An Extrapolative Model of House Price Dynamics Charles G. Nathanson Kellogg School of Management Northwestern University
[email protected] Edward L. Glaeser Department of Economics Harvard University
[email protected] March 2015 10004 An Extrapolative Model of House Price Dynamics∗ Edward L. Glaeser Charles G. Nathanson Department of Economics Kellogg School of Management Harvard University Northwestern University
[email protected] [email protected] March 2015 Abstract A modest approximation by homebuyers leads house prices to display three features that are present in the data but usually missing from perfectly rational models: momentum at one- year horizons, mean reversion at five-year horizons, and excess longer-term volatility relative to fundamentals. Valuing a house involves forecasting the current and future demand to live in the surrounding area. Buyers forecast using past transaction prices. Approximating buyers do not adjust for the expectations of past buyers, and instead assume that past prices reflect only contemporaneous demand, as with a capitalization rate formula. Consistent with survey evidence, this approximation leads buyers to expect increases in the market value of their homes after recent house price increases, to fail to anticipate the price busts that follow booms, and to be overconfident in their assessments of the housing market. ∗First draft: November 2014. We thank Ian Dew-Becker, David Levine, Giacomo Ponzetto and seminar partici- pants at Kellogg, UPF/CREI, and EUI for helpful comments, and Nina Tobio and Aidan McLoughlin for excellent research assistance. Nathanson thanks the Guthrie Center for Real Estate Research for financial support. Metropolitan area housing prices display significant momentum (Case and Shiller, 1989), mean reversion (Cutler, Poterba and Summers, 1991), and excess variance relative to fundamentals (Glaeser et al., 2014).