HEDONIC PRICE-RENT RATIOS, USER COST, AND DEPARTURES FROM EQUILIBRIUM IN THE HOUSING MARKET

Departures of the housing market from equilibrium can be detected by comparing the actual price-rent ratio with the user cost of owner occupying. Empirical implementation of this idea, however, is problematic for two reasons. First, the price-rent ratio needs to be quality adjusted. Second, the expected capital gain –an important input into the user cost formula –is not directly observable. Using a large data set for Sydney-Australia, we show how these problems can be resolved using hedonic methods. Otherwise, the user cost approach can generate highly misleading results. Housing markets seem to be particularly prone to booms and busts. Recent events have also shown how the housing market can impact on the rest of the economy, as a bust in the US housing market precipitated a global financial crisis. It is particularly important therefore that policymakers and other market participants can detect departures from equilibrium before they become too extreme. One way of detecting such departures is to compare the user cost of owner-occupying with the cost of renting. In equilibrium households should be indifferent between owner occupying and renting. When the user cost of owner-occupiers is higher (lower) than the cost of renting, then the price-rent ratio is too high (low). Departures from equilibrium therefore can be detected by comparing the actual median price-rent ratio with the price-rent ratio derived from the user-cost equilibrium condition. Attempts to apply the user-cost equilibrium condition to actual housing markets encounter two serious problems. First, the price and rent used to compute the price-rent ratio in the user cost formula should refer to the same dwelling or to dwellings of the same quality. If there is a quality difference between the sold and rented dwellings this invalidates the user-cost equilibrium condition.