Does Investment Risk Affect the Housing Decisions of Families

I. INTRODUCTION The purpose of this article is to investigate the effect of heightened price volatility in housing markets on homeownership and housing demand. The literature on housing markets has recognized that buying a home involves consumption and investment motives, as in Ranney (1981), Henderson and Ioannides (1983), and Fu (1995). Purchasing a home requires a concentrated investment in housing stock that for most families is not easily diversified (Caplin et al., 1997). Indeed, in 1995, the typical American household had most of its gross assets in real estate and held no corporate equity, and only households in the top 10% of the wealth distribution held portfolios that were diversified (Tracy et al., 1999). In 1998, despite strong stock market gains, home equity was a dominant investment for most households. Although roughly two-thirds owned their homes, less than half of all households held stock; of those households owning both stocks and homes, 60% had more wealth in home equity than in stocks (Di, 2001). Nominal house prices in U.S. cities have generally risen over time, with some cities experiencing periods of steep house-price appreciation. However, homeowners in many cities have been exposed to considerable downside risk. According to repeat-sales price indexes published by the Federal Home Loan Mortgage Corporation (Freddie Mac), significant one-year declines in home prices are not uncommon. For example, nominal declines of 15%, 5%, and 9% occurred in San Antonio in 1985, Denver in 1987, and Boston in 1990, respectively. Sustained house-price declines have occurred in Texas, California, and the Eastern states. For example, in the Long Beach-Los Angeles metropolitan area, the nominal price of single-family homes declined 22% from 1990 to 1996. (1) Furthermore, there is evidence that losses at the time of sale are surprisingly common. (2) What is not clearly understood is the extent to which families are responsive to such house-price risk. The investment literature has demonstrated that risk-averse households prefer to hold less risk at a given expected rate of return. When house-prices are uncertain, homeownership and demand relationships depend on the distribution of the random price variable. (3) Fu (1991) characterizes the price distribution by its first and second moments and shows that the likelihood of homeownersbip and the demand for owner-occupied housing are increasing in the expected rate of house-price appreciation and decreasing in house-price volatility. These results do not hold, however, for liquidity-constrained households: When households cannot borrow against the expected future gains of housing investment for current consumption, the theoretical effects on housing choices of the expected rate of return and house-price uncertainty are ambiguous (Fu, 1995). Thus, the effect of price volatility on housing choices remains to be determined empirically. The empirical research on housing markets includes a number of micro-level econometric studies on the determinants of homeownership and housing demand. These studies provide a framework for the present study and have shown that a household's after-tax relative cost of homeownership, permanent and transitory income, and family composition are important in explaining housing decisions (e.g., see Rosen, 1979; Dynarski and Sheffrin, 1985; Henderson and Ioannides, 1987; 1989). In addition, homeownership is negatively impacted by income uncertainty (Haurin, 1991) and by an inability to generate savings for a down payment, as in Henderson and Ioannides (1987), Linneman and Wachter (1989), Haurin et al., (1994), and Gyourko et al. (1999). Nevertheless, despite the importance of owner-occupied housing in the portfolios of homeowners, surprisingly little empirical work exists on the housing choices of families in the presence of house-price uncertainty. Rosen et al. (1984) provide some empirical evidence on the question of housing choices and risk. …