Understanding the Irish price–rent ratio: an unobserved component approach

Abstract

This article examines the movements in the Irish price-to-rent ratio over the period 1976 to 2012. We use the Campbell–Shiller present value formula to decompose the price–rent ratio into the present discounted values of expected future housing market fundamentals, i.e., rent growth, real interest rate and risk premium for investing in housing. Treating the expectations of the fundamentals as unobserved components, we cast the Campbell–Shiller formula into a state–space model and estimate the deep parameters by maximum likelihood method. It is found that that the variations in the price–rent ratio are mostly due to the expected housing premium, while the expected rent growth and real interest rate account for only small fractions of variations in the price–rent ratio. It is also found that, while the individual contributions of the expected market fundamentals sum up much larger variations than in the price–rent ratio itself, the correlations among them considerably dampen fluctuations in the ratio.