By Olaf Weeken of the Bank's Monetary Instruments and Markets Division.
House prices have risen rapidly in recent years. While there is little doubt that the rates of increase observed are unsustainable, there is uncertainty as to the sustainability of the level of house prices. This article applies asset-pricing theory to the housing market to gain additional insights into some of the factors accounting for this rise in house prices. It presents estimates of the ratio of house prices to net rentals (a concept close to an equity market's price to earnings ratio). This ratio is currently well above its long-term average, a situation that in the past has often been followed by periods in which real house prices have fallen. However, a simple 'dividend' discount model of the housing market suggests that lower real interest rates can account for part of the increase in the ratio of house prices to net rentals since 1996. Nevertheless, to account fully for this increase, the housing risk premium would need to have fallen too. Comparing the implied housing risk premium now with that in the late 1980s may suggest that house prices are closer to sustainable levels now than was the case in the late 1980s. However, because of data and model limitations no firm conclusions can be drawn.