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STUDIES ON HOUSING PRICE DYNAMICS Elias Oikarinen Sarja/Series A-9:2007 Copyright Elias Oikarinen & Turku School of Economics ISBN (nid.) (PDF) ISSN (nid.)
STUDIES ON HOUSING PRICE DYNAMICS Elias Oikarinen Sarja/Series A-9:2007 Copyright Elias Oikarinen & Turku School of Economics ISBN (nid.) (PDF) ISSN (nid.) (PDF) UDK Esa Print Tampere, Tampere 2007 ACKNOWLEDGEMENTS A number of people have had a significant role in the completion of this doctoral thesis. I have had a great privilege to do research surrounded by many talented and pleasant scholars at Turku School of Economics. In 1999 Professor Paavo Okko offered me a position in a research project studying economic development of various Finnish regions. At that time I was not yet fully motivated to do doctoral studies. With his admirable and tolerant attitude Paavo let my motivation grow in peace and offered me some further research projects. Eventually, I found the motivation and seriously started to aim at a doctoral degree in the summer of All the time Paavo has supported and encouraged me and showed belief in me even though it took several years before I seriously started the studies. Without Paavo s patience and support I would probably never have completed the doctoral thesis. I will always be grateful to Paavo. The real estate economics course lectured by Asko Miettilä raised my initial interest in real estate markets. Asko was the person who originally introduced me to Professor Okko. Asko s influence has been of great importance to the commencement of this thesis. Doctor Hannu Kahra, in turn, has had a great impact on my interest in empirical analysis employing time series econometrics. I took part in Hannu s stimulating course in time series econometrics at the beginning of my doctoral studies. Since then Hannu has given me guidance in various questions concerning econometrics and as a colleague he has been most inspiring and pleasant. Furthermore, I am in gratitude to Professor Heikki A. Loikkanen and to Professor Matti Virén. Their thorough examination of the thesis produced notable improvements. I am also indebted to Professor Mika Widgrén and Doctor Martti Vihanto for their support and to my mother Marja-Leena, who checked the language of the thesis with great carefulness. Finally, it is a great honor Professor Peter Englund, the distinguished scholar, accepted the invitation to act as an official opponent of my thesis. The thesis has been supported financially by the Finnish Foundation for Share Promotion, Foundation for Economic Education (Liikesivistysrahasto), Jenny and Antti Wihuri Foundation, Kluuvi Foundation, OKOBANK Research Foundation, Real Estate Education and Training Institute in Finland, Real Estate Foundation and Yrjö Jahnsson Foundation. I gratefully acknowledge their support. Moreover, I am grateful to the Finnish Doctoral Programme in Economics for financing my studies during Turku, August 2007 Elias Oikarinen CONTENTS INTRODUCTION TO STUDIES ON HOUSING PRICE DYNAMICS MOTIVATION AND PURPOSE OF THE STUDY THEORETICAL ASPECTS OF HOUSING PRICE FORMATION Static models Adjustment process No-arbitrage condition between user costs and rental prices Co-movement between regional housing markets DIFFERENCES BETWEEN HOUSING AND FINANCIAL ASSETS Special features of housing investments Major implications of the special features PREVIOUS LITERATURE ON HOUSING PRICE DYNAMICS Data Theoretical framework and empirical methods Empirical results Long-run income elasticity Other long-run elasticities Adjustment towards the fundamental level Linkages between regional housing markets Linkages between housing markets and financial asset markets FEATURES AND DEVELOPMENT OF THE FINNISH HOUSING MARKETS Structure and features of the Finnish and HMA housing markets Institutional changes and the development of Finnish housing markets since the 1970s COINTEGRATION AND ITS IMPLICATIONS Concept of and tests for cointegration Various potential reasons for cointegration Implications of cointegration Structural breaks DATA AND ITS PROBLEMS Housing indices Fundamental variables Do the data problems make the analyses defective? EMPIRICAL STUDIES OF THE THESIS REFERENCES... 91 ASSESSING PRICES AND PRICE DYNAMICS IN THE HELSINKI HOUSING MARKET INTRODUCTION EMPIRICAL MODEL AND DATA Motivation and data of the long-run model Short-run model Institutional changes and development of the variables RELEVANT PREVIOUS STUDIES DIFFERENT RATIOS TO EVALUATE HOUSING PRICES Price-to-income and price-to-rent ratios No-arbitrage condition ECONOMETRIC ANALYSIS Long-run relation Short-run dynamics SUMMARY AND CONCLUSIONS REFERENCES APPENDIX 1 ANNUAL MODEL APPENDIX 2 ADDITIONAL TABLES AND FIGURES HOUSING PORTFOLIO DIVERSIFICATION POTENTIALS IN THE HELSINKI METROPOLITAN AREA INTRODUCTION LITERATURE REVIEW DATA EFFICIENT FRONTIER AND CORRELATION ANALYSIS COINTEGRATION BETWEEN THE MARKETS Cointegration and diversification Methodology Results SUMMARY AND CONCLUSIONS REFERENCES APPENDIX ADDITIONAL TABLES AND FIGURES THE DIFFUSION OF HOUSING PRICE MOVEMENTS FROM CENTRE TO SURROUNDING AREAS INTRODUCTION DYNAMICS OF REGIONAL HOUSING PRICE MOVEMENTS THEORETICAL CONSIDERATION PREVIOUS RESEARCH DATA DESCRIPTION METHODOLOGY RESULTS OF THE ECONOMETRIC ANALYSIS Dynamics between the centre and the other parts of the HMA Dynamics between the HMA and the other parts of Finland Dynamics between provincial capitals and surrounding provinces Impulse response analysis CONCLUSIONS REFERENCES APPENDIX 1 CONSTRUCTION OF INDICES APPENDIX 2 ADDITIONAL TABLES PRICE LINKAGES BETWEEN STOCK, BOND AND HOUSING MARKETS EVIDENCE FROM FINNISH DATA INTRODUCTION LITERATURE REVIEW DATA METHODOLOGY EMPIRICAL FINDINGS Correlation analysis Econometric analysis Sample from 1970Q1 to 2006Q Sample from 1989Q1 to 2006Q4 including bond prices SUMMARY AND CONCLUSIONS REFERENCES APPENDIX ADDITIONAL TABLES AND FIGURES INTRODUCTION TO STUDIES ON HOUSING PRICE DYNAMICS 9 10 11 1 MOTIVATION AND PURPOSE OF THE STUDY Housing prices are not only affected by the general economic conditions but are also likely to have substantial effects on the macroeconomy. There are a number of reasons why housing markets are of great importance to the overall economy and why policy makers should be concerned about housing prices. Housing composes the majority of many households wealth, and the wealth effect of housing on consumption is significant, apparently even larger than the wealth effect of financial assets (see e.g. Case et al. 2001, Benjamin et al. 2004, Campbell and Cocco 2004). Hence, a decline in the housing price level leads to less consumption. A drop in housing prices is likely to have a negative effect also on housing construction. Furthermore, a notable fall in housing prices would affect the banking sector by inducing unanticipated losses for mortgage lenders, which could strain the financial system. Moreover, lending is likely to decrease as housing prices drop because of the significant role of housing as collateral. Finally, institutional investors such as pension funds usually have a notable part of their funds invested in housing and housing related securities. Through the effect of housing wealth on household consumption, on construction activity and on the financial sector, housing price movements may strengthen and on some occasions even create macroeconomic cycles. The volatility induced by housing markets on the broad economy is likely to be the larger the stronger co-movement is between regional housing markets. That is, for the macroeconomy it is more harmful if booms and busts occur simultaneously in distinct regional markets. Notable differences between price cycles in regional housing markets, in turn, could create diversification benefits not only for a housing investor but for the whole nation as well. Also the links between housing markets and the other asset markets are of importance to the economy. Obviously, co-movement between different asset prices lessens the diversification gains obtainable to a portfolio investor. Perhaps even more importantly, positive linkages between financial asset markets and housing markets toughen economic cycles. This is reinforced by the fact that simultaneous crash in the stock and housing markets or crash in one market followed by a bust in the other market in a relatively close future may put into trouble even large banks that hold widely diversified portfolios. It is probable, for example, that housing and equity price movements notably contributed to the deep recession in Finland in the early 1990s. Weakening in 12 the economic fundamentals evidently influenced housing and stock prices negatively during the early 1990s. At the same time, however, decreasing asset prices further exacerbated the depression by affecting consumption and construction activity negatively and by putting the bank sector into trouble. Finnish housing markets have gone through major institutional changes during the past two decades. Firstly, in the late 1980s the Finnish financial market was deregulated. Secondly, in 1993 there was a reform in the tax codes concerning the deductibility of mortgage interest payments in taxation. Thirdly, rent regulation was released in several stages during These institutional changes may have had major impacts on the housing price dynamics. Furthermore, mainly due to increased migration from peripheral areas to the Helsinki Metropolitan Area (HMA) and to a couple of other centres in Finland, regional housing price development has diverged to a much greater extent since the early 1990s than earlier. Divergence of the housing price development between distinct regions may have improved the geographical diversification opportunities of a housing portfolio. On the other hand, sharp rise in real housing price level in some areas and at the same time housing price stagnation in some other regions have put households into unequal positions. The increasing difference in the housing prices between a few growing centres and the rest of the country is also likely to hinder the movement of labour force thereby disturbing the operation of the labour market. Globalization of capital markets, in turn, may have altered the interdependences between different asset categories. In particular, since housing market is always unavoidably local to a great extent and the stock market is mostly driven by global forces today, co-movement between housing and stock prices may have weakened to some extent. Despite the significance of housing wealth to the economy, empirical evidence of housing price dynamics in Finland and also in the other countries is still relatively limited. Moreover, housing prices have often been analyzed as if one country formed one coherent housing market. In reality, however, there are many distinct housing markets within Finland for example. Housing in one area cannot be considered a substitute for housing in another region geographically far away. In other words, housing price dynamics are a local phenomenon, and national level data may obscure important economic differences between different cities or regions. 1 1 Note, however, that in some cases the use of national level housing price data is sensible. For example, in the fourth essay of this research national housing price index is employed. This is because in that particular study it is useful that housing price data represent the whole Finnish housing portfolio. When evaluating, for instance, the effects of housing prices on national consumption instead of analyzing e.g. the over- or undervaluation of housing, national housing price index is a reasonable variable to be used. The attention towards the interdependences between housing and financial assets has been even scarcer. Previous empirical literature has typically ignored linkages between different asset categories. If interdependence between asset markets and the differences between regional housing markets are ignored, important information relevant to portfolio allocation and to predictability of asset price movements as well as to policy decisions is left aside. This may lead to defective conclusions and actions. For instance, recent research has shown that predictability in asset returns may lead to strong horizon effects (see e.g. Balduzzi and Lynch 1999, Lynch and Balduzzi 2000, Barberis 2000, Campbell and Viceira 2002). This is important to long-horizon investors, in particular, such as pension funds and real estate investors in general. Also the possibility and effects of structural breaks, typically caused by institutional changes, on price dynamics and linkages between different markets have often been neglected in the empirical literature. If structural breaks have actually occurred but are not catered for, misleading conclusions may be made regarding both diversification opportunities and price dynamics in general. The purpose of this study is to bring new empirical evidence on housing price dynamics as well as on linkages between regional housing markets and between housing and financial assets. The empirical analyses are based on Finnish data, and structural changes are tried to take account of in each of the empirical studies. The firsts essay studies housing price formation within a single metropolitan area, i.e. the HMA. The purpose of the second article, in turn, is to study co-movement between housing prices in different areas within the HMA and in various cities in Finland, and to evaluate the implications of the co-movement between different areas for housing portfolio diversification. The third empirical study examines the diffusion of housing price movements from central areas to surrounding regions. Finally, linkages between stock, bond and housing prices are analyzed in the fourth essay. The second and fourth essays concentrate on diversification potentials of a portfolio. In those two studies a large investor s viewpoint is taken. This is because, in general, only a large investor, such as a pension fund or some other institutional investor, can hold large enough housing portfolio to be able to exploit the diversification potentials properly. Hence, when the text refers to an investor, the investor stands for institutional investor that holds large housing portfolio, not for an owner-occupant of housing. Furthermore, investment housing refers to dwellings that are rented out, i.e. whose purpose is to bring wealth to the owner in the form of rental cash flows and appreciation, not to satisfy the owner s demand for housing consumption. 13 14 A major reason for previous empirical research to concentrate on the financial markets has been the substantially better quality of the data from the financial markets compared with the available data from the housing market. Data concerning housing prices is relatively infrequent and short and has got also other problems such as the heterogeneity of housing. As explained in section 7 of this introductory part of the research, there are also a number of problems with the data employed in this thesis. Furthermore, the empirical methods used in the four essays are not without complications. Nevertheless, it is reasonable to assume that the data and methods employed in this research are reliable enough to be able to draw a number of conclusions concerning housing price dynamics and linkages between regional housing markets and between housing and financial assets. This introductory chapter discusses issues related to the four empirical studies included in the thesis. This section gives an overview of the topic of the thesis, after which the theoretical aspects of housing price dynamics are discussed. Then, existing literature on housing price dynamics and linkages between housing markets and financial assets markets is reviewed. In the fourth section, some features of the Finnish housing markets and of the HMA housing market are presented and the development of the Finnish housing markets during the last three decades is delineated. In the same context, the influences of institutional changes on the housing price development are discussed. Next, cointegration, the central methodological concept of this research, is presented and its implications are considered. Complications with the data utilized in the empirical studies are pondered in section seven. Finally, the four studies the research consists of are briefly summarized. 15 2 THEORETICAL ASPECTS OF HOUSING PRICE FORMATION Housing price level is dependent on a large number of factors. Some of these factors are macroeconomic, i.e. they influence housing prices in all regions within a country in a similar way. There are, however, also a number of regional, or local, variables that drive housing prices. Because of the importance of the regional factors, a country such as Finland contains numerous distinct regional housing markets. Housing price level, growth and dynamics may differ significantly between different regional markets. Hence, it is sensible to analyze the operation of a housing market not at the national level but at the regional level. A metropolitan area is a reasonable basis for analyzing housing price dynamics since, in general, dwellings within a metropolitan area can be regarded as relatively close substitutes for one another. The aim of this section is to give a brief theoretical overview of the price formation and dynamics in a metropolitan housing market. Interdependence between different regional housing markets is discussed as well. Price of a dwelling consists of the physical structure together with the value of land upon which the house is built. Similarly, the growth rate of the price of a house is the weighted average of increase in the value of the structure and appreciation of land the house stands upon. The price of the structure is typically measured as the replacement cost of the physical building, after accounting for depreciation. Land, in turn, is the factor that makes a house worth more than the cost of putting up a new structure of similar size and quality on a vacant lot. In other words, land is the market value associated with the location, size and attractiveness of the site. In this study, housing always refers to the entity consisting of both the structure and the site. 2.1 Static models In the short run, housing supply is typically extremely inelastic. Housing supply responds slowly to positive demand shocks because construction of new dwellings is time consuming and also zoning decisions take time. Downwards adjustment of housing supply, in turn, is slow because of the slow depreciation of the structures. In the long horizon the supply curve of housing 16 is much gentler. Nevertheless, the supply curve is likely to be upward-sloping even in the long-run. 2 This is because the value of land increases as the metropolitan area occupies more area (see e.g. DiPasquale and Wheaton 1996, Chapter 3). With geographical constraints (water, mountains etc.), building restrictions and other impediments to construction, housing supply schedule can be quite vertical even in the long horizon. It should be noted that the growth of a metropolitan area might take place through higher density as well. The implications are similar to the case where the growth occurs by larger occupied area, however: also greater density leads to higher housing prices (see DiPasquale and Wheaton, 1996, Chapter 4). The four-quadrant model introduced by DiPasquale and Wheaton (1992) can be used to examine housing price formation in the long run. 3 In the model, graphed in Figure 1, the two right-hand quadrants represent the market for the use of space, while the two left-hand quadrants deal with the asset market for the ownership of housing. Rental price level is set in the upright quadrant. The vertical axis represents rental level per square meter (R), whereas the horizontal axis shows the housing stock. In equilibrium, rental level is such that demand for housing (D) equals the stock. Together with the capitalization rate (i), the net (of maintenance costs) rental level determines housing price level
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