New Study Says Fundamentals, Not Bubbles, Explain Recent Growth of Housing Prices

September 19, 2005 — With memories of large stock market declines still fresh, many pundits and even some economists observing the large increases in housing prices over the past five years, have been quick to declare a bubble. But a new study released today belies this conventional wisdom and finds that most cities in the United States show little evidence of a housing bubble as of the end of 2004.

In a study covering 46 single-family housing markets from 1980 to 2004, Todd Sinai, associate professor of Real Estate at the Wharton School of the University of Pennsylvania; Charles Himmelberg, senior economist at the Federal Reserve Bank of New York; and Christopher Mayer, Paul Milstein Professor of Real Estate, Columbia Business School, confront misperceptions about the underlying drivers behind the decade-old real estate boom. The researchers find that recent growth rates of house prices do not reflect a bubble - and, in fact, are largely explained by basic economic fundamentals such as low interest rates, strong income growth among high-income Americans, and unusually low housing prices in the mid-1990s.

The study, Assessing High Housing Prices: Bubbles, Fundamentals and Misperceptions, finds no evidence that buyers are bidding up the price of houses based on unrealistic expectations of future price increases. The study shows that conventional metrics for assessing the housing market such as price-to-rent ratios or price-to-income ratios ignore the effects of lower real, long-term interest rates, and thus fail to accurately reflect 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 and fairly priced. Amongst the common misperceptions that the study aims to dispel are:

Misperception #1: The rising price of housing
necessarily means that ownership is becoming more expensive The price of a house is not the same as the annual cost of owning a house. The study calculates the actual cost of owning a house relative to rents and incomes, and finds that these ratios were well within historical norms at the end of 2004. Previously, during the mid-1990s, housing prices were actually somewhat undervalued, and at least part of the increase in house prices over the past ten years reflects a return of these valuation ratios to long-run historical norms.

Misperception #2: High house price growth implies a bubble
When the real cost of long-term borrowing is low, as it is today, the study shows that changes in long-term interest rates have a disproportionately large effect on house prices. Thus, given the decline in real, long-term interest rates since 2000, it is not surprising that house prices have risen as much as they have. However, the other side of the coin is that the housing market may be especially vulnerable to unexpected future rises in real, long-term interest rates or negative shocks to local economies.

Misperception #3: The cities with the highest price increases (or the highest price-to-rent ratios) are the most overvalued
In some local housing markets such as San Francisco, Los Angeles, San Diego, New York, and Boston, house price growth has exceeded the national average rate of appreciation for at least 60 years. In cities with higher long-term rates of price appreciation, the annual cost of owning is lower, hence house prices should be higher (relative to rents or incomes). At the same time, house prices in high-priced cities are more sensitive to real, long term interest rates because interest expense is a higher fraction of annual ownership costs.

In sum, the study concludes that the current U.S. housing values are consistent with strong economic fundamentals. The reduction in ownership costs caused by lower real, long-term interest rates, in particular, has largely offset the rise in housing prices. However, the study also cautions that when real, long term interest rates are already low, further changes in rates can have a disproportionately large impact on the housing market. An unexpected rise in real interest rates or a negative shock to household incomes could cause house prices to decline. But this fact does not mean that today houses are systematically mis-priced.

Assessing High House Prices: Bubbles, Fundamentals and Misperceptions:* Todd Sinai, Associate Professor of Real Estate, Wharton School Charles Himmelberg, Senior Economist, Federal Reserve Bank of New York Christopher Mayer, Paul Milstein Professor of Real Estate, Columbia Business School

*The views expressed in the paper are solely those of the authors and are not necessarily reflective of views at the Federal Reserve Bank of New York or the Federal Reserve System.