Housing Return And Construction Cycles

Abstract

This paper presents a model of a mature city that depends upon the rehabilitation of old home sites for new housing. Within the model housing returns, housing construction, mortgage loan terms, and household maintenance behavior are all endogenous. The model?s premise is that the value of a home, unlike the value of many other financial assets, depends upon the care its owner exerts on upkeep. Banks respond to this moral hazard problem by restricting the size of the loans they are willing to issue. As a result people bid what the can for housing, rather than what they may wish to. This in turn ties housing prices to changes in the endowment process which are both predictable and time varying. When endowments are growing quickly (a city with a rapidly growing economy) housing prices exhibit above market expected returns. Because banks within the model act rationally, they set mortgage terms based upon their beliefs regarding future housing prices. This leads to the empirically verified prediction that current mortgage loan to value ratios can be used to forecast future housing returns. Developers are also fully cognizant of how housing prices are set and react accordingly. When housing prices are expected to increase faster than the rate of interest developers acquire land for construction. Then once the developers believe housing returns will stop increasing they develop and sell their holdings leading to a construction boom. Thus, the model predicts that developer holdings can be used to forecast housing returns.