Tuesday, March 10, 2009

Houses Last too Long

Our house is 97 years old. It is but one of millions of examples of houses that outlive the persons who built them.

Of course, its good to have something durable. But my point is that such an extremely durable asset will use resources well beyond the construction phase -- effort will be needed to ensure that a house is adequately used.

Often the person building a house will build it to suit their purpose, but that person's life circumstances will change and it will be time to find another occupant for the house, get them financing, etc.

Economists often say that the value of a house is the present value of the flows of shelter, convenience, privacy, etc., that the house provides to its occupants. That is incorrect, because you have to subtract off the costs of finding the right occupants and putting them in place!

The pie graph below, from my "The Housing Cycle and Prospects for Technical Progress" (read a non-technical version here; the technical version is forthcoming) shows that the subtraction is not trivial. The owner of a house gets less than half of the flows of shelter, convenience, privacy, etc., that the house provides to its occupants.

This simple fact reveals an important factor driving the housing boom and bust of the 2000s.

1 comment:

Milton Recht said...

I would like to raise several points that possibly have significance to any analysis of house price changes.

1. House prices have two components. It is composed of the price of the land and the price of the physical structure. I would think that the price component of the physical structure would not deviate significantly from its replacement costs including materials, labor, permits and other regulatory costs, but data can prove otherwise. If the price of the structure did deviate from its replacement cost, homeowners with extra land would expand and sell for an extraordinary profit. Likewise, builders on undeveloped tracts would reap extra profit in excess of costs plus normal profits. Did developers reap excess profits? Is there any data that indicates whether the change in home prices differed from replacement costs in the value of the structure or if the change in the costs of the underlying buildable lot was the primary cause of the housing boom and bust? Possibly, there are different economic reasons for change in costs of structure versus change in land price. It seems that the greatest costs increases were in communities with population growth and a lot of new construction. Could it have been just the increasing marginal costs of the undeveloped land?

2. The Case Shiller index gives more weight to shorter duration home ownership than long duration home ownership sales. The index does exclude very short homeownership sales, such as within six months, as not indicative of an arms length transaction and not a reliable price change. The index logic is that a house owned over longer periods may have physical changes made to it that distort the appreciation component of the price change. However, this may more true from a valuation point of view for houses owned over shorter time durations. For example, a recent St. Louis Fed study found that 80 percent of subprime mortgages end within three years. Included in the number are mortgage prepayments due to the sale of the homes. Houses of shorter home ownership periods may have undergone extensive remodeling in the bathrooms, kitchens, etc. before the benefit of the improvement depreciates. A longer owned home may have more value-depreciated changes. The index could be biased upward due to the continued value of the new improvements in shorter time period owned homes and more so when owners are willing to make improvements in their homes.

3. As all physical structures depreciate and suffer wear, could the changes in home prices be due to a change in expected depreciation and other house costs? Did homeowners undertake more repairs and replacement and did the quality of the materials and the work be such that depreciation costs and other house costs changed? Were there any technological or regulatory reasons to expect house structure components to last longer than in the past, to need replacement less often due to environmental or regulatory concerns, or that other house related costs would decline? Were there economic reasons for owners to change their home reinvestment rate?

4. Did household formations expectations change due to changes in expected birth rates, immigration, military deployment, etc. and cause a change in housing demand? Were there changes in geographic mobility so that excess house inventory due to the inefficiencies of selling and buying a home would change?