OLS methods are used to control the heterogeneity in individual housing characteristics and quality differences across tenure types. As expected based on Ambrose et al (2014), AHS CAP rates are much more volatile than BLS CAP rates. Standard deviations of annual AHS CAP rates (national average value is 2.27%) are much larger than those of BLS CAP rates (national average value is 0.57%). Moreover, in inland cities, especially those in Rust Belt, AHS CAP rates reflect more rental risk than BLS CAP rates do. This divergence is smaller in coastal cities where housing price appreciation is more volatile. This implies that past research using the BLS Rent Index to analyze rental risk may be biased.

After formulating CAP rate measures for a panel of cities, this data is used to test the dividend pricing hypothesis (DPH) in housing by studying the trade-off between the capitalization rate and subsequent house price appreciation. In previous tests, even allowing for the fact that actual appreciation does not equal expected appreciation, evidence for the DPH has not been strong. This research has included an implicit assumption that risks associated with housing investment are common across housing markets. In addition, many previous tests have used BLS CAP rates or assumed that the CAP rate was constant across cities and/or over time. In this second essay, statistically constructed estimates of the AHS CAP rate and the variance in total return are used to conduct tests of the DPH. The result is far stronger than those obtained in previous studies of a cross section of U.S. cities. But, when the BLS Rent Index is used to measure CAP rates and risk, the results are not consistent with the DPH.

Finally, these findings about total return to housing investment are used to explain the stockholding paradox. Homeowners tend to hold housing and risk-free assets, but not equities or bonds in their personal portfolios. This has been called the "stockholding paradox" and has been explained by observing that the correlation between the rate of appreciation of national housing prices and returns to the S&P; 500 is relatively high. The common conclusion in the literature has been that homeowners derive only modest diversification benefits from holding stocks and choose instead to amortize their mortgages. In contrast to the empirical literature on the stockholding paradox, Brueckner (1997) has demonstrated the theoretical proposition that consumption constrained households, those whose wealth is a fraction of housing value, will not find holding the market portfolio efficient. This research proceeds from Brueckner's observation. First, total return to homeownership, including both appreciation and AHS CAP rate is measured. Second, properties of optimal portfolios for households under various degrees of consumption constraints are identified. Third, optimal portfolios of individual stocks are determined. The results show that portfolios of individual stocks, which vary by city, are far more attractive than the market portfolio for homeowners. This suggests a resolution to the stockholding puzzle. Homeowners could benefit from holding portfolios designed to offset the unique risk of the cities where they live but they lack information on what these portfolios might be. Given this information gap, holding the market portfolio is not particularly attractive for most homeowners.