The Valuation of Houses in an Uncertain World with Substantial Transaction Costs

This paper presents a dynamic model of residential real estate valuation that takes into account the uncertain time paths of rents and prices and the substantial transaction costs. By temporarily postponing decisions, buyers and sellers obtain additional information about future rents and prices and may avoid transactions that are costly to reverse. One implication is that the combination of substantial uncertainty and high transaction costs can create a large wedge between a household’s reservation prices for buying and selling, which can explain why there is so much inertia in the housing market. key words: housing market, buying versus renting, housing uncertainty The Valuation of Houses in an Uncertain World with Substantial Transaction Costs Residential real estate can be viewed as investment, much like corporate stock, in that the owner anticipates receiving an uncertain cash flow over many years. With stock, the shareholder receives dividends; with a house, the homeowner receives housing services that would otherwise have to be paid for by renting. An important difference between the markets for stocks and houses is that people don’t switch back and forth between owning and renting houses the way they jump in and out of stocks. Renters who become homeowners typically remain homeowners unless there is a substantial change in their lives. For example, after their children leave home, a couple may sell their house and move into a rental property; once they transition from owning to renting, they typically stay renters. One possible explanation for this hysteresis is that rental and purchase properties are quite distinct, so that people with different preferences separate into renters and owners. However, similar properties are often available for rent or purchase. Another possible explanation us that tax laws make home ownership more financially attractive for heavily taxed households, so that people in different tax brackets separate into renters and owners. It is certainly true that households in high tax brackets have higher reservation prices for buying than do households in low tax brackets. But there surely are some households whose reservation prices are close to market prices, and who would choose to rent rather than own (or own rather than rent) if market prices were somewhat higher or lower relative to rents. For such households, the question is why they do not switch from renting to owning, or vice versa, when rent/price ratios change substantially. In Boston, for example, the ratio of the home price index to the rent index rose by more than 60% between 1983 and 1987, fell by more than 20% between 1987 and 1993, and rose by 40% between 1996 and 2003. There were comparable swings in Los Angeles and San 1