Heterogeneous Housing Markets: Structural Implications for Pricing and Risk

Abstract

Housing market analysis is normally rooted in one of two distinct modeling frameworks. Either in one where house prices are residually determined by changes in macroeconomic variables such as interest rates, wages, inflation, unemployment and the cost of construction. This approach ignores interplay between market segments and treats housing markets as homogenous. Alternatively, is the analysis rooted in a framework that highlights the same interaction between segments. The latter approach, acknowledging that the housing market is not one market but rather a number of interlinked market segments, can be referred to as a heterogeneous housing market theory camp. Empirical assessments regarding whether housing markets are in or out of equilibrium are however – often due to weak data availability - often derived from the homogeneous housing market theory camp, analyzing house prices responses following shocks to income, rent or interest rates. This paper is concerned with the implications these two distinct theoretical camps have for the structure of risk and the structure of pricing in housing markets. Stated differently, whether empirical assessments derived from the homogeneous theory camp underestimate – or overestimate – pricing and risk in real housing markets? We present a conventional linear housing market model and consider the structure of pricing and risk as well as how different market structures responds to shocks. First we ignore the interrelation between segments. The results derived from this benchmark give indications on the structure of pricing and the structure of risk that will come about in models where housing markets are treated as homogenous residuals. We compare our benchmark with the two heterogeneous scenarios: First a housing market characterized by equity induced up-trading. Second, we allow home equity withdrawal and intergenerational transfer of housing wealth as elder households assist younger adults to become home-owners. When comparing the structure of pricing and risk that come about in these two heterogeneous housing market scenarios to those derived in our homogeneous benchmark we are able to assess the value added, in terms of increased understanding regarding the structures of pricing and risk in housing markets, by allowing for heterogeneous market frameworks. The model shows how out of equilibrium assessments derived from frameworks that abstract away from the interplay between segments might in part be explained by this abstraction. Second, we see how the former framework significantly underestimates house price risk. A main message from the paper is the urgent need for improving data quality on housing market at the micro level to allow for empirical assessments taking market interplay into account.