Capital Structure And Investment In Real Assets

Apartments and houses are highly substitutable in production and consumption. As a result, performance disparity between these assets is based on financial differences and not technology or preferences. Even as the market for new houses has become highly volatile, that for apartments has remained stable. Apartment starts in the United States did not increase during the asset market boom of 2003-2007. Starts on houses soared, rising more than 80% during the same period. This pattern has existed since at least 1986, even as returns and prices on both assets have fluctuated. These observations have greater urgency given evidence that housing investment is the business cycle (Leamer (2007)). Two-thirds of the variation in U.S. output comes from lagged volatility in housing starts. This finding is apart from the consequences of housing collapses on financial institutions and the international economy. This paper argues that the failure of apartments to collapse is not accidental. Apartment investment is with a transparent and constrained contract design. Projects are awarded in local contests for tax credits. All potential investments are observed prior to being started. Winners sell the credits for equity to publicly-traded firms in another transparent competition. The debt market provides residual financing in a reverse pecking order, conditional on observing winning the contest and raising equity. The geographic limitation, transparent sorting and prior equity provision discipline the market. Investment has low sensitivity to financial variables including interest rates and the term and capital structure. Houses have a double-leveraged financial design with debt and a call option, and little geographical limitation. Guaranteed nonrecourse debt creates a conventional pecking order. Borrowers obtain the maximum debt with equity as a residual. The guarantee is capitalized in the strike price of a call option to invest in houses prior to production. The contract mitigates agency problems of poor quality, since the buyer refuses delivery at the cost of the premium. However, the callís risk is potentially devastating. There are few limits on calls with buyers holding options on numerous houses by paying nominal premiums. When house prices decline or interest rates rise buyers cancel, leaving producers with inventory in bad markets. The guaranteed debt and call contracts lead houses to be highly sensitive to financial market variables, including interest rates, the term and capital structure. Financial variables have no impact on apartment returns and output, but are determinants of those for houses. Contract design potentially mitigates devastating housing cycles, with implications for aggregate output and the banking system. The application is to apartments and houses for 25 U.S. cities over 1991-2007. The earnings-price ratio is the yield for both assets. The net rent adjusted for time to sell is equated with the user cost of housing services. The user cost is not an identity, but a weighted sum of interest rates, capital structure and capital gains. Asymmetric performance of financial variables is confirmed. Both asset types have rent-price rates decreasing in capital gains as predicted by user costs. A 1% rise in capital gains reduces the adjusted rent-price ratio by 0.53% for houses and 0.43% in apartments. There are three critical differences for investment between these markets. First, the yield-price ratio is effective at limiting investment in apartments, while that for houses is not. A drop in the yield-price ratio by 1% reduces investment in apartments by 0.43%. Second, investment in houses is sensitive to the capital structure, yet has no effect on investment in the apartment market. A 1% increase in the loan-to-value ratio on houses leads to a 0.83% increase in investment. No similar results obtain for apartments. Finally, investment in houses expands when short-term interest rates are reduced. A 1% reduction (or three basis points at a 3% base interest rate) leads to an increase of 0.15% in investment in houses. Apartments output does not increase if short-term interest rates fall. The investment in apartments is disciplined and constrained by locally-limited tax credits sold in a transparent public equity market. Houses are produced by a distinct, debt-oriented contract. A call option capitalizes mortgage guarantees, but potential homebuyers have insurance to escape delivery. The difference in contract design offers promise in mitigating the impact of financial crashes on real markets, lenders and the national and international economies.