What explains house prices?

ARTICLES ABOUT WHAT MOVES HOUSE PRICES

Introduction
50 years ago economists began to draw correlations between the business cycle (fluctuations in GDP growth, interest rate changes, etc) and property prices. What determines changes in property prices? The health of the wider economy and financial conditions seemed good places to start looking.

Initially this seemed a tremendously positive avenue for research, since house prices are cyclical, like so much else in the economy. But what emerged was a composite picture. House buyers are indeed affected by economic growth, inflation, and interest rates, confirming economists’ a priori assumptions. However while house prices are roughly correlated with these growth indicators, the correlation is frustratingly imprecise.

House prices move in smooth, long cycles – unlikely, if they are extremely sensitive to changes in economic conditions. Later research on house buyers’ psychology, conducted 20 years ago, showed that house buyers pay little attention to ‘fundamental’ economic factors and much more attention to recent house prices. What tends to motivate house buyers in period ‘T’ is the behaviour of house prices in period ‘T-1’. Historic prices house therefore moved more to centre stage in econometricians’ work.

More recently, the housing market’s dramatically positive response to lower inflation and interest rates over the past 15 years has made researchers realise that buyers are highly sensitive to nominal interest rates. Previously, economists had tended to assume that real (after inflation) interest rates would be critical. But it emerged that buyers are generally cash-constrained. Reductions in nominal interest rates, and developments in the financial markets, both dramatically increase willingness to buy houses.

The reduction in inflation and interest rates also focused attention on market context - above all on the structure of mortgage products (floating or fixed) in different countries. Different tax rates, subsidies, and demographic developments further complicate the picture.

A very diverse picture emerges. Predictions about housing markets in general are agonizingly hard to make. Research increasingly focuses on understanding the key differences between markets, and their impact on the transmission of changes in economic variables (GDP growth, inflation changes, interest rates changes, etc).

The behaviour of home buyers in boom and post-boom markets
Karl Case and Robert Shiller, November 1988

When making decisions about what should be paid for a house, buyers rely largely on news about recent house prices – i.e., their expectations about price growth in period T, are largely formed by news about house price growth in period T-1. House prices are clearly not ‘efficient’ in the sense of responding to news about housing demand and supply factors.

A long run house price index: The Herengracht Index, 1628-1973
University of Limburg, Piet Eichholtz, August 1996

The longest house price time-series in existence! The Herengracht index records house sales and purchases on Amsterdam’s famous canal from the date of construction (1628) to recently (1973) (4,253 transactions).

So is property a great long term investment? Not for capital growth!
There was only 0.45% per year increase in house prices between 1629 and 1972/3, despite 20-fold nominal price rises. If 1632 had been chosen as the base year, the real increase would have been zero.

Conclusion: In the very long term, house prices tend to rise at the rate of inflation.

Explaining changes in house prices
BIS Quarterly Review, Gregory Sutton, September 2002

Looks at house price increases in US, UK, Canada, Ireland, Netherlands and Australia 1995-2001.

• A 1% increase in GNP growth is associated with a 1% - 4% house price rise after 3 years, an effect especially strong in Ireland.
• A 1% decrease in interest rates is associated with a 1/2% - 1% house price rise after 1 year.
• Higher equity prices produce higher house prices in all countries, but the effect is specially strong in the UK. The authors suggest that this could be because equity price rises forecast GNP growth.

Each effect explains about 7%-15% of house price changes over a 3-year period.

Structural factors in the EU housing markets
European Central Bank, March 2003

The principal factors affecting house price dynamics include:

1. Household incomes
2. Interest rates (real and possibly also nominal)
3. Household formation or other demographic variables
4. Supply side variables;
5. Financial market institutions and credit availability, and
6. Taxes, subsidies and other public policies directly related to housing

Twin peaks in equity and housing prices
BIS Quarterly Review, Claudio Borio and Patrick McGuire, March 2004

Stock market price peaks tend to precede housing price peaks, with a lag of around 2 years, according to this study of 13 industrial countries since the 1970s.

• House price peaks tend to occur in the wake of comparatively strong economic conditions, especially when accompanied by credit and equity price growth (‘financial imbalances’).
• Increases in interest rates, specially nominal interest rates, are of major importance in bringing to a halt rising housing prices.
• The size of the subsequent house price decline is related to the size of the previous increase, as is typical of boom-bust cycles. House price declines are especially large where there have been financial imbalances.

In concluation: equity price peaks have considerable predictive power. An equity peak doubles the likelihood of a subsequent house price peak.

What drives housing price dynamics: cross country evidence
BIS Quarterly Review, March 2004

Interest rates are usually considered centrally important in the determination of house prices, but this article shifts attention to a factor arguably underlying changes in interest rates – changes in inflation.

High inflation:

• raises house prices in the zone of countries characterized by fixed interest-rate mortgages without equity withdrawal (e.g.: Germany), where housing investment is seen as an inflation-hedge.
• has a negative effect on house prices in:
  1. The zone of countries characterized by floating interest rates (e.g.: the UK)
  2. The zone characterized by fixed interest rates with equity withdrawal (e.g.: the US).

In these zones house prices are strongly affected by changes in nominal interest rates.

House prices depend on previous house price rises, economic growth, interest rates, affordability, credit growth, and the current stock of housing supply.

Housing markets and the business cycle
Pietro Catte, Nathalie Girouard, Robert Price and Christophe André, OECD 2004

Three current policy issues - 1. The global house price boom
IMF World Economic Outlook September 2004, Marco Terrones

Looks at the linkages between housing markets and the business cycle in ten OECD countries.

Real house price movements tend to lag cyclical peaks and troughs -- but in ways that differ not only across countries but also from one cycle to another.

These differences appear to be connected both to macro-economic factors (such as inflation variability) but also structural factors. House prices seem to be subject to larger oscillations in countries where housing supply is relatively inelastic and where a favourable tax treatment of mortgage interest encourages the leveraging of housing equity.

Recent house price developments and the role of fundamentals
OECD Economic Outlook No 78, December 2005

The current house price boom is strikingly out of step with the business cycle, contrary to the traditional explanations.

The article points to local factors: “House prices can…be affected by….features that are particular to [a] market. Of note are restrictions on the availability of land for residential housing development that can constrain the responsiveness of supply.” It pinpoints zoning regulations, demographic developments, and financial deregulation in mortgage markets as key factors.

The determinants of house prices in Central and Eastern Europe
Balázs Égert and Dubravko Mihaljek, BIS Working Papers, September 2007-10-21

In eight transition economies of Central and Eastern Europe (CEE), house prices are determined largely by economic fundamentals, plus some transition-specific factors, in particular the institutional development of housing markets and housing finance and quality effects.