Claudia Sitgraves:
Home Improvement, Housing Supply, and House Price Dynamics

Residential housing represents a large fraction of most American households’ assets. Most homeowners can invest in housing not only by buying a home, but also via home improvements – adding a room or a story to the house, replacing windows, remodeling kitchens, and the like. Although expenditures on home improvements represented an estimated two percent of national output in 1995 (an estimate calculated before the recent housing bubble, during which home improvement activity increased dramatically), there has been limited research incorporating home improvement expenditures into economic models of housing investment, or exploring the determinants of housing investment more generally.

To fill this gap, my research project focuses on the relationship between property owners’ investment decisions and changes in the profitability of housing investment, as measured by neighborhood-level house price growth. I am developing a model of housing investment in which improvement decisions depend both on the growth in housing values between the time the property was last improved and the current period, and on the fluctuations (or volatility) of price growth. Using data on housing prices and home improvements, I analyze the relationship between price growth and volatility, and improvement activity.

Why might homeowners’ improvement decisions depend on price growth and price fluctuations? If we view the home as a capital investment which produces residential services in each period, standard models of capital investment predict that owners will invest in their project up to the point where the cost of an additional unit of investment just equals the additional value produced by that unit of investment. Property owners will be more likely to make investments in their properties, and will make larger investments, when the value of investment–the value of their home– increases.

There are additional aspects of real estate investment that affect this cost-benefit analysis. The value of additional housing will vary in the future as the price of residential services fluctuates, and there is uncertainty over what the future path of housing prices will be. If homeowners dislike uncertainty over their future profits, larger fluctuations can reduce the incentive to invest. Moreover, most investment in real estate is irreversible–if a property owner remodels his kitchen, he can’t undo the improvements and recoup the costs of investment should he change his mind.
Irreversibility can cause property owners to delay investment even if they have no inherent aversion to uncertainty over future profitability.

To test the hypothesis that property owners are more likely to make investments when house price growth is strong, and less likely when price volatility is high, I have been using data on property sales and permitting activity in 79 Los Angeles neighborhoods between 1999 and 2008.
I was able to obtain data through the generous support of IBER. To abstract from households’ other motivations to make home improvements that are unrelated to investment decisions and are potentially correlated with neighborhood-level price growth, I restrict my sample of properties to those owned by nonresident landlords.

I construct neighborhood-level price indices and estimate the relationship between both price growth and volatility, and the probability of improvement activity, the value of improvements, and the square footage of improvements. My preliminary analysis indicates that short-term cumulative price growth (between 2 and 4 years, depending on the measure of home improvement used) has the expected positive effect on homeimprovement. In addressing this question, I hope not only to test economic theories of capital investment, but also to improve our understanding of the process of development in urban neighborhoods, in order to facilitate economic investment in underserved communities.

Claudia Sitgraves is a PhD Candidate in Economics at UC Berkeley.