The Changing Relationship between UK Home Prices and Rents

Abstract

The present value models of house prices predict that house prices andrents are related via a stable price-to-rents ratio, as house prices areequal to the present discounted values of future rents. The prolongeddivergence of the UK house prices from rents since the mid-1990s hasput into question the stability of the price-rents relation. In this paper, wereexamine the changing relationship between house price and rents using aMarkov-switching error correction model, and we find two distinctregimes in the price-rents relation. In one regime, which is identifiedmainly in the pre-1988 era, the long-run equilibrium relationshipcorresponds to the prediction of the present value models, i.e., the stableprice-to-rents ratio. The other regime, prevailing since 1988 forward,also involves a stationary price-rents relation. As such, this regime is notcharacterized with speculative bubbles. However, the long-run relation inthis regime is difficult to explain by the present value models, and theidentified regime period exhibits a long swing in the price-rents ratio.