House prices in Spain: is the evidence of overvaluation robust?

Since late 1997 house prices in Spain have grown by around 150% in nominal terms. In real terms, the increase has exceeded 100%. Changes on such a scale in a variable that is important for analysing the situation and outlook for any developed economy warrant per se investigating which factors explain these movements. As a starting point, it should be pointed out that the rises observed in property values in the recent past are not, despite their intensity, a one-off episode in the historical trajectory of our economy. And nor is this the case when they are compared with recent developments in other countries such as the United States, the United Kingdom or Ireland, among others. The rise in house prices in Spain has run in parallel with a series of substantial changes in variables such as interest rates, household income, employment and demographics, to cite a few, whose behaviour influences property values. Under these conditions it is worthwhile disentangling the causes behind the marked property market boom and, in particular, the extent to which this may be explained by changes in the fundamentals of residential asset prices. Only thus may the future outlook for the market be evaluated in greater depth. Specifically, a distinction should be drawn between three possible alternative hypotheses, with widely different consequences in terms of the most likely future course of property prices and, therefore, of the foreseeable behaviour of the main macroeconomic and financial magnitudes that depend on them. According to one hypothesis, the growth of house prices would be fully determined by the trend of its long-run fundamentals, such as income, interest rates and demographic variables. Under these conditions, property prices would be in equilibrium and additional changes therein would not be expected unless there were fresh changes in their fundamentals. Assuming likewise that the changes in house prices have responded to changes in their fundamentals, one possible alternative is that the level reached stands temporarily above its longrun value as a consequence of the existence in this market of specific rigidities that prevent supply from reacting immediately to an expansion in demand. In this case, there would be an excessive response in the short run by prices which, subsequently, would autonomously move onto a trajectory returning them gradually to equilibrium. It is in these circumstances that there may be said to be overvaluation in the market and, consequently, a gradual adjustment of prices may be expected even if the fundamentals were to hold stable. Finally, there is also a theoretical possibility that, irrespective of the changes caused by alterations to their fundamentals, house prices may increase as a result of the firming of expectations about future property price rises. By fuelling speculative demand, such expectations would ultimately be self-fulfilling. In this case, property prices would not only stand above their equilibrium level but would likewise outpace the adjustment path level proper to an overvaluation episode. It is at that point that mention of a bubble is warranted and, therefore, when a sudden change of expectations prompting an abrupt adjustment may be considered significantly likely. To compare the likelihood of these three alternative hypotheses requires the use of formal statistical methods. Indeed, papers in the past few years have analysed the recent behaviour of house prices in Spain from different analytical approaches which, essentially, may be grouped into two major blocks. On one hand are the macroeconomic-type models in which, along the lines laid down in Poterba (1984), house prices are approximated as a function of the variables which determine the supply of and demand for housing in a similar fashion to any durable good. On the other are financial-type models in which, as in Case and Schiller (1989), property is modelled as an asset that generates future income flows - in the form of rents or accommodation services - and whose equilibrium price may be derived through conventional valuation techniques under non-arbitrage conditions. In both cases, however, the emphasis has traditionally been placed (as Table 1 shows) on evaluating the discrepancy between observed house prices and their theoretical long-run equilibrium prices. Indeed, the studies cited coincide in identifying a positive difference between both variables at the end of the sample used. However, only in certain cases has an attempt been made to compare real data with a level that would be consistent with a gradual adjustment path towards equilibrium. As seen, this latter comparison is crucial for being able to distinguish between overvaluation and bubble situations. In this latter group is the paper by Ayuso and Restoy (2003) which, using a very specific and stylised valuation model, offered evidence in favour of the overvaluation hypothesis. This article extends the Ayuso and Restoy (2003) paper in two directions. First, it considers a reasonably broad set of asset valuation models, allowing the robustness of the results to be tested against more flexible approaches to the problem. Further, it studies the stability of the conclusions obtained when tax considerations, which were absent from the original paper, are brought into the analysis. The following section briefly summarises the main characteristics of the financial approach and the results in Ayuso and Restoy (2003). The third section then tests the robustness of these results when alternative asset valuation models are estimated. The fourth section studies the sensitivity of the models to tax considerations. Finally, the main conclusions are drawn.