Most of the public concern about housing markets is based on claims that house prices have increased at historically anomalous rates and that house prices have outpaced incomes. The first claim is based on inaccurate historical data. The second is linked to relaxed credit constraints. House prices are likely to fall further, but not for the reasons usually proposed.Housing - Prices

François Ortalo-Magné

Morris A. Davis

Peter Rupert

English

Research Papers in Economics

What’s Really Happening in Housing Markets?
by Morris A. Davis, François Ortalo-Magné, and Peter Rupert
July 2007
ISSN 0428-1276
Recent trends in house prices have 
induced a certain amount of hand-
wringing among leading econo-
mists, policymakers, and bloggers of 
some repute. In the eight-year boom 
ending sometime last summer, they 
warned that house prices were ris-
ing much faster than ever before, and 
that such appreciation was unwar-
ranted. As a consequence, these com-
mentators are predicting that prices 
will fall, perhaps disastrously so. 
According to the most widely cited 
historical data on house prices (com-
piled by Robert J. Shiller for the 2005 
edition of his book, Irrational Exu-
berance), house prices were roughly 
ﬂ  at from 1890 to 1997 (after adjust-
ing for inﬂ  ation), but since 1998, they 
have climbed 6 percent per year in 
the aggregate. Adding to analysts’ 
sense of trouble is that the rate of 
house-price appreciation over the 
boom has varied widely across the 
United States. The more populated 
coastal states, such as California and 
Florida, have experienced nominal 
gains on the order of 10 percent per 
year, whereas prices in Midwestern 
and interior states, like Michigan and 
Nebraska, appreciated approximately 
4 percent per year. The acceleration 
of prices in the aggregate reﬂ  ects the 
fast growth of house prices in the 
coastal states, so the argument goes, 
but because growth in house prices 
has outpaced the growth of residents’ 
income in these states, analysts argue 
that the rise in house prices is not sup-
ported by economic “fundamentals.” 
Their observations imply that house 
prices on the coasts, and therefore in 
the aggregate, should fall to be more 
in line with income and fundamentals. 
But there is a problem with the data on 
which these projections rest. They are 
inaccurate in a particularly important 
period—the 1970s, a decade which, 
as it turns out, does offer a precedent 
for the current situation. A different 
source of data on housing prices sug-
gests that a housing boom similar to 
the 1998-2006 boom occurred some-
time between 1970 and 1980. 
As for what might be behind the latest 
housing boom, two reasonable expla-
nations spring to mind. One has to do 
with the price of land, and the other 
with relaxed credit constraints. 
The value of the land on which a 
house sits contributes a part of the 
total price of a home. While housing 
structures are reproducible with little 
additional cost, land is in ﬁ  xed sup-
ply. To understand changes in house 
prices, it is necessary to study the 
price of residential land. Data indicate 
that the real price of land has been 
marching steadily upward since 1950. 
If the 1998–2006 boom to house 
prices reﬂ  ects demand for housing-
related amenities, then the data on 
land prices argue that this boom is a 
continuation of earlier trends. 
Relaxed credit constraints could 
explain the outpacing of house price 
appreciation to incomes. House 
prices can and should be expected to 
surge if credit constraints are unex-
pectedly relaxed for ﬁ  rst-time home-
buyers who are credit or down-pay-
ment constrained. This surge can 
occur even when incomes remain 
constant; when credit constraints 
change over time, incomes and 
house prices should not be expected 
to increase at the same rate. 
 Historical Housing Prices 
Until recently, the only long time 
series of house prices for the United 
States had been compiled by Shiller 
(2005). Shiller constructs this series 
by splining together available 
house price data from 1890–1934 
from Grebler, Blank, and Winnick 
(1956), the home-purchase compo-
nent of the CPI-U from 1953–1975, 
the OFHEO from 1975–1987, and 
the Case-Shiller-Weiss index from 
1987–2005. To ﬁ  ll in the gap, Shiller 
constructs an index of house prices 
from 1934 to 1953 by compiling data 
on the sales price of houses from 
ﬁ  ve major cities based on newspa-
per advertisements. These data, after 
adjusting for consumer price inﬂ  a-
tion, show almost no trend increase 
in house prices until about 1997, lead-
ing Shiller and others to conclude that 
the boom to house prices from 1998–
2006 is historically anomalous. 
But there are reason to believe the 
Shiller series is inaccurate for the late 
1960s and early 1970s—a period for 
which his data source was the CPI-U. 
John Greenlees (1982) ﬁ  rst reported 
that the home purchase component 
Most of the public concern about 
housing markets is based on claims 
that house prices have increased at 
historically anomalous rates and 
that house prices have outpaced 
incomes. The ﬁ  rst claim is based on 
inaccurate historical data. The sec-
ond is linked to relaxed credit con-
straints. House prices are likely to 
fall further, but not for the reasons 
usually proposed.
Federal Reserve Bank of Clevelandof the CPI-U is signiﬁ  cantly biased 
down—a result of the methodol-
ogy used to extract the housing data. 
But Shiller does not correct for the 
bias when he incorporates the CPI-U 
housing prices into his series.
Davis and Heathcote (2006) have 
compiled a long time series of con-
stant-quality house prices by reconcil-
ing decade-by-decade changes in the 
aggregate market value of housing 
(based on micro data from the Decen-
nial Census of Housing) with year-by-
year data on residential investment, 
as published in the National Income 
and Product Accounts (NIPA). 
Although the Shiller series and Davis 
and Heathcote series differ in every 
decade, the most pronounced differ-
ence between the two series occurs 
in the 1970s (see table 1). The Davis 
and Heathcote data show a real aver-
age annual rate of appreciation just 
shy of 4½ percent per year, whereas 
the rate of growth of the CPI-U in 
that decade is less than 2 percent per 
year. If the Davis and Heathcote data 
are to be believed, the boom to house 
prices in 1998–2006 in the aggregate 
has a close historical precedent in 
1970–1980. 
 Land Prices 
Housing prices are based on two com-
ponents of the house, land and struc-
ture. Because increasing the quantity 
of structures is less costly than increas-
ing the quantity of “good” residential 
land, any change in the price of hous-
ing will largely come from an increase 
in the demand for land. By “good” we 
mean land with short commutes, low 
crime, or other desirable amenities. 
On average in the United States, the 
price of land used for residential pur-
poses has been rising rather steadily 
since the 1950s (see ﬁ  gure 1).1 
Because the price of land has been 
rising faster than the cost of struc-
tures, land has become a larger pro-
portion of the housing price. This pro-
portion is quite different in different 
cities across the United States, how-
ever. If land’s share of house prices is 
high in a location, then an increase in 
the demand for land will have a large 
effect on the price of the house (land 
plus structure). Conversely, if land 
is a small component of the overall 
price, then an increase in the demand 
for land will have only a small effect 
on housing prices. What this means 
is that observing housing prices alone 
can mask the increase in demand for 
certain locations. 
Changes in the price of land have 
been large, not only in the coastal cit-
ies, but in many of the interior cit-
ies as well (see table 2). Indeed, the 
growth in land prices in St. Louis 
has far outpaced that in New York, 
Boston, and San Francisco. The 
increase in land prices in Minneapo-
lis is roughly the same as that seen in 
New York City. Of course, the price 
of land did not appreciate this rapidly 
for every city in the United States. 
Four cities located in the Fourth Fed-
eral Reserve District were included in 
the study from which table 3 is taken, 
and three of these did not see a pro-
nounced change to the price of devel-
oped residential land, the exception 
being Pittsburgh.
The evidence suggests that for the 
price of land—the component of 
housing that is in ﬁ  xed supply—the 
1998–2004 period was not a time of 
unprecedented growth. In addition, 
although the growth of housing prices 
took place mainly on the coasts, this 
is largely because land is a much 
more scarce resource on the coasts, 
land is a larger share of the house 
price, and house prices on the coasts 
more closely track the price of land. 
The price of land, in contrast, rose in 
most of the 46 cities studied. We see, 
then, that the boom was widespread 
across the United States (not just on 
the coasts), and probably reﬂ  ects a 
continuation of demand-side pressure 
FIGURE 1  NATIONAL HOUSE AND LAND PRICE INDEXES, 
 1950–2000
TABLE 1  ESTIMATES OF REAL GROWTH IN HOUSING PRICES 
  ANNUALIZED REAL RATE OF CHANGE)
Decade
Shiller 
2005
Davis and Heathcote 
2006
1950–1960 0.23 0.10
1960–1970 0.11 0.62
1970–1980 1.79 4.35
1980–1990 0.63 1.32
1990–2000 0.81 1.01
2000–2006 x 6.60
Source: Davis and Heathcote (2006).
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000
10.0
5.0
4.0
3.0
2.5
2.0
1.5
1.0
0.5
USA long structures cost index
1950=1.0
USA long land price index
USA long house price indexfor housing that may have origins as 
early as 1950.
 Credit Constraints and Prices 
Any change in the ability to purchase 
a home, such as from innovations in 
the lending environment, can have a 
large impact on the level and vola-
tility of housing prices. In a world 
where ﬁ  rst-time home buyers face 
binding constraints and housing is in 
ﬁ  xed supply, prices can vary without 
any changes in income. Two com-
mon constraints faced by homebuyers 
are that a mortgage payment cannot 
be any larger than a given fraction of 
income and that a homebuyer must 
put down equity in the house of no 
less than a certain percentage. 
The best way to see the impact of a 
change in constraints on house prices 
is through a simple example using a 
change in the down payment require-
ment. Consider the case where starter 
homes cost $100 and the down-pay-
ment requirement is 10 percent. 
Households need to save $10 in order 
to purchase a home. At any point in 
time, there are a number of house-
holds that are working toward this 
objective and that will have accumu-
lated savings ranging between $0 and 
$10. If the down-payment require-
ment is suddenly reduced to 5 per-
cent, then all households with sav-
ings between $5 and $10 can afford 
a starter home assuming the price 
remains ﬁ  xed at $100. However, if 
more starter homes cannot be built 
instantaneously, and the price remains 
ﬁ  xed at $100, then more people will 
be able to purchase starter homes than 
the number of starter homes that are 
available to be purchased. Given no 
new starter homes are built, a require-
ment for the market for starter homes 
to clear—that is, the number of sell-
ers of starter homes equals the num-
ber of households that can afford to 
buy—is that only households with 
savings of $10 are able to buy a home 
of their own. With the required down 
payment set at 5 percent, the price 
of starter homes must rise to $200—
because 5 percent of $200 is $10. 
As Ortalo-Magné and Rady (2006) 
noticed, the effects on the housing 
market do not end with the increase 
in the price of starter homes. This is 
because many who of those who own 
starter homes would have bought 
more expensive homes if they had 
not been constrained by their abil-
ity to obtain credit. As the price of 
their starter home increases, they 
enjoy capital gains; in the previous 
example, the capital gains would 
equal $200 – $100 = $100. These 
capital gains enable them to trade 
up to a more expensive house. The 
fact that all owners of starter homes 
enjoy signiﬁ  cant capital gains, by the 
same reasoning as before, pushes up 
the demand for, and price of, more 
expensive homes. 
The key take-away from this rea-
soning is that changes to credit con-
straints directly map to changes in 
house prices when housing is in 
relatively ﬁ  xed supply. If housing is 
not in relatively ﬁ  xed supply, then 
a change in credit constraints might 
lead to more new housing and rela-
tively small changes in house prices. 
The fact that house prices outpaced 
income in the coastal areas and not 
in the interior could very well reﬂ  ect 
a combination of two factors: The 
relaxation in credit constraints that 
may have occurred everywhere, and 
the fact that new housing is relatively 
hard to build in many places on the 
coasts and is more easy to build in the 
so-called “ﬂ  y-over” states. 
 What’s Next?
House prices may still fall in the 
future, but for a different reason than 
most analysts seem to realize. To 
start, the change in credit constraints 
discussed above will cause house 
prices ﬁ  rst to rise but then to fall. 
The process centers around the fact 
that, assuming credit constraints do 
not change again, the price of starter 
homes will remain ﬂ  at. New starter-
home owners will therefore have little 
or no capital gains to use to ﬁ  nance 
the purchase of a more expensive 
trade-up home. The fact that these 
homeowners have no capital gains 
implies that, relative to the previous 
cohort of expensive-home buyers, 
they have relatively low down-pay-
ments to apply to the purchase of 
their more expensive trade-up homes. 
Since the equilibrium price of expen-
sive homes is directly linked to the 
down-payment, low down payments 
(relative to the previous set of expen-
sive-home buyers) will drive down 
the price of these homes. Second, 
private mortgage originators have 
announced substantial changes to 
their subprime variable-rate mortgage 
programs, which are likely to result 
TABLE 2  LAND’S SHARE IN 1998 AND REAL GROWTH IN
  HOUSE AND LAND PRICES FROM 1999–2004
Real cumulative percent 
increase, 1999–2004
Land’s share, 1998 Home values Land values
Coastal cities
Boston 0.60 81.2  128.6
Los Angeles  0.65 96.9  139.0
New York City 0.44 92.4  192.3
San Francisco 0.81 73.5  89.4
Other interior cities
Houston 0.19 25.4  107.2
Milwaukee 0.33 35.5  90.7
Minneapolis/St. Paul  0.25 59.6  190.8
St. Louis  0.12 34.4  233.1
Fourth District cities
Cincinnati 0.34 20.8 41.0
Cleveland 0.36 17.1 33.0
Columbus 0.39 18.9  29.6
Pittsburgh 0.13 22.8  153.0
Source: Davis and Palumbo (2006).Morris A. Davis is an assistant pro-
fessor at he University of Wiscon-
sin-Madison School of Business, 
François Ortalo-Magné holds the 
Robert E. Wangard Chair in Real 
Estate at the University of Wiscon-
sin-Madison School of Business, 
and Peter Rupert is a research advi-
sor at the Federal Reserve Bank of 
Cleveland.
The views expressed here are those 
of the authors and not necessarily 
those of the Federal Reserve Bank 
of Cleveland or the Board of Gover-
nors of the Federal Reserve System 
or its staff. 
Economic Commentary is published 
by the Research Department of the 
Federal Reserve Bank of Cleveland. 
To receive copies or be placed on 
the mailing list, e-mail your request 
to 4d.subscriptions@clev.frb.org or 
fax it to 216.579.3050. 
PRSRT STD
U.S. Postage Paid
Cleveland, OH
Permit No. 385
Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101
Return Service Requested:
Please send corrected mailing label to the 
above address.
Material may be reprinted if the source is 
credited Please send copies of reprinted 
material to the editor.
in the sharply curtailed availability of 
this type of credit. Using exactly the 
same reasoning as before, tightening 
credit standards will cause the price 
of starter homes to fall, thus reducing 
the wealth of the current owners of 
starter homes, which will itself trigger 
a chain-reaction decline in the price 
of trade-up homes. 
 Footnotes
1. The price of farm land, on aver-
age in the United States, has also been 
increasing since 1950 at an average 
annual real rate of 1.9 percent per 
year.  However, unlike the price of 
land used for residential purposes, the 
price of farm land peaked in 1982, 
declined sharply until 1994, and then 
increased again from 1994–2006, 
such that the inﬂ  ation-adjusted price 
of farm land did not return to its 1982 
level until 2005.  See the USDA web 
site  http://www.ers.usda.gov/Brief-
ing/LandUse/aglandvaluechapter.htm 
for details.
 Recommended Reading
Karl E. Case and Robert J. Shiller. 
2003. “Is There a Bubble in the Hous-
ing Market? An Analysis,” Brookings 
Papers on Economic Activity, vol. 2, 
pp. 299–342. 
Morris A. Davis and Jonathan Heath-
cote. 2006. “The Price and Quantity 
of Residential Land in the United 
States,” Journal of Monetary Eco-
nomics, forthcoming. 
Morris A. Davis and Michael G. 
Palumbo. 2006. “The Price of Residen-
tial Land in Large U.S. Cities,” Journal 
of Urban Economics, forthcoming. 
François Ortalo-Magné  and Sven 
Rady. 2006. “Housing Market 
Dynamics: On the Contribution of 
Income Shocks and Credit Con-
straints,” Review of Economic Stud-
ies, vol. 73, no. 2, pp. 459–85. 
John S. Greenlees. 1982. “An Empiri-
cal Evaluation of the CPI Home Pur-
chase Index, 1973–1978,” Real Estate 
Economics, vol. 10, pp. 1–24 .
Robert J. Shiller. 1982. “Consump-
tion, Asset Markets and Macroeco-
nomic Fluctuations,” Carnegie-Roch-
ester Conference Series on Public 
Policy, vol. 17, pp. 203–38.
Robert J. Shiller. 2005. Irrational 
Exuberance, 2nd Edition, Princeton: 
Princeton University Press. 
Robert J. Shiller. 2006. “Long-Term 
Perspectives on the Current Boom 
in Home Prices,” The Economists’ 
Voice, vol. 3, no. 4, Article 4.

What’s really going on in housing markets?

http://www.clevelandfed.org/research/Commentary/2007/07.pdf

What’s really going on in housing markets?

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics