Assessing High House Prices: Bubbles, Fundamentals, and Misperceptions

TLDR

Conventional price‑to‑rent and price‑to‑income ratios can mislead because they ignore long‑term interest‑rate dynamics and varying long‑run price growth across markets, especially when rates are low and growth is high. The study builds annual single‑family housing cost measures for 46 U.S. metros over 25 years to assess price levels relative to rents and incomes. These cost measures are derived by combining purchase price, mortgage, taxes, and maintenance costs, then compared with local rent and income data.

Abstract

We construct measures of the annual cost of single-family housing for 46 metropolitan areas in the United States over the last 25 years and compare them with local rents and incomes as a way of judging the level of housing prices. Conventional metrics like the growth rate of house prices, the price-to-rent ratio, and the price-to-income ratio can be misleading because they fail to account both for the time series pattern of real long-term interest rates and predictable differences in the long-run growth rates of house prices across local markets. These factors are especially important in recent years because house prices are theoretically more sensitive to interest rates when rates are already low, and more sensitive still in those cities where the long-run rate of house price growth is high. During the 1980s, our measures show that houses looked most overvalued in many of the same cities that subsequently experienced the largest house price declines. We find that from the trough of 1995 to 2004, the cost of owning rose somewhat relative to the cost of renting, but not, in most cities, to levels that made houses look overvalued.