Housing Demand

Tenure Choice
The Tax Treatment of Housing
 Household Level Housing Demand
• Understanding housing demand is central for analyzing housing markets

• We often model the demand function for housing services by household h in

region r using the following constant elasticity form:
𝛽
𝜃
𝑞ℎ𝑟 = 𝛼ℎ𝑟 𝑝𝑟 𝑦ℎ𝑟

quantity of price per unit of household

housing services housing services income
(price index)
• Take logs to get

ln 𝑞ℎ𝑟 = ln 𝛼ℎ𝑟 + 𝛽 ln 𝑝𝑟 + 𝜃 ln 𝑦ℎ𝑟

price elasticity income elasticity

of demand of demand
(<0) (>0)
 Aggregate Housing Demand
• Our analysis of housing markets used housing demand aggregated to local labor
markets (index by r)

• To derive this, add up household level housing demand over all households h in
region r:
𝛽 𝜃
𝑄𝑟 = 𝑝𝑟 ෍ 𝛼ℎ𝑟 𝑦ℎ𝑟
ℎ∈𝑟

• Note that this is still constant elasticity in the price index. Taking logs,
𝜃
ln 𝑄𝑟 = 𝛽 ln 𝑝𝑟 + ln ෍ 𝛼ℎ𝑟 𝑦ℎ𝑟 ≈ 𝛽 ln 𝑝𝑟 + 𝜃 ln 𝑦𝑟 + ln ෍ 𝛼ℎ𝑟
ℎ∈𝑟 ℎ∈𝑟
• Holding incomes and preferences (the second term) constant, a location
with a 10% higher price index will have a (b x 10)% higher quantity of
housing services demanded
• Holding prices and preferences constant, a location with 10% higher avg
income will have a (q x 10)% higher quantity of housing services demanded
• Holding income, preferences, and prices constant, a location with 10%
more people will have 10% higher quantity of housing services demanded
 Visualization

Log Aggregate
Home Region Housing
Price Demand
Index Individual (horizontal sum of individual demands)

Household
Demand
pr

qhr Log quantity of housing services Qr

Aggregate housing demand is greater if

• Population is higher (adding more individual demand curves)

• Household incomes are higher (each individual demand curve is shifted out more)
 Estimating Housing Demand
• This is difficult because we do not directly observe the quantity of housing
services

• We may observe household expenditure on housing in some data sets

(annual rent, home purchase price)
• Begin with the household level demand expression from above
ln 𝑞ℎ𝑟 = ln 𝛼ℎ𝑟 + 𝛽 ln 𝑝𝑟 + 𝜃 ln 𝑦ℎ𝑟
• Add ln 𝑝𝑟 on both sides to put the log expenditure on housing
(ln 𝑞ℎ𝑟 + ln 𝑝𝑟 = ln(𝑞ℎ𝑟 𝑝𝑟 ) = ln 𝐸ℎ𝑟 on the left hand side. The result is a
regression equation which can be run at the household h level:

ln 𝐸ℎ𝑟 = 𝛾 + (𝛽 + 1) ln 𝑝𝑟 + 𝜃 ln 𝑦ℎ𝑟 + 𝑢ℎ𝑟

• While econometric identification (finding randomization in p and y) is difficult,

attempts to estimate an equation like this have indicated that -1<b<0 and 0<q<1.
 Housing Wealth

Source: Gyourko (2009)

 The User Cost of Housing
• The user cost is the annual cost of owning or renting

• Once we understand user cost, we can analyze the rent/own (aka

tenure) decision
• Owners (user cost is implicit rent):
– Make mortgage payments
– Pay property taxes
– Incur depreciation
– Earn housing capital gains
– Maintenance costs and insurance
• Renters:
– Pay rent, but rent is determined by costs incurred by landlords
 The User Cost of Housing to Owner-Occupiers
• The key considerations for a home of value 𝑉 = 𝑞 ∗ 𝑣 are
– Interest costs on a mortgage 𝑖𝑉 per period
• Assume that a 100% mortgage is taken out on the home and is paid back forever
(almost the same as a 25-30 year amortization mortgage). If the mortgage interest
𝑖𝑉
rate 𝑖 is the same as the interest rate used for discounting, then 𝑉 = σ∞
𝑡=1 𝑡
1+𝑖
– Local property taxes ℎ𝑉 per period
– Depreciation 𝑑𝑉 per period
– Capital gains 𝑔𝑉 per period (untaxed for primary residence in Canada and
untaxed up to a $250,000 per person in the US)
– Maintenance costs 𝑚𝑂 𝑉 per period
• Homeowners’ annual cost for one unit of housing services is thus
𝑣 𝑖 + ℎ + 𝑑 + 𝑚𝑜 − 𝑔
• US federal tax treatment: Owner-occupiers can deduct local property taxes and
interest payments on the mortgage from federal income taxes at marginal rate
𝜏. If they elect to take this deduction, their user cost becomes
𝑣 1 − 𝜏 𝑖 + ℎ + 𝑑 + 𝑚𝑜 − 𝑔
– Since the 2017 “Tax Cuts and Jobs Act”, which raised the standard deduction, it only makes
sense for those with very high incomes to take this home mortgage interest deduction
– 30% (half of homeowners) itemized in 2017, 10% (one-sixth of homeowners) itemized in 2018
 The User Cost of Housing to Renters

• Think about a landlord:

– Buys a home at price 𝑣 and rents it out at price 𝑝 per unit of housing services.
– Can deduct property taxes, mortgage interest, maintenance and depreciation
costs from their federal income tax liability at marginal rate 𝜆
– Landlord’s annual cost is thus 1 − 𝜆 𝑖 + ℎ + 𝑑 + 𝑚𝑟 𝑣
– Besides 𝑝, landlords also earn capital gains 𝑔𝑣, both of which are taxed by the
Canadian federal government (only 50% of the capital gains are taxed). Thus,
𝜆
annual revenue per unit of housing services rented is 1 − 𝑔𝑣 + 1 − 𝜆 𝑝
2

• Perfect competition in the rental market means that landlords’ profits must be 0:
𝜆
𝑔𝑣 1 − 2 + 𝑝 1 − 𝜆 = 1 − 𝜆 𝑖 + ℎ + 𝑑 + 𝑚𝑟 𝑣

• Therefore, the equilibrium rental price per unit of housing services is

𝜆
1−2
𝑝 = 𝑖 + ℎ + 𝑑 + 𝑚𝑟 − 𝑔 𝑣
1−𝜆

• In the US, 𝑔𝑣 1 − 𝜆 + 𝑝 1 − 𝜆 = 1 − 𝜆 𝑖 + ℎ + 𝑑 + 𝑚𝑟 𝑣 -𝜆𝑣𝑒, so

𝑝 = 𝑖 + ℎ + 𝑑 + 𝑚𝑟 − 𝑔 𝑣 − 𝜆𝑣𝑒/(1-𝜆) “Excess Depreciation”

Tax rule
 Tenure Choice
• People choose the lower cost option of owning or renting.

• Our two user cost formulas for Canada for a home of value V are:
– owner cost = 𝑖 + ℎ + 𝑑 + 𝑚𝑜 − 𝑔 𝑉
𝜆
1−2
– rental cost = 𝑖 + ℎ + 𝑑 + 𝑚𝑟 − 𝑔 1−𝜆 𝑉
– Renting thus looks cheaper than owning given the tax treatment and assumptions of
the model

• In the US:
– owner cost = 1 − 𝜏 𝑖 + ℎ + 𝑑 + 𝑚𝑜 − 𝑔 𝑉
– rental cost = 𝑖 + ℎ + 𝑑 + 𝑚𝑟 − 𝑔 𝑉 − 𝜆𝑒𝑉/(1 − 𝜆)
• Where 𝑒 is the excess depreciation rate
– If e is small, owning is cheaper than renting but if 𝜏 is small, renting is cheaper than
owning

• This model is very simple and avoids:

– Dynamics
– Rent or home price risk
– Investment motives
 Why do So Many People Own in Canada?

• Rental market may not be competitive

– 0 profit assumption for landlords may be incorrect

• Thicker market in owner-occupied stock

– Difficult to find a rental unit appropriate for raising a family

• Higher rental maintenance costs may get passed on in higher rents

– Owners take better care of their units than renters

• Owning is a tax preferred investment vehicle

– No capital gains taxes for owner-occupied homes that appreciate. Other
types of capital gains are taxed

• Owning as a hedge against rent risk

 Why do So Many People Rent in the US?

• Tax advantage of owning only accrues to higher income people

• Liquidity constraints
– People can’t get a mortgage
– Different rates for different types of people
– Big rise in homeownership rates with the expansion of cheap credit

• Transactions costs and expected mobility:

– Housing market transactions are very costly: 6% - 10%.
– Therefore if own a home for fewer than 5 years, the transaction cost is likely
more than the cheaper cost of ownership.
Some Facts about Tenure Choice
Historical Homeownership Rates in the US

Bounced around at
63-68% since 2000

At 66% in 2023
Recent Homeownership by Age in the US
 Homeownership in Canada
75.0
CG

70.0 CA
TO
65.0 VA
HX
60.0 QC Homeownership rates
55.0 MTL stable or saw only slight
50.0 growth after 2011
45.0

40.0

35.0
1971 1976 1981 1986 1991 1996 2001 2006 2011

Source: Statistics Canada, CMHC

100
90.6
90 82.9
80 75.9

• Income (wealth) affects 70

69
65.2
60
housing demand, as housing 50
51.8

37
is a normal good 40
30
20
10
0
Total Under $20,000 to $40,000 to $60,000 to $80,000 to $100,000
households $20,000 $39,999 $59,999 $79,999 $99,999 and over