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short essays and reports on the economic issues of the day
2005 ■ Number 27

Bubbling (or Just Frothy) House Prices?
Massimo Guidolin and Elizabeth A. La Jeunesse
eal U.S. house prices, on average, have appreciated by 6
Yet, do the P/I ratios observed on the two coasts constitute a
bubble? Note that when real estate is evaluated as a potential
percent annually since 2000, a historically high rate when
investment, housing prices should be determined by discounting
compared with the 2.7 percent annual rate between 1975
the expected flow of income (rents) and other services using an
and 1999. Certain states have had especially high average annual
appropriate risk-adjusted capitalization rate. Considering the difrates since 2000: 12 percent in California, 11 percent in Rhode
ference between capitalization rates implied by house price indices
Island, and 10 percent in Nevada, Hawaii, and Florida. With such
and long-term government bond yields, we find indications
high rates of house price growth, many experts in the press and
against the presence of a bubble. House price data imply that the
academic circles have debated whether we are currently facing a
spread between capitalization rates and long-term bond yields
house price bubble.
has increased from an average level of 0.7 percent for the period
House price bubbles are characterized by homebuyer expecta1975-99 to an average level of 2.3 percent for the period since
tions of unusually rapid price appreciation. Thus, many buy a
2000. These positive spreads imply that house prices have in fact
home they consider expensive, in relation to current rental prices,
remained consistent with risk-adjusted discounting of future rents.
under the expectation of continued price increases. When buyers
In fact, the spread has increased substantially in all 50 states (and
perceive that prices have stopped increasing, however, expectathe District of Columbia) between the 1975-99 period and the
tions normalize and demand falls. House prices fall as the bubble
more recent period since 2000. Even in states that have compar“bursts.” Economic consequences of a potential housing burst are
atively low spreads (e.g., California and Massachusetts), the figure
especially worrisome. Lower home values reduce homeowners’
has remained positive and more than doubled between the two
wealth, causing significant declines in consumer demand and
periods. In conclusion, the evidence in favor of a recent housing
thus in GDP. In fact, Case, Quigley, and Shiller (2001) point out
bubble is controversial at best. Ongoing research is struggling to
that the elasticity of consumption to housing wealth appears much
isolate real house price increases justified by underlying fundahigher than the elasticity to stock market equity. History further
mentals from irrational, possibly harmful, excesses. ■
indicates that banks’ balance sheets—when proper risk manage1
Karl E. Case, John M. Quigley, and Robert J. Shiller, “Comparing Wealth Effects:
ment strategies are not in place—can be heavily exposed to price
The Stock Market versus the Housing Market.” Working Paper No. 8606, National
bursts in real estate. For these reasons, policymakers are keen on
Bureau of Economic Research, 2001.
trying to identify the presence of a bubble.
Although criteria for detecting a bubble are debatable,
Housing Price Index/Personal Income Per Capita
we present a standard indicator of house affordability—
Average Annual Value, 2000:Q1–2005:Q2
prices divided by per capita income (P/I)—for all states
plus the District of Columbia. (See map.) P/I provides a
better measure than house price appreciation because it
accounts for the evolution of income, a key factor in housing demand. California, New York, and Massachusetts,
for instance, have high P/I ratios.
According to our calculations of P/I growth rates, if
bubble conditions do exist, they appear only on the two
coasts and in Michigan. Since 2000, for example, the
average P/I ratios for California, Massachusetts, Oregon,
Rhode Island, and New York have been at least 13 percent
above their respective averages for the 1975-99 period.
On the other hand, the same 2000-05 P/I measure for
Texas, Oklahoma, Mississippi, and North Dakota has
declined by 24 percent below its average for the 1975-99


Views expressed do not necessarily reflect official positions of the Federal Reserve System.