Assessing High House Prices: Bubbles, Fundamentals and Misperceptions

TLDR

Rapid house‑price growth can stem from fundamental supply‑demand forces or unsustainable bubbles, yet conventional metrics such as price‑to‑rent or price‑to‑income ratios often misrepresent market conditions, making seemingly exuberant markets appear overpriced when they may be reasonably priced. The paper aims to assess whether house prices reflect a bubble or fundamental demand by applying an economically grounded framework. The authors develop an imputed annual rental cost measure, a variant of the user cost of housing, and apply it to 25 years of data across diverse markets to estimate housing‑cost trajectories. The analysis corrects four common fallacies about housing costliness and finds little evidence of a bubble by the end of 2004.

Abstract

How does one tell when rapid growth in house prices is caused by fundamental factors of supply and demand and when it is an unsustainable bubble? In this paper, we explain how to assess the state of house prices—both whether there is a bubble and what underlying factors support housing demand—in a way that is grounded in economic theory. In doing so, we correct four common fallacies about the costliness of the housing market. For a number of reasons, conventional metrics for assessing pricing in the housing market such as price-to-rent ratios or price-to-income ratios generally fail to reflect accurately the state of housing costs. To the eyes of analysts employing such measures, housing markets can appear “exuberant” even when houses are in fact reasonably priced. We construct a measure for evaluating the cost of home owning that is standard for economists—the imputed annual rental cost of owning a home, a variant of the user cost of housing—and apply it to 25 years of history across a wide variety of housing markets. This calculation enables us to estimate the time pattern of housing costs within a market. As of the end of 2004, our analysis reveals little evidence of a housing bubble.