House prices, expectations, and time-varying fundamentals

Paolo Gelain and Kevin Lansing

Journal of Empirical Finance, 2014, vol. 29, issue C, 3-25

Abstract: We investigate the behavior of the equilibrium price–rent ratio for housing in a standard asset pricing model and compare the model predictions to survey evidence on the return expectations of real-world housing investors. We allow for time-varying risk aversion (via external habit formation) and time-varying persistence and volatility in the stochastic process for rent growth, consistent with the U.S. data for the period 1960 to 2013. Under fully-rational expectations, the model significantly underpredicts the volatility of the U.S. price–rent ratio for reasonable levels of risk aversion. We demonstrate that the model can approximately match the volatility of the price–rent ratio in the data if near-rational agents continually update their estimates for the mean, persistence and volatility of fundamental rent growth using only recent data (i.e., the past 4years), or if agents employ a simple moving-average forecast rule for the price–rent ratio that places a large weight on the most recent observation. These two versions of the model can be distinguished by their predictions for the correlation between expected future returns on housing and the price–rent ratio. Only the moving-average model predicts a positive correlation such that agents tend to expect high future returns when prices are high relative to fundamentals—a feature that is consistent with a wide variety of survey evidence from real estate and stock markets.

Keywords: Housing bubbles; Expectations; Excess volatility; Predictability; Time-varying risk premiums; Expected returns (search for similar items in EconPapers)
JEL-codes: D84 E32 E44 G12 O40 R31 (search for similar items in EconPapers)
Date: 2014
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (54)

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Related works:
Working Paper: House prices, expectations, and time-varying fundamentals (2013)
Working Paper: House Prices, Expectations, and Time-Varying Fundamentals (2013)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:empfin:v:29:y:2014:i:c:p:3-25

DOI: 10.1016/j.jempfin.2014.05.002

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