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Working Papers

Housing and Behavioral Finance

Working paper #610
Christopher J. Mayer and Todd Sinai

We examine the relative roles of fundamentals and psychology in explaining U.S. house price dynamics. Using metropolitan area data, we estimate how the house price-rent ratio responds to fundamentals such as real interest rates and taxes (via a user cost model) and availability of capital, and behavioral conjectures such as backwards-looking expectations of house price growth and inflation illusion. We find that user cost and lagged five-year house price appreciation rate are the most important determinants of changes in the price-rent ratio and lending market efficiency also is capitalized into house prices, with higher prices associated with lower origination costs and a greater use of subprime mortgages. We find no evidence in favor of behavioral explanations based on the one-year lagged house price growth rate or the inflation rate. The causes of a house price boom appear to vary over time, with interest rate fundamentals mattering more than backwards-looking price expectations in the house price run-up of the 2000s and vice versa during the 1980s boom.

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