Colwell (JHE, 2002) on DW model

Journal of Housing Economics Overview

  • Citation: Journal of Housing Economics 11, 24–39 (2002) doi:10.1006/jhec.2001.0301

  • Author: Peter F. Colwell

  • Institution: Department of Finance, University of Illinois at Urbana—Champaign

  • Received: December 10, 2000

Introduction to the DiPasquale–Wheaton (DW) Model

  • Purpose: DW model illustrates long-run equilibrium in the aggregate real estate market and connects with financial capital markets.

  • Strengths:

    • Pedagogical power and compactness of presentation.

  • Weaknesses:

    • Assumes 'cap' rate is exogenous (fixed).

    • Requires trial and error to find long-run equilibrium.

    • Lacks clarity on short-run adjustments.

    • Ignores expectations and vacancies.

Enhancements to the DW Model

  • The paper aims to address the limitations of the DW model:

    • Adding new mechanisms to improve descriptive accuracy while accepting potential complexity increase.

    • Extensions include:

      1. Description of the DW model.

      2. Long-run supply introduction.

      3. Analysis of parameter changes on equilibrium.

      4. Refinement of the rent-price linkage.

      5. Introduction of protracted adjustment.

      6. Consideration of expectations and vacancies.

      7. Concluding insights.

The Four Quadrant Structure of the DW Model

  • Quadrant Breakdown:

    • Northwest Quadrant: Links rent and price (critical in model).

    • Southwest Quadrant: Contains construction supply curve.

    • Southeast Quadrant: Reflects true depreciation.

    • Northeast Quadrant: Shows demand for rental units.

  • Linkage in Northwest Quadrant:

    • The 'cap' rate reflects the ratio of rent to price (higher 'cap' rate = steeper line).

    • Stability attributes of the 'cap' rate contribute to the model's rigidity.

Understanding Long-Run Equilibrium

  • Visual Representation Challenges:

    • Long-run equilibrium is determined by multiple vertices aligning across quadrants.

    • Suggests a rectangle can identify equilibrium through derived supply curves.

  • Long-Run Supply Curve Creation:

    • Connect points touching demand curves and LRS (long-run supply) to find equilibrium.

    • Equilibrium identified at intersection of LRS and demand curve.

Impact of Parameter Changes on Long-Run Equilibrium

  • Comparative Statics:

    • New equilibrium achieved by shifts in supply or demand.

    • Changes lead to visible adjustments in rents or construction levels as shown in table:

      • Increase in demand: No change in capital stock, increase in rent.

      • Increase in construction supply: Increase in capital stock, decrease in rent.

      • Changes in depreciation or operating expenses inverse relationship to capital stock.

Linking Rent to Price Correctly

  • Realization of True Cap Rate:

    • Cap rate connects net operating income (NOI) to price rather than directly linking rent.

    • Inclusion of gross income multiplier offers a more accurate representation.

  • Model Correction Implications:

    • Incorporation of operating expense ratios influences long-run supply function.

Protracted Adjustment Process Explanation

  • Adjustment Nature:

    • Time taken to switch from one long-run equilibrium to another includes cyclical overshooting and dynamic behavior.

  • Graphical Representation of Investment:

    • Distinction between gross investment and depreciation indicates net investment trend.

Expectations and Vacancies Introduction

  • **Demand Components:

    • Transaction Component:** Natural vacancy rates.

    • Speculative Component: Fluctuations in vacancy levels related to perceived price levels.

  • Effective Rent Model:

    • Adjusts for vacancy impacts on rental revenue, allowing for comprehensive demand insights.

Conclusion of Model Enhancements

  • Reflection on Improvements:

    • Adds clarity to the understanding of long-run equilibrium and factors influencing it while maintaining model accessibility.

  • Model Adaptation Trade-off:

    • Increased complexity may yield richer analysis but at the cost of simplicity.

References

  • Various academic references are included, emphasizing the extensive literature upon which the enhancements and assertions are built.