Understanding the Irish price–rent ratio: an unobserved component approach

Abstract

This article examines the movements in the Irish price-to-rent ratio over the period 1976 to 2012. We use the Campbell–Shiller present value formula to decompose the price–rent ratio into the present discounted values of expected future housing market fundamentals, i.e., rent growth, real interest rate and risk premium for investing in housing. Treating the expectations of the fundamentals as unobserved components, we cast the Campbell–Shiller formula into a state–space model and estimate the deep parameters by maximum likelihood method. It is found that that the variations in the price–rent ratio are mostly due to the expected housing premium, while the expected rent growth and real interest rate account for only small fractions of variations in the price–rent ratio. It is also found that, while the individual contributions of the expected market fundamentals sum up much larger variations than in the price–rent ratio itself, the correlations among them considerably dampen fluctuations in the ratio.

Keywords:

• price-to-rent ratio
• Campbell–Shiller formula
• unobserved components
• variance decomposition

JEL Classification:

• P25
• R21

Funding

This work was supported by Hankuk University of Foreign Studies Research Fund.

Notes

¹ Van Binsbergen and Koijen (2010) and Kishor and Morely (2010) apply an unobserved component approach for the US stock market and housing market, respectively.

² In earlier version of the article, we also used AR(1) specification as in Van Binsbergen and Koijen (2010) and Kishor and Morely (2010), but AR(2) specification turned out to better fit the data.

³ Details are available upon request.

⁴ http://www.globalpropertyguide.com/Europe/ireland/Rental-Yields

⁵ For example, the contribution of the expected rent growth to the price–rent ratio is measured by the product of the factor loading vector and the filtered estimates of .