FRBSF Economic Letter
2003-06; March 7, 2003
House Price Bubbles
The possibility of a "bubble" in house prices has received
considerable attention lately. To be sure, house price appreciation has
been strong in spite of the slowdown in the economy. From the beginning
of the recession in the second quarter of 2001 through the third quarter
of 2002, house prices rose at an annualized rate of 7%, according to the
Office of Federal Housing Enterprise Oversight (OFHEO). By contrast, in
the comparable period around the last recession in 1990-1991, house prices
rose at a more modest 2% annualized rate.
A key concern about a house price bubble is that gains in housing wealth--either
unrealized gains or gains extracted through home sales or refinancing--may
be partly responsible for the relative strength in consumer spending.
If a bubble exists, and it bursts, causing home prices to fall, then an
important prop for consumption would be gone.
A house price bubble can be defined simply as a deviation of the market
price from the fundamental value of the house. The definition implies,
however, that identifying a bubble as it is developing will not be so
easy, since the fundamental value of a house is generally unobservable.
In this Economic Letter, rather than trying to identify deviations
from a fundamental value, I will adopt two different strategies to evaluate
house prices. The first is to compare the recent price appreciation with
the behavior of house prices in similar stages of past cycles. In this
analysis, I show that house prices continued to grow much later into this
business cycle than in the early 1990s cycle. The second strategy assesses
whether house prices are high relative to their underlying rental value.
This analysis shows that house prices are indeed high relative to rents,
but that only mild declines in house prices and average growth in rents
would be necessary to restore their long-run relationships.
House price dynamics
One important stylized fact of the housing market is that changes in
house prices display strong persistence. It is widely thought that a lack
of persistence is one of the hallmarks of an efficient market. It is not
surprising then that persistence in house price changes is usually explained
by appealing to the frictions in real estate markets. Real estate markets
do not clear immediately after a shock to the economy. It takes time for
buyers and sellers of existing houses to search for each other. And it
takes time for developers to bring new houses to market after an increase
in demand and to work off inventories when demand weakens.
The second interesting feature of the house price data is that it is
unusual to observe declines in nominal prices. In the national data in
Figure 1, we do not observe any nominal declines in year-over-year price
changes over the past 20 years. While real price declines are more common,
and some local markets even experience nominal declines, actual transaction
prices tend to increase during good times and then flatten out during
bad times. A possible explanation for this is that houses serve as both
an investment and a consumption good. If the state of the economy worsens,
but homeowners can still make their mortgage payments, then they can continue
to live in the house and delay selling until a more favorable time. This
point is relevant to our current environment. If the housing market weakens,
then it is more likely that we will see large declines in the volumes
of sales and not necessarily large declines in prices.
The unusual strength of the housing market
House price appreciation over the past several quarters has been high,
despite the recession and the moderate recovery. This strength contrasts
with the behavior of the housing market in the early 1990s when prices
essentially leveled off just as the economy headed into recession.
We can see the unusual strength of house prices in two ways, each of
which helps shed light on the housing market's behavior during the recent
cycle. First, since supply is relatively fixed in the short run, we can
use a measure of housing demand, the user cost of housing capital, to
gauge why demand has been so strong over the past few years. The user
cost can be interpreted as the cost of investing in one more unit of housing
for one period. We will focus on a stripped-down version of the user cost
that includes the after-tax mortgage rate and the expected house price
appreciation, the two components affecting the cost of ownership that
fluctuate most over time. High interest rates raise the user cost, and
thus reduce demand. High expected capital gains reduce the user cost,
and thus increase demand, as capital gains on housing represent a form
Figure 2 shows that the user cost is extremely low (negative) at this
point in the business cycle. To be sure, the rapid fall in interest rates
over the past year has brought down the after-tax mortgage rate. But an
even more important driver of the user cost today is the expected appreciation
rate on housing assets. Demand--and, along with it, presumably, house
prices--has been strong during the recent downturn primarily because house
prices are expected to rise in the future.
This result raises the question of how expectations are estimated. I
estimate expectations of next quarter's appreciation rate with the four-quarter
moving average of past house price appreciation rates. While this approach
is crude and not particularly appealing from a theoretical viewpoint,
it is not a bad predictor of actual house price changes. This is because
there is so much persistence in quarterly house price changes.
The optimism about house prices in the user cost calculations could reflect
several things, including, of course, a bubble. But a non-bubble explanation
could be that people expect lower interest rates or robust income growth
in the future. The main point, then, is that if house prices are to be
justified by fundamental variables, then it is the expectations about
these variables, and not the current values, that explain the strong demand
at this point in the business cycle.
A second way to gauge the extent to which house price appreciation has
been unusual is to look at the relationship between house prices and the
value of the service flow generated by owner-occupied housing. An indicator
of that service flow is the owners' equivalent rent series, which is published
by the Bureau of Labor Statistics (BLS). Figure 3 plots the ratio of the
OFHEO national house price index to the BLS's owners' equivalent rent
index. The horizontal line at 1.27 is the long-run average of the ratio.
Note that a decline in this derived ratio below the average level does
not necessarily indicate declines in the level of house prices. Rather,
declines in the ratio denote periods where rental values are growing faster
than house prices. This derived ratio is an attempt to construct a measure
akin to the P/E ratio so commonly used in stock market analysis (see Leamer
2002). While we believe that house prices and service flow values should
be related, the stability of this relationship is a matter of some debate.
That is, large and long-lived deviations of this series from its average
are not sufficient proof of mispricing or a bubble. However, if there
were indeed a bubble in the housing market, we might expect to see signs
of it in the historical house price/rental value ratio.
As Figure 3 demonstrates, house prices rose faster than rental values
over the past few years, in sharp contrast to the pattern in the 1990-1991
cycle. With the rise in house prices relative to rental rates in recent
quarters, the house price/rental value ratio has moved above its long-run
average, suggesting that house prices are indeed high relative to rents.
How far would house prices have to fall?
One of the convenient features of the house price/rental value ratio
in Figure 3 is that it lends itself nicely to simulations. Therefore,
we can answer the question of how far prices have to fall in order to
force the house price/rental value ratio back to its long-run average.
An instantaneous correction would require house prices to fall by 11%
to restore the long-run relationship between house prices and rental values.
However, such an abrupt correction would be unprecedented for the U.S.
house price series. Following the observation that declines in nominal
house prices are unusual, I hold the house price index fixed at its current
level and allow the rental price index to grow at its average quarterly
rate (approximately 1% per quarter). Under this scenario, the house price/rental
value ratio reverts back to its average level by the fourth quarter of
2005. This scenario implies a period of flat prices for three years, which
is not remarkably different from the five years of slow appreciation in
the early 1990s.
Alternatively, we can look at scenarios where nominal house prices decline
(-1% per quarter and -2% per quarter) and rental values grow at their
average rate. Under these scenarios, the house price/rental value ratio
reverts back to its long-run average by the first quarter of 2004 and
the third quarter of 2003, respectively.
In summary, the house price/rental value ratio does not indicate that
house prices are drastically out of line with their historical relationship
with rental values. Relative balance in the housing market could be restored
without the kinds of declines observed in the NASDAQ or in Japanese property
markets during the early 1990s.
[URLs accessed February 2003.]
Krainer, J. 2002. "House
Price Dynamics and the Business Cycle." FRBSF Economic Letter
2002-13 (May 3).
Leamer, E. 2002. "Bubble
Trouble? Your Home Has a P/E Ratio Too." UCLA Anderson School
Forecast Quarterly Forecast Journal.