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ERES Conference 15-18 June, 2011, Eindhoven The Adjustment of Housing Prices Towards the Housing Market No-Arbitrage Relation. By Elias Oikarinen. Background. Housing market no-arbitrage relation gives the asset market equilibrium for housing prices

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ERES Conference15-18 June, 2011, EindhovenThe Adjustment of Housing Prices Towards the Housing Market No-Arbitrage Relation

By

Elias Oikarinen

background
Background

Housing market no-arbitrage relation gives the asset market equilibrium for housing prices

In practice, long-lasting deviations from the no-arbitrage relation have been perceived in a number of countries

The adjustment process towards the no-arbitrage relation is a central question regarding the dynamics and predictability of housing markets

 of importance to households, construction companies, investors and to economic policy makers

Nevertheless, empirical research on the adjustment towards the no-arbitrage relation is limited

aim of the study
Aim of the Study

To examine empirically the adjustment towards the no-arbitrage relation in the Helsinki Metropolitan Area (HMA) and in the rest of Finland

To investigate the role of liquidity constraints in the adjustment process

To estimate the impact of a user cost shock on the free-market housing prices, rents and supply

To examine whether the dynamics notably differ between the regions

housing market four quadrant model 1
Housing market four-quadrant model (1)

2

ASSET MARKET:

Rent (€/m

)

PROPERTY MARKET:

Rent determination

Valuation

P=R/u

D = S

2

2

Price (€/m

)

Stock (m

)

S = C/d

P=F(C)

2

ASSET MARKET:

Construction (m

)

PROPERTY MARKET:

Construction

Stock adjustment

asset market equilibrium the no arbitrage relation
Asset market equilibrium – the no-arbitrage relation

E(u) = after-tax opportunity cost of capital (%) + depreciation/maintenance (%) – expected appreciation (%)

In the Finnish case, where the imputed rent is not taxed:

Because of the notable frictions in the housing market, substantial and long-lasting deviations from the asset market equilibrium relation may emerge and the price adjustment towards the relation may be highly sluggish

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The adjustment dynamics and magnitudes after a user cost shock are of particular interest:via asset price level the shock affects supply, rental price level and the equilibrium price/rent-ratio

The theory leaves the adjustment speeds and magnitudes open

 To get information on the actual adjustment process, rigorous empirical analysis is needed

Liquidity constraints may influence the adjustment speed

Adjustment dynamics may differ between regions

econometric model
Econometric Model

System of three error-correction models:

Where

(R = 0.72*Y – 2.4*S / 0.67*Y – 2.9*S)

(S = 0.23*P – 0.06*CC / 0.31*P – 0.03*CC)

Exact lag structure and variables not know a priori

potential complication
Potential Complication

Comparability between the housing price and rental price series - different dwellings

Privately finance flat market price data and square meter prices are used: diminishes the heterogeneity problem

User cost measurement

Expected appreciation

Risk premium

Liquidity constraints

Other data complications

E.g. measurement of liquidity constraints

empirical findings
Empirical Findings

Asset prices appear to adjust towards the no-arbitrage relation significantly but slowly

No evidence of asymmetric adjustment or liquidity constraints affecting the adjustment speed

Housing price growth and supply changes are highly predictable

Also the adjustment speeds of R and S towards the long-term equilbirium relations are low (but significant)

Adjustment slower in HMA

Rental price response greater in the rest of Finland

asset price does most of the adjustment in hma
Asset price does most of the adjustment in HMA

The estimated impact of a 10% increase in u on asset price level, rental price level and on housing stock, HMA

outside hma prices adjust less and rents more
Outside HMA prices adjust less and rents more

The estimated impact of a 10% increase in u on asset price level, rental price level and on housing stock, rest of Finland

concluding remarks
Concluding Remarks
  • Theory does not give the adjustment speeds or magnitudes
  • Housing prices adjust significantly but slowly towards the asset market equilbirium condition
  • It appears that asset prices do the major part of the adjustment after a user cost shock in a highly supply restricted area (HMA)
  • The role of rental price adjustment is notably greater in less supply restricted regions (other parts of Finland)
  • The impact of changes in the tax code are more complicated: need for further research
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Asset market disequilibrium (€/m2, annual level) together with real housing price and rental price indices, HMA
computation of the user cost
Computation of the user cost

Maintenance costs from Statistics Finland

A prediction model for expected appreciation

Prediction for nominal price growth based on an ECM (predictors: one period lagged values of nominal housing appreciation, nominal aggregate income and of the deviation from a long-run relation between housing prices and aggregate income)

Constant risk premium at 2% (following Himmelberg et al. 2007)

Risk-free cost of capital is the average after-tax mortgage rate