Lecture 1 House prices and capitalization
- Christian Hilber “The economic implications of house price capitalization: A
synthesis” only the first part: pp 301- 321.
Why is real estate important?
- Large part of the capital stock and investment is real estate
Pension funds and insurance companies invest in real estate
- Cities are real estate
Housing affordability is a concern in many metropolitan areas
Land use planning affects real estate markets
- Housing is the most important consumption good and for owner-occupiers usually the
most important asset
House prices have an important impact on consumption expenditure
- Real estate markets can be volatile (bubbles and crashes)
The financial crisis started with the subprime mortgage crisis
1.1 Capitalization - Hilber
Houses have a fixed location
- Buying or renting a house means: getting access to a specific municipality or
neighborhood
- ‘Municipalities and neighborhoods differ enormously in their levels of local public
goods provision, accumulation of social capital or private investments in the housing
stock.’
- These differences are not explained by natural amenities
- Such as scenic views, the nearby presence of nature (although they play a role)
The paper focuses on differences associated with local public services and taxes that are
capitalized in house prices
- Basic mechanism: local public goods make a neighborhood more attractive
- Hence households are willing to bid a higher price for housing in neighborhoods with
more/better public goods
- If all else is equal: in equilibrium this may result in price differences between
neighborhoods
- The paper considers in some detail how this mechanism works
Background
Samuelson (1954): markets cannot provide public goods
- Consumption is non -exclusive
- Free rider problem
Tiebout (1956): local public goods are different
- Households ‘vote with their feet’
- Communities can decide to provide a local public good
- Households that appreciate it join the community and pay for the public good; the
others move elsewhere
Oates (1969): if this is true, then fiscal differences between municipalities must be
capitalized in house prices
, - Higher real estate taxes reduce house prices; better schools, nicer parks have the
opposite effect
Example for the Netherlands
Allers en Vermeulen ‘Capitalization of equalizing grants’
Context:
- Municipalities provide many local public goods
- In the Netherlands municipalities are financed predominantly by the national
government
- Not by local taxes
- The paper studies the impact of a change in the rules of this mechanism
- Some municipalities gained, other lost
- If the financial means are used by the local governments to provide services that are
useful for their inhabitants, and they are aware of this, capitalization must be
expected
- Alternatively, local governments might use the means inefficiently, or
inhabitants do not notice the spending
Implications
A 1 euro increase in local public spending leads to an increase in house prices of 0.033%.
This is approximately 78 euro, which is roughly the present value of a permanent 1 euro
increase in government spending for a household consisting of 2.3 persons.
- Conclusion: there is full capitalization.
The authors also consider the effect of a change in the way buildings of schools are
financed. In accordance with the theory, they find no impact of this measure on house
prices.
- This is just one example, out of very many, of capitalization effects
How does capitalization occur?
The idea is that households notice the public goods available in a particular neighborhood
- This is reflected in their willingness to pay for housing per neighborhood
- Such price differences thus reflect the marginal values attached by households to
local public goods
- And this is exploited in so -called hedonic price studies of traffic noise, presence of
parks, local crime rates, school quality
To understand this, we can use the familiar supply -demand diagram
If we do so, we find that the amount of capitalization depends on the elasticities of demand
and supply:
- A: if demand is fully elastic, there will be full capitalization independent of the supply
elasticity
- B: if supply is fully inelastic, there will be full capitalization, independent of the
demand elasticity
- C: in intermediate cases (not fully elastic demand, somewhat elastic supply) there will
be partial capitalization
,The demand side
Demand is fully elastic if households are homogeneous, mobility is costless and people have
no specific preferences over locations.
- This appears to be an unrealistic case
If households are heterogeneous and supply of amenities differs over places, there will be
sorting
- Example: The willingness to pay for a view on the Golden Gate Bridge differs among
households
- This causes a downward sloping demand curve for such views
- The price of the view is determined by the marginal household that realizes such a
view
Relocation costs, including attachment to one’s home, also cause downward sloping
demand curves.
The supply side
Supply of housing is usually not easy to change
- Refurbishing or replacing existing buildings is expensive
- There may not be much space available for new buildings, especially in built -up
areas
More developed locations have lower supply elasticities
d log H d H P
- Housing supply elasticity: =
d log P d P H
- With a linear housing supply curve that has a positive intercept the supply elasticity
decreases in H
- This is a ‘mechanical’ argument. Check!
- In more developed locations there is less space left and housing competes with other
types of land use
- If there are many homeowners, they oppose further development to protect their
wealth
- This is Fischel’s ‘homevoter hypothesis’ that interferes with the amount of
developed land
- Local land scarcity can have a causal effect on the overall regulatory restrictiveness
, - Hilber and Robert -Nicoud refer to this as the ‘influential landowner’
hypothesis
Real Estate and Urban Economics
Capitalization of local public goods in house prices is also studied in urban and
environmental economics
- The value attached by homeowners to these public goods can be measured from this
capitalization effect
- The interest is not in the functioning of the housing market per se
- In real estate economics the emphasis is on the functioning of real estate markets
- For instance: the conditions under which full capitalization can be expected
- The reaction of housing construction to capitalization
1.2 House prices
Measurement of house prices
The issue: for homogeneous commodities there is often only one price
- All units are identical, so on a competitive market the ‘law of one price’ should be
expected to hold
- Arbitrage enforces this law
- In practice there are sometimes different prices even for homogeneous goods
- For instance: sugar, gasoline
- For heterogeneous goods, there may be many prices
- If there are homogeneous varieties, there may be one price per variety
- Housing is extremely heterogeneous
- Even with identical characteristics, the location may make a difference
- Sometimes for identical houses located next to each other
Example: proximity to water
We used fixed effects for rows of identical terraced housing to isolate the effect of proximity
to water.
The estimated effect is smaller than without such fixed effects, but still significant
Explanation?
How can we talk about “the” price of housing?
One possibility: Average or a similar measure
- For instance: the NVM (Dutch association of real estate agents) uses the median
price in broad segments
This is not satisfactory from a theoretical point of view
- For instance: in one year more luxury houses may be sold, in another more houses
of decent quality
- One would ideally separate quality aspects from the total price of housing
This suggests a multiplicative specification: 𝑅 = 𝑃 ∗ 𝑄
𝑅 : the (total) purchase price of a house
𝑃 : the (pure) price component
𝑄 : the quality component
Muth’s model of housing and hedonic price analysis
- Christian Hilber “The economic implications of house price capitalization: A
synthesis” only the first part: pp 301- 321.
Why is real estate important?
- Large part of the capital stock and investment is real estate
Pension funds and insurance companies invest in real estate
- Cities are real estate
Housing affordability is a concern in many metropolitan areas
Land use planning affects real estate markets
- Housing is the most important consumption good and for owner-occupiers usually the
most important asset
House prices have an important impact on consumption expenditure
- Real estate markets can be volatile (bubbles and crashes)
The financial crisis started with the subprime mortgage crisis
1.1 Capitalization - Hilber
Houses have a fixed location
- Buying or renting a house means: getting access to a specific municipality or
neighborhood
- ‘Municipalities and neighborhoods differ enormously in their levels of local public
goods provision, accumulation of social capital or private investments in the housing
stock.’
- These differences are not explained by natural amenities
- Such as scenic views, the nearby presence of nature (although they play a role)
The paper focuses on differences associated with local public services and taxes that are
capitalized in house prices
- Basic mechanism: local public goods make a neighborhood more attractive
- Hence households are willing to bid a higher price for housing in neighborhoods with
more/better public goods
- If all else is equal: in equilibrium this may result in price differences between
neighborhoods
- The paper considers in some detail how this mechanism works
Background
Samuelson (1954): markets cannot provide public goods
- Consumption is non -exclusive
- Free rider problem
Tiebout (1956): local public goods are different
- Households ‘vote with their feet’
- Communities can decide to provide a local public good
- Households that appreciate it join the community and pay for the public good; the
others move elsewhere
Oates (1969): if this is true, then fiscal differences between municipalities must be
capitalized in house prices
, - Higher real estate taxes reduce house prices; better schools, nicer parks have the
opposite effect
Example for the Netherlands
Allers en Vermeulen ‘Capitalization of equalizing grants’
Context:
- Municipalities provide many local public goods
- In the Netherlands municipalities are financed predominantly by the national
government
- Not by local taxes
- The paper studies the impact of a change in the rules of this mechanism
- Some municipalities gained, other lost
- If the financial means are used by the local governments to provide services that are
useful for their inhabitants, and they are aware of this, capitalization must be
expected
- Alternatively, local governments might use the means inefficiently, or
inhabitants do not notice the spending
Implications
A 1 euro increase in local public spending leads to an increase in house prices of 0.033%.
This is approximately 78 euro, which is roughly the present value of a permanent 1 euro
increase in government spending for a household consisting of 2.3 persons.
- Conclusion: there is full capitalization.
The authors also consider the effect of a change in the way buildings of schools are
financed. In accordance with the theory, they find no impact of this measure on house
prices.
- This is just one example, out of very many, of capitalization effects
How does capitalization occur?
The idea is that households notice the public goods available in a particular neighborhood
- This is reflected in their willingness to pay for housing per neighborhood
- Such price differences thus reflect the marginal values attached by households to
local public goods
- And this is exploited in so -called hedonic price studies of traffic noise, presence of
parks, local crime rates, school quality
To understand this, we can use the familiar supply -demand diagram
If we do so, we find that the amount of capitalization depends on the elasticities of demand
and supply:
- A: if demand is fully elastic, there will be full capitalization independent of the supply
elasticity
- B: if supply is fully inelastic, there will be full capitalization, independent of the
demand elasticity
- C: in intermediate cases (not fully elastic demand, somewhat elastic supply) there will
be partial capitalization
,The demand side
Demand is fully elastic if households are homogeneous, mobility is costless and people have
no specific preferences over locations.
- This appears to be an unrealistic case
If households are heterogeneous and supply of amenities differs over places, there will be
sorting
- Example: The willingness to pay for a view on the Golden Gate Bridge differs among
households
- This causes a downward sloping demand curve for such views
- The price of the view is determined by the marginal household that realizes such a
view
Relocation costs, including attachment to one’s home, also cause downward sloping
demand curves.
The supply side
Supply of housing is usually not easy to change
- Refurbishing or replacing existing buildings is expensive
- There may not be much space available for new buildings, especially in built -up
areas
More developed locations have lower supply elasticities
d log H d H P
- Housing supply elasticity: =
d log P d P H
- With a linear housing supply curve that has a positive intercept the supply elasticity
decreases in H
- This is a ‘mechanical’ argument. Check!
- In more developed locations there is less space left and housing competes with other
types of land use
- If there are many homeowners, they oppose further development to protect their
wealth
- This is Fischel’s ‘homevoter hypothesis’ that interferes with the amount of
developed land
- Local land scarcity can have a causal effect on the overall regulatory restrictiveness
, - Hilber and Robert -Nicoud refer to this as the ‘influential landowner’
hypothesis
Real Estate and Urban Economics
Capitalization of local public goods in house prices is also studied in urban and
environmental economics
- The value attached by homeowners to these public goods can be measured from this
capitalization effect
- The interest is not in the functioning of the housing market per se
- In real estate economics the emphasis is on the functioning of real estate markets
- For instance: the conditions under which full capitalization can be expected
- The reaction of housing construction to capitalization
1.2 House prices
Measurement of house prices
The issue: for homogeneous commodities there is often only one price
- All units are identical, so on a competitive market the ‘law of one price’ should be
expected to hold
- Arbitrage enforces this law
- In practice there are sometimes different prices even for homogeneous goods
- For instance: sugar, gasoline
- For heterogeneous goods, there may be many prices
- If there are homogeneous varieties, there may be one price per variety
- Housing is extremely heterogeneous
- Even with identical characteristics, the location may make a difference
- Sometimes for identical houses located next to each other
Example: proximity to water
We used fixed effects for rows of identical terraced housing to isolate the effect of proximity
to water.
The estimated effect is smaller than without such fixed effects, but still significant
Explanation?
How can we talk about “the” price of housing?
One possibility: Average or a similar measure
- For instance: the NVM (Dutch association of real estate agents) uses the median
price in broad segments
This is not satisfactory from a theoretical point of view
- For instance: in one year more luxury houses may be sold, in another more houses
of decent quality
- One would ideally separate quality aspects from the total price of housing
This suggests a multiplicative specification: 𝑅 = 𝑃 ∗ 𝑄
𝑅 : the (total) purchase price of a house
𝑃 : the (pure) price component
𝑄 : the quality component
Muth’s model of housing and hedonic price analysis
