Equity premium in housing

We base our analysis on model used by Davis. In the model economy the representative agent maximizes the
following utility function:

1
(1 )
( , )
1
t t
t t
c h
u c h

(

=

, (1)
where
t
h is housing services,
t
c is consumption of all other goods. The parameter (0,1) captures the
relative preference of housing services and consumption, the parameter (1, ) captures the degree of
relative risk aversion, and ( ,1) measures the intra-temporal elasticity of substitution between housing
and consumption.
In order to capture that housing is also treated as an asset we assume that the housing services are proportional
to the housing stock,

t t
h H = , (2)
where
t
H is the real stock of housing, and is the parameter that relates the housing stock to housing
services. We assume that there is a transaction cost related to housing asset. That is if the representative agent
buys a housing asset then spends additional dollars per a dollar of the asset price, and when sells the asset
receives only (1 ) of the selling price. Then the representative agent maximizes her discounted expected
lifetime utility,

0
0
( , )
t
t t
t
U E u c H

=
=

, (3)
subject to the budget constraint:

1 1 1
(1 ) (1 ) (1 )
t t t t t t t t t
c p H a r a p H w
+
+ + + = + + + . (4)

The first order conditions with regards to
t
c ,
t
H , and
1 t
a
+
are given respectively by:
( , ) 0
c t t t
u c H = , (5)

1 1
( , ) (1 ) [(1 ) ] 0
H t t t t t t t
u c H p E p
+ +
+ + = , (6)

1 1
[(1 ) ] 0
t t t t
E r
+ +
+ + = (7)
Using the explicit form of the utility function given in (1) together with (2) the following Euler equation for housing
is obtained. For that we recall the fundamental pricing relationship. Here we take into account that a decrease in
unit of consumption is compensated also by an increase in the marginal utility of additional housing.

| |
1 1 1
[ ( , ) ( , )] ( , )
t c t t H t t t t c t t
p u c H u c H E p u c H
+ + +
= . (8)
By re-arranging we obtain the following:

| |
1 1
1 0
t t t t
d E m
+ +
= , (9)
where

1
( , ) 1
( , )
H t t t
t
c t t t
u c H H
d
u c H c

| |
= =
|
\ .
, (10)

1
1 1 1
1
(1 )( / )
(1 )( / )
t t t
t
t t t
c H c
m
c H c

+ + +
+
| | ( +
=
| (
+
\ .
, (11)

1
1
1
1
t
t
t
p
p

+
+

=
+
. (12)
Here
t
d captures the dividend of having housing asset, or its rental income.
We can expand
| |
1 1 t t t
E m
+ +
as

| | | | | | | |
1 1 1 1 1 1
cov ,
t t t t t t t t t t
E m E m E m
+ + + + + +
= + (13)
Substituting for
| |
1 t t
E m
+
from

| |
1
1
1
t t f
t
E m
R
+
+
= ,
By re-writing this expression we obtain,

| | | | | | | |
1 1 1 1 1 1
cov ,
f
t t t t t t t t t t t
E m R d E m E m
+ + + + + +
= + (14)
Dividing by
| |
1 t t
E m
+
, we write,

| |
| |
| |
1 1
1 1 1
1
cov ,
t t t f f
t t t t t
t t
m
R R d E
E m

+ +
+ + +
+
= + (15)
We can re-formulate

| |
| |
1
1 1
1 1 1
1
1 1 1 1
cov ,
(1 )( / )
cov ,
(1 ) ( / )
t t t
t t t
t t
t t t t t t t
m
c H c
E m E c E H c

+ +
+ + +
+
+ + + +
(
(
| | + (
( =
|
(
( +
(
\ .
(

.
Then the equity premium for housing asset can be written as,
| |
1
1 1 1
1 1 1 1
1 1 1
(1 )( / )
cov ,
(1 ) ( / )
f f t t t
t t t t t t t
t t t t t
c H c
E R d R
E c E H c

+ + +
+ + + +
+ + +
(
(
| | + (
( + =
|
(
( +
(
\ .
(

. (16)
The equity premium,
| |
1 1
( 1)
f
t t t t
E R d
+ +
+ , can thus be easily computed. Expected house asset
returns equal the risk-free rate plus a premium for bearing risk, which depends on the covariance of
the housing asset returns with the marginal rate of substitution (MRS) between consumption and
housing,
( , )
( , )
H t t
c t t
u c H
u c H
. So if the housing asset covaries positively with MRS that is, the capital gain in
states when MRS is highcommand a high premium because these states are risky. In states when
consumption is high, the marginal utility of consumption is low. It is reasonable to assume that the
housing stock does not change as rapidly as consumption. Hence, in high consumption periods MRS
is increasing. Therefore, if the capital gains also increase in those periods, the housing asset is riskier
than the risk-free asset and has to pay a premium. Overall, this premium is determined by the
covariance between the MRS of consumption and housing and the capital gains from holding a
housing asset.