This study aims to determine whether there is a long-run relationship between house prices and rents in US cities. This long-run relationship has been implied by formal asset-pricing models but has often been difficult to find empirically.
The author examines this question with a brand-new data set on house prices and rents compiled by researchers at the Philadelphia Fed, which has overcome some previous measurement problems of previous indices, among them an underestimate of rent growth. The author also allows for structural breaks in the relationship, while previous studies had imposed parameter constancy.
While previous, flawed measures indicated a large difference in geographical dispersion between house prices and rents, the new indices show only a slight difference in such spatial variation. Importantly, while using standard testing methods yields little evidence of a long-run relationship between prices and rents for most cities, allowing for breaks with the Lee–Strazicich test reveals such a long-run relationship in most markets.
Given the existence of a long-run relationship, high levels of home prices relative to rents are still indicative of housing market froth.
To the best of the author’s knowledge, this is the first study on this topic that uses this new data set, which has been specifically developed to overcome the deficiencies of previous house price and rent indices. It is also among very few that allow for structural breaks in the price-rent relationship, which is important given the numerous changes in the US housing market over recent decades, such as securitization and more widely available credit.
