Understanding Housing Market Volatility

JOSEPH FAIRCHILD, JUN MA, SHU WU
2015 Journal of Money, Credit and Banking  
The Campbell-Shiller present value formula implies a factor structure for the price-rent ratio of the housing market. Using a dynamic factor model, we decompose the price-rent ratios of 17 major housing markets into a national factor and independent local factors, and we link these factors to the economic fundamentals of the housing markets. We find that a large fraction of housing market volatility is local. And the local volatilities mostly are due to time-variations of idiosyncratic housing
more » ... arket risk premiums, not local growth. At the aggregate level, the growth and interest rate factors jointly account for up to 47% of the total variations in the price-rent ratio. The rest is due to the aggregate housing market risk premium and a pricing error. We find evidence that the pricing error is related to money illusion, especially at the onset of the recent housing market bubble. The rapid rise in housing prices prior to the 2008 financial crisis was accompanied by both a large increase in the pricing error and a large decrease in the housing market risk premium.
doi:10.1111/jmcb.12246 fatcat:5nyh34mdnrgf5ozcidzer3nes4