features Evaluating the Risk of Housing Investment

Households in the United States have long tended to concentrate their wealth in housing. In 2001, 68% of U.S. households were homeowners, according to the Federal Reserve’s Survey of Consumer Finances.1 The net worth of the median homeowner household was $171,700. The value of the median household’s primary residence was $123,000, and its housing equity was $53,000, or about 31% of its total net wealth. The risk confronting households holding large amounts of undiversified real estate has been recognized by Case, Shiller, and Weiss, and by Caplin et al.2 Case, Shiller, and Weiss propose the establishment of cash-settled real estate futures and options markets to allow better hedging and diversification. Caplin et al. urge the creation of partnership markets for housing equity. In December 2004, the Chicago Mercantile Exchange announced it was proceeding to offer futures contracts based on the cost of housing in different major cities in the United States.3 This article focuses on assessing the risk of housing investment. Although most homeowners consider housing to be a consumption good, it is clear that housing also represents an investment. Although imputed rent is consumed when a homeowner occupies a house, this benefit is excluded from the risk and return analysis in this study. When judged on the basis of movements in aggregate price indexes, housing appears to be a relatively low-risk investment. For example, the Office of Federal Housing Enterprise Oversight (OFHEO) produces a series of aggregate price indexes for existing housing that are often used to assess current housing trends. Drawing on annual data from the national OFHEO House Price Index for 1975– 2003 yields the series of capital gain returns shown in Table 1 for one-, three-, five-, seven-, and ten-year holding periods. abstract