Speculating on Home Improvements ∗

We develop a speculation-based theory of home improvements. Housing services are produced from a mix of land and structures. Homeowners have an option to increase their structures (i.e. make improvements) holding fixed their land. Speculative improvements arise because overconfident homeowners mistakenly believe they can add to structures for a lower cost than a competitive construction industry. Improvements are increasing and convex in home prices. There is excessive home remodeling in equilibrium. And the change in the recoup ratio (the ratio of resale value of improvements to construction costs) is negatively correlated with construction cost growth controlling for home price appreciation. We provide evidence consistent with our theory using data on the costs and recoup values of remodeling projects across U.S. cities. ∗Hong and Scheinkman acknowledge support from National Science Foundation Grants. We thank Hui Fang, James Luo, and Yupeng Liu for research assistance. We also thanks Antonio Bernardo, Hanno Lustig and Brian Melzer, and students at the Gerzensee, CEMFI and Shanghai Advanced Institute for Finance summer schools for helpful comments. †Princeton University (e-mail: [email protected]) ‡Princeton University and NBER (e-mail: [email protected]) §Princeton University and NBER (e-mail: [email protected])