House Prices and Fundamentals: 355 Years of Evidence
Abstract (Via Ambrose, Eichholtz,Lindenthal @SSRN)
This paper examines the long run relation between prices and rents for houses in Amsterdam from 1650 through 2005. We first demonstrate that these series are cointegrated, a necessary condition for studying movements of the rent-price ratio. We then estimate the deviation of house prices from fundamentals and find that these deviations can be persistent and long-lasting. Lastly, we look at the feedback mechanisms between housing market fundamentals and prices, and find that market correction of the mispricing occurs mainly through prices not rents. This correction back to equilibrium, however, can take decades.
Excerpt (Via Ambrose, Eichholtz,Lindenthal @SSRN)
Several lessons can be learned from our analysis. First, house prices and rents are cointegrated, indicating that they are likely to be driven by the same underlying fundamentals. Second, our analysis of the rent-price ratio reveals sustained periods of “bubble” and “crisis” conditions, which can continue without a corresponding correction (or crash). Third, our analysis shows that changes in house prices and rents are both mechanisms for “correcting” imbalances between prices and fundamentals. Between these, prices appear to have greater importance in correcting disequilibria.
Based on these findings, our investigation into the long-run developments of house prices and rents has implications for the current debate over the recent price increases in worldwide housing markets. While it appears that many markets currently have bubble characteristics, our study shows that bubble crashes are not inevitable in the short run. While prices do revert back to fundamentals, this reversion may take decades.
H/T To Finance Professor for finding this