Dynamic Asset Pricing in a System of Local Housing Markets

For most people , buying a house is one of the most significant investment decisions of their lifetimes. Economists have mainly focused on the consumption aspects of this process. For example , a typical model in urban economics might frame the decision of where to live as a discrete choice over a bundle of housing and neighborhood attributes such as location , square footage , schooling options, and crime levels. The investment side of the problem has received considerably less atten tion , a surprising omission since housing assets constitute approximately two-thirds of the aver age American household’s financial portfolio , serve an important role in saving for retirement and, as has become increasingly apparent , can be quite risky. This paper views housing markets from an asset-pricing perspective, using finance theory to relate the risk premium of a housing asset (the difference between its expected return and the return for a risk-free investment) to its exposure to risk. As usual in finance, what matters for the risk premium of a housing asset is its exposure to systematic risk, not idiosyncratic risk. In our model, there are two forms of systematic risk to which housing assets are exposed: national risk (which is common to houses everywhere) and local risk (which affects all houses within a given metropolitan area, but nowhere else). Houses are said to be of the same type h if they are located in the same metropolitan area and have the same exposure to systematic risk. Our main conclusions are that (1) houses of every type face a common set of risk prices (λ * for the national risk and λ m for the local risk specific to