House prices: fundamentals do matter

Across North America and much of Europe, countries have experienced record highs in house price to income ratios. To what extent have common factors driven this trend? A new paper by Kieran McQuinn and Gerard O'Reilly at the Central Bank of Ireland proposes A Model of Cross-Country House Prices. The authors find that despite substantial national differences, capacity to borrow - as reflected by income and interest rates - has been a common driver of house price increases:

In this paper we propose that a cross-country house price demand schedule can be adequately represented by a price suggested by the average amount that can be borrowed in each country with the latter being determined by current disposable income levels and interest rates.

Rising incomes and low interest rates have fuelled the housing boom:

The model is applied to a panel of 16 OECD countries from 1980 to 2005 using both single country-by-country and panel econometric approaches. Our results support the existence of a long-run relationship between actual house prices and the amount individuals can borrow and we find plausible and statistically significant adjustment, across countries, to this long run equilibrium.

A nice piece of work, on which others can build.

Comments

[Arthur Eckart]

Over the U.S. housing boom, the U.S. homeownership rate rose from roughly 67% to only 69%. It seems doubtful the U.S. homeownership rate will fall much in a U.S. housing bust, given Census, Treasury, and Fed data (Treasury data first two links below and Fed data next two links).

http://www.ustreas.gov/press/releases/hp529.htm

http://www.ustreas.gov/

http://research.stlouisfed.org/publications/net/

http://research.stlouisfed.org/publications/mt/

[Taggert Brooks]

It seems they miss an important factor in the current environment. The willingness of banks to take on clients they previously would not have. The so called sub prime boom market is really just an increase in willingness to lend given an interest rate and income level, or what the authors call an ability to borrow. Many more people were able to borrow during this boom, thus further fueling the home price appreciation. I do not know if that was an international phenomenon, and I'm not sure I could immediately produce a variable which captures that idea.

[Arthur Eckart]

Taggert, I suspect, "financial innovation" wasn't included to avoid multicollinearity. Also, Census data show U.S. home prices haven't appreciated substantially more or less in the 2000s than in prior decades. Moreover, data suggest, home improvements increased the value of houses more than demand for houses exceeding supply.

[Arthur Eckart]

Also, I may add, income and interest rates, in general, seem to be the two most powerful factors that determine house prices, although location, condition, taxes, etc. also influence house prices. The link below (of U.S. data) states: "remodeling expenditures by home owners and rental property owners totaled $233 billion in 2003, accounting for 40% of all residential construction and improvement spending..."

http://www.jchs.harvard.edu/publications/remodeling/remodeling2005.pdf