Research Program in Finance

This paper presents a model that derives both housing returns and housing construction patterns from events in the real economy. The value of a home, unlike the value of many other financial assets, depends upon the care its owner exerts on upkeep. Within the model banks respond to this moral hazard problem by restricting the size of the loans they are willing to issue. As a result housing prices no longer follow a random walk, but rather are tied to changes in the endowment process which are both predictable and time varying. That is, in some states of nature homeowners expect to earn an above market return on their housing purchase while in others they expect to earn a below market return. Developers in the model are fully cognizant of the housing price process and react accordingly. The result is a construction cycle that seems at odds with conventional wisdom. When endowments are growing quickly (a city with a rapidly growing economy) housing prices exhibit above market expected returns. However, since housing prices are expected to increase faster than the rate of interest, developers delay construction. Thus, during periods of rapid expected economic growth housing construction ceases until one reaches the crest whereupon development booms. In response housing supplies dwindle during economic booms (as homes deteriorate) and then increase when the boom ends.