Developing a Regime-Switching Present Value Model: An Application to the UK Housing Market

Abstract

In contrast to the prediction of the present-value model, many empirical studies find the price-rent ratio nonstationary. This finding is frequently interpreted as evidence of speculative bubbles. In this paper, we seek an alternative explanation. Allowing the expectations of future housing market variables to switch between two distinctive regimes, we derive a present value formula for the price-rent ratio whose mean is regime-dependent. Applied to the U.K. housing market, our model successfully identifies two distinctive regimes in the expectations of the investors and the mean of the price-rent ratio. Standard unit root tests are strongly supportive of the stable relation between house price and rents, once the regime-specific means of the ratio are taken into account. It is also found that the higher mean of the ratio in one regime does not reflect higher rates of expected rent growth. Instead, it is due to the lower discount rate for future payoffs in that regime.