Equity premium in housing

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
,
where
t
H
is the real stock of housing, and

is the parameter that relates the housing stock to housing

services. However, the agent may not be able to pay off the value of the house right away, and hence, has to
borrow to pay for the house. We denote the equity share in the house by
(1 )
t
a
. Thus, the amount of mortgage
debt will be given as
t t t
p a H
. Then the representative agent maximizes her discounted expected lifetime utility,
0
0
( , )
t
t t
t
U E u c H

,
subject to the budget constraint:
1 1
[1 (1 )]
t t t t t t t t t
c p H a e a r p H
+ +
+ +
.
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
,
[ ]
1 1 1 1
( , ) 1 (1 ) [ ( , )] 0
H t t t t t t t t t c t t
u c H p r a E p a u c H
+ + + +
+ +
,
1 1 1 1 1 1
[(1 ) ( , )] 0
t t t t t t t c t t
p H E r p H u c H
+ + + + + +
+ +
Using the explicit form of the utility function given in together with the following Euler equation for housing is
obtained. For that we recall the fundamental pricing relationship.
[ ] [ ]
1 1 1 1
1 (1 ) ( , ) ( , ) ( , )
t t t c t t H t t t t t c t t
p r a u c H u c H E p a u c H
+ + + +
+
.
By re-arranging we obtain the following:
[ ]
1 1
1 0
t t t t
d E m
+ +

,
where
[ ] [ ]
1
( , ) 1 1 1
1 (1 ) ( , ) 1 (1 )
H t t t
t
t t t c t t t t t t
u c H H
d
p r a u c H p r a c

_


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

+ + +
+
_ 1 +

1
+
, ]
,
[ ]
1 1
1
1 (1 )
t t
t
t t t
p a
p r a

+ +
+

+
.
Here
t
d captures the dividend of having a 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
+ + + + + +
+
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
+ + + + + +
+
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

+ +
+ + +
+
+
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

+ +
+ + +
+
+ + + +
1
1
_ + 1
1

1
1 +
1
,
] 1 ]
]
.
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

+ + +
+ + + +
+ + +
1
1
_ + 1
1 +

1
1 +
1
,
] 1 ]
]
.
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 the 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 co-varies positively with MRS that is, the capital gain in states
when MRS is high, then it commands 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.
The other important factor that derives the magnitude of the premium is the
level of leverage,
t
a , the home-owners assumes. Clearly,
0
t
t
d
a

>

and
1
0
t
t
a

>

.
Hence, the higher the leverage, the higher is the variability of agents
consumption. To compensate for that risk, the agent requires a higher premium.