Intrinsic and Rational Speculative Bubbles in the U.S. Housing Market 1960-2009

Abstract: We examine the residential property market in the United States during the period 1960?2009, focusing on the long run relationship between house prices and rents. Using a Markov regime switching model, we find that a structural break occurred in the price-rent ratio series in 1998, which may have been caused by the presence of bubble in the market. We first test for the presence of an intrinsic bubble, and our results provide strong evidence that one existed during the pre-1998 period only. Constructing a separate test on the post-1998 period, we find that house prices were driven only by past price increases and not by fundamentals, implying the presence of rational speculative bubbles. The second goal of this paper is to provide a better understanding of whether changes in rents are useful in predicting house price movements, as earlier research in this area has been inconclusive. We contribute to the debate by examining how changes in rents influence returns in periods distinguished by whether or not there were intrinsic bubbles. Our results show that changes in rents can predict future returns in the housing market only in periods when there is an intrinsic bubble.