Interdependence Effects of Housing Abandonment and Renovation

Journal of Real Estate Research, The, Oct-Dec 2003 by Simmons-Mosley, Tammie X

Abstract This study uses a methodology for analyzing the interdependence effects of abandonment and renovation for profit-maximizing landlords. After using a Prisoners' Dilemma game of abandonment to establish the existence of the interdependence phenomenon between internal rates of return, a Stackelberg framework is employed to model the interdependence effects of abandonment and renovation. The Stackelberg model appropriately defines the timing payoffs of the landlords' operational decisions. This model shows that as long as one landlord does not abandon, the optimal decision for the other landlord is to renovate their property.

Sociologist and more specifically human ecologists usually assume that if the population size or composition of a neighborhood changes then change will follow in the other components of the system as well. This perspective may be traced to the conception, developed by the Chicago School urbanists, of neighborhoods as "natural areas," (Schwirian, 1983).1

Urbanists and ecologists assert how a new social system can invade a neighborhood, which may cause a succession from the old system to a new system. With succession and the creation of new systems, changes in social characteristics, familism2 and economic status may result in neighborhood decline. If succession takes place, the newcomers may have no personal bond to the established structures. Therefore, conventional upkeep and maintenance may not be a focal concern of these immigrants. For instance, residential properties in these new social system neighborhoods may experience blight, which may result in property abandonment.

Housing abandonment may be optimal or suboptimal. Optimal abandonment may occur when a property has an alternative higher and better use than its current use, and/or it is financially feasible to walk away from the property rather than to sell it. This phenomenon is seen more often in seasoned properties. In general, as the property ages, its quality declines.3 Furthermore, the initial quality of a property may be low due to the developer using cheap building materials. Arnott, Davidson and Pines (1983) present a theoretical model, which shows a relationship between building age and optimal abandonment for a profit-maximizing landlord. They suggest that if demolition and maintenance cost were sufficiently high, then it would be optimal for a developer to construct a property, lease it for a period of time and abandon it. Landlords, who will only hold their properties for a limited time prior to abandoning, may be likely to trade better building materials for lower construction cost. Inferior quality may hasten landlords to abandon. If it is not financially feasible for landlords to walk away, then their decision to abandon may be suboptimal.4

This article discusses suboptimal housing abandonment, which may result in allocative and spatial inefficiencies. The sources of these two economically unpleasant outcomes may include subsidies to suburbanization, improper implementation of property tax levies and externalities arising from poor neighborhood infrastructure and surrounding abandoned buildings. The allocative inefficiency of housing capital may result in a reduction in the size of the lowincome housing stock, and the acceleration of decentralization (suburbanization) that can produce wasteful commuting, environmental degradation and other problems. Besides the aforementioned allocative inefficiency problems, suburbanization may lead to spatial inefficiency. Cars not paying their social cost and fiscal zoning might be examples of this inefficiency, which may also result in unequal distributions of housing locational choices across income classes. For instance, fiscal zoning may exclude low-income families from more affluent neighborhoods.

According to the 2000 U.S. Census Bureau survey, there were 115,904,641 housing units within the United States and the District of Columbia. Landlords frequently make operational decisions that affect these units. Acquiring, renovating and disposing of property are the three primary decisions faced by landlords. The decisions made by these landlords also affect individuals, communities and government entities, because property values and conditions are spatially interdependent. For instance, a renovated building might add value to a neighborhood. Furthermore, a landlord's divestment decision can influence the surrounding properties in that an abandonment decision may adversely affect adjacent property values. Suboptimal abandonment is demonstrated in a Prisoners' Dilemma game framework and with a Stackelberg model, which illustrate the interdependent effects of abandonment, and abandonment and renovation, respectively. Both models support the interdependence phenomenon of how one landlord's abandonment and/or renovation decisions may affect the other landlord's profit.

The rest of the article is organized as follows. First, the relationship between suburbanization, suboptimal abandonment and renovation is examined. Next, a Prisoners' Dilemma game framework of abandonment is discussed. This is followed by a Stackelberg model that is used to show optimal abandonment and renovation strategies. Finally, concluding comments are presented.