Elizabeth A. La Jeunesse

Massimo Guidolin

English

Research Papers in Economics

November 2005 NationalEconomicTrends
Views expressed do not necessarily reflect official positions of the Federal Reserve System.
R
eal U.S. house prices, on average, have appreciated
by 6 percent annually since 2000, a historically high
rate when compared with the 2.7 percent annual rate
between 1975 and 1999. Certain states have had especially
high average annual rates since 2000: 12 percent in California,
11 percent in Rhode Island, and 10 percent in Nevada, Hawaii,
and Florida. With such high rates of house price growth, many
experts in the press and academic circles have debated whether
we are currently facing a house price bubble.
House price bubbles are characterized by homebuyer expec-
tations of unusually rapid price appreciation. Thus, many buy a
home they consider expensive, in relation to current rental prices,
under the expectation of continued price increases. When buyers
perceive that prices have stopped increasing, however, expecta-
tions normalize and demand falls. House prices fall as the bubble
“bursts.” Economic consequences of a potential housing burst
are especially worrisome. Lower home values reduce home-
owners’wealth, causing significant declines in consumer demand
and thus in GDP. In fact, Case, Quigley, and Shiller (2001) point
out that the elasticity of consumption to housing wealth appears
much higher than the elasticity to stock market equity. History
further indicates that banks’ balance sheets—when proper risk
management strategies are not in place—can be heavily exposed
to price bursts in real estate. For these reasons, policymakers
are keen on trying to identify the presence of a bubble.
Although criteria for detecting a bubble are debatable, we
present a standard indicator of house affordability—
prices divided by per capita income (P/I)—for all states
plus the District of Columbia. (See map.) P/I provides
a better measure than house price appreciation because
it accounts for the evolution of income, a key factor
in housing demand. California, New York, and
Massachusetts, for instance, have high P/I ratios.
According to our calculations of P/I growth rates,
if bubble conditions do exist, they appear only on the
two coasts and in Michigan. Since 2000, for example,
the average P/I ratios for California, Massachusetts,
Oregon, Rhode Island, and New York have been at
least 13 percent above their respective averages for the
1975-99 period. On the other hand, the same 2000-05
P/I measure for Texas, Oklahoma, Mississippi, and
North Dakota has declined by 24 percent below its
average for the 1975-99 period.
Yet, do the P/I ratios observed on the two coasts
constitute a bubble? Note that when real estate is eval-
uated as a potential investment, housing prices should be deter-
mined by discounting the expected flow of income (rents) and
other services using an appropriate risk-adjusted capitalization
rate. Considering the difference between capitalization rates
implied by house price indices and long-term government bond
yields, we find indications against the presence of a bubble.
House price data imply that the spread between capitalization
rates and long-term bond yields has increased from an average
level of 0.7 percent for the period 1975-99 to an average level
of 2.3 percent for the period since 2000. These positive spreads
imply that house prices have in fact remained consistent with
risk-adjusted discounting of future rents. In fact, the spread
has increased substantially in all 50 states (and the District of
Columbia) between the 1975-99 period and the more recent
period since 2000. Even in states that have comparatively low
spreads (e.g., California and Massachusetts), the figure has
remained positive and more than doubled between the two
periods. In conclusion, the evidence in favor of a recent housing
bubble is controversial at best. Ongoing research is struggling
to isolate real house price increases justified by underlying
fundamentals from irrational, possibly harmful, excesses.
—Massimo Guidolin and Elizabeth A. La Jeunesse
1Karl E. Case, John M. Quigley, and Robert J. Shiller, “Comparing Wealth
Effects: The Stock Market versus the Housing Market.” Working Paper No. 8606,
National Bureau of Economic Research, 2001.
research.stlouisfed.org
Bubbling (or Just Frothy) House Prices?
Housing Price Index/Personal Income Per Capita
Average Annual Value, 2000:Q1–2005:Q2
4.55-5.41
5.42-6.22
6.23-7.54
7.55-9.46
9.47-11.43
Consult ALFRED™, our new source of vintage economic data, at research.stlouisfed.org/tips/alfred/.

Bubbling (or just frothy) house prices?

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Bubbling (or just frothy) house prices?

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