1. Turun kauppakorkeakoulu  Turku School of Economics ERES Conference 15-18 June, 2011, Eindhoven The Adjustment of Housing Prices Towards the Housing Market No-Arbitrage Relation By Elias Oikarinen

2. Turun kauppakorkeakoulu  Turku School of Economics Background Housing market no-arbitrage relation gives the asset market equilibrium for housing prices In practice, long-lasting deviations from the no-arbitrage relation have been perceived in a number of countries The adjustment process towards the no-arbitrage relation is a central question regarding the dynamics and predictability of housing markets  of importance to households, construction companies, investors and to economic policy makers Nevertheless, empirical research on the adjustment towards the no-arbitrage relation is limited

3. Turun kauppakorkeakoulu  Turku School of Economics Aim of the Study To examine empirically the adjustment towards the no- arbitrage relation in the Helsinki Metropolitan Area (HMA) and in the rest of Finland To investigate the role of liquidity constraints in the adjustment process To estimate the impact of a user cost shock on the free- market housing prices, rents and supply To examine whether the dynamics notably differ between the regions

4. Turun kauppakorkeakoulu  Turku School of Economics Housing market four-quadrant model (1) ASSET MARKET:Rent (€/m 2 )PROPERTY MARKET: Valuation Rent determination P=R/u D = S Price (€/m 2 )Stock (m 2 ) S = C/d P=F(C) ASSET MARKET:Construction (m 2 )PROPERTY MARKET: ConstructionStock adjustment

5. Turun kauppakorkeakoulu  Turku School of Economics Asset market equilibrium – the no-arbitrage relation E(u) = after-tax opportunity cost of capital (%) + depreciation/maintenance (%) – expected appreciation (%) In the Finnish case, where the imputed rent is not taxed: Because of the notable frictions in the housing market, substantial and long-lasting deviations from the asset market equilibrium relation may emerge and the price adjustment towards the relation may be highly sluggish

6. Turun kauppakorkeakoulu  Turku School of Economics User cost change in the four-quadrant model

7. Turun kauppakorkeakoulu  Turku School of Economics The adjustment dynamics and magnitudes after a user cost shock are of particular interest: via asset price level the shock affects supply, rental price level and the equilibrium price/rent-ratio The theory leaves the adjustment speeds and magnitudes open  To get information on the actual adjustment process, rigorous empirical analysis is needed Liquidity constraints may influence the adjustment speed Adjustment dynamics may differ between regions

8. Turun kauppakorkeakoulu  Turku School of Economics Closer look at the impact of a user cost shock

9. Turun kauppakorkeakoulu  Turku School of Economics Adjustment paths of the equilibrium price level and the actual price level

10. Turun kauppakorkeakoulu  Turku School of Economics Econometric Model System of three error-correction models: Where ( R = 0.72*Y – 2.4*S / 0.67*Y – 2.9*S) (S = 0.23*P – 0.06*CC / 0.31*P – 0.03*CC) Exact lag structure and variables not know a priori

11. Turun kauppakorkeakoulu  Turku School of Economics Potential Complication Comparability between the housing price and rental price series - different dwellings Privately finance flat market price data and square meter prices are used: diminishes the heterogeneity problem User cost measurement Expected appreciation Risk premium Liquidity constraints Other data complications E.g. measurement of liquidity constraints

12. Turun kauppakorkeakoulu  Turku School of Economics Empirical Findings Asset prices appear to adjust towards the no-arbitrage relation significantly but slowly No evidence of asymmetric adjustment or liquidity constraints affecting the adjustment speed Housing price growth and supply changes are highly predictable Also the adjustment speeds of R and S towards the long- term equilbirium relations are low (but significant) Adjustment slower in HMA Rental price response greater in the rest of Finland

13. Turun kauppakorkeakoulu  Turku School of Economics Asset price does most of the adjustment in HMA The estimated impact of a 10% increase in u on asset price level, rental price level and on housing stock, HMA

14. Turun kauppakorkeakoulu  Turku School of Economics Outside HMA prices adjust less and rents more The estimated impact of a 10% increase in u on asset price level, rental price level and on housing stock, rest of Finland

15. Turun kauppakorkeakoulu  Turku School of Economics Concluding Remarks Theory does not give the adjustment speeds or magnitudes Housing prices adjust significantly but slowly towards the asset market equilbirium condition It appears that asset prices do the major part of the adjustment after a user cost shock in a highly supply restricted area (HMA) The role of rental price adjustment is notably greater in less supply restricted regions (other parts of Finland) The impact of changes in the tax code are more complicated: need for further research

16. Turun kauppakorkeakoulu  Turku School of Economics Asset market disequilibrium (€/m2, annual level) together with real housing price and rental price indices, HMA

17. Turun kauppakorkeakoulu  Turku School of Economics Computation of the user cost Maintenance costs from Statistics Finland A prediction model for expected appreciation Prediction for nominal price growth based on an ECM (predictors: one period lagged values of nominal housing appreciation, nominal aggregate income and of the deviation from a long-run relation between housing prices and aggregate income) Constant risk premium at 2% (following Himmelberg et al. 2007) Risk-free cost of capital is the average after-tax mortgage rate