House Prices, Fundamentals and Bubbles

TLDR

Housing makes up a large share of household portfolios, and because arbitrage is limited, corrections toward fundamental value are expected to be slow. The study compares actual UK house prices with their fundamental values using a time‑varying present‑value approach. The analysis finds no evidence of an explosive rational bubble, shows that intrinsic bubbles significantly affect prices, and that price movements are largely driven by momentum.

Abstract

Abstract: This paper studies actual (real) house prices relative to fundamental (real) house values. Such a focus is warranted since housing constitutes a large fraction of most household portfolios, and its characteristics are such that, in contrast to what prevails in financial markets, arbitrage will be limited and hence correction toward ‘true’ value is likely to be a prolonged process. Using UK data and a time‐varying present value approach, our results preclude the existence of an explosive rational bubble due to non‐fundamental factors. We further find that intrinsic bubbles have an important role to play in determining actual house prices although price dynamics appear to impact, particularly in periods of strong deviation from fundamental value. Price dynamics are found to be driven by momentum behaviour.