House prices and fundamental value

• Main Authors: KRAINER, John, WEI, Chi Shen
• Format: text
• Language: English
• Published: Institutional Knowledge at Singapore Management University 2004
• Subjects: Residential housing prices; house price bubble; price-rent ratio; housing value; United States; Finance and Financial Management; Real Estate
• Online Access: https://ink.library.smu.edu.sg/lkcsb_research/6777; https://ink.library.smu.edu.sg/context/lkcsb_research/article/7776/viewcontent/HousePrices_el2004_27.pdf
• Institution: Singapore Management University

The performance of the residential housing market over the last ten years has been remarkable. According to the Office of Federal Housing Enterprise Oversight (OFHEO), house prices have appreciated at an annual rate of 5.4% on average (68.9% over the whole time period). Perhaps even more remarkable is that the performance was strong even when economic activity overall was weak. Average annual appreciation rates have been 7.4% (26% in total) since the collapse of the Nasdaq in 2000 and 7.1% (20% in total) since 2001:Q1, the beginning of the 2001 recession. In contrast, since the start of the 2001 recession, the S&P 500 and Nasdaq have averaged negative annual returns of –2.43% and –1.42% respectively. These kinds of statistics have generated an enormous amount of commentary along with suspicions of a house price bubble. At first glance, housing would appear to be just the type of market that is susceptible to systematic mispricings. Most market participants have little experience, making transactions only infrequently. Asymmetric or incomplete information between buyers and sellers about demand and prices is acute. Even with the advent of new technologies, the matching of buyers with sellers remains cumbersome and slow. And unlike other markets, there are no good ways to “short” the housing market if prices get too high. This Economic Letter describes one of the measures commonly used to gauge the fundamental value of housing — the price-rent ratio.We describe the kinds of forces that cause the ratio to move over time and document which forces appear to be most important. We document the way that the housing market typically adjusts to changes in economic fundamentals.