If Isaac Newton were alive today, he probably wouldn’t need to have an apple fall from a tree and crash on his head to discover the concept of gravity. A cursory look at the behavior of house prices in industrial countries over recent decades would surely have inspired him to conclude that what goes up, must come down.
Periods of prolonged rises followed by protracted falls are a surprisingly common feature of house prices in industrial countries. In a new study of house prices that I wrote with several of my former colleagues at the U.S. Federal Reserve Board, we identify no fewer that 44 episodes of house price booms and busts in industrial countries since 1970. Given the eye-popping gains in house prices in Ireland over the past decade, the foreign experience is particularly relevant.
Our study shows that certain financial conditions, such as low interest rates and financial deregulation, are usually present in past house price surges, though other factors such as demographics and buoyant income growth also help explain these booms.
We also looked at the relationship between house prices and rents across countries. Previous Fed research has shown that comparing houses price and rents provides a useful benchmark for valuing housing, in the same way that the ratio of stock prices to dividends is commonly used to measure valuation in the stock market. Put simply, rents are a key determinant of the value of housing and as such should not move too far out of line with prices. House prices that are unusually high relative to rents may indicate that housing is overvalued.
Interestingly, price-rent ratios are currently at historical highs in several foreign countries, including Australia, the United Kingdom, and the United States. In each of these countries, prices have risen sharply relative to rents since the mid-1990s; in the United Kingdom, for example, the price-rent ratio has roughly doubled over the past decade.
What would this approach say about the valuation of housing in Ireland? Ireland’s price-rent ratio is currently higher than at any time for which we have reliable data, having soared since early 2002 as rents began to decline. In the first quarter of 2005, the average price paid for a house nationally was about €256,000 and the average annual rent, according to estimates by Davy Stockbrokers, was €8,800. The resulting price-rent ratio of 29 stood roughly 2½ times above its level in 1996! The price-rent ratio in Dublin is currently further above its trend level than in either in London or New York.
The jump in Ireland’s price-rent ratio doesn’t necessarily mean that housing is overvalued. High price-rent ratios can be justified by low interest rates, and therefore at least some of the increase in prices relative to rents can be explained by the drop in interest rates over recent years. It is an open question, however, whether all of the run-up in prices can be attributable to lower interest rates.
Demographic factors are often cited as a factor driving Irish house prices. The bulge in population of young Irish adults and large inflows of migrants are undoubtedly factors that are boosting the demand for housing. However, it is not clear that these factors should have a greater effect on house prices than
Importantly, the foreign experience shows that when elevated price-rent ratios eventually decline to their historical average, the adjustment is brought about by falls in prices, not by increases in rents. Looking ahead, it is certainly true that the price-rent ratio is not a good predictor of house prices over the next year or two. Most indicators suggest that red-hot demand for houses continues to support gravity-defying house prices. But the price-rent ratio has proven its worth as a predictor of future house prices over longer forecast horizons. So as we sit in our back gardens staring up proudly at our sky-high priced homes, we would be well-advised to watch out for falling apples.
This article was also published by The Sunday Independent.