The Determinants of House Price Dynamics: A Survey

Literature Survey

Course: Real Estate Markets and Analysis

The Determinants of House Price Dynamics: A Survey

The dynamics of housing prices has been a controversial subject and has been studied and investigated by many individuals. There are many reasons for the increased study of house price dynamics. The fact that ownership of houses composes a major part of private sector wealth is one among several reasons. There is a growing number of individuals who spend part of their income on houses. Therefore, the movement of house prices determines in part household expenditure and thus may also influence household consumption. A decline in housing prices would therefore diminish private sector wealth and would thus also influence other factors concerning the economic well-being of private households.

Most authors focus on macroeconomic factors, such as the real interest rate or inflation when trying to explain the determination of housing prices. Nevertheless, most of the writers acknowledge the possibility that there might be other factors influencing the price dynamics of housing. These factors could be of demographic nature (e.g. age of population) or could be related to certain policy changes by governments. The list of possible variables influencing the dynamics of housing prices seems endless. Despite this fact, the survey of the following three papers give some insights into which factors drive housing price dynamics and which factors seem rather irrelevant.

The paper by Englund and Ioannides (1997) studies the dynamics of housing prices in 15 OECD countries. The authors try to find out whether housing prices are predictable, what the determinants of housing prices are and whether there is an international housing price cycle.

The authors give an introduction into their topic by presenting various graphs (see figure 1) showing housing prices of owner-occupied homes for 15 OECD countries during the period 1970 till 1992. They elaborate that the graphs show large swings in housing prices. Moreover, they note that there are pronounced similarities in almost all the graphs. In addition, they point out that in nearly all these countries cycles are observed with several consecutive years of rising prices followed by declining prices. Particularly the authors pay attention to the similarities in high peaks of all the countries after the house price boom in the latter half of the 1980s. Next, Englund and Ioannides perform an autoregression on yearly changes in log real housing prices and find that house price dynamics display "a remarkable degree of homogeneity" (p.129). This indicates that housing markets in different countries are very similar and that lagged house prices have predictive power in explaining house price changes. Furthermore, the authors extend their regression to include other factors that may drive housing prices. They include three explanatory variables into their regression: the growth of GDP, the change in the real interest rate, and the rate of change of individuals between the ages 20-30. Again, the data consist of yearly values over a range of 22 years. Subsequently, an ordinary least square regression is performed where the change of yearly house prices is regressed on previous mentioned variables. Unfortunately, the regression results for the demographic variable does not turn out well and is therefore not incorporated in their paper. The authors conclude that demographics do not appear to matter at all in determining house prices. This outcome is in contrast to the other variables, which are both significant. They find that real GDP growth and the change of the real interest rate have predictive power in explaining future house price changes. In particular, they find that one percent faster GDP growth this year gives 0.77 percent faster house price growth tomorrow (p.130).Therefore, Englund and Ioannides conclude that historical prices, GDP growth rate and the real interest rate explain the movement of housing prices.

In addition to exploring the previous mentioned variables, the authors also investigate another factor, namely country specific tax reforms as a possible determinant of housing prices. The authors investigate policy changes which may influence the movement of housing prices. In order to perform the test, the data from tax reform years of all OECD countries since the 1980's is taken into account, since that area was marked by major reforms with unfavorable tax treatment for homeowners. Nevertheless, even by adjusting the data for expectations, the results turn out insignificant for the determination of housing prices. Finally, in the last part of their paper, the authors try to find out whether there is an international housing cycle across countries. Although they find that there are some degrees of synchronisation across countries whose financial markets are linked (see figure 1), they do not find conclusive support of an international housing cycle. Thus, they recommend performing different research methods where attention is restricted to groups of countries for which such evidence is strongest and more data is available.

Similar to the article by Englund and Ioannides (1997), Tsatsaronis and Zhu (2004) study the determinants of housing prices focusing on OECD1 countries. In unison with Englund and Ionnides (1997), they first show a graph (see figure 2) showing inflation adjusted house price movements of 17 industrialized countries between 1970 and 2003 during a period of 33 years. They elaborate that residential real estate prices are characterized by long swings. Furthermore, they show that each country experienced about two full cycles over this period of 33 years. Moreover, they indicate that most countries experienced a house price boom after the 1990s. Housing price growth was particularly strong in Ireland, the Netherlands and the United Kindom (average growth rates 11%). This price trend was followed by more Nordic countries. On the other hand, they note that Germany and Switzerland show a rather flat price curve, indicating that prices have remained constant in the past. In addition, there has been a downward trend in Japan, since the bursting of the so-called bubble economy in the early 1990s.

Tsatsaronis and Zhu use the graphs to clarify their aim to find the main drivers of house prices that can account for the differences in the dynamics of these countries. They believe that different mortgage structures in various countries could account for the difference in the swings of the graphs. In order to test their assumption, they form three groups of countries that are broadly homogenous with respect to the structure of their mortage finance markets. Variables such as the interest rate adjustability,