The Fundamental Determinants Of House Price Developments In Industrial Countries

In order to assess whether the steep increase of house prices in several industrial countries in the last ten years constitutes a house price bubble as often mentioned in the press and public debate we analyse the key fundamental determinants of residential house prices. We argue that the often used historic comparisons of simple ratios like the house price/ rent ratio, the house price/ income ratio or the house price/ construction cost ratio are inadequate measures of over- or undervaluated markets. Instead models should be used that capture the interaction of several fundamental determinants and include the impact of interest rates on house prices. We present three such models: In the Dividend Cash Flow Model (DCF) house prices equal the discounted cash flow of all expected future cash flows. Hence, they result from the interplay between current rent levels, expected future growth of rents, risk free interest rates and risk premia for real estate investments. The Affordability Model shows that house prices developments result from the interaction of nominal income growth and changes of real or nominal interest rates. As a third model we use an econometric approach. Using panel regression technics we show that real house prices depend on real construction cost, real rents, real income, real interest rates and the output gap. We apply all three models for ten industrial countries. For each approach we calculate a range of plausibel estimates of under- respectively overvaluation using several plausible assumptions. Overall we come to the conclusion that in most countries house price developments can be explained to a large degree by fundamental factors. However, a significant overvaluation is shown for UK and slight overvaluations result for the US, the Netherlands and Australia. The German and the Japanes house markets appear undervaluated.