Regime switching and the (in)stability of the price-rent relationship: evidence from the US

Abstract

Present value models of house prices assert that in the absence of self-fulfilling bubbles, a house price is equal to the present discount value of all future rents, which implies a linear relationship between house price and rent, and hence a stable price-to-rent ratio. Using a Markov switching error correction model, we re-examine this relationship in the US housing market and find two distinctive regimes: one with a long-run relation between house price and rent predicted by the present value models and the other in which the relation is nonlinear. Furthermore, we find evidence that deviations of house prices from the present value models' predictions are caused by the overreaction of house prices to movements in rents rather than speculative bubbles attributable to extraneous factors.