Home Prices and Income in the UK: Uncovering an Elusive Relationship Through Accounting for Nonlinearities.

Abstract

Asset prices and fundamentals can move apart, as during bubble episodes. However, in the long run, they should exhibit a stable relationship. For UK housing, previous studies have investigated whether home values share a long run relationship with income. However, results thus far have not yet found such stability in the interaction between the two variables. These previous papers have imposed linear adjustment on the relationship. Nonlinear adjustment, however, has been shown to be a feature in a number of housing market relationships. Determining which variables are the most important fundamentals and attaining proper measurement present challenges in such an investigation. In this study, we utilize a data set consisting of home prices relative to first time buyer income for the UK and its thirteen constituent regions, which gives us a direct measure of affordability. Following previous studies, we test for the stationarity of the home price/first time buyer income ratio with linear tests, and, as in past studies, fail to find a long run relationship. However, we then employ the nonlinear Enders Granger test, and find a stationary relationship between home values and income for the UK and seven of the thirteen regions. In particular, the regions closest to London appear most clearly to have a stationary relationship between home values and income.