By Carles Vergara, Professor at IESE In spite of the crisis that it is undergoing, the real-estate sector represents a very important part of today’s economy. Nevertheless, there is hardly any scientific research on the economic decision making in regard to real estate assets. The “atypical” nature of these assets calls for an analysis of how we make decisions on spending and investment in these assets. The studies being carried out by Prof. Carles Vergara specifically tackle two of these issues: the predictability of housing prices and their impact on transaction costs; and equity sharing programs in the real-estate sector.

Optimal Portfolio Choice with Predictability in House Prices and Transaction Costs

Transactions in some assets, such as those in the real estate sector, are affected by high transaction costs and by price predictability. With this in mind, in collaboration with Stefano Corradin (European Central Bank) and Jose Fillat (Federal Reserve) we are developing a model of portfolio optimization of consumption and durable goods (real estate) that includes both transaction costs (such as those that must be paid on the sale of a house) and price prediction.

The model shows that consumers consider two variables in making their decisions: the Wt/HtPt ratio of total wealth (Wt) per value of the real-estate assets (Ht•Pt: Housing stock by price); and the rate of expected growth in house prices.

For consumers, it is optimal not to change their holdings of real-estate stock continuously, but rather to wait until a major change occurs in their wealth before making this adjustment. That is, consumers will only increase or reduce their holdings of real estate assets when the Wt/HtPt ratio reaches an optimum upper or lower limit. When real estate prices cannot be predicted, these limits remain constant. However, the predictability component in real-estate prices causes these limits to vary over time.

Upper or lower limits will be respectively reduced or increased when it is expected that housing prices will rise or fall. In our research, we are using PSID and SIPP data for the United States to prove the existence and the main characteristics of these limits.

Moreover, the numeric simulations that we are carrying out show that a reduced transaction cost and low levels of price predictability can cause real-estate bubbles and portfolio optimization decisions that are consistent with the data.

Why Should I Sell a Fraction of my House? The Welfare Benefits of Equity Sharing Programs

Should you sell part of your house? One way of doing this is through Equity Sharing Programs, which enable owners to sell part of the equity of their houses to investors, while keeping the majority of the capital of it. These make financing easier when it comes to buying a property, or equally, make it possible to reduce the equity investment in one’s home, allowing this amount to be invested in another product.

The implementation of these programs is also highly advantageous for investors in the real-estate sector, since it enables them to diversify their portfolio more widely, for example by purchasing 10% of several houses instead of buying 100% of just one.

The author demonstrates an in-depth understanding of the dilemma faced by many families:

1) If they rent a house, they hold 0% of the equity in the house and pay a rent to the owner. On one hand, they are able to diversify their portfolio of investments more widely because they are not “over-invested” in their own house; but, on the other hand, the future rent that they will have to pay is subject to a very high risk (“rent risk”).

2) If they buy a house, they hold 100% of the equity in the house and pay no rent. Their portfolio has a very high exposure to the price of their home (for example, their house might represent 95% of their portfolio and stock market shares only 5%— or it might even be composed of 180% in the house and -80% in bonds, which would be equivalent to taking out a mortgage). However, they would have no rent risk because they are not paying rent.

The results of this study reveal that there is an optimum midpoint between renting and buying. If we are half tenants and half purchasers, we only “suffer” and “benefit” from part of the pros and cons of rental and purchase. In the final analysis, the author proves that it is socially optimal for us to be partial owners of our homes.