Price-rent Ratio Research Articles

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

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.

Testing for rational bubbles in the US housing market

The presence of a bubble in the US housing market prior to the 2007 subprime mortgage financial crisis is investigated. This is done by looking into the relationship between house prices and rental prices, known as the price–rent ratio, which is an important measure of a potential deviation between house prices and its fundamental value. Additionally, the interest rate is taken into account since it is an important factor in determining demand for housing mortgages and thereby influencing house prices, and explosive behavior of house prices is considered. These relationships are investigated through a theoretical and econometrical framework. The empirical evidence suggests that there was a bubble in the housing market prior to the financial crisis, even when controlling for the decreasing interest rate and the fundamental information given by the rental price in the period. Explosiveness was the main source of the price increase, such that a bubble was present in the housing market after correcting for other fundamental factors. The econometric procedures used in the analysis may therefore be relevant for monitoring the housing market.

Credit constraints, inelastic supply, and the housing boom

In this paper, I develop a dynamic general equilibrium model to study the sensitivity of house price changes with respect to credit constraints. I find that house prices are sensitive to changes of the down payment requirements if owner-occupied houses and rental houses are inelastically supplied. I then use the model to evaluate the housing boom during the 1995–2005 time period. I find that, under the assumption that owner-occupied housing and rental housing cannot be converted to each other, the increase in real household income and the decline in down payment requirements can explain a large fraction of the observed house price and price–rent ratio changes during the 1995–2005 time period. However, the model fails to match the interest rate changes during the 1995–2005 period.

House Prices, Expectations, and Time-Varying Fundamentals

We investigate the behavior of the equilibrium price-rent ratio for housing in a standard asset pricing model and compare the model predictions to survey evidence on the return expectations of real-world housing investors. We allow for time-varying risk aversion (via external habit formation) and time-varying persistence and volatility in the stochastic process for rent growth, consistent with U.S. data for the period 1960 to 2013. Under fully-rational expectations, the model significantly underpredicts the volatility of the U.S. price-rent ratio for reasonable levels of risk aversion. We demonstrate that the model can approximately match the volatility of the price-rent ratio in the data if near-rational agents continually update their estimates for the mean, persistence and volatility of fundamental rent growth using only recent data (i.e., the past 4 years), or if agents employ a simple moving-average forecast rule for the price-rent ratio that places a large weight on the most recent observation. These two versions of the model can be distinguished by their predictions for the correlation between expected future returns on housing and the price-rent ratio. Only the moving-average model predicts a positive correlation such that agents tend to expect high future returns when prices are high relative to fundamentals -- a feature that is consistent with a wide variety of survey evidence from real estate and stock markets.

The equilibrium effect of fundamentals on house prices and rents

Using a dynamic equilibrium model of housing tenure choice with fully specified markets for homeownership and rental properties, and endogenous house prices and rents, this paper studies the effect of fundamentals on equilibrium house prices and rents. Lower interest rates, relaxed lending standards, and higher incomes are shown to account for approximately one-half of the increase in the U.S. house price–rent ratio between 1995 and 2006, and to generate the pattern of rapidly growing house prices, sluggish rents, increasing homeownership, and rising household indebtedness observed in the data.

Understanding Housing Market Volatility

The Campbell-Shiller present value formula implies a factor structure for the price-rent ratio of the housing market. Using a dynamic factor model, we decompose the price-rent ratios of 17 major housing markets into a national factor and independent local factors, and we link these factors to the economic fundamentals of the housing markets. We find that a large fraction of housing market volatility is local. And the local volatilities mostly are due to time-variations of idiosyncratic housing market risk premiums, not local growth. At the aggregate level, the growth and interest rate factors jointly account for up to 47% of the total variations in the price-rent ratio. The rest is due to the aggregate housing market risk premium and a pricing error. We find evidence that the pricing error is related to money illusion, especially at the onset of the recent housing market bubble. The rapid rise in housing prices prior to the 2008 financial crisis was accompanied by both a large increase in the pricing error and a large decrease in the housing market risk premium.

House Price Dynamics: Fundamentals and Expectations

We investigate whether expectations that are not fully rational have the potential to explain the evolution of house prices and the price-to-rent ratio in the United States. First, a stylized asset-pricing model solved under rational expectations is used to derive a fundamental value for house prices and the price-rent ratio. Although the model can explain the sample average of the price-rent ratio, it does not generate the large and persistent ‡fluctuations observed in the data. Then, we consider a rational bubble solution and two extrapolative expectations solutions: one that features a constant extrapolation parameter and one in which the extrapolation coefficient is an increasing function of the deviation of the growth rate of rents from its mean. In this last solution the degree of extrapolation is stronger in good times than in bad times, generating waves of over-optimism. We show that under this solution the model not only is able to match key moments of the data but can also replicate the run up in the U.S. house prices observed over the 2000-2006 period and the subsequent sharp downturn.

Pricing the US residential asset through the rent flow: A cross-sectional study

The paper explores how the standard consumption-CAPM fares in pricing housing returns and regional rental income streams in a cross-section of regions. In particular, we estimate the Euler equations associated with the gross housing returns inclusive of price appreciations and rents jointly for several metropolitan areas of the US. The representative agent has a Constant Relative Risk Aversion (CRRA) utility. The rent growth is allowed to depend on the business cycle. When biannual data from 1978 to 2007 is used, the parameter estimates are reasonable, and the model is not rejected. Large standard errors indicate uninformative estimates. The implied price rent ratio time series averages are similar to the data; however the model misses the boom-bust pattern in the prices. The model significantly understates the average and the variance of the price appreciations. Results are robust to allowing housing consumption directly in the utility function or using the Epstein–Zin–Weil utility.

Housing Price Forecastability: A Factor Analysis

We examine U.S. housing price forecastability using principal component analysis (PCA), partial least squares (PLS), and sparse PLS (SPLS). We incorporate information from a large panel of 128 economic time series and show that macroeconomic fundamentals have strong predictive power for future movements in housing prices. We find that (S)PLS models systematically dominate PCA models. (S)PLS models also generate significant out-of-sample predictive power over and above the predictive power contained by the price-rent ratio, autoregressive benchmarks, and regression models based on small datasets.

The Macroeconomic Effects of Housing Wealth, Housing Finance, and Limited Risk-Sharing in General Equilibrium

This paper studies the role of time-varying risk premia as a channel for generating and propagating fluctuations in housing markets, aggregate quantities, and consumption and wealth heterogeneity. We study a two-sector general equilibrium model of housing and non-housing production where heterogeneous households face limited opportunities to insure against aggregate and idiosyncratic risks. The model generates large variability in the national house price-rent ratio, both because it fluctuates endogenously with the state of the economy and because it rises in response to a relaxation of credit constraints and decline in housing transaction costs (financial market liberalization). These factors, together with a rise in foreign ownership of U.S. debt calibrated to match the actual increase over the period 2000-2006, generate fluctuations in the model price-rent ratio that explain between 80 and 100 percent of the increase in the national price-rent observed in U.S. data over this period. The model also predicts a sharp decline in home prices starting in 2007, driven by the economic contraction and by a presumed reversal of the financial market liberalization. Fluctuations in the model's price-rent ratio are driven by changing risk premia, which fluctuate endogenously in response to cyclical shocks, the financial market liberalization, and its subsequent reversal. By contrast, we show that the inflow of foreign money into domestic bond markets plays a small role in driving home prices, despite its large depressing influence on interest rates. Finally, the model implies that procyclical increases in equilibrium price - rent ratios reflect rational expectations of lower future housing returns, not higher future rents.

Pricing the US Residential Asset Through the Rent Flow: A Cross-Sectional Study

The paper explores how the standard consumption-CAPM fares in pricing housing returns and regional rental income streams in a cross-section of regions. In particular, the paper estimates the Euler equations associated with the gross housing returns inclusive of house price appreciations and rents jointly for several metropolitan areas of the United States. The representative agent has a Constant Relative Risk Aversion utility function. The rent growth is allowed to depend on the lagged Chicago Fed National Activity Index to capture the business cycle dependence of the rents. When biannual data from 1978 to 2007 is used, the parameter point estimates are reasonable, and the model is not rejected on the basis of the Generalized Method of Moments J-Test. However, the estimates are not very informative since the standard errors can be quite large. When the point estimates from the Euler equations are in turn used to price the rent cash flows in the model, the resulting price rent ratio time series averages are in the same ballpark as the data, however the model completely misses the boom-bust pattern in the prices. In addition, the model significantly understates the average and the variance of the house price appreciations. Results are robust to assuming i.i.d. rent growth rather than predictable. Results also exhibit robustness to allowing housing consumption directly in the utility function as in Piazzesi, Schneider and Tuzel (2007) or using the Epstein-Zin-Weil utility function as in Epstein and Zin (1989) and Weil (1989) instead of the Constant Relative Risk Aversion.

Housing Market Risks in the United Kingdom

House prices in the United Kingdom rose rapidly in recent years. The run-up, larger than any other in U.K. history, leveled off early last year. House prices are currently declining at rates faster than those seen in the early 1990's downturn. The housing downturn, however, is far from complete. Using the price-rent ratio as a guide, house prices are likely to fall at least a further 30 percent before leveling off. Given the historic links between housing and real activity, the downturn is likely to be associated with very slow growth. Going forward, we recommend the price-rent ratio as the appropriate measure of housing valuation.

Housing Market Risks in the United Kingdom

House prices in the United Kingdom rose rapidly in recent years. The run-up, larger than any other in U.K. history, leveled off early last year. House prices are currently declining at rates faster than those seen in the early 1990's downturn. The housing downturn, however, is far from complete. Using the price-rent ratio as a guide, house prices are likely to fall at least a further 30 percent before leveling off. Given the historic links between housing and real activity, the downturn is likely to be associated with very slow growth. Going forward, we recommend the price-rent ratio as the appropriate measure of housing valuation.

Money Illusion and Housing Frenzies

A reduction in in‡ation can fuel run-ups in housing prices if people suer from money illusion. For example, investors who decide whether to rent or buy a house simply comparing monthly rent and mortgage payments do not take into account that in‡ation lowers future real mortgage costs. We decompose the price-rent ratio in a rational component -meant to capture proxy eect and risk premia -and an implied mispricing. We …nd that in‡ation and nominal interest rates explain a large share of the time-series variation of the mispricing, and that the tilt eect is unlikely to rationalize this …nding.

House Price Developments and Fundamentals in the United States

This paper discusses the limitations of the price-income ratio, the price-rent ratio, and of affordability measures as indicators of housing market conditions. For the purpose of assessing whether house prices are misaligned, the most sensible approach is to calculate the user cost of ownership and the implied theoretical ratio of house prices to rents, and compare the latter with the observed ratio. On the basis of this methodology, US house prices appear to have departed from fundamentals since 2004, cumulating an overvaluation of between 25 and 30 per cent by the third quarter of 2006.

Mortgage Market Induced Booms and Busts in the Housing Market in a Modified DiPasquale-Wheaton Model

In this paper, we offer a nontechnical pedagogical tool that demonstrates the interrelationship between the mortgage market and the housing market. While the importance of the mortgages in the housing market is well established in the literature, an instructive model is still needed. We present a novel and straightforward extension of the DiPasquale and Wheaton (DPW) model, with a price-rent (PR) ratio that incorporates the loan-to-value (LTV) ratio. In our modified DPW model, the LTV adjusted PR ratio allows for an explicit analysis of the opposing effects of lending gain and risk pricing on the user costs of housing. Moreover, the model highlights how changes in the mortgage market may contribute to booms and busts in the markets for both owner-occupied and rental housing.

China's Urban Housing Reform: Price-Rent Ratio and Market Equilibrium

China's urban housing marketisation hinges on a sensible ratio of housing price to rent. This research derives a rational level for such a ratio and examines its distortions under the Chinese system. It shows that the prevailing housing price to rent ratios are significantly higher than the rational level for both subsidised and free-market housing. Unique Chinese housing market equilibria are analysed and policy recommendations on commercialising Chinese urban housing are suggested.