How Can One Tell When the Housing Market Is Out of Equilibrium?

Abstract

Purpose -One way of detecting departures from equilibrium is by comparing house prices and rents. Here I assess the viability of this approach.Design/methodology -Error-correction models (ECMs) based on price and rent indexes can be used to forecast movements in house prices. The short-term forecasting ability of ECMs is limited though due to the long persistence of departures from equilibrium. ECMs also suffer from the limitation that they do not tell us whether the price-rent ratio is above or below its equilibrium level at any given point in time. To answer this question it is necessary to make cross-section comparisons of prices, rents and user cost (i.e., the cost incurred by owning a house). Findings -A meaningful cross-section comparison requires that prices and rents are quality adjusted.This may require the use of hedonic methods. The equilibrium price-rent ratio (which is derived from the user cost) is difficult to compute since it depends on the expected capital gain. Also, both the actual and equilibrium price-rent ratios differ depending on which segment of the housing market is considered.Originality/value -The housing market, which is prone to booms and busts, can very significantly affect the rest of the economy. Hence it is important that central banks and governments can detect when the housing market is out of equilibrium. I show here how difficult it is to detect such departures.