Are House Prices Nearing a Peak?

Are House Prices Nearing a Peak? A Probit Analysis for 17 OECD Countries


House prices have been moving up strongly in real terms since the mid-1990s in the majority of OECD countries, with the ongoing upswing the longest of its kind in the OECD area since the 1970s. If interest rates were to rise significantly, real house prices may be at risk of nearing a peak. The historical record suggests that the subsequent drops in prices in real terms might be large and that the process could be protracted. To quantify the probability that a peak is nearing in the current situation a probit model was estimated for the period 1970-2005 on a restricted set of what are generally agreed to be the main explanatory variables. Aside from interest rates, these include measures of overheating, such as the gap between real house prices and their long-run trend and the rate of change in real house prices in the recent past. The main finding is that an increase in interest rates by about 1 to 2 percentage points would result in probabilities of a peak nearing of 50% or more in the United States, France, Denmark, Ireland, New Zealand, Spain and Sweden.


House prices have been moving up strongly in real terms since the mid-1990s in the majority of OECD countries, with the ongoing upswing the longest of its kind in the OECD area since the 1970s. As reported in Girouard et al. (2006), several measures, such as the user cost of owner-occupied housing and affordability indicators, suggest that house prices are not that much out of line with the fundamentals in most markets. However, the extent to which real house prices look to be fairly valued depends critically on interest rates remaining at or close to their recent historical lows. Interest rates have already edged up since late 2005, and, if they were to rise significantly further, real house prices may be at risk of nearing a peak. The historical record suggests that the subsequent drops in prices in real terms might be large and that the process could be protracted. This would have negative implications for activity, which in turn could necessitate a monetary policy response.


Since the 1970s, house prices in real terms (the ratio of actual house prices to the consumer price index) in the OECD have been on a secular upward trend, rising by on average 3% per annum in the area as a whole (Table 1). This is generally attributed to rising demand for housing space linked to increasing per capita income, growing populations, supply factors such as land scarcity and restrictiveness of zoning laws, quality improvement that is not properly taken into account in the price index and comparatively low productivity growth in construction.

This suggests that global factors have been at work to sustain the current housing boom. These factors include the easing of monetary policy stances in the wake of the 2000-01 downturn and the associated massive injection of liquidity, the exceptionally low levels of term premiums on longer-term bond yields and easier access to credit owing to the liberalisation of mortgage markets.

For example, the general increase in indebtedness, which is another striking feature of the current upswing, has been mostly offset by the decline in borrowing rates. As a result, households do not seem to devote a greater share of their income to debt service than in the not-too-distant past. A comparison of price-to-rent ratios with the inverse of the imputed user cost of housing over the past ten years also does not suggest that real house prices are greatly overvalued in most markets, and where they do, it can be explained by features that are particular to those markets, such as restrictions on the availability of land for residential housing development becoming more acute due to tough zoning rules, cumbersome building regulations and slow administrative procedures.

However, the extent to which real house prices look to be fairly valued depends critically on interest rates remaining at or close to their current historical lows. If interest rates were to rise significantly, house prices would come under downward pressure as the user cost would fall out of sync with the prevailing price-to-rent ratios or because affordability constraints kick in. Real house prices would have to adjust downwards, but with inflation lower than in previous episodes, a bigger share of the burden of the adjustment will need to be borne by nominal house price decreases. However, nominal house prices tend to exhibit downward stickiness: when overall conditions weaken, owners of existing homes tend to withdraw from the market rather than suffer a capital loss, while builders will develop fewer new properties. As a result, in a low inflation environment the adjustment of real prices will be drawn-out. This is illustrated by the negative cross-country correlation observed between the level of inflation and the duration of houseprice- contraction phases, although there is also a tendency for real prices to fall less at low inflation (Figure 2). The upshot is that the effects of the adjustment may be less disruptive than in past episodes of contraction but may also depress economic activity for a longer period.


To estimate the individual country models, the following procedure was used. As a first step, the model as presented in Equation (1) was re-estimated for each individual country. Subsequently, experiments were carried out with a view to improving the performance of each individual country model. There were a few cases where the specification used in the pooled model also proved optimal for the individual country models (Spain and Switzerland). In all other cases the specification was changed in a number of ways (Table 5):

• In several cases entering the inflation rate as an additional explanatory variable improved the equation significantly (United States, France, Denmark, New Zealand and Sweden). This variable enters the equation with a negative sign, suggesting that higher inflation eases the financing constraint facing households and therefore makes a peak less likely.

Both sets of estimates (pooled and individual) point to the same group of countries as being at risk of nearing a peak if interest rates significantly increase from their levels observed in the fourth quarter of 2005: the United States, France, Denmark, Ireland, New Zealand, Spain and Sweden. This prediction is conditional on the development of interest rates and it also depends on the validity of the historical relationships as estimated.