Making Our Neighborhoods, Making Our Selves by George C. Galster

Author:George C. Galster
Language: eng
Format: epub
Publisher: University of Chicago Press

Inefficiencies in Property Owners’ Investment Behaviors: Theory

As I will summarize below, owners of residential properties in a neighborhood could undertake a host of potential actions that have financial consequences not only for the property in question but also for other properties nearby. These positive and negative externalities emanate from decisions related to how much is invested in the dwelling and parcel, whether the owner occupies the premises, and whether the property should be converted to a nonresidential use or abandoned completely. In all cases, the nature of the inefficiency-inducing externality is similar: the individual owners assess what makes most financial sense from their perspective, and largely overlook what makes social sense when we account for all affected parties’ benefits and costs.

Two hypothetical examples suffice to illustrate. In the first case, an owner might ask herself whether investing $50,000 in upgrading her dwelling is worth it in terms of enhancing her own property’s value; should she assess this prospective increase in discounted future value as only $40,000 she will be unlikely to undertake the investment because it would incur a $10,000 loss. What this self-interested rationality overlooks in this hypothetical example is that each of the ten neighboring homes would gain $2,000 in value were she to upgrade. Thus, from society’s perspective she should invest $50,000 in upgrading because she and the other owners in aggregate would reap $60,000 gain in value (that is, $40,000 plus 10 × $2,000). The practical problem here—the failure of decentralized, market-based resource allocation mechanisms—is that the extra $20,000 in social benefit is external to the decision maker, and so she does not “do the right thing” by investing resources in her dwelling. Some sort of collective organizational mechanism must be devised (such as an $11,000 tax on the beneficiaries of $20,000 of externalities, which is then offered to the prospective upgrader in the form of a subsidy) to overcome this misallocation of our resources.

In the second example, an owner is struggling with a long-term cash flow on a rental property. Due to weak conditions in the submarket in which this dwelling is classified, the owner finds he cannot collect enough in rents to cover the minimum costs required to keep the property in operation. If no financial relief is found despite all feasible cost-saving measures, the desperate owner may assess that the current net loss of $1,000 per month is unsustainable, whereupon he suspends all property upkeep and payments on taxes, insurance, and perhaps mortgage, and “milks” the property for whatever he can get until foreclosure and seizure inevitably occur.4 The social inefficiency of this choice of not to invest rests on the fact that the undermaintenance and eventual abandonment of the dwelling reduces neighboring properties’ values substantially, as I will document below. If the aggregate value of these external losses were to prove greater (in discounted present value terms) than $1,000 per month, the social inefficiency is manifest.

Strategic gaming also can play an important role in guiding the investments in property in a distorted fashion.

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