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Understanding House Price Dynamics

Understanding House Price Dynamics

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For most homeowners, housing is the single most important component of their nonpension wealth. Therefore, a change in house prices greatly affects the total wealth of many households. Furthermore, movements in house prices can affect people’s lives indirectly. For example, the surge in the number of mortgage defaults and foreclosures during the recent recession was triggered in part by a drop in house prices, and this surge damaged the health of the financial institutions that either directly or indirectly owned mortgage loans. In turn, the deteriorating health of the financial sector was one of the factors contributing to the recession. Naturally, for both policymakers and for people who want to make sound financial decisions, it is important to understand how and why house prices move. In “Understanding House-Price Dynamics,” Makoto Nakajima explains a simple theory that helps us better understand house-price dynamics. The theory — called the user cost-rent equivalence — is based on the close relationship between user costs, which are the costs of owning a house for a year, and rents.
For most homeowners, housing is the single most important component of their nonpension wealth. Therefore, a change in house prices greatly affects the total wealth of many households. Furthermore, movements in house prices can affect people’s lives indirectly. For example, the surge in the number of mortgage defaults and foreclosures during the recent recession was triggered in part by a drop in house prices, and this surge damaged the health of the financial institutions that either directly or indirectly owned mortgage loans. In turn, the deteriorating health of the financial sector was one of the factors contributing to the recession. Naturally, for both policymakers and for people who want to make sound financial decisions, it is important to understand how and why house prices move. In “Understanding House-Price Dynamics,” Makoto Nakajima explains a simple theory that helps us better understand house-price dynamics. The theory — called the user cost-rent equivalence — is based on the close relationship between user costs, which are the costs of owning a house for a year, and rents.

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Published by: Federal Reserve Bank of Philadelphia on Jun 28, 2011
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20 Q2 2011
Business Review 
www.philadelphiafed.org
Makoto Nakajima
 is an economistin the ResearchDepartment of the PhiladelphiaFed. This articleis available freeof charge at www.philadelphiafed.org/research-and-data/publications/.
F
BY MAKOTO NAKAJIMA
Understanding House-Price Dynamics*
*The views expressed here are those of theauthor and do not necessarily representthe views of the Federal Reserve Bank of Philadelphia or the Federal Reserve System.
or most homeowners, housing is thesingle most important component of theirnonpension wealth. Therefore, a change inhouse prices greatly affects the total wealthof many households. Furthermore, movements in houseprices can affect people’s lives indirectly. For example,the surge in the number of mortgage defaults andforeclosures during the recent recession was triggered inpart by a drop in house prices, and this surge damagedthe health of the financial institutions that eitherdirectly or indirectly owned mortgage loans. In turn, thedeteriorating health of the financial sector was one of thefactors contributing to the recession. Naturally, for bothpolicymakers and for people who want to make soundfinancial decisions, it is important to understand how andwhy house prices move. In this article, Makoto Nakajimaexplains a simple theory that helps us better understandhouse-price dynamics. The theory — called the usercost-rent equivalence — is based on the close relationshipbetween user costs, which are the costs of owning a housefor a year, and rents.
The ups and downs of houseprices affect our lives substantially.About two-thirds of U.S. householdsown a house, and for mosthomeowners, housing is the singlemost important component of theirnonpension wealth. Therefore, achange in house prices greatly affectsthe total wealth of many households.For example, if there is a largedrop in the price of a house, thehomeowner is more likely to receiveless money when selling his house inthe future. Under this circumstance,it is probably a sound decision to cutback on household expenditures.House prices are also important forthe one-third of households who arenot homeowners, since many of themare young households that are savingmoney to buy their first house. Higherhouse prices could force many of them to delay or give up their plansto buy a house. Lower house priceshelp young households while hurtinghomeowners.
1
Moreover, the recent recessionseems to suggest that movements inhouse prices also affect people’s livesindirectly. The surge in the numberof mortgage defaults and foreclosureswas triggered in part by a drop inhouse prices. Furthermore, this surgedamaged the health of the financialinstitutions that either directly orindirectly owned mortgage loans,and the deteriorating health of thefinancial sector was one of the factorscontributing to the recession.Naturally, for both policymakersand for people who want to makesound financial decisions, it isimportant to understand how andwhy house prices move. This articlepresents a simple theory that helpsus better understand house-pricedynamics. The theory — called theuser cost-rent equivalence — is based
1
See the
Business Review
article by Wenli Liand Rui Yao for a more detailed analysis of howhouse-price changes affect the consumption andwell-being of American households.
 
on the close relationship between usercosts, which are the costs of owning ahouse for a year, and rents.We’ll start with some observationsabout the housing market, thenreview recent economic research thatanalyzes house-price dynamics. Sinceeconomists are still trying to improvetheir understanding of how houseprices move, there are many theoriesthat explain house-price dynamicsother than the one presented in thisarticle. We will take a brief look atsome of the other theories. Then we’lldiscuss the theory that we focus on inthis article and examine how elementsthat affect house prices, according toour theory, change over time and theimplications of such changes for houseprices. Finally, we’ll carry out a simplenumerical exercise to see what fractionof the recent rise in house pricescan be accounted for by the theorypresented here and by the data.Interested readers are encouragedto look at Wenli Li and Fang Yang'srelated
Business Review
article, whichanalyzes the economic benefits andcosts of homeownership.
SOME OBSERVATIONS ABOUT HOUSE PRICES
The trend of the average houseprice between 1975 and 2009 is shownin Figure 1. This is a
real
index in thesense that the house prices shown inthe figure are relative to the pricesof nonhousing goods and services. Aconstant
real
house price doesn't meanthat the
 nominal
house price (the oneswe see in newspaper ads) is constant;rather, it most likely means that houseprices are, on average, rising at thesame pace as other goods we regularlypurchase. The average house pricerose about 1.5 percent faster thanother prices per year over this period.What is striking about the figure isthat the trend is relatively flat until themid-1990s. Since then, there has beena substantial increase (until the endof 2006) and a substantial drop (since2007). Around the end of 2006, whenthe average house price peaked, houseprices were about 60 percent higherthan their level in the mid-1990s.The recent increase and declinein the average house price have beenaccompanied by similar changes in thehomeownership rate (Figure 2). Thefigure plots both the homeownershiprate (left scale) and the averagereal house-price index (right scale),which was shown in Figure 1. Untilthe mid-1990s, about 64 percent of U.S. households lived in housingthat they owned. But in 2005, thehomeownership rate went up to 69percent and then came down to 67percent. Matthew Chambers, CarlosGarriga, and Don Schlagenhauf find that the increase is an outcomeof demographic changes as well asdevelopments in the mortgage loanmarket, in particular, the proliferationof new types of mortgage loans withlow down-payment requirements andlow introductory rates.Although this article focuses onhow and why the national averagehouse price moves, it is important tokeep in mind that behind the averagehouse-price dynamics, there aresubstantial differences across regionsof the U.S. (Figure 3). The Pacific,New England, and Middle Atlanticregions exhibit the most volatilemovements. On the other hand, theaverage house price in the West-SouthCentral region changed very littlebetween 1975 and 2009. The house-price bubble and subsequent burst thatwe often hear about does not applyequally to all regions of the U.S. Ingeneral, the regions that experienced alarger increase in house prices are alsoexperiencing a larger drop in houseprices. The level of average houseprices in regions with volatile house-price movements is still high comparedwith that in the mid-1990s.House-price dispersion across U.S.
Business Review 
 
2 2011 21
www.philadelphiafed.org
Real House Price Index for the U.S. (1975 = 100)FIGURE 1
806040200120100140160180200
1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 20052008
Index
Data source: Federal Housing Finance Agency
 
22 Q2 2011
Business Review 
www.philadelphiafed.org
cities also increased, and the disper-sion across cities is even larger thanthe dispersion across regions. A studyby Stijn Van Nieuwerburgh and Pierre-Olivier Weill focuses on this increasingdispersion of house prices across U.S.cities. They show that house-price dis-persion across U.S. cities can increasewhen the dispersion of wages acrosscities increases. For example, higherhouse prices in San Francisco reflectthe higher wages earned by people liv-ing in San Francisco.Finally, let's look at the trend of average rents. It is important to knowthe dynamics of rents because, asmentioned above, the theory pre-sented in this article suggests a stronglink between house prices and rents.Figure 4 shows the trend of averagereal rents for primary residences sincethe 1970s. Like average house prices,average rents have gone up since themid-1990s. However, the fluctuationsare much less pronounced. The aver-age annual growth rate of rents is 0.5percent, compared with a 1.5 percentaverage annual growth rate of houseprices. However, we need to be awarethat rents have some measurementissues. In their study, Theodore Crone,Leonard Nakamura, and RichardVoith argue that the growth rate of rents has been higher than the officialdata suggest.
RECENT ATTEMPTS TOUNDERSTAND HOUSE-PRICEDYNAMICS
Because of their obvious impor-tance, particularly in recent years,house-price dynamics have been an ac-tive area of research. Perhaps the mostimportant question is, why did houseprices go up substantially? Theoriesthat attempt to explain rising housingprices can be placed into three groups.The first group of studies dealswith the inflexible nature of hous-ing supply; it takes time to build a
Homeownership Rate and House PriceFIGURE 2Real House Price Index for U.S. Regions(1975 = 100)FIGURE 3
PercentPercent
House Price IndexHomeownership Rate
70200691806816067140661206360651006240648061206001975 19811978 1984 1987 1990 1993 1996 1999 2002 2005 2008
Data source: U.S. Census Bureau and Federal Housing Finance AgencyNote: Homeownership rate is computed by dividing the number of households living in owner-occupied housing units by the total number of households.Data source: Federal Housing Finance Agency
Index
150100500250200300350400450
1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 20052008
East North CentralMiddle AtlanticMountainNew EnglandEast South CentralPacificSouth AtlanticWest North CentralWest South CentralUSA

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