Academic journal article Real Estate Economics

Risk and Return within the Single-Family Housing Market

Academic journal article Real Estate Economics

Risk and Return within the Single-Family Housing Market

Article excerpt

The largest single investment for most American families is the house in which they live - and that house is often the major part of the family's wealth portfolio. Accordingly, most homeowners consider the property's investment potential or the expected rate of return in deciding whether to buy a house and what house to buy (Case and Shiller 1988).(1) The decision to buy one's residence is necessarily a joint consumption-investment decision, and the investment is a lumpy one, since equity sharing or partial ownership arrangements are not common (Brueckner 1997). In practice, then, the unsystematic risk associated with the structure of one's home or the neighborhood in which it is located cannot be eliminated by diversification. Meyer and Wieand (1996) have shown in a theoretical model that even though this risk cannot be diversified away, the price associated with the risk is the market price that applies to any risky asset in a portfolio. And Goetzmann (1993) has demonstrated that, if it were practical, diversification both within and among metropolitan housing markets would reduce risk. These studies imply that the offer price for a house whose returns are riskier will be lower than the offer price for an otherwise similar house, and the expected rate of return will be higher. This paper empirically evaluates the risk-return trade-off within the single-family housing market.(2) Specifically, we ask: Do local housing markets with higher risk, i.e., a larger variation in the returns on individual houses, also have higher average returns?

In the first section we show how the positive correlation between risk and return in the owner-occupied housing market follows directly from utility maximization. In the second section we describe the data used to test whether risk and return have been positively related in local housing markets. In the third section we report our empirical results. The fourth section seeks to identify some characteristics of local housing markets associated with higher risk. The basic conclusions of the paper and suggestions for further research are set forth in the fifth section.

Risk and Return within the Housing Market

A theoretical model demonstrating the positive relationship between risk and expected return in the owner-occupied housing market has been developed by Berkovec (1989). The model was employed by Gat (1994) to examine risk and return in neighborhood housing markets in Tel Aviv. In this section we derive a result similar to Berkovec's on the relationship between risk and return across housing markets. Since we confine our investigation to the single-family housing market, this is not an asset pricing model that attempts to identify the relative risk of housing in a diversified portfolio.

The model is based on the homeowner's maximization of his expected utility. Expected utility depends on expected consumption of a non-housing composite good, X, and the consumption of housing, H, expressed in terms of quality-adjusted housing units. The homeowner's expected income consists of labor income Y, which is known for certain, and the return on his housing investment with an expected appreciation rate [k.sub.i], that is, the expected appreciation for neighborhood i. The variability in appreciation among houses in neighborhood i is denoted [[Sigma].sub.i]. This variability in appreciation introduces uncertainty in the homeowner's expected income and affects his utility negatively. The expected utility function to be maximized is

U(X, H, [[Sigma].sub.i]) (1)


[Delta]U/[Delta]X [greater than] 0, [Delta]U/[Delta]H [greater than] 0, [Delta]U/[Delta][[Sigma].sub.i] [less than] 0

The maximization is reduced to a one-period problem by assuming that the homeowner's wealth remains the same from one period to the next and all income from labor and the housing investment is used to service the debt on the house and consume the composite good, X. …

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