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Economic Quarterly

First Quarter 2011

Optimal Contracts for Housing Services Purchases

Borys Grochulski

In this article, we study tradeoffs associated with homeownership and renting. We consider a model in which housing capital generates housing services, but also requires regular maintenance. A household wants to purchase a flow of housing services. Maintenance on the house providing this flow to the household can be performed by the household itself or by an outside property manager. We abstract from taxes or other government distortions. The household contracts with a bank/landlord that has funds sufficient to make a lumpy housing investment. We do not assume that the bank/landlord can observe the household's effort, consumption, or savings. We show that simple renting of the house from the bank/landlord is an optimal contract for the provision of housing services to the household, conditional on the outside property manager being hired. If the manager is not hired, it is optimal for the bank/landlord to lend the money to the household to acquire housing services by purchasing a home. In this arrangement, the bank's interest is secured by a zero-down, fixed-rate mortgage with a clause prohibiting subordinated financing. We use a parameterized example to compare the values that an average household can obtain in the renting contract against the owning contract. In this example, renting clearly wins.

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